INCOME TAX ISSUES AFTER THE DEATH OF A SPOUSAL JOINT TENANT

By Margaret Conway

Several recent circuit court and tax court cases provide further support to Gallenstein v. United States (1992 CA6, 70 AFTR 2d 92-5683, 975 F2d286) on the estate tax treatment of spousal joint interests created prior to 1977. All of these decisions hold that the full value of jointly held spousal property is includable in the estate of the spouse who contributed to the purchase of the property. Therefore, a survivor of such an interest that did not contribute toward the purchase of the property is entitled to a full step-up in basis for the property upon the death of the contributing spouse. These precedents are particularly noteworthy, as the IRS instructions for the Federal Estate Tax Return, Form 706, continue to require the inclusion of only one-half of the value of spousal joint property, regardless of which spouse purchased the property or when the joint interest was created.

Statutory History

The estate tax treatment of spousal joint interests is controlled by IRC section 2040. Prior to 1976, that section stated that a decedent's gross estate was required to include the entire value of all jointly held property. An exception to this rule was permitted where a survivor established that he or she acquired the interest in the property from the decedent for full and adequate consideration. Basically, a survivor had to track the amount he or she had contributed to the purchase of the jointly held property in order to keep a portion of it out of the decedent's estate. IRC section 2040 applied to all types of joint interests.

In 1976, IRC section 2040 was amended to include subsection (b), which created a new rule for spousal joint interests. Subsection (b)(1) provided that spouses who created joint interests after 1976 were required to exclude 50% of the value of the qualified joint interest from the estate of the first spouse to die, regardless of who had provided the consideration for the purchase of the property. Subsection (b)(2) defined qualified joint interests to essentially be joint interests between spouses, held as tenants by the entirety or as joint tenants with rights of survivorship, which constituted a gift when created. In 1978, the statute was further amended through the addition of subsections (c), (d), and (e), which included a provision for an election to apply subsection (b) to joint interests created prior to 1977.

The Economic Recovery Tax Act of 1981 (ERTA) eliminated all estate and gift taxes between spouses by providing for an unlimited marital deduction. ERTA amended the definition of a qualified joint interest under IRC section 2040(b)(2) to include any interest in property held by the decedent and the decedent's spouse as either tenants by the entirety or joint tenants with right of survivorship. It eliminated the requirement that a gift be created in order for the joint interest to qualify. The amendment adopted in 1978 providing for the election to apply the 50% inclusion rule to spousal joint interests created prior to 1977 was also repealed. All of the 1981 amendments are applicable to estates of decedents dying after December 31, 1981.

With the establishment of an unlimited marital deduction, the estate tax treatment of spousal joint interests is essentially irrelevant. Regardless of the value assigned to the qualified joint interest, no estate tax will be paid on the transfer of this property to a surviving spouse. However, the impact of a 50% versus full fair market valuation creates an income tax issue for the surviving spouse. The higher the step-up passed from the estate, the lower the taxable gain on the spouse's return when the property is sold. Should the property remain unsold at the time of the surviving spouse's death, the estate tax would be computed based on the fair value at that time.

With respect to qualified joint interests created after 1977 for decedents dying after 1981, the rules are quite clear: Only a 50% step-up in basis is available. However, the question arises as to the appropriate treatment of pre-1977 qualified joint interests: Should they be included in the estate of the decedent based on the contribution rule or the 50% inclusion rule?

Gallenstein v. United States

The Gallenstein case addresses the issue of how to treat spousal joint interests created before 1977 where the deceased joint tenant died after 1981. The taxpayer had originally reported a gain on her income tax return on the sale of real property she had held jointly with her husband since 1955. The gain had been computed using only a 50% basis step-up from her husband's estate. The taxpayer's amended income tax return sought a refund of the taxes paid on this gain, which the IRS denied. The taxpayer filed suit for the refund on the premise that the entire value of the property should be included in the decedent's estate, as the spousal joint interest was created prior to 1977 and the surviving spouse did not contribute to the purchase of the joint interest.

The IRS argued that the 1981 change in the definition of qualified joint interests in subsection (b)(2) acts to repeal the original effective date of subsection (b). The IRS maintained that the 50% inclusion rule applied to all spousal joint interests of decedents dying after December 31, 1981. The premise asserted was that it was Congress's intention to eliminate tracing for all qualified joint interests when it amended the code in 1981. The IRS concluded that Congress's actions in providing a new definition of qualified joint interests, establishing the unlimited marital deduction, and repealing the election subsections were clearly evidence of this intent. The IRS also referred to the discussion in the legislative history in supporting this conclusion.

The Sixth Circuit Court of Appeals ruled in favor of the taxpayer. The court found inconsistencies in the IRS's arguments. The court concluded that the repeal of subsections (c), (d), and (e) in 1981 indicated that when Congress wished to repeal a particular IRC section, it did so expressly. Thus, the court concluded it would be inappropriate to use the express repeal of these sections as a basis for interpreting what Congress did not expressly enact.

The court also concluded that the government's appeal to legislative history was inappropriate. Referring to past precedent, the court concluded that, as Congress enacted the plain language of the statutes and not the accompanying reports, the use of the legislative history to find an express repeal exceeds its judicial role.

With respect to considering that there had been an implied repeal of the effective date of subsection (b), the court found that neither of the special circumstances of implied repeal had been met. An implied repeal of an earlier act is allowed where the provisions of two acts are in irreconcilable conflict. The court concluded that, although the statutes produce a different result when applied to the same factual situation, they are not mutually exclusive. Thus, no irreconcilable conflict exists to support implied repeal.

The second special circumstance of implied repeal requires that the new statute cover the whole subject matter of law such that the prior statute has no effect. For this circumstance to apply, the intent of the legislature to repeal must be clear and manifest. The court concluded that this criterion was also not met. The 1981 amendments do not prevent the 1976 statute from remaining effective. Congress also did not expressly repeal the effective date of subsection (b)(1) although it did make other express repeals to subsections of IRC section 2040.

Patten v. United States

The Fourth Circuit Court of Appeals also ruled in favor of the plaintiff, Patten, the administrator of the estate of Marjory L. Blaney (1997 CA 4, 80 AFTR 2d 97-5108, 116 F3d 1029). The decedent was the sole owner of real property left to her upon her husband's death in 1989. The property had been held jointly by the couple since 1955. Both the estate tax return and the income tax return of the surviving spouse reflected only a 50% step-up in basis for the property. Upon the death of the surviving spouse, Patten filed an amended income tax return seeking a refund on the taxable gain reported from the sale of the property. Patten's premise was that the property should have been passed to Blaney at full fair market value given that it was held jointly prior to 1977 and she had not contributed toward its purchase. The IRS refused the refund and Patten filed suit.

The court affirmed the decision reached in Gallenstein: There was no evidence of express or implied repeal of the effective date of IRC section 2040(b)(1). The court also did not find merit in an additional argument offered by the government that was not presented in Gallenstein. The IRS suggested that leaving the 1976 amendment intact would provide an unintended windfall to the taxpayer. The government argued that the elimination of estate and gift taxes between spouses in 1981 encourages surviving spouses to include the full value of the property in the decedent's estate so as to maximize the step-up. As there is no corresponding cost by way of an increase in the estate tax, this could not have been Congress's intent. The court found that this premise, "if something is good for the taxpayer, it cannot be Congress's intent," was an unacceptable legal argument.

Therese Hahn v. Commissioner

The IRS issued a notice of deficiency to Hahn in 1996 regarding her 1993 income tax return (110 TC No. 14). Hahn had reported no taxable gain on sale of property inherited from her husband's estate. The estate had included the full market value at the date of death for the property which had been held jointly by the decedent and Hahn since 1972 and for which Hahn had given no consideration toward the purchase price. The IRS asserted that Hahn was only permitted a 50% step-up on this property pursuant to IRC section 2040(b)(1).

On March 4, 1998, the Tax Court ruled for the taxpayer, concluding that the IRS's arguments regarding legislative history, potential for abuse, and express repeal of the other subsections did not satisfy the criterion for implied repeal. The court noted that the Gallenstein decision rejecting both express and implied repeal has been followed by every other court that examined this issue, including Patten v. U.S., Baszto v. U.S. [80 AFTR 2d 97-7 440 (Florida 1997)], Wilburn v. U.S. [80 AFTR 2d 97-7553, 97-2 USTC par. 50881 (Maryland 1997)], and Anderson v. U.S. [78 AFTR 2d 96-6555, 96-2 USTC par. 60235 (Maryland 1996)].

The Tax Court also addressed the IRS contention that the statutes create a potential for abuse. The IRS had argued that surviving spouses would be more likely to assert that the decedents had provided full consideration for jointly held property to achieve a full basis step-up, regardless of how the property was actually acquired. The Tax Court concluded that the IRS misunderstood the burden of proof in this situation. Although IRC section 2040(a) does raise a rebuttable presumption that the decedent furnished the entire consideration for the jointly held property, this section applies to estate tax filings only. For income tax purposes, however, IRC section 1014(b)(9) allows a step-up in basis only for property required to be included in the decedent's gross estate. Thus, in the income tax setting where the step-up is utilized to compute taxable gain, the burden of proof is on the taxpayer. The surviving spouse must prove that the decedent furnished the consideration for the jointly held property in order to receive the step-up. The Tax Court referred to Madden v. Commissioner [52 TC 845 (1969)] in reaching these conclusions.

Form 706, United States Estate Tax Return and Internal Revenue Instructions

The IRS recently released the July 1998 revision of Form 706. Although the revision reflects estate tax changes made by the Taxpayer Relief Act of 1997 and the technical corrections made through the IRS Restructuring and Reform Act of 1998, it does not address the line of decisions nullifying its position on pre-1977 spousal joint interests. Line 1b of Schedule
E--Jointly Held Property, Qualified Joint Interests--indicates that only one-half of the total date-of-death value of these interests should be included in the estate regardless of when the property was acquired. The instructions to Schedule E do not address the issue that pre-1977 spousal joint interests might qualify for different treatment (i.e., 100% inclusion).

Conclusions

Tax advisors for estates with pre-1977 qualified joint interests may wish to consider these precedents when preparing the decedent's estate tax return. Where the surviving spouse did not contribute toward the acquisition of the property, the tax advisor may wish to override the calculations indicated on Schedule E and report the full fair market value of the property on the return. The tax advisor should be prepared to document this position. The surviving spouse would then utilize this full step-up in computing the taxable gain or loss when the property is eventually sold. In the event that the noncontributing spouse dies first, following the instructions to Schedule E will result in a 50% step-up in basis. Although this may be contradictory to the precedents set forth in the cases discussed above, the IRS would be forced to challenge a taxpayer following its own instructions. *

Margaret Conway, CPA, is an assistant professor at Kingsborough Community College.

Editors:
Eric M. Kramer, JD, CPA
Farrell Fritz

Alan D. Kahn, CPA
The AJK Financial Group

Contributing Editors:
Richard H. Sonet, JD, CPA
Marks Shron & Company LLP

Frank G. Colella, LLM, CPA
Own Account

Lawrence M. Lipoff, CPA
Rogoff & Company, P.C.

Jerome Landau, JD, CPA

James B. McEvoy, CPA
The Chase Manhattan Bank

Nathan H. Szerlip, CPA
Edward Isaacs & Company LLP

Lenore J. Jones, CPA
Jacobs Evall & Blumenfeld LLP

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.