IRS Attempts Collection Against Surviving Spouse and Marital Deduction Property

In a recent U.S. District Court case from the Southern District of California, the court ruled on several motions to dismiss relating to the IRS’ attempt to impose liability on a surviving spouse for estate taxes on the estate of her decedent husband, even though the property received by the surviving spouse was eligible for the marital deduction. The IRS attempted various approaches. Some of the more interesting approaches are discussed below, along with the court’s resolution.
The facts are somewhat lengthy. Boiling them down to the key aspects, Allen Paulson (the decedent) entered into a prenuptial agreement with his spouse-to-be, Madeleine Pickens. The agreement included obligations for Mr. Paulson to make certain gifts to Ms. Pickens when he died. Mr. Paulson’s living trust made provisions for Ms. Pickens, but gave her the ability to elect to receive either under the prenuptial agreement or the living trust provisions. The living trust provided for substantial gifts to a marital trust.

After Mr. Paulson’s death . . .

U.S. v. Paulson, Case No. 3:15-cv-02057, U.S. District Court, Southern District of California (September 6, 2016)

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Of Spousal Gifts and the Substance Over Form Doctrine

U.S. spouses each have a unified credit that allows for substantial gifting to third parties without requiring the payment of gift tax. What happens if one spouse has assets to be gifted away, but that spouse does not have sufficient remaining unified credit exemption to cover the gift and wants to use the exemption of the other spouse?

At times, the spouses can agree to split the gift for gift tax purposes, which treats 1/2 the gift as coming from each spouse. This allows the unified credit of the spouse not making the gift to be used to avoid gift tax on the 1/2 that such spouse is treated as making. However, it can be an imperfect solution if the spouse with the assets does not have enough unified credit to offset his or her 1/2 of the gift.

Oftentimes, the parties may contemplate having the party with the assets transfer them by gift to the other spouse (a tax-free gift under the gift tax marital deduction), and then the receiving spouse makes a gift to the third party applying his or her own unified credit. The question in these circumstances is whether the IRS will respect the transaction and allow the receiving spouse’s unified credit to be applied to the gift to the third party, or whether it would seek to apply the “substance over form” doctrine to treat the gift as coming from the spouse who transferred the assets to the other spouse and does not have enough unified credit to fully cover the gift.

This is not a black and white issue. On one end of the spectrum. . .

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