Tax Court Finds §2036(a)(2) Triggers Inclusion in Estate

The Tax Court again agreed with the IRS that a family limited partnership arrangement (FLP) had run afoul of IRC §2036(a), the IRS’s most successful route to undo such planning due to “bad facts.”  But, in the case of Estate of Powell v. Commissioner, 148 TC No. 18 the Tax Court, for the first time since it proposed a “lack of real fiduciary duties” theory for invoking IRC §2036(a)(2) in the case of Estate of Strangi v. Commissioner¸ TC Memo 2003-145 that the Court invoked that provision, rather than the general “implied life estate” theory under IRC §2036(a)(1) to unwind the plan.  Also, the majority opinion also provided that IRC §2043 served to limit the inclusion in the estate to only the excess value of the assets transferred over the interest received.

The plan in this case was very much a “deathbed” plan, with the transfers occurring one week before Nancy Powell died.  As well, at the time of the transfers Nancy was incapacitated as well as terminally ill, so her son, acting under a Power of Attorney (POA), formed the partnership with himself as general partner and then transferred Nancy’s assets into the partnership in exchange for a 99% limited partnership interest.   On that same day, her son, again acting under the POA, transferred Nancy’s limited partnership interest to a charitable lead annuity trust (CLAT).

Clearly, this is a very “bad facts” case and a taxpayer loss probably isn’t surprising for most readers.  But the Court’s analysis in this case did both finally invoke the “second” §2036(a) option from the Strangi case and broke some new ground on the proper amount to be included in the decedent’s estate in the case of a §2036(a) problem.

Since, under the plan, the decedent had transferred her interests in the assets during her life, the transfer was reported on a gift tax return.  At the end of the day, following the discounts both for the transfer of assets to the FLP and then a second discount to arrive at the remainder interest gifted via the CLAT, Nancy’s Form 706 reported only a net transfer of $1,661,422 despite starting with assets valued at over $10,000,000.

The IRS position was that all this final week of life frenzy of paper asset transfers should be ignored via one of three grounds:

It is determined that the decedent retained at her death the possession, enjoyment, or right to the income from property she transferred to NHP * * * or the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income there from such that the property transferred to the partnership valued at $10,022,570 on the valuation date is includible in the gross estate under IRC § 2036(a).

Alternatively, it is determined that the decedent retained at her death a power to change the enjoyment of property transferred to NHP * * * through exercise of a power * * * by the decedent alone or in conjunction with any other person * * * to alter, amend, revoke, or terminate such that the property transferred to the partnership valued at $10,022,570 on the valuation date is includible in the gross estate under IRC § 2038(a).

Alternatively, it is determined that the decedent retained at her death a power to change the enjoyment of a 99% limited partnership interest in NHP * * * through exercise of a power * * * by the decedent alone or in conjunction with any other person * * * to alter, amend, revoke, or terminate such that the value of the 99% limited partnership interest is includible in her gross estate under IRC § 2038(a) at its fair market value of $10,022,570. The fair market value of the 99% partnership interest is determined without regard to certain rights and restrictions identified in IRC § 2703(a).

The Tax Court looked at the §2036(a) issue.  The IRS advanced two different theories for why §2036(a) should bring the assets back into the estate. 

  • The transfer was subject to an implied agreement under which Nancy would retain the possession or enjoyment of the property, or the right to receive income under the proper as described in IRC §2036(a)(1)
  • Nancy retained the right, in conjunction with her sons, to dissolve the partnership and thus control who would enjoy the property, a violation of IRC §2036(a)(2).

While neither provision would apply had Nancy transferred her interest in a “bona side” for full and adequate consideration per §2036(a), the IRS argued that the estate had failed to show any significant nontax consideration for the formation of the partnership.

While §2036(a)(1) has most often been used by the Court to justify an inclusion under §2036(a) of assets in an estate, in this case the Tax Court skipped any analysis regarding whether IRC §2036(a)(1) would apply and instead concluded that IRC §2036(a)(2) applied, rendering the question of whether there was an implied retained interest no longer relevant.

The estate’s defense regarding the §2036(a)(2) issue is rather unique, as the estate did not appear to contest the issue.  Rather, as the Court described it:

The estate does not deny that decedent's ability to dissolve NHP with the consent of her sons constituted a “right * * * in conjunction with * * * [others], to designate the persons who shall possess or enjoy the property [she transferred to the partnership] or the income therefrom”, within the meaning of section 2036(a)(2). Nor does the estate challenge respondent's assertion that decedent's transfer of cash and securities to the partnership was “not a bona fide sale for an adequate and full consideration in money or money's worth”. The estate’s only response to respondent's section 2036(a)(2) argument is that, upon her death, decedent did not retain her interest in NHP. The estate apparently reasons that, even if decedent’s interest in NHP gave her the right to designate the beneficiaries of the assets she transferred to the partnership, she did not retain that right for the remainder of her life (and the brief period for which she held the right was not ascertainable only by reference to her death). Consequently, the estate argues, section 2036(a)(2) does not apply to decedent’s transfer of cash and securities to NHP.

However, the Tax Court rejected this idea for two separate reasons.  First, as it would be a transfer within three years of her death, IRC §2035 would bring the cash and securities transferred back into her estate if there had been a valid gift of her interest, along with any gift tax paid.

Second, there was a more basic problem—the Power of Attorney did not grant the son the right to make any gifts in excess of the annual exclusion.  The estate argued that while it was true that the POA did have that limitation in it, the son’s general authority to manage Nancy’s property allowed him to make such a transfer.  The Tax Court turned to the applicable state law (California in this case) to determine if he did have the authority to make the gift.

California caselaw contravenes the estate's claim that the general authority granted to Mr. Powell to convey decedent's property included the power to make gifts. California courts have long applied the general principle requiring an express grant of authority to make gifts to hold that general grants of authority to convey property do not provide the power to make gifts. See Shields v. Shields, 19 Cal. Rptr. 129, 130-131 (Ct. App. 1962) (citations omitted) (“A power of attorney conferring authority to sell, exchange, transfer or convey real property for the benefit of the principal does not authorize a conveyance as a gift or without a substantial consideration[,] and a conveyance without the scope of the power conferred is void.”); Bertelsen v. Bertelson, 122 P.2d 130 (Cal. Ct. App. 1942) (holding that grant of general authority to convey property did not encompass gifts); see also Estate of Swanson v. United States, 46 Fed. Cl. 388, 392 (2000) (applying California law in Federal estate tax case and concluding that a power of attorney that gave an attorney-in-fact “significant powers to manage and convey” the decedent's property “could not give him the power to make gifts without expressly doing so”), aff'd, 10 F. App'x 833 (Fed. Cir. 2001).

The Court thus found that §2036(a)(2) applied in this case, as there was no authority to make the gift, so Nancy had not disposed of the interest in the FLP.  As the Court did in Strangi, the Court found this case did not invoke the fiduciary duty of the donor to other partners, a duty that lead the Supreme Court to find that such rights had not been retained in the case of United States v. Byrum, 408 U.S. 125 (1972).

Byrum is key to virtually all family limited partnership planning if a bona fide sale cannot be shown, since the inclusion is triggered if there is available to the donor “the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.”  Obviously, the partners acting as a whole almost always could undertake the prohibited designation.  Byrum has been interpreted to hold that there was not such a right when the partner owed a fiduciary duty to other partners.

As the Tax Court explains:

In Byrum, the (Supreme) Court held that a decedent’s retained right to vote shares of stock in three corporations that he had transferred to a trust for the benefit of his children did not cause the value of those shares to be included in the value of his estate under section 2036(a)(2). The Court rejected the Government's argument that, through his ability to vote the transferred shares, the decedent could affect the corporations’ dividend policy and thus the trust's income. Among other things, the Court noted that the decedent, as the controlling shareholder of each corporation, owed fiduciary duties to the minority shareholders that circumscribed his influence over the corporations’ dividend policies.

The Strangi decision had held Byrum did not apply if there were no equity holders with an adverse interest.  Again, in this case, the Court found that the only true “duty” that the son held in this case under the POA was to the decedent, holding:

In addition to his duties as NHP's general partner, Mr. Powell owed duties to decedent that he assumed either before he created the partnership or at about the same time. Nothing in the circumstances of the present cases suggests that Mr. Powell would have exercised his responsibility as general partner of NHP in ways that would have prejudiced decedent's interests. Because decedent held a 99% interest in NHP, whatever fiduciary duties limited Mr. Powell's discretion in determining partnership distributions were duties that he owed almost exclusively to decedent herself. Finally, the record provides no indication that NHP conducted meaningful business operations or was anything other than an investment vehicle for decedent and her sons. We conclude that any fiduciary duties that limited Mr. Powell's discretion in regard to distributions by NHP were "illusory" and thus do not prevent his authority over partnership distributions from being a right that, if retained by decedent at her death, would be described in section 2036(a)(2).

The Court did go down one unique path, this time not just accepting that the property transferred should be treated as part of the decedent’s estate, but rather looking to IRC §2043(a) to limit the inclusion to the value transferred in excess of the value of the partnership interest the decedent received.  That interest, due to the Court’s view that the transfer to the CLAT was void or voidable, was included in Nancy’s estate and, the Court noted, if the full value transferred to the FLP was included in Nancy’s estate, this would result in a double taxation result.

As the Court notes, Section 2043 reads:


(a) In General. — If any one of the transfers, trusts, interests, rights, or powers enumerated and described in sections 2035 to 2038, inclusive * * * is made, created, exercised, or relinquished for a consideration in money or money's worth, but is not a bona fide sale for an adequate and full consideration in money or money's worth, there shall be included in the gross estate only the excess of the fair market value at the time of death of the property otherwise to be included on account of such transaction, over the value of the consideration received therefor by the decedent.

Judge Lauber, in an opinion that concurred in result only, argued the Court had gone down this path without any compelling need to do so.  First, the Court has not felt a need to deal with this in the past, since the holding generally results in the partnership being a non-entity.  As the concurrence notes:

This is where I part company with the Court, because I do not see any “double inclusion” problem. The decedent’s supposed partnership interest obviously had no value apart from the cash and securities that she allegedly contributed to the partnership. The partnership was an empty box into which the $10 million was notionally placed. Once that $10 million is included in her gross estate under section 2036(a)(2), it seems perfectly reasonable to regard the partnership interest as having no distinct value because it was an alter ego for the $10 million of cash and securities.

This is the approach that we have previously taken to this problem. See Estate of Thompson, 84 T.C.M. (CCH) at 391 (concluding that the decedent’s interest in the partnership had no value apart from the assets he contributed to the partnership); Estate of Harper v. Commissioner, T.C. Memo. 2002-121, 83 T.C.M. (CCH) 1641, 1654; cf. Estate of Gregory v. Commissioner, 39 T.C. 1012, 1020 (1963) (holding that a decedent’s retained interest in her own property cannot constitute consideration under section 2043(a)). And this is the approach that I would take here. There is no double-counting problem if we read section 2036(a)(2), as it always has been read, to disregard a “transfer with a string” and include in the decedent’s estate what she held before the purported transfer — the $10 million in cash and securities.

The Judge Lauber goes on to describe the majority’s machinations as “a solution in search of a problem,” and voices a concern that the Court may have opened the door to aggressive tax planning attempting to make use of this analysis.

Indeed, the Court seems to acknowledge the analytical infirmities of its approach, conceding that its formulation could “result in a duplicative reduction in transfer tax.” See op. Ct. n.7. The possibility of a “duplicative reduction in transfer tax” may invite overly aggressive tax planning. By adopting an untried new theory without first hearing from the parties, we risk creating problems that we do not yet know about. The more prudent (and conservative) approach in my view would be to adhere to the letter and spirit of our precedent, leaving the law in the relatively stable position it appears to occupy now.