Internal Revenue Service(I.R.S.)

Field Service Advisory

1992

CC:TL-N-***

FS:P&SI:***

to: District Counsel, *** CC:***

from: Assistant Chief Counsel (Field Service) CC:FS

subject: ***

This is in response to your request for tax litigation advice dated ***

ISSUES

1. Whether *** pounds of marijuana are includible in the decedent’s gross estate.

2. If includible, at what fair market value should the marijuana be included on the estate tax return

3. If includible, may the estate claim a debt or loss deduction pursuant to I.R.C. §§ 2053 or 2054.

CONCLUSIONS

1. To the extent that a decedent has an interest in an illegal asset, that asset should be included in the decedent’s gross estate. However, in this case, it is questionable whether we have a strong enough fact pattern so that we can prevail that the decedent had an ownership interest in the marijuana. In a case where we are litigating a new position that has not been previously asserted, we should go forward with a case with a very strong fact pattern supporting our position. The instant case involves a new position and it lacks a factual basis that strongly supports the position that we are arguing. Therefore, this case is not the vehicle which we would prefer to use in raising this contention for the first time in court.

2. The fair market value of the marijuana is the price at which it would be sold to the ultimate consumer, not the price a dealer would pay when offering it for resale.

3. The estate may not claim a debt or loss deduction under the facts in the instant case.

FACTS

*** (decedent), a resident of *** died on *** The decedent was killed when a stolen plane that he was piloting crashed while attempting to land *** The crash occurred ***

The plane was destroyed by the crash. At the scene, bales or portions of bales of marijuana were found. The total weight of this marijuana was *** pounds. The police also recovered $*** in cash from the wreckage. The sheriff’s department seized the drugs and the cash.

Shortly after the crash, the police stopped and arrested two individuals in a truck on *** In the back of the truck were bales of marijuana totalling *** pounds. Both of the accomplices were later convicted of conspiracy to traffic marijuana and of possession of marijuana.

The two individuals stated that the decedent contacted them at their homes on *** They met him in *** and the three of them drove out to an *** area of *** that was *** deserted at night.

The decedent then told his two accomplices to be at that site the next night *** between 10 and 10:30 p.m. with a truck. They were to offload the drugs from the plane. One accomplice was to drive the truck to *** while the decedent and the other accomplice were to *** They were then to meet in *** where the two accomplices would be paid by the decedent. At least one of the accomplices had participated with the decedent in similar activities in the past.

On *** the two accomplices drove to the landing site. While they were setting up the landing lights, the decedent’s plane, while attempting to land, struck a tree and power lines behind the two accomplices and crashed. The accomplices picked up several bales that had scattered as a result of the crash and left the scene.

For several years prior to his death, the decedent had been suspected by local and Federal authorities of drug smuggling. He was never arrested for drug activities. He was arrested or stopped several times for activities involving airplanes that had been used in drug activities or with the type of airplane equipment that is frequently used in drug activities.

DISCUSSION

Issue 1. Includibility in gross estate

Pursuant to section 2031, “The value of the gross estate of the decedent shall be determined by including to the extent provided for in this part, the value at the time of his death of all property …”

Treas. Reg. § 20.2031-1(a) states that:

the value of the gross estate of a decedent who was a citizen or resident of the United States at the time of his death is the total value of the interests described in sections 2033 through 2044… . In arriving at the value of the gross estate the interests described in sections 2033 through 2044 are valued as described in this section … The contents of sections 2033 through 2044 are, in general, as follows:

(1) Sections 2033 and 2034 are concerned mainly with interests in property passing through the decedent’s probate estate. Section 2033 includes in the decedent’s gross estate any interest that the decedent has in property at the time of his death.

Section 2033 provides that “The value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.” Section 2033 includes in the gross estate the value of all property beneficially owned by the decedent at the time of his death. Treas. Reg. § 20.2033-1. Treas. Reg. § 20.2033-1 points out that the estate tax “is an excise tax on the transfer of property at death and is not a tax on the property transferred.”

It is the equitable ownership, rather than legal title, which is taxed. See Commissioner v. Chase Manhattan Bank, 259 F.2d 231, 260 (5th Cir. 1958), cert. denied, 359 U.S. 913 (1959); Lowndes, Kramer & McCord, Federal Estate and Gift Taxes § 4.2 (3d ed. 1974). Generally, state law controls the issue of ownership or interest for tax purposes. [However, federal regulations may preempt inconsistent state property laws.] See United States v. Chandler, 410 U.S. 257 (1973). When the United States is not a party, a federal court is not bound by a state trial court’s decision as to property rights of a decedent under state law, but is bound only when the decision is made by the highest court of the state. If there is no decision by the state’s highest court, the federal court must decide for itself what the state law is by taking the various state decisions into consideration. Commissioner v. Estate of Bosch, 387 U.S. 456 (1967).

The taxpayer has the burden of proving by a preponderance of the evidence that the Commissioner’s determination is erroneous. See Carson v. Commissioner, 560 F.2d 693 (5th Cir. 1977); Ireland v. United States, 621 F.2d 731 (5th Cir. 1980). In making his case, the taxpayer must overcome a presumption of correctness which attaches itself both to the deficiency determination and to the facts which support it. See Rockwell v. Commissioner, 512 F.2d 882 (9th Cir.), cert. denied, 423 U.S. 1015 (1975). However, before the Commissioner can rely on the presumption of correctness, the Commissioner must offer some substantive evidence showing that the taxpayer received income from a charged illegal activity. Erickson v. Commissioner, 937 F.2d 1549 (10th Cir. 1991).

In the instant case, the decedent has definitely been shown to have a contact with the marijuana - he died while in possession of it. However, the estate contends the decedent was merely a pilot-for-hire, while the Examination division believes he owned the marijuana.

While we recognize that the income tax and the estate tax are not to be construed in pari materia, yet concepts utilized in one sphere may be applicable in another sphere. See Kuhn v. United States, 392 F. Supp. 1229, 1239 (S.D. Tex. 1975). We believe that the courts will apply a similar analysis in determining whether the decedent had an interest in the marijuana which would make it includible in his gross estate as the courts have applied in determining whether a taxpayer has received income from the sale of an illegal substance. In both cases, the courts concern would be with who received the economic benefit attendant to equitable ownership of the drug.

There are numerous cases that have examined the income tax consequences arising from the Service’s assertion that a taxpayer received income from an illegal activity. The Second Circuit Court of Appeals best summarized the applicable factual basis necessary in order for the presumption of correctness to attach. As the Second Circuit stated in Llorente v. Commissioner, 649 F.2d 152, 156 (2d Cir. 1981):

The decisions relied upon by the Commissioner … do not support his contention. On the contrary, they indicate … that mere linking of a taxpayer with the drug business will not suffice and that the presumption will attach only upon a showing that the taxpayer’s involvement was sufficient to support an inference that he received or used funds in the course of his engagement in the unlawful activity.

Thus, the Service’s determination is entitled to the presumption of correctness where the taxpayer owns specific non-cash assets determined by the Service to represent taxable income [Delaney v. Commissioner, 743 F.2d 670 (9th Cir. 1984) (gold coins); Schad v. Commissioner, 87 T.C. 609 (1986), aff’d, 827 F.2d 774 (11th Cir. 1987) (real estate)] or where the Service has determined that there is unreported income by use of the net worth, bank deposit, cash expenditures or source and application of funds methods [Llorente v. Commissioner, 74 T.C. 260 (1980), aff’d in part, rev’d in part, 649 F.2d 152 (2d Cir. 1981); Taglianetti v. United States, 398 F.2d 558 (1st Cir. 1968), aff’d, 394 U.S. 316 (1969); Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979)].

If there is no evidence of unreported income, the courts have required the Service to establish some evidence that the taxpayer received income from the illegal activity. In Weimerskirch, the Service had relied upon statements of two informers in determining that the taxpayer had unreported income from heroin sales. The Ninth Circuit, in reversing the Tax Court, held there was no substantive evidence linking the taxpayer to the sale of narcotics. In Llorente, the Second Circuit, in partially reversing the Tax Court, determined that there had to be some evidence linking the taxpayer with tax-generating acts such as the purchase or sale of controlled substances. It was insufficient to establish that the taxpayer’s business premise was used by members of a conspiracy to discuss and transact cocaine sales and that the taxpayer met with other members of the conspiracy and was aware of the activity. In Jackson v. Commissioner, 73 T.C. 394 (1979), the Tax Court found that there was no evidence linking the taxpayer to a narcotics operation during the applicable time period where no government agent had any direct contact with the taxpayer nor his activities during the time frame at issue and the government’s entire case was based upon allegations made by an unreliable informant.

However, in Erickson v. Commissioner, T.C. Memo. 1989-552, aff’d, 937 F.2d 1549 (10th Cir. 1991), the taxpayer argued he was merely a pilot-for-hire and did not have an interest in the marijuana. The Tax Court held the Service’s determination was entitled to a presumption of correctness where the taxpayer was in possession of drugs seized with the aircraft and where he had testified in a different proceeding that he had an ownership or possessory interest in the marijuana cargo in the plane. In a footnote, the Tax Court stated “Petitioner was clearly in possession of the Cessna 404 and that would appear to be sufficient to put petitioner to his burden of proof as to the source of the drugs.” 58 TCM (CCH) 352, 353 n. 4 (1989). In examining this case, the Tenth Circuit concluded that drugs were close to being cash equivalents. Once it had been demonstrated that the taxpayer had drugs in his possession, then the taxpayer retained the burden of explaining the source and nontaxability of funds (or drugs) in his possession. The Tenth Circuit also concluded that there was a rational underpinning for the notice of deficiency.

In Erickson, the Service also used a cash expenditures method to determine the taxpayer’s income. The Tenth Circuit determined that petitioner has the burden of proof where respondent has connected petitioner through substantive evidence to a likely source of the expenditures and has shown the petitioner has no likely source for a decrease in net worth. The Tenth Circuit concluded that there was sufficient evidence which, taken as a whole, connected the taxpayer to a likely source of income, the drug trade, to explain possession of enough money to purchase the drugs. In looking at the evidence, the Tenth Circuit considered (1) the taxpayer’s testimony that he had an ownership interest in the marijuana cargo, (2) that he engaged in cash transactions and (3) that he possessed a hangar and several planes.

Kent v. Commissioner, T.C. Memo. 1986-324, did not involve the question of the presumption of correctness attached to a notice of deficiency. In Kent, the Tax Court concluded that the taxpayer was a credible witness and that he established he did not provide the money for a boat or for the drugs seized on the boat, he did not supply the two crewmen and he did not make the arrangements for the rendezvous to pick up the drugs. Of particular significance was the fact that there was no possible source established whereby the taxpayer could have accumulated the funds to purchase the boat or the drugs. The Tax Court concluded that the taxpayer was employed to operate a boat used to smuggle drugs into the country, but that he did not own the drugs.

In Schad, the court again had to address the factual issue of whether a taxpayer had unreported income. The Tax Court distinguished the Weimerskirch line of cases by holding that the taxpayer had money in his possession which he used to attempt to purchase marijuana and that he had no reasonable explanation for the source of the money. The court held that it was incredible that the taxpayer would withdraw approximately $175,000 from a cash hoard on the suggestion of a casual friend and, on hearing it was to be used to purchase marijuana, the taxpayer would then engineer all further activities involved in the purchase but that he had never before been involved in the purchase or sale of marijuana. The court was not convinced that the $175,000 was not money made that year from narcotics dealings.

Based upon the foregoing, we believe that the Service can show a rational basis for issuing a notice of deficiency in this case based on the fact that the decedent was in possession of the drugs. Under Erickson, the drugs can be considered a cash equivalent and the taxpayer would have the burden of proof as to their source.

However, looking at the cases overall, we are very concerned that we cannot factually establish that the decedent owned the drugs. According to the estate’s representative’s December 3, 1991, letter, the decedent was in poor economic condition. Unless we have some evidence of cash transactions, ownership of assets used in drug transportation, or an accumulation of assets not supported by his reported income, we are unlikely to prevail in establishing that the decedent was the owner of the marijuana, even with the presumption of correctness that attaches to the notice of deficiency.

We would note that, even though there is evidence that the decedent arranged for his two accomplices to meet him and to offload the marijuana, neither of them testified that the decedent claimed any ownership interest in the marijuana. At this point, the only evidence supporting our contention is the fact that the decedent died while transporting the marijuana. Such evidence equally supports a finding that the decedent was hired to transport the drugs. In looking at the type of evidence that must be produced to prevail in these cases, we believe that more evidence is necessary in order for us to prevail on this issue.

We believe that a decedent’s gross estate must include all assets, including illegal ones, in which he has an interest. The assets should be included in the gross estate at their fair market value. Such fair market value should account for the fact that the asset is illegal and that there may not exist a ready market for the asset. As the Tenth Circuit noted in Erickson, drugs are close to being cash equivalents. The decedent, if he owned the drugs, had the full use, possession and enjoyment of the drugs. There is a market for the drugs and he had the apparent ability to easily sell the drugs. On his death, the same rights would be transferred to the objects of his bounty. Thus, the drugs would be includible in the decedent’s gross estate.

However, unless there can be established a better factual basis for contending that the decedent was the owner of the drugs, we do not view this case as the proper litigating vehicle with which to advance this proposition. A far stronger factual case may arise in the future where the decedent is the open, notorious beneficial owner of illegal property that we can establish that he could easily sell to raise money as necessary and where his family steps into his shoes and continues to use, possess and enjoy the illegal asset. See PLR 9125005 (stolen art objects). We agree with the *** memorandum that bad facts can equal bad law. Thus, in the absence of a better record, we do not recommend that a notice of deficiency be issued in this case.

Issue 2. Fair market value

In the event that further evidence is developed that supports the contention that the decedent owned the marijuana, the marijuana should be included in the decedent’s gross estate at its fair market value. The fair market value 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 to sell and both having reasonable knowledge of relevant facts. Treas. Reg. § 20.2031-1(b).

While the presence of a limited market is a factor to be taken into account, it is not a bar to valuation. See Estate of Smith v. Commissioner, 57 T.C. 650 (1972). Thus, the fact that the marijuana can only be sold in an illicit market is not a bar to its valuation.

The test to be used for valuation for estate and gift tax purposes is generally the same as that used for charitable contribution deduction purposes. United States v. Parker, 376 F.2d 402 (5th Cir. 1967); Treas. Reg. §§ 1.170A-1(c)(2), 20.2031-1(b), 25.2512-1. Treas. Reg. § 20.2031-1(b) provides:

Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, … Thus, in the case of an item includible in the decedent’s gross estate, which is generally obtained by the public in the retail market, the fair market value of such an item of property is the price at which the item or a comparable item would be sold at retail… . The value is generally to be determined by ascertaining as a basis the fair market value as of the applicable valuation date of each unit of the property.

In Goldman v. Commissioner, 388 F.2d 476 (6th Cir. 1967), the court determined the value of a large number of medical journals contributed to a charity by an individual who was not a dealer. The court held that the fair market value should be computed “on the price an ultimate consumer would pay, and that which might be paid by a dealer buying to resell is not a proper consideration.” 388 F.2d at 478; see also Alma Piston Co. v. Commissioner, T.C. Memo. 1976-107, aff’d, 579 F.2d 1000 (6th Cir. 1978).

In Anselmo v. Commissioner, 80 T.C. 872 (1983), the Service argued that gem stones contributed to a charity must be valued as if they were sold in bulk. The Tax Court disagreed and stated that each individual stone was a separate unit of property for valuation purposes because individual stones are frequently sold in the applicable market. Because there are large numbers of similar stones sold each year, no blockage discount would be applicable.

Using a similar analysis, the value of the marijuana should be computed based on the price an ultimate consumer would pay in the illicit marketplace. This value should be based on unit sales of the marijuana, and not the bulk price of bales of marijuana. We believe the October 21, 1991, technical advice memorandum is correct in concluding that the fair market value of the marijuana is the retail street value of average grade marijuana.

Issue 3. Section 2053 or section 2054 deduction

The *** memorandum did not ask that we address the estate’s arguments regarding the sections 2053 and 2054 issues. We would, therefore, note only that we agree with the October 21, 1991, technical advice memorandum on these issues.

This document may include confidential information subject to the attorney-client and deliberative process privileges, and may also have been prepared in anticipation of litigation. This document should not be disclosed to anyone outside the Service, including the taxpayer involved, and its use within the Service should be limited to those with a need to review the document in relation to the subject matter or case discussed herein.

If you have any additional questions, please contact Helen Rogers at FTS (202) 566-3521.

DANIEL J. WILES

By:

ROBERT B. MISCAVICH
Senior Technician Reviewer
Passthroughs & Special Industries
(Field Service)