The Facts Clarify the Issue

On March 28, 1975, John Leahy died, leaving an estate valued at approximately $7.2 million. Under his will, the residuary estate was divided into a marital trust and a residuary trust. John's wife, Gladys, was the income beneficiary of both trusts, and she had a general power of appointment over the corpus of the marital trust.

Gladys died in November 1981. In her will, she exercised her general power of appointment over the marital trust in favor of an inter vivos trust set up for the benefit of her three grandchildren. At the time of Glady's death, John's estate had substantially increased in value, to approximately $28.2 million. The trusts established under his will had not as yet been funded.

In June 1982, John's estate sold stock and reported a taxable gain of $23.6 million using an income tax basis of $1.8 million that represented the stock's value at the date of John's death. One month later, his estate distributed $2.6 million to the marital trust.

In August 1982, Gladys' estate filed its federal estate tax return including as an asset the $2.6 million received by the marital trust, treating it as a pecuniary or fixed bequest. However, on audit, the IRS concluded that the bequest from John to the marital trust was a fractional share that entitled Gladys' estate to a proportionate share of the appreciation in value in John's estate from the time of John's death to Gladys' death. This increased the value of the trust by $6.3 million to $8.9 million.

John's estate then sought an income tax refund of $1.5 million for the 1982 tax year. The reason for the refund claim was the John's estate was entitled to a step-up in tax basis of the assets sold to the same extent that the IRS included it for estate tax purposes (i.e., the appreciated value in Gladys' estate). The District Court ruled in favor of the government. This decision was recently reversed by the Second Circuit.

And Now the Discussion

IRC Sec. 1014 generally provides that an individual who "acquires" property from a decedent may use as its income tax basis the fair market value of the property at the date of the decedent's death. In this case, the IRS contended that John's estate always possessed the marital trust property and therefore, Gladys' appointee never " acquired" anything from Gladys' estate. Consequently, the IRS stated that John's estate could not use the value of the stock at Gladys' date of death as its basis in the stock.

The Second Circuit in its reversal stated that the IRS applied inconsistent positions in dealing with Gladys' estate tax and John's estate income tax and was being overly formalistic. It was an undisputed fact that as a result of Gladys' general power of appointment, though the trust had not yet been funded, the marital trust property was includable in her estate. Gladys was the beneficial owner of the trust's assets for estate tax purposes. At her death, as a result of her testamentary exercise of the general power of appointment, the inter vivos trust for her grandchildren acquired an interest in the property. The executor of John's estate was responsible for managing its property and liquidating the estate. Accordingly, although it retained legal title to the estate's assets, the estate did not possess any real ownership interest in the property. Without a beneficial interest, the estate merely held and managed the property on behalf of the beneficiaries of the marital trust. Consequently, the Second Circuit concluded that whether John's estate was permitted to use a stepped-up basis under Sec. 1014 was a function of whether Gladys' appointee, the inter vivos trust, could have used a stepped-up basis to calculate capital gains from sales of marital trust property made subsequent to Gladys' death.

The court determined that Gladys' appointee could have used the stepped-up basis. Under Sec. 1014(b)(4), property passing without full and adequate consideration under a general power of appointment exercised by the decedent by will is considered property acquired from the decedent.

Therefore, the Second Circuit concluded that since the inter vivos trust, would have been able to use the stepped-up basis, John's estate was entitled derivatively to use a basic calculated at the time of Gladys' death to determine the amount of capital gain upon the sale of the property after her death.