Transfers of stock with retained voting rights.

Sec. 2036(a) requires that a decedent's gross estate include the value of transferred property to the extent the decedent, at his death or within three years of death, retained an interest in the transferred property. An "interest" is defined as "(1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom."

The classic transaction governed by Sec. 2036(a) involves a transfer in trust of property in which the transferor retains the right to the income for life. Under Sec. 2036(a), a decedent's estate will include the entire value of the trust corpus at the estate tax valuation date. In addition, transfers made with retained interests are also subject to Federal gift tax when made, even though the donee does not take possession of the property until a future date. The value of the gift will depend on whether the transferor has retained a qualified interest. The retained interest will be a qualified interest that may be valued and subtracted from the value of the total property transferred if any of the following apply:

* The transferor retains an annuity payable at least annually or the right to receive a fixed percentage of the corpus payable at least annually;

* The property is a residence transferred to an irrevocable trust and is to be used entirely as a personal residence by the person holding the income interest;

* No interest is transferred to or for the benefit of the donor's family;

* The transfer is wholly incomplete for gift tax purposes; or

* The transfer is to a "pooled income fund" or a qualifying charitable remainder trust when the "lead" interest is held by a member of the donor's family.

If the interest retained by the transferor is not a qualified interest, the entire value of the property transferred in trust will be subject to gift tax when transferred. If there is a qualified interest, the gift is the present value of the remainder. If, under Sec. 2036, the value of the trust property is included in the transferor's gross estate on death, adjustments are made in calculating the estate tax to adjust for the prior taxable gift.

As originally enacted, Sec. 2036 did not consider the retention of the right to vote stock transferred to another to be the retention of an interest for purposes of causing the inclusion of property in the decedent's gross estate. Sec. 2036(b) was later adopted to include the retention of the right to vote the transferred stock of a closely held corporation within the meaning of Sec. 2036(a)(1) if the decedent had the power to vote at least 20% of the corporation's stock. (This section was enacted in response to the 1972 case of Byrum. In that case, the Supreme Court held for the taxpayer when the decedent transferred the voting stock of closely held corporations to a trust paying income to a designated beneficiary for his life, while the taxpayer retained the right to vote the transferred stock and veto any attempted dispositions by the trustee. The IRS attempted to include the value of the trust corpus in the taxpayer's estate, claiming that the decedent maintained control over the corporation via the retention of voting rights of the transferred stock coupled with the voting privilege in the stock that he kept and, thus, he could withhold the payment of dividends to the trust. This would give the decedent the opportunity to designate the persons who received the income, causing estate inclusion under Sec. 2036(a)(2). The Service also argued that because the taxpayer retained the voting rights, the decedent still "enjoyed" the transferred stock under Sec. 2036(a)(1). The Supreme Court rejected these arguments and a legislative solution was sought.)

The enactment of Sec. 2036(b) results in the inclusion in the gross estate of the value of transferred stock when the transferor retains the right to vote. The provision also applies to the indirect retention of voting rights gained through a voting trust or otherwise.

Some states permit shareholders to modify voting rights by contract without the use of a voting trust; Ohio, for example, has a statutory provision that permits this via the use of what is known as a "close corporation agreement." This agreement can govern many corporate matters, including who may vote certain stock. There are no court cases indicating whether or not a close corporation agreement that retains a controlling vote to the transferor of voting stock would cause the stock to be included in his estate on death if the contract was in force at his death or within three years of death. It is likely, however, that such agreements will be problematic. Some courts have held that inclusion occurs if there is a side agreement or understanding in effect at the time of or prior to the transfer.

This begs the question, however, of what happens if the agreement is entered into after the transfer takes place. At the time of transfer, the transferor would have no retained interest in the property. Assuming no prior agreement or understanding between the parties exists and assuming no undue influence by the transferor, entering into an agreement such as this more than a short time after the transfer may work. However, the IRS has shown it has little patience for transactions designed with the primary purpose of circumventing these rules. Letter Ruling (TAM) 9518002, in which a taxpayer attempted to interpose a third party and use option agreements to transfer stock out of his estate but still retain voting control, was (not surprisingly) decided against the taxpayer.

One potential way around these problems would be to recapitalize the company into voting and nonvoting common stock. A transfer of nonvoting common stock will remove the value of the stock from the estate while the transferor retains voting control. Since the transferor has not retained the vote in the stock transferred, this should circumvent Sec. 2036.