PAYMENT OF STATE INHERITANCE TAX WITH PROPERTY OTHER THAN CASH CONSTITUTES 'TAXES ACTUALLY PAID' FOR PURPOSES OF SECTION 2011 CREDIT

Rev. Rul. 86-117

ISSUES

1. Does the payment of state inheritance taxes with property, in lieu of cash, pursuant to state law, constitute "taxes actually paid" to a state for purposes of the federal estate tax credit under section 2011 of the Internal Revenue Code?

2. If so, does the estate realize gain or loss upon the disposition of property in payment of state inheritance tax liability?

FACTS

The decedent, D, a resident of state ST, died on April 16, 1984. Under the laws of ST, the inheritance tax liability of any beneficiary, heir, surviving joint tenant, or other transferee may be paid by the transfer of money, property other than money, or both, to the state or to a political subdivision of the state. In-kind payments of the tax liability by a transfer of property other than money are permitted only where the property will be used for public purposes and are subject to approval and acceptance by the governmental entity that receives the property.

Twelve months after D's death, D's executor filed a state inheritance tax return and, in part payment of the inheritance tax liability, transferred to the local political subdivision of ST a parcel of real estate that at the time had a fair market value of $77,000. The ST taxing authority certified that ST's acceptance of the property constituted payment of $77,000 in satisfaction of the estate's inheritance tax liability. The executor filed a timely federal estate tax return in which the value of the transferred property was included as a part of D's gross estate. On the federal estate tax return, the executor did not elect the alternate valuation date prescribed by section 2032 of the Code. The parcel was therefore included in the gross estate at its date of death fair market value, which was $70,000. After satisfying the state inheritance tax liability, D's executor filed for a federal estate tax refund. The claim for refund was based on the payment of state inheritance taxes, including the $77,000 payment made by transferring the real estate.

LAW AND ANALYSIS

Section 2011 of the Code provides that, within the limitations of section 2001(b), the tax imposed by section 2001 shall be credited with the amount of any estate, inheritance, legacy or succession taxes actually paid to any state or the District of Columbia, in respect of any property included in the gross estate (not including any taxes paid with respect to the estate of a person other than the decedent).

Section 2011(c) provides that, in general, the credit allowed for state taxes described above shall include only such taxes as were actually paid and credit therefor claimed within 4 years after the filing of the estate tax return.

Section 2011 is specific that the amount for which a credit is claimed must be "actually paid." However, neither the Code nor the Estate Tax Regulations limit the medium of payment of state death taxes that qualify for the credit under section 2011 to cash payments.

Rev. Rul. 74-178, 1974-1 C.B. 196, holds that when an executor transfers appreciated property in settlement of a claim against the estate, the estate realizes gain measured by the excess of the amount of the claim over the estate's basis in the property.

Section 1001(a) of the Code provides, in part, that the gain from the disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain.

Section 1011(a) of the Code provides, in part, that the adjusted basis for determining the gain from the disposition of property shall be the basis determined under the applicable provisions of the Code.

Section 1014(a) of the Code provides, generally, that the basis of property in the hands of a person acquiring the property from a decedent shall be the fair market value of the property at the date of the decedent's death or, where there is an appropriate election, at the alternate valuation date as provided in section 2032.

The amount actually paid to a state or subdivision for state death taxes is not always equivalent to the amount of the tax liability discharged by the payment. For example, if a state accepts $2,000 in settlement of a tax liability of $3,000 dollars, the amount actually paid for purposes of section 2011 is $2,000. See Commonwealth Trust Co. of Pittsburgh v. Driscoll, 50 F. Supp. 949 (W.D. Pa. 1943). aff'd per curiam, 137 F.2d 653 (3rd Cir. 1943), cert. denied, 321 U.S. 764 (1944), and Smith v. Commissioner, 59 F.2d 533 (7th Cir. 1932), aff'g in pertinent part, 23 B.T.A. 278 (1931). Similarly, the fact that the state accepts property worth $2,000 to discharge a tax liability of $3,000, even when the liability is undisputed, does not mean that $3,000 is the amount actually paid. Rather, $2,000, the fair market value of the property used to discharge the tax liability, is the amount actually paid.

Conversely, if for some reason the executor transfers property worth $3,000 in settlement of a $2,000 inheritance tax liability, only $2,000 is actually paid for purposes of section 2011. Any amount paid in excess of the tax liability discharged is not a payment of state tax.

For federal estate tax purposes, the fair market value of property is defined by section 20.2021-1(b) of the regulations. In general, the fair market value of property includible in a decedent's gross estate is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the relevant facts. The regulations also explain that the fair market value of an item is not determined by a forced sale price.

In any case in which the value of property affects the federal estate tax liability, the fair market value must be determined under section 2031 of the Code, and is within the jurisdiction of the Internal Revenue Service. This remains true even if the state, for its own purposes, assigns a different value.

In this case the estate realizes a $7,000 gain on the transaction the difference between the liability satisfied and the basis in the property. If the property had had a fair market value less than the undisputed amount of the liability satisfied, the amount realized would have been only the fair market value. For example, if the property had had a fair market value of $75,000, the amount realized would have been $75,000, and the gain would have been only $5,000. The $2,000 excess of the undisputed liability that was satisfied over the fair market value of the property given in exchange is income from the discharge of indebtedness. Section 1.1001-2(c) of the Income Tax Regulations, Example (8).

HOLDINGS

1. The payment of state inheritance taxes in property, in lieu of cash, pursuant to state law, constitutes "taxes actually paid" to the state for purposes of the federal estate tax credit under section 2011 of the Code. The amount of state inheritance tax treated as paid under section 2011 of the Code is the lesser of: 1) the amount of state inheritance tax liability discharged by the transfer of the property, or 2) the fair market value of the property on the date of the transfer.

2. D's estate realized a $7,000 gain measured by the difference between the estate's basis determined under section 1014 of the Code ($70,000) and the amount of the state tax liability that was discharged ($77,000).