In Estate of Trombetta v. Commissioner, (T.C. Memo. 2013-234),the Tax Court ruled that a taxpayer’s lifetime transfers of real property to two trusts were transfers with a retained interest, and, therefore, the properties were includible in her gross estate. The court also ruled that the estate wasn’t entitled to a charitable contribution deduction, but was entitled to a deduction for mortgage indebtedness.
Taxpayer Transferred Properties to Trusts
Helen Trombetta, a California resident, owned two apartment buildings known as the Black Walnut Square property and the Tierra Plaza property. In 1993, Helen transferred these properties to an annuity trust of which she was the sole grantor and sole beneficiary. Helen was also a trustee of the trust, together with three of her children. She possessed 50 percent of the trust voting rights, with the three other trustees splitting the remaining voting rights. The trust agreement provided that Helen would receive an annuity from the trust for 180 months; however, she had the power to reduce the term at any time. At the later of the termination of the annuity term and Helen’s death, the property in the trust would pass to Helen’s descendants. Helen intended for her retained interest in the properties to be a qualified interest under Internal Revenue Code Section 2702(b)(1).
Both the Black Walnut Square and the Tierra Plaza properties were subject to mortgages for which Helen was personally liable; following the transfers, the trust paid the interest and principal owed on the mortgages, although the trust never assumed the mortgages. The trust agreement provided that in the event the trust income exceeded the annuity payment due for a given month, the trustees could distribute the excess income to Helen or allow the income to accumulate in the trust.
The same year, Helen also transferred a residential property, known as the Modesto property, to a trust that was intended to be a qualified personal residence trust under IRC Section 2702 (the residence trust). The trust agreement provided that Helen had the right to use the trust property as a personal residence and the right to receive the trust income. The trust term was 180 months, subject to Helen’s power to reduce the term. Upon termination, if Helen was living, the trust property would be distributed to her descendants. If Helen wasn’t living, the property would be distributed as provided in her will.
Helen reported the transfers to the annuity trust and the residence trust on her 1993 gift tax return. She reported that the Black Walnut Square and Tierra Plaza properties had a net value of $1,425,802 and that her retained interest had a value of $921,809; therefore, the value of the gift to the annuity trust was $503,993. Helen reported that the Modesto property had a net value of $150,000 and that her retained interest had a value of $92,491; therefore, the value of the gift to the residence trust was $57,509.
From 1994 to 2001, the amounts of the annuity payments to Helen from the annuity trust often differed from the schedule set forth in the trust agreement. For months in which Helen needed less income, the trustees made smaller distributions than required by the trust agreement and agreed that the undistributed portion of the annuity payments, together with accrued interest, would be paid to Helen or her estate at a later date. For months in which Helen needed more income, the trustees made distributions in excess of those required by the trust agreement, thereby reducing any balance owed to Helen from the trust. In 1999, at Helen’s direction, the annuity trust entered into a 34-year residential lease and option agreement. In 2001, Helen determined that she no longer needed the full amount of the annuity payments to meet her living expenses; therefore, for the remainder of the trust term, the annuity payments to Helen were less than the scheduled amounts due. That same year, the annuity trust paid off the mortgage secured by the Black Walnut Square property and borrowed $721,801.27 from Helen Properties, L.P., a limited partnership formed by Helen. The promissory note, for which Helen was personally liable, was secured by the Tierra Plaza and Black Walnut Square properties.
In 2006, Helen, having been diagnosed with cancer, reduced the term of the annuity trust by 24 months so that the trust would terminate on July 31, 2006. She also reduced the residence trust term such that the trust would terminate in the month following her death. She further amended the residence trust agreement and her will to provide that if the trust terminated after her death, the Modesto property would be transferred to a charitable remainder unitrust (CRUT). In amending the residence trust, Helen believed her estate would be entitled to a charitable contribution deduction of $250,000.
Helen died on Sept. 15, 2006. The annuity trust paid to the Helen’s estate the balance of $121,979.28 that was due to her from underpayments on the scheduled annuities. The trustee of the residence trust created the Helen Trombetta Charitable Remainder Unitrust and transferred the Modesto property to the CRUT. The trustee of the residence trust then filed a petition for reformation of the trust with the California superior court. The trustee argued that the Helen’s intent in amending the residence trust agreement was to remove the assets in the trust from her estate, which could only be accomplished by terminating the residence trust before she died. However, Helen erroneously amended the residence trust agreement to provide for the termination of the trust after her death. The trustee requested that the amendment be altered to provide that the trust term would instead terminate prior to Helen’s death. The court granted the trustee’s request.
Helen’s estate tax return didn’t include the Tierra Plaza, Black Walnut Square or Modesto properties in the value of Helen’s gross estate. The estate tax return also took a charitable contribution deduction for the value of the property transferred to the CRUT and a deduction for the unpaid amount of the indebtedness attributable to the promissory note from Helen Properties, L.P. The Internal Revenue Service issued a notice of deficiency, arguing that the full fair market values of the Tierra Plaza, Black Walnut Square and Modesto properties should have been included in the Helen’s estate and that both the charitable contribution deduction and the mortgage payable deduction should be disallowed.
Annuity Trust
The Tax Court held that the entire value of the Tierra Plaza and Black Walnut Square properties was includible in Helens’ estate under IRC Section 2036(a) because there was an implied understanding between the Helen and the trustees that Helen would retain lifetime possession or enjoyment of the properties. The factors contributing to the court’s decision were: (1) Helen made all decisions with respect to the properties and the trustees generally acted on Helen’s recommendation, (2) Helen took the lead role in negotiating and refinancing the properties following their transfer to the annuity trust, (3) Helen retained sole signatory authority with respect to the disposition of the properties and, therefore, retained de facto control over the properties and their disposition, (4) Helen and her children could distribute income in excess of the scheduled annuity payments to Helen, allowing her to maintain the same enjoyment of the properties and their income stream as she had before the properties were transferred to the annuity trust, (5) the annuity trust applied the income from the properties to discharge Helen’s loan obligations with respect to the properties, and (6) Helen’s motivation in transferring the properties to the annuity trust was minimizing her estate taxes and didn’t have a legitimate business purpose. The combination of these factors led the court to conclude Helen didn’t absolutely part with all title, possession and enjoyment of the transferred properties. The court declined to hold that Helen retained an interest only in the annuity payments and instead found that Helen retained an interest in the entirety of the transferred properties. The court rejected the estate’s argument that Section 2036(a) shouldn’t apply to Helen’s transfers of the Tierra Plaza and Black Walnut Square properties because the transfers were part of a bona fide sale in exchange for full and adequate consideration. The court reasoned that since a portion of the transfers to the annuity trust was a gift by Helen, she didn’t transfer the properties for full and adequate consideration. Furthermore, the transfers weren’t arm’s-length transactions; instead, Helen, as the sole beneficiary and sole grantor of the annuity trust, stood on both sides of the transaction.
The court also rejected the estate’s assertion that there was a bona fide sale because Helen had a nontax purpose for the transfers. Courts generally apply the “legitimate and significant nontax reasons” standard to determine whether a bona fide sale has taken place in the context of a transfer to a family limited partnership. The court declined to apply a similar standard to determine whether the bona fide sale exception was met in this case, stating that a transfer to a grantor trust isn’t comparable to a transfer to a family limited partnership, particularly when no individual other than the grantor has a present interest in the trust. The court further concluded that Helen’s reduction of the annuity trust term constituted a relinquishment of a right with respect to the properties, and, therefore, the value of the transferred properties was includible in Helen’s gross estate under IRC Section 2035. When Helen reduced the trust term, she relinquished the right to: (1) receive the annuity payments, (2) distribute excess income to herself, (3) invade trust corpus, and (4) change the amounts of the distributions to the remainder beneficiaries. Since Helen relinquished these rights within three years of her death, Section 2035 required that the properties in the annuity trust be included in her gross estate.
Residence Trust
The Tax Court found that Helen also retained possession and enjoyment of the Modesto property within the meaning of Section 2036(a)(1) because she had the right to reside in and actually did reside in that property until her death. Therefore, the full value of the Modesto property was includible in her gross estate.
Charitable Contribution Deduction
The Tax Court disallowed the estate’s claimed charitable contribution deduction because the property passed to charity as a result of the trustee’s actions rather than Helen’s actions. Pursuant to the judicial reformation of the residence trust, the trust term ended before Helen’s death; Accordingly, the trust property should have passed to Helen’s descendants. The trustee, nevertheless, distributed the trust property to the CRUT. Since the trust agreement didn’t provide that the trust property would pass to the CRUT if the trust terminated prior to Helen’s death, the estate wasn’t entitled to a charitable contribution deduction.
Mortgages Payable Deduction
Finally, the Tax Court concluded that since Helen was personally liable for the mortgage indebtedness identified by the promissory note issued to Helen Properties, L.P. on behalf of the annuity trust, Helen’s estate was entitled to deduct the full unpaid amount of the indebtedness attributable to the promissory note.