Tax Me or Don't... but Stop Stringing Me Along After Estate of Powell, Is Gifting With Strings Attached Permissible?

• Jurisdiction: United States,Federal
• Author: By Joy Paeske, Esq.
• Publication year: 2018
• Citation: Vol. 24 No. 1

TAX ME OR DON'T... BUT STOP STRINGING ME ALONG AFTER ESTATE OF POWELL, IS GIFTING WITH STRINGS ATTACHED PERMISSIBLE?

By Joy Paeske, Esq.^*

I. EXECUTIVE SUMMARY

Estate of Powell v. Commissioner¹ is the first case to hold that retention of a limited partnership interest can also be the retention of the right to control the enjoyment of transferred property either alone or in conjunction with others under Section 2036(a)(2) ofthe Internal Revenue Code,² thus causing the entire value of any assets transferred to the partnership to be included in the decedent's taxable estate. Powell also advances a new methodology to calculate the valuation of the assets transferred to a family limited partnership, limited liability company, or corporation (hereinafter collectively referred to as "Entity") that should be included in a decedent's estate whenever Section 2035 or 2036 applies. Such methodology may result in double taxation of any appreciation in the value of Entity interests from the initial contribution to the Entity up to the date of the decedent's death.

Given Powell's unusual fact pattern involving deathbed planning, the ruling for estate tax inclusion of the Entity assets is not surprising. However, prior Tax Court cases involving Entities have generally been focused on estate tax inclusion of Entity assets in a decedent's estate under Section 2036(a) (1). While the Internal Revenue Service ("Service") has raised arguments for estate tax inclusion under Section 2036(a)(2) in prior cases, very few courts have given credence to these arguments and instead relied on Section 2036(a)(1) as the basis for inclusion of Entity assets in a decedent's estate. Therefore, while most practitioners have been mindful of the landmine posed by Section 2036(a)(2), the application of that subsection has caused less concern, either because the few cases that have addressed this provision had unusual facts, or because of a reliance on United States v. Byrum,³ discussed below.

II. SUMMARY OF CASES INVOLVING SECTION 2036(A) PRIOR TO POWELL

To help understand the issues in the Powell opinion, a brief background of Section 2036(a) is outlined below. Section 2036, entitled "Transfers with Life Estates," is concerned with "inter vivos transfers where outright disposition of the transferred property is delayed until the transferor's death."⁴ In general, Section 2036 requires that property transferred by a decedent with a retained life estate be included in the decedent's gross estate at its date of death value. Section 2036(a)(1) requires estate tax inclusion if a decedent retains the right to possess or enjoy the transferred property, or the income from it. Section 2036(a)(2) requires estate tax inclusion if a decedent retains the right, either alone or in conjunction with others, to designate the persons who can possess or enjoy the property or income from such transferred property.

A. Section 2036(a)(1)

Section 2036(a)(1) is concerned with whether a decedent retained a legally enforceable right or an "implied understanding" that such decedent would retain the enjoyment and possession of assets transferred to an Entity, or the income from it. Most litigation over estate tax inclusion of Entity assets is based on Section 2036(a)(1). In nearly two-thirds of these cases, the Service prevailed when the court found that a decedent made a transfer to an Entity with an implied agreement that the decedent retain enjoyment of the transferred assets during his or her lifetime. An implied understanding of retained enjoyment has been found when a pattern of distribution to the decedent based on decedent's needs existed, or the decedent failed to retain sufficient assets outside the Entity to cover the decedent's living expenses, including payment of the estate tax.

B. Section 2036(a)(2)

Section 2036(a)(2) includes in a decedent's gross estate transfers in which the decedent retained control over others' interests in the transferred property—namely, the power to decide who will have the right to use or possess the property or the income from such property. Section 2036(a)(2) requires inclusion even when the transferor did not retain a direct beneficial interest in the transferred property following the transfer but merely controlled who would. Until Powell, there were very few published cases with significant discussion of Section 2036(a)(2). In these cases, the Service sought to argue that significant control or influence should equate to the right to control or designate who could enjoy the property contributed to the Entity.

1. United States v. Byrum

In United States v. Byrum,⁵ the decedent, Mr. Byrum, had been a majority shareholder in three closely held corporations. While each corporation had minority shareholders unrelated to the decedent, Mr. Byrum owned over 70% of the stock in each corporation. Mr. Byrum transferred shares of stock in each of the three corporations to a trust for the benefit of his children. He named an independent corporate trustee of the trust and gave the corporate trustee broad powers with respect to control and management of the trust, with the exception of the following retained powers: (i) to vote the transferred shares; (ii) to veto the sale or transfer of any trust assets, including the shares transferred to the trust; (iii) to approve investments and reinvestments; and (iv) to remove the trustee and designate another corporate Trustee to serve as successor.⁶ The Service argued that because Mr. Byrum had the power to use his majority position and influence over the corporate directors to regulate the flow of dividends, he could control the flow of income to the trust and therefore designate the persons who could enjoy the income from the transferred stock.⁷

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The Supreme Court began its analysis by defining the term "right" within the meaning of Section 2036(a)(2) as "an ascertainable and legally enforceable power."⁸ The court reasoned that because a majority shareholder owes legally enforceable fiduciary duties to the other shareholders, such duties preclude the imputation of a right to designate under Section 2036(a)(2).⁹ Because Mr. Byrum's right to vote the transferred stock was circumscribed by a corporate fiduciary duty, he did not have a legally enforceable right to vote the shares in a manner that would achieve his personal or family-related objectives.¹⁰ Further, while Mr. Byrum did retain the right to vote shares held by the trust and to veto investments and reinvestments, the corporate trustee alone, not Mr. Byrum, had the right to pay out or withhold income, and to designate who among the beneficiaries enjoyed such income.¹¹ The end result was no inclusion under Section 2036(a)(2).

2. Estate of Strangi v. Commissioner

Estate of Strangi v. Commissioner¹² is the quintessential "bad facts" deathbed planning case. In Strangi, the Tax Court considered the issue whether Section 2036 should apply to cause estate tax inclusion of assets transferred to an Entity shortly before Mr. Strangi's death. Acting under a power of attorney, Mr. Strangi's son-in-law, Mr. Gulig, commenced the following course of action within two months of Mr. Strangi's death. First, acting in his capacity as Mr. Strangi's attorney-in-fact, Mr. Gulig created a limited partnership to which he transferred approximately 98% of Mr. Strangi's wealth in exchange for a 99% limited partnership interest. The general partner of the partnership was a corporation. Additionally, Mr. Gulig, again, acting in his capacity as Mr. Strangi's attorney-in-fact, transferred assets to the corporate general partner in exchange for a 47% interest in the corporation. Mr. Strangi's children transferred assets to the corporation in exchange for the remaining 53% interest in the corporation. Prior to Mr. Strangi's death, the partnership assets were used to pay for Mr. Strangi's personal expenses, including medical bills and housekeeping expenses. Additionally, Mr. Strangi continued living in the residence transferred to the partnership without paying rent.

On remand, the Tax Court held that Section 2036(a)(1) applied due to an implied agreement that Mr. Strangi would retain enjoyment of the assets transferred to the partnership. However, the court also found that Section 2036(a)(2) applied based on Mr. Strangi's ability to control two different aspects of the partnership. First, Mr. Strangi retained the right to vote on partnership liquidation. Under the partnership agreement, if all the limited partners and the general partner agreed, a liquidation could occur. Also under the shareholders' agreement, the corporate general partner could consent to partnership liquidation. Second, because Mr. Strangi owned a 47% interest in the corporate general partner, Mr. Strangi could act together with the other shareholders of the corporate general partner to control partnership distributions.

The Strangi court distinguished Byrum because it believed that any fiduciary duties owed by Mr. Strangi to his children were "illusory."¹³ Because Mr. Gulig was Mr. Strangi's attorney-in-fact, the court did not believe that Mr. Gulig would disregard his preexisting obligation to Mr. Strangi. Also, because Mr. Strangi owned 99% of the partnership, any fiduciary duties that limited his authority were "essentially to himself."¹⁴ The court concluded that "[i]ntra family fiduciary duties within an investment vehicle simply are not equivalent in nature to the obligations created by [the] United States v. Byrum. . . scenario."¹⁵

3. Kimbell v. U.S.

In Kimbell v. U.S.,¹⁶ the decedent transferred assets to a limited partnership in exchange for a 99% limited partnership interest. The 1% general partner was a limited liability company ("LLC") owned 50% by the decedent and 25% by each of her children. The decedent's son was the manager of the general partner LLC. The partnership agreement provided that 70% of the limited partner interests could remove the general partner. Further, the partnership agreement...