The purpose of Section 2036(a) is to include in a decedent’s gross estate the values of any inter vivos (during life) transfers that are essentially testamentary (at death) in nature. Section 2036(a) applies only when three conditions are satisfied:
- The decedent made an inter vivos transfer of property;
- The decedent’s transfer was not a bona fide sale for full and adequate consideration; and
- The decedent retained an interest or right in the property that they did not relinquish before death.
The recently published Tax Court case of Estate of Clyde W. Turner, Sr. provides an in-depth discussion of Section 2036 with regards to determining whether the assets transferred during life were includable in the decedent’s estate.
The decedent, Clyde W. Turner, Sr., had formed a successful lumber company with his brothers during his life. Clyde used income generated by the company to acquire additional wealth, primarily consisting of bank stock. His family retained an estate planner who subsequently established the Turner & Company Limited Liability Partnership (the partnership.)
The partnership was funded with cash, shares of bank stock, CDs, and various other investment accounts. Its three general purposes listed in the partnership agreement were to make a profit, to increase the family’s wealth, and to provide a means whereby family members can become more knowledgeable about the management and preservation of their assets.
In addition to the three general purposes, the partnership agreement also listed nine specific purposes including: management by the most qualified person, elimination of fractional ownership, facilitation of gifting, protection of assets, protection against creditors, protection against failed marriages, increased family involvement regarding investments, avoiding family disputes, and governing family transfers.
At this point Clyde was in his 80s and in good health. He opted to retain $2 million of assets outside of the partnership. Later, he and his wife gave limited partnership interests in the partnership to their three children and grandchildren. The following year Clyde became seriously ill and passed away. At the time of his death, he still held a .5% general partner interest and a 27.8% limited partner interest in the partnership. The IRS issued a notice of deficiency, determining that the value of assets Clyde transferred should be included in his gross estate under Section 2036.
The court engaged in a lengthy analysis of Section 2036 and first determined that an inter vivos transfer took place when Clyde’s assets were transferred to the partnership in exchange for his general and limited partner interest. The court next looked to whether the exchange constituted a bona fide transaction, thus excepting the transfer from Section 2036.
A bona fide sale exception requires both an arm’s length transaction, and full and adequate consideration. Because the exchange here was within the context of a family limited partnership, the record must show the existence of a legitimate and significant non-tax reason for the creation of the partnership.
The court found that the reasons provided in the partnership agreement failed to establish a legitimate and significant nontax reason for the formation of it. Although consolidation of assets could be a legitimate nontax purpose, this is not the case if the partnership is “just a vehicle for changing the form of the investment in the assets, a mere asset container.”
In this case, the assets consisted of passive investments that did not require active management. Clyde even stated that he wanted to form the partnership because he lacked a coherent investment plan. The court interpreted this as showing there was nothing unique to protect or perpetuate. Additionally, although resolution of family disputes may be a legitimate nontax purpose, no such purpose was found here. Any ill will existing among the children was not related to money, and therefore, could not be solved by creation of the partnership. Furthermore, family asset protection reason was also found unpersuasive.
Additionally, the court noted several additional factors that indicated that the transfers were not a bona fide sale, including the following:
- The decedent stood on both sides of the transaction,
- The partnership was established without the other family members, co-mingling of personal and partnership funds and paying estate planning fees from the partnership, and
- Assets were not transferred to the partnership until 8 months after its formation.
Ultimately, the bona fide sale exception did not apply to the decedent’s transfer.
The final inquiry concerned whether Clyde retained, for his life, the possession or enjoyment of the transferred property. Generally, property is included in a decedent’s gross estate, if he retained, by express or implied agreement, possession or enjoyment of the right to income from the transferred property.
Factors indicating that Clyde retained an interest in the transferred assets include a transfer of most of his assets, continued use of the transferred property, co-mingling of personal and partnership assets, disproportionate distributions to the transferor, use of partnership funds for personal expenses, and testamentary characteristics of the arrangement.
The first issue concerned the management fees Clyde paid to himself. The partnership agreement allowed for reasonable management fees, but the court found $2,000 per month to be excessive, especially considering evidence suggesting that he did not manage the partnership at all, and he had already retained enough assets outside of the partnership to satisfy his living expenses. The court also found that the partnership resembled an investment account, from which withdrawals could be made at any time, rather than a business activity conducted for profit.
The second issue concerned Clyde’s personal attachments to the bank stock – he had made it clear that he was fond of the stock and it was never to be sold. The court interpreted this as an implied agreement. Finally, the court found the family’s testimony – that tax savings were never discussed – to be lacking in credibility, which in turn affects the credibility of testimony concerning the intended purpose of the partnership.
The court went further and found that Clyde, under Section 2036(a)(2,) retained the right to designate the person who shall enjoy or possess the property. The court reached this conclusion by noting that Clyde, as a general partner, had absolute discretion to make distributions of the partnership income and had authority to amend the partnership agreement at any time without consent of the limited partners.
Consequently, Section 2036 includes the values of the transferred property in Clyde’s estate.
Hyman G. Darling, Esq.
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