The IRS’s Strategic Litigation Approach: One Case at a Time

In the complex landscape of tax law, the IRS plays a significant role in shaping and enforcing tax laws and regulations.

One of the key strategies employed by the IRS is the careful selection of cases to litigate, particularly when previous decisions have favored taxpayers. By patiently waiting for the right set of facts to emerge in an appropriate jurisdiction, the IRS can strategically pursue cases that have the potential to alter the interpretation of tax law, establish precedents, or even prompt Supreme Court review. This approach demonstrates the agency’s ability to navigate the legal system and gradually mold tax law to better align with its objectives and interpretations. This gives the IRS a long-term advantage over taxpayers when it comes to being able to win cases in court. This is in addition to other advantages the IRS has when it comes to U.S. Tax Court litigation.

The recent Estate of Gerson, 507 F.3d 435 (6th Cir. 2007) provides a prime example of this. It involves the federal generation-skipping transfer (“GST”) tax. The GST tax is an important consideration for tax attorneys and their clients when engaging in estate tax planning. This case shows how the IRS effectively overruled prior court cases by choosing which court to challenge the same dispute in for a different taxpayer.

Facts & Procedural History

As noted above, this is a generation-skipping transfer (“GST”) tax case. The case involves a revocable trust created by Benjamin Gerson for his wife, Eleanor Gerson, which became irrevocable upon his death in 1973. Eleanor died in 2000, leaving the trust corpus to her grandchildren.

The trust gave the surviving Leanor a general power to appoint the trust assets to anyone she wanted upon her demise. Pursuant to her estate documents, Elanor opted to appoint the trust assets to her grandchildren upon her demise. Thus the trust assets skipped over her children and passed to her grandchildren.

The IRS issued a notice of deficiency, asserting that the transfer triggered the GST tax. The IRS assessed a GST tax of $1,144,465 on the proceeds of an irrevocable trust.

The estate challenged the deficiency in the U.S. Tax Court. The estate claimed that a grandfather clause protects these assets from taxation, even though a treasury regulation suggests otherwise. The tax court agreed that the estate owed $1,144,465, leading to this appeal.

About the GST Tax

The federal GST tax is a separate tax in addition to the federal estate and gift taxes. We haven’t addressed the GST tax on this site before, so it may help to pause to consider a few of the nuances of this tax.

The GST tax is a federal tax imposed on transfers of wealth made to family members who are more than one generation below the grantor or unrelated individuals at least 37.5 years younger than the grantor. The GST tax aims to ensure that wealth transfers skipping a generation are taxed equitably and to prevent tax avoidance through estate planning techniques. It is designed to capture the tax on wealth transfers that would have been paid if the transfer had been made directly to the immediate next generation (e.g., from grandparent to parent, then from parent to child).

The GST tax applies to three types of transfers: direct skips, taxable terminations, and taxable distributions.

1. Direct Skips (I.R.C. § 2612(c)) – A direct skip is a transfer of property subject to either estate or gift tax to a “skip person,” defined as an individual assigned to a generation two or more generations below the generation assignment of the transferor (IRC § 2613(a)).

2. Taxable Terminations (I.R.C. § 2612(a)) – A taxable termination occurs when a trust terminates due to death, lapse of time, or release of a power and the property is transferred to a skip person. This type of transfer does not include any transfer made during the life of the transferor, which would be considered a direct skip.

3. Taxable Distributions (IRC § 2612(b)) – A taxable distribution is any distribution from a trust to a skip person, other than a taxable termination or direct skip. The distribution is subject to the GST tax to the extent it exceeds the distributee’s adjusted basis in the property.

The GST tax applies when there is a transfer of wealth to a skip person. The tax rate is determined by multiplying the taxable amount by the applicable rate, which is the maximum federal estate tax rate in effect at the time of the transfer (I.R.C. § 2641(a)). The maximum federal estate tax rate is 40%.

The GST tax has an exemption, known as the GST exemption, which allows individuals to make a certain amount of generation-skipping transfers without incurring the tax. The amount changes frequently (update, the GST tax exemption was $11.7 million per individual in 2021).

The Estate & GST Tax in This Case

The trust assets were likely not subject to estate taxes upon Eleanor’s demise because the property qualified for the unlimited marital deduction. The trust assets may have been subject to estate taxes in Eleanor’s estate upon her demise.

According to the IRS and the U.S. Tax Court, the trust assets were also subject to the GST tax upon Eleanor’s demise. Her estate argued that the transfer to the grandchildren was not subject to the GST tax because the trust qualified for the trust tax exemption established by Congress in 1985. Thus, the Estate acknowledges that the GST tax would usually apply, but refers to an effective date provision that grandfathers certain unaltered irrevocable trusts established before 1985.

The GST Tax Grandfather Provision

This provision, found in the Tax Reform Act of 1986, Pub.L. No. 99-514, § 1433(b)(2)(A), 100 Stat. 2717, 2731, states that the tax does not apply to “any generation-skipping transfer under a trust which was irrevocable on September 25, 1985, but only to the extent that such transfer is not made out of corpus added to the trust after September 25, 1985.” The Estate asserts that because Eleanor never added any assets to the corpus, this provision resolves the case in their favor.

The IRS disagreed, arguing that testators were required to include the skip transfer in the trust instrument itself or grant no more than a limited power of appointment before 1985. The IRS adopted this view in a regulation, which the estate contests as being contrary to the plain language of the effective date provision. Treasury Regulation § 26.2601-1(b)(1)(i) states that the grandfather exception “does not apply to a transfer of property pursuant to the exercise, release, or lapse of a general power of appointment that is treated as a taxable transfer under chapter 11 or chapter 12.”

The U.S. Tax Court acknowledged in its opinion that two other federal circuit courts of appeal, the Eighth and Ninth Circuits, have previously decided this exact case, and those cases were decided in favor of the taxpayers. The estate essentially argued that the IRS enacted Treasury Regulations in an attempt to overturn these two prior circuit court of appeal decisions. The IRS, on the other hand, contended that their Treasury Regulation served as a gap filler, asserting that Congress failed to specifically address the exemption as it applied to transfers from irrevocable trusts. Consequently, the IRS claimed it had the authority to promulgate a Treasury Regulation to fill that void.

The Takeaway

It seems that this case will be subject to the law of the Sixth Circuit Court of Appeals. If the IRS is successful in this appeal, they will likely attempt to use the Sixth Circuit opinion to bring the case before the Supreme Court. If this case had arisen in the Eighth or Ninth Circuits, the IRS would probably not have pursued the case, considering the previous decisions in favor of the taxpayers. This strategy exemplifies how the IRS operates: it patiently waits for the right set of facts to emerge in the appropriate jurisdiction before taking action.