In “How Soon Is Now: Estate of Moore & the Unraveling of Deathbed Estate Planning,” Professor Beckett G. Cantley and Geoffrey C. Dietrich discuss in detail the interpretation and application of Internal Revenue Code Section 2036 by the Tax Court to so-called deathbed transfers, relevant cases, including Moore, and the policy behind the Tax Court’s interpretation of the rules.
Background
Cantley and Dietrich start off with a brief summary of the federal gift and estate tax laws as they apply today to individuals who make gifts or have a taxable estate in excess of $11.7 million. They then go on to explain the common end-of-life transactions that may attract the attention of the Internal Revenue Service and caution against such last-minute planning due to the uncertainty over whether such deathbed planning will in fact accomplish the decedent’s tax objectives.
Two transactions frequently scrutinized by the IRS involve: (i) family limited partnerships (FLPs) and (ii) the use of valuation discounts to leverage the lifetime gift tax exemption. In the context of an FLP, family members serve as general or limited partners of a family business or other pooled assets. Rather than making a capital contribution to the FLP, limited partners are gifted their ownership interest by a senior member of the family and have little control over the management of the FLP. These limited partnership interests generally will have a lower value than the underlying assets of the FLP, due to lack of marketability of the interest and lack of control by the limited partner over the FLP, both resulting in a lower valuation of the partnership interest for estate or gift tax purposes.
The article opines that the opportunity to make discounted transfers of FLP interests doesn’t end at the initial transfer of ownership interest to a limited partner, but can continue into other estate and tax planning transactions. Transfer of an FLP interest to a grantor retained annuity trust (GRAT) or charitable lead annuity trust (CLAT) enables the grantor to take an additional valuation discount for the retained right to the FLP’s income stream for a term of years, which would have a lower value than transferring the FLP interest as an outright gift. Sales to children, other family members or trusts also provide a means to transfer FLP interests presumably at a value lower than outright sale of the underlying assets. While the sale will result in the frozen value of the FLP interest remaining in the transferor’s estate, all appreciation will be moved out of the estate and to the purchaser, while using little or no gift tax exemption.
While the article provides a simplified explanation of the mechanics of GRATs and CLATs, Cantley and Dietrich could clarify how these specific trust structures differ from other types of trusts to allow for further discounting, specifically by including a brief discussion of IRC Sections 2702 and 7520.
IRC Section 2036(a)
IRC Section 2036(a) includes in the value of a decedent’s gross estate any property over which the decedent retained possession or enjoyment, had the right to possess or enjoy, or had the right to designate who shall possess or enjoy such property. The article provides insight into congressional intent behind the purpose of this Section, and then goes on to discuss the interpretation and application of IRC Section 2036 by the IRS and Tax Court in the fundamental cases Estate of Bongard, Estate of Strangi, Estate of Powell and Estate of Moore.
In each of these cases, the Tax Court applied the following test to determine whether IRC Section 2036 may apply to the transfer of property, namely FLP interests: (1) the decedent made a lifetime transfer of property; (2) the transfer was not a bona fide sale for adequate and full consideration, which requires that there be a legitimate nontax reason for the FLP; and (3) the decedent retained an interest or right enumerated in Section 2036(a)(1) or (2) or (b) in the transferred property that the decedent did not relinquish before death.
Cantley and Dietrich then discuss their view on the policy behind application of Section 2036 and focus primarily on its effect on deathbed transfers. Although the pertinent case law reflects a pattern of transfers being made for tax planning purposes very near the transferor’s death, the article’s focus on the relationship between the application of Section 2036 and deathbed planning may be too pronounced. While it’s accurate to use these cases and Section 2036, together with IRC Section 2035, to caution against tax planning at the end of one’s life, it’s important to note that the timing of a transfer isn’t part of the Section 2036 multipronged test applied by the Tax Court. Deathbed transfers clearly strengthen the argument that a legitimate nontax reason didn’t exist for creating the FLP, but that argument could be made in any situation in which an FLP was established as part of a comprehensive estate and tax planning structure. Cantley and Dietrich allude to this risk that Section 2036 should be considered for any FLP transfers (not just deathbed transfers) in their discussion regarding steps to take in order to avoid application of Section 2036 but could be more clear in their explanation.