In a reviewed opinion (Estate of Nancy H. Powell, et al. v. Commissioner, 148 T.C. No. 18), the Tax Court has granted partial summary judgment for the IRS, concluding that the gross value of an estate includes the value (approximately $10 million) of a limited partnership interest that the decedent's son attempted to transfer to a charitable lead annuity trust (CLAT) on behalf of the decedent shortly before she died. Granting partial summary judgment for the estate, the Court also concluded that the value of the limited partnership interest is not subject to gift tax.

Although all of the 17 Tax Court judges who reviewed the case agreed that the entire value of the decedent's partnership interest that her son attempted to donate to the CLAT is includable in the estate, nine of the judges concurred in the result only and seven drafted a concurring opinion explaining where their reasoning diverged from the majority's opinion.

Facts

The decedent died on August 15, 2008, leaving her son as executor of her estate. On August 6, 2008, her son had formed a family limited partnership (FLP), executing a certificate of limited partnership as the general partner and filing it with the Delaware secretary of state. Two days later, on August 8, the son: (1) acted on his mother's behalf in transferring approximately $10 million in cash and securities from her revocable trust to the FLP in exchange for a 99% limited partner interest, and (2) purported to act on his mother's behalf under a power of attorney (POA) by transferring her limited partnership interest to the CLAT. Under the terms of the CLAT, the mother's foundation was entitled to a specified annuity for the remainder of the decedent's life, and the remaining CLAT assets would be divided equally upon her death between two trusts established for her two sons.

The POA: (1) permitted the decedent's son to convey the decedent's property, if she was incapacitated, "to the full extent of the federal annual gift tax exclusion" under Section 2503(b), and (2) included a ratification provision, stating: "The principal hereby ratifies and confirms all that the agent shall do, or cause to be done, by virtue of this power of attorney." The decedent was incapacitated during the period at issue.

Gift tax returns filed for the decedent's 2008 tax year reported a $1.66m taxable gift stemming from the purported transfer of the 99% interest to the CLAT. This amount was based on an appraiser's valuation concluding that the remainder interest in the CLAT was worth approximately $7.52m. This value reflected a 25% discount for lack of control and marketability applied to the approximately $10m balance in the FLP's accounts at the time of the transfer to the CLAT.

In separate deficiency notices, the IRS determined a $5.87m estate tax deficiency and a $2.96 million gift tax deficiency for 2008. The IRS asserted that the 99% limited partner interest was worth approximately $8.52m on the date of death and that the sons' total remainder interest in the CLAT was worth approximately $8.36m because the decedent was terminally ill when the gift was made.

The estate moved for summary judgment in the Tax Court, asserting there was no estate or gift tax deficiency. The IRS moved for partial summary judgment, presenting three, apparently alternative, arguments: (1) the value of the cash and securities transferred from the decedent's revocable trust to the FLP in exchange for a 99% limited partnership interest is includible in the value of the decedent's gross estate under Section 2038(a); (2) the value of these assets is includible in the value of the gross estate under either Section 2036(a)(1) or 2036(a)(2); or (3) the value of the limited partnership interest that the decedent received is includible in the value of her gross estate because her son did not have authority to transfer that interest to the CLAT.

Law and analysis

Whether Section 2036(a) or Section 2035(a) applies

Section 2031(a) requires the value of a gross estate to include all of the decedent's property to the extent provided in Sections 2033-2046. Generally, Section 2036 requires the value of property that the decedent transferred be included in the gross estate if the decedent retained a right to income from the property or the right to designate a beneficiary of the property. Section 3028 generally requires the value of transferred property to be included in the value of the gross estate if, at the time of death, the decedent held the right to alter, amend, revoke or terminate the transferee's enjoyment of the property.

In the instant case, the IRS contended that: (1) Section 2036(a)(1) applied to the son's transfer of cash and securities to the FLP because the transfer was subject to an implied agreement through which the decedent retained possession or enjoyment of the transferred property or the right to income from the property, and (2) Section 2036(a)(2) applied because the decedent could have dissolved the partnership and designated who would receive the transferred property or income from the property. Further, the IRS asserted that the bona fide sale exception to Section 2036(a) did not apply because the estate did not show a significant nontax purpose for creating the FLP and, due to the claimed valuation discount, the transfer was not made for full and adequate consideration. The Tax Court concurred with the Service's Section 2036(a)(2) argument and therefore did not consider the Section 2036(a)(1) argument.

In response to the Section 2036(a)(2) argument, the estate asserted that the decedent did not retain her interest in the FLP at the time of death because, although her interest included the right to designate beneficiaries of the transferred assets, "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)."

Rejecting the estate's argument that the value of the gross estate should not include any portion of the value of the cash and securities transferred to the CLAT, the Court noted that: (1) the estate's position assumes that the transfer to the CLAT was valid, and (2) even if the transfer were valid, Section 2035(a) requires transfers to which Section 2036 might apply that occur within three years of a decedent's death to be included in the estate.

The Court cited Estate of Strangi v. Commissioner, T.C. Memo. 2013-145, as supporting its conclusion that the decedent's ability, with her sons, to dissolve the FLP constituted a right in conjunction with others to designate those who will possess or enjoy the property she transferred or the income from that property, within the meaning of Section 2036(a)(2). Under substantially similar facts, the Court concluded in Estate of Strangi that the "ability to join with others to dissolve the partnership justified the application of [S]ection 2036(a)(2) to the property he transferred in exchange for his partnership interest." Further, citing another parallel between the two cases, the Court pointed out that it had concluded in Estate of Strangi that, through his son-in-law, the decedent retained the right to determine the amount and timing of partnership distributions. (For more on Estate of Strangi, see Tax Alert 2005-582.)

Granting the Service's summary judgment motion, the Court concluded that the transfer of cash and securities to the FLP was subject to the decedent's retained right "'to designate the persons who shall possess or enjoy' those assets 'or income therefrom'" under Section 2036(a). Because the estate did not challenge the Service's assertion that the transfer did not constitute a bona fide sale for adequate and full compensation, the Court noted that: (1) if the decedent retained rights to the transferred cash and securities at the time of her death, their value must be included in her gross estate to the extent required under Section 2036(a); and (2) if her gift to the CLAT was valid (and she had actually given up all rights to the cash and securities), the value of the assets must nonetheless be included in her estate under Section 2035(a) because the transfer occurred less than three years before she died.

How Section 2043(a) limits amounts includible under Section 2036(a) or 2035(a)

The Court noted that both Sections 2036(a) and 2035(a) must be read in conjunction with Section 2043(a), which provides that, if a transfer like the one at issue involves insufficient consideration, "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 therefore by the decedent." In other words, if the decedent received inadequate consideration for a transfer, Section 2043(a) requires the estate to be made whole by including "the amount by which the transfer depletes the decedent's estate," the Court explained.

Having concluded that the transfer of cash and securities to the FLP constituted a transfer "'enumerated or described' in either [S]ection 2036(a)(2) or [S]ection 2035(a)," the Court noted that Section 2043(a) would limit the amount included in the gross estate to the amount that the fair market value (valued on the date of death) of the transferred cash and securities exceeded the value of the 99% limited partner interest in the revocable trust that was issued in exchange for the assets. But, because the estate did not challenge the Service's contention that the decedent's son had no significant nontax reason for creating the FLP, the transfer did not constitute a bona fide sale for adequate and full consideration. As a result, the Section 2043(a) limitation applied under either Section 2036(a)(2) or 2035(a) "includes in the value of the decedent's gross estate the amount of any discounts applicable in valuing the 99% limited partner interest … issued in exchange for the cash and securities (an amount that could colloquially be characterized as the 'hole' in the doughnut)." Nonetheless, if the gift to the CLAT were void or revocable, Section 2038(a) would apply and the value of the gross estate would "also include the value of that interest (the 'doughnut')," the Court explained.

Majority's application of 'recycling of value' theory

The majority opinion notes that this is the first time the court has applied Section 2043(a) "in accordance with its plain terms, to limit the amount includible in the value of a decedent's gross estate by reason of the application of either [S]ection 2036(a) or [S]ection 2038(a) to a transfer to a family limited partnership." This issue has not arisen, the Court states, because "in cases in which the decedent continues to own on the date of death part or all of the partnership interest she received in exchange for the transferred assets, the Commissioner customarily includes in the value of her gross estate the value of the assets transferred inter vivos to the partnership in lieu of the value of the partnership that the decedent actually owned at death." Because the IRS challenged, in the instant case, the validity of the gift (the donation to the CLAT) that the decedent used to dispose of her interest in the FLP, the Court now has "the opportunity to fill that lacuna and explain why a double inclusion in the decedent's estate is not only illogical, it is not allowed."

Citing Estate of Harper v. Commissioner, T.C. Memo 2002-121 (see Tax Alert 2002-517), the Court noted that it has previously "suggested that a partnership interest did not qualify as 'consideration', for purposes of either [S]ection 2036(a) or [S]ection 2043(a), if the formation of the partnership did not involve a genuine pooling of assets so that the value of the partnership interest issued to the decedent 'derived solely' from the assets he contributed." Fact patterns like this represent "a circuitous 'recycling' of value" rather than a true payment of consideration, the Court concluded.

Whether the gift to the CLAT was valid

Ultimately, the Court concurred with the Service's claim that the decedent's son lacked the authority under the POA to transfer the decedent's 99% limited partnership interest to the CLAT and, therefore, state (California) law deemed the gift as either void or revocable. Although the POA permitted the son to dispose of the decedent's property, the POA also limited the son's power to dispose by gift to the extent of the annual federal gift tax exclusion.

Rejecting the estate's assertion that the POA's ratification provision authorized the son to make the gift to the CLAT, the Court noted that "ratification generally occurs only after the agent's act in question," and "the provision on which the estate relies only ratifies acts done 'by virtue of' the POA." Having already concluded that the son made the transfer outside the authority granted to him in the POA, the Court determined that the ratification provision did not apply. Concluding that the transfer to the CLAT was either void or revocable, the Court agreed with the Service's contention that the entire value of the partnership interest was includable in the gross estate under Section 2033 (regarding property owned by a decedent at death) if the transfer was void or Section 2038 (regarding revocable transfers) if it was revocable.

Concurring opinion

The concurring opinion explains why seven of the 17 Tax Court judges who participated in this case would reach the same conclusion but for quite different reasons and felt the need to "write separately to emphasize what the Court did not decide and to highlight what the Court need not have decided." (Two other judges concurred with the majority opinion in conclusion only but did not participate in the concurring opinion, bringing to nine the total number who disagreed with the majority's reasoning.)

What the majority did not decide

The concurring opinion notes that the majority never addressed whether the FLP that held the 99% interest transferred to the CLAT was a valid partnership, pointing out that, although the decedent contributed $10 million in cash and securities, her sons "contributed nothing more than unsecured promissory notes." Further, when her one son transferred the decedent's assets to the FLP, he "was essentially negotiating with himself: He signed the partnership agreement both as a general partner of the partnership and for his mother as her trustee." The concurring opinion states that the invalidity of the partnership was not addressed because the Service did not articulate the issue and addressing it might require resolving disputed facts (which would have made the issue inappropriate for summary judgment).

What the majority need not have decided

The concurring opinion agrees that Section 2036(a)(2) applies to the instant facts, noting that the "decedent clearly 'made a transfer' of the $10 million in cash and securities. And she clearly retained the proverbial 'string' that pulls these assets back into her estate." But the concurrence does not follow the majority's "'double inclusion' problem," and instead views the FLP as "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)," the opinion explains, "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."

The concurring opinion finds precedent for its approach in a string of Tax Court cases, and sees "no double-counting problem if we read [S]ection 2036(a)(2), as it has always 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." Finally, the concurrence takes the majority to task for declining to "take this straightforward path to the correct result" and instead adopting "as the linchpin of its analysis [S]ection 2043(a)," which neither party cited in its brief.

Implications

This is a fully reviewed opinion because the Tax Court wanted to articulate the interaction between Section 2036 (or, if applicable, Section 2035) and Section 2043. Although the Tax Court has ruled on several occasions that Section 2036 applied to transfers to FLPs created during a decedent's life, this was the first time the facts presented a situation in which the decedent did not own the partnership interests received in the creation of the FLP at death (the partnership interests were owned by the CLAT, although the court subsequently ruled that the partnership assets were includable in the decedent's estate because the transfer to the CLAT was void or voidable).

Section 2043 includes in a decedent's estate transfers for insufficient consideration. However, the inclusion is limited to the difference between the value of the assets at the date of the decedent's death and value of the consideration received by the decedent in transactions to which Section 2036 may apply. In other words, the amount of any discounts and the appreciation of the assets between the date of transfer and the date of the decedent's death (the doughnut hole) are included in the decedent's estate. The estate does not include the assets actually transferred (the doughnut). The majority's theory is that to include the assets actually transferred would create a double counting in the decedent's gross estate — the assets transferred for insufficient consideration and the consideration received for the assets transferred (i.e., the partnership interest).

The concurring opinion admonishes the majority for taking an unnecessarily complex route to reach a conclusion that could have been arrived at rather straightforwardly, and on which the court had opined in several prior cases (noting in those cases that the decedent either owned the assets at death or had made a gift of the assets for no consideration). The concurring opinion reasons that, once the assets representing the partnership interest are included in the decedent's estate, the partnership has no value separate and apart from the assets. Therefore, there is no double counting as the majority opinion contends.

Under either theory, the amount includible in the decedent's estate was the date-of-death value of the assets transferred to the FLP. The concurring opinion perceives the majority opinion as validating the discounts in valuing the FLP interests for estate tax purposes and potentially inviting "overly aggressive tax planning." Although that may be true, the majority opinion seems to correctly apply the rules under Section 2036 (or Section 2035) and Section 2043.

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