Third Circuit allows exclusion of asset from gross estate when only remainder interest had been sold.

In Est. of D'Ambrosio, 101 F3d 309 (1996), rev'g 105 TC 252 (1995), the Third Circuit ruled that preferred stock was excludible from the gross estate when a decedent had sold only the remainder interest m the stock. Prior cases had required that the entire (fee simple) interest in the property be sold for it to be excludible from the gross estate.

Sec. 2036(a) includes in the gross estate "the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life ... 1. the possession or enjoyment of, or the right to the income from, the property...." If adequate consideration is not received, the transferred property is included in the transferor's gross estate, less the consideration received, under Sec. 2043(a). Sec. 2031 (a) requires the date of death value to be used for the gross estate (unless the alternate valuation date is elected under Sec. 2032). Typical Sec. 2036(a) situations include the decedent giving his residence to relatives but retaining the right to occupy it for life or the decedent giving land or securities to relatives and retaining the right to income for life. In these situations, the assets are included in the decedent's gross estate. (The remainder interest in these examples is the right to receive the assets when the decedent dies.)

In D'Ambrosio, Rose D'Ambrosio and her son owned all of the stock of Vaparo Corporation in 1983. Between 1983 and 1987, Rose gave all of her stock, except for 470 noncumulative preferred shares, to unidentified donees. In 1987, at age 80, she sold the remainder interest in the 470 preferred shares to Vaparo for $1,324,014, which she would receive as an annuity. (This amount was calculated using the actuarial tables under Regs. Sec. 20.2031.) The entire value of the preferred shares was $2,350,000, which left $1,025,986 for the income interest that she retained. When she died in 1990, she had received two annuity payments totaling $592,078. Also, she had received $23,500 in dividends in 1987, but no dividends were paid from 1988-1990. (Since the parties stipulated to these valuations, the Tax Court accepted them. However, the court noted that a life estate in noncumulative preferred stock that paid infrequent dividends might have no value.)

Rose's executrix did not include any interest in the preferred stock in Rose's gross estate. The IRS added the date-of-death value of the preferred stock, less the value of the annuity, to her gross estate, for a net adjustment of $1,025,986. (The value of the stock had not changed since 1987.) The Service argued that the "bona fide sale" exception in Sec. 2036(a) applied only if the entire interest in the property was sold for its fair market value (FMV), while Rose had sold only the remainder interest. The executrix argued that the entire interest in property consists of the life estate plus the remainder; since Rose sold the remainder for its FMV and retained the life estate, her entire interest in the property was accounted for. Both the annuity payments of $592,078 and the dividends of $23,500 were included in her gross estate under Sec. 2033.

The Tax Court, relying on previous cases, ruled that the sale of the remainder interest did not qualify as a bona fide sale under Sec. 2036(a). Regarding this technique as an abusive tax avoidance scheme, the court concluded that Rose's transfer of the remainder interest at age 80 to a family-owned corporation for over $1 million less than the entire value of the stock was an attempt to deplete the gross estate.

The Court of Appeals ruled that Rose's sale was a bona fide sale under Sec. 2036 and therefore the stock was excludible from her gross estate. To support its ruling, the court examined the cases relied on by the IRS and the Tax Court in light of the language and objective of Sec. 2036(a). Two of these cases involved a widow's election in community property states. The husband's will offered the widow a life estate in all of the community property or the entire interest in the half of the community property that she already owned. A third case involved a similar choice in a divorce situation. In each case, the taxpayers chose the life estate. The Court of Appeals in D'Ambrosio described the choice each woman made as trading "the remainder interest in her half of the community property in exchange for a life estate in her husband's half."

In deciding after the women died whether these transactions qualified for the bona fide sale exception in Sec. 2036(a), the courts compared the entire interest in the half of the community property transferred to the life estate to the half of the community property received. Not surprisingly, the courts ruled that there were no bona fide sales, since the purchaser did not pay for the entire interest when only receiving a remainder interest.

Examining the language of Sec. 2036(a), the Court of Appeals in D'Ambrosio ruled that "extent of any interest therein" means the remainder interest, and it is the remainder that is included in the transferor's gross estate under Sec. 2036(a) if there is no bona fide sale. From a policy standpoint, the court pointed out that the objective of Sec. 2036(a) is to prevent the depletion of the gross estate by transfers for less than FMV The court presented examples demonstrating that the value of the gross estate is unchanged when the remainder interest is sold for its FMV. These examples assume that the transferor lives exactly as long as predicted by the actuarial tables and that the return on investment for the consideration received equals the return on the remainder transferred. These assumptions are valid over large numbers of taxpayers.

D'Ambrosio is binding only in Pennsylvania, New Jersey and Delaware. It is uncertain whether other circuits or the Tax Court will adopt this ruling. (Perhaps the Supreme Court will ultimately decide the issue.) From Peter Barton, CPA, MBA, J.D., Professor of Accounting, College of Business and Economics, University of Wisconsin-Whitewater, Whitewater, Wisc.