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Assets includible in a transferor's estate.

A common challenge encountered by practitioners working in the estate and financial planning area is how to help a taxpayer retain lifetime control or enjoyment of an asset while eliminating the asset from the taxpayer's estate. For many years a straightforward and successful approach allowed taxpayers simply to transfer a remainder interest in the asset, while retaining a life estate in it or its income. It was argued that since the transferor's interest, i.e., the life estate, terminated at his death, the transferor possessed no interest in the asset capable of estate inclusion. Court decisions and statutory enactments, however, largely eliminated this tactic. The end was signaled in the Supreme Court's landmark decision in Church.' The Court applied a substanceover-form-type analysis to find the life-estatetransfer-of-remainder gambit analogous to a testamentary transfer, and the asset involved includible in the transferor's estate.

See. 2036 constitutes the principal statutory impediment to using the life-estate-transfer-of-remainder stratagem. In recent years the provision has been increasingly identified with its provisions concerning traditional corporate and partnership estate freezes. Sec. 2036's scope extends much further, however: Sec. 2036(a)is of primary importance to most attempts at retaining enjoyment of an asset while avoiding its estate inclusion. Somewhat surprisingly, the amendment of Sec. 2036(c) during the late 1980s, and the expansive interpretation accorded it by the Service in Notice 89-99) gave the Service an additional weapon with which to seek estate inclusion for transactions typically scrutinized under Sec. 2036(a).

The repeal of Sec. 2036(c) in the Revenue Reconciliation Act of 1990 (RRA) did away with this additional threat to inclusion. The legislative actions, however, were not entirely benevolent. As part of the RRA, provisions were enacted that make many Sec. 2036 planning techniques vulnerable to gift tax, while leaving open the potential application of estate inclusion under Sec. 2036(a).

This article will examine the scope of Sec. 2036(a), the planning options available for contending with its provisions and the impact of relevant RRA provisions and recently proposed regulations on such options. Sec. 2036(a) Sec. 2036(a)requires that the gross estate of a decedent include the value of all interests in property that the decedent has transferred (for less than adequate and full consideration in money or money's worth in a bona fide sale), in which the decedent has retained:

[] The possession of, enjoyment of, or right to income from, the property, or

[] The right, either alone or in conjunction with another, to designate who will enjoy or possess the property or income therefrom, for any of the following:

1. The transferor's life.

2. A period not ascertainable without reference to the transferor's death. For example, a transfer will not avoid Sec. 2036's provisions if it involves a transfer of property in trust, with income to be paid to the transferor at the end of each year, except for the year in which he dies, with the remainder on his death to go to another person. It should be noted that Sec. 2036 or 2037 may cause an inclusion of transferred property in the transferor's gross estate when he retains a reversionary interest in the property, or income thereto, even if this does not come to fruition. 3. A period that does not in fact end before the transferor's death.

Example 1: X transfers property in trust retaining an interest in income from the property for 10 years and providing that following the 10-year period the remainder is to go to Z. X dies in the seventh year following the transfer. Since X's interest survived his death, Sec. 2036 requires an inclusion in X's estate.

* Transactions included in a gross estate

The diversity of situations susceptible to inclusion in a transferor's gross estate under Sec. 90361a1 is substantial. Transfers in trust when the transferor retained the right to discharge the trustee: This treatment has been applied even though the transferor did not retain a potential direct interest in the possession or enjoyment of the transferred property? The reasoning behind this treatment is that the taxpayer's ability to remove the trustee is tantamount to actual control over the trust income or corpus.

While retention of a power to remove or discharge is often desirable, it is clearly fatal to avoiding estate inclusion. Alternative courses of action, which may allay grantor fears of unsatisfactory conduct by a trustee, and which do not entail as severe a risk of estate inclusion, include the careful selection of a friend or trusted third party to serve as trustee, and providing a power to remove or discharge a trustee, based on express conditions, to a trusted third party.

Transfers with regard to which the transferor (grantor) has retained the power to designate who will possess or enjoy the transferred property or the income therefrom.4 Transfers of assets made to another, e.g., a trust, to be used to discharge a legal obligation of the transferor:s Examples include the use of the transferred assets or the income there from to pay creditors of the transferor, or legal obligations of child support of the transferor. To be includible in the transferor's estate the obligation must be outstanding at the transferor's death. Example 2: Transferor T transfers assets in trust to provide income for the support of his four children until they reach the age of majority. On a child's reaching the age of majority, that child's share of income will be paid to him directly each year; on the death of a child, the child's interest will go outright to the child's estate. At the time of T's death only one of the four children is below the age of majority. As a result, only one-fourth of the income of the trust is considered to be expended to discharge a legal obligation of the transferor and, thus, is the percentage of the value of the property in trust includible in the transferor's estate under Sec. 2036(a).

Transfers made subject to the reciprocal trust doctrine:6 The reciprocal trust constitutes an apparently crafty, but usually futile, attempt to retain enjoyment of property while keeping it out of the transferor's estate. To the extent transfers in trust are found reciprocal, a grantor-transferor will be deemed to have retained enjoyment or possession of the property transferred. Case law reveals that reciprocal trusts will be found to the extent the following two elements are deemed extant: (1) The trusts are interrelated and (2) the arrangement, to the extent of mutual value, leaves the grantors in the same economic position they would have been in had they retained control over the income they transferred in trust.7

The treatment of reciprocal trusts is based on the net effect of the transfer. According to the Supreme Court, the motives of the respective grantors are not relevant to a determination of whether reciprocal trusts exist.

Example 3: X and Y are brothers. Each agrees to transfer $100,000 in trust. The trust established by X provides that the $100,000 he transferred will be held in trust, with income payable to Y for life, with the remainder to Y's children. The trust established by Y mirrors that of X, and provides that $100,000 will be held in trust, with income to X for life and the remainder to X's children.

Based on these facts it appears that the trusts are interrelated and have a mutual value of $100,000. Thus, the entire value transferred in trust by X should be includible in his estate. The value transferred in trust by Y, meanwhile, should be included in Y's estate. Had X transferred $60,000 in trust and Y $100,000, only $60,000 would be includible in each estate under the reciprocal trust doctrine.

The Est. of Levy[8] case, however, suggests that reciprocal trusts will not be found when substantive differences exist between the terms of the trusts. In Levy, the trusts were found to be substantially different because one trust provided a special power of appointment over either income or corpus for the benefit of the income beneficiary, and the other did not. Despite the outcome in Levy, taxpayers should be aware of the significant risk of having trusts found to be reciprocal when they appear interdependent and substantially similar.

Under the new rules, a reciprocal trust will likely be viewed as a transfer of a remainder interest in property with retention of a term interest by the transferor to the extent of mutual value. As a consequence of the retained interest probably not constituting a qualified interest, a gift will typically be considered made of the entire value of the property. Should estate inclusion occur later, the amount so included will be reduced in light of any gift taxes already paid?

Purported transfer of entire interest in property, while transferor continues to use the property until death: This is a common matter of dispute between the Service and taxpayers. Using a substance-over-form-type argument, there would seem to be little doubt that when a purported transferor continues to use an asset for life, even though ownership of the asset has been transferred to another, a life estate in possession or enjoyment of the asset should be found. In fact, this approach has been used by the courts to find Sec. 2036 applicable when the transferor continued to use an asset for life even though such use was pursuant to an unenforceable agreement? The courts seem to have carved out an exception, however, for continued use by a transferor of a residence to which title has been transferred to the transferor's spouse. [11]

Sec. 2036 generally requires that a decedent's gross estate include the at-death value of any interest in property the decedent has transferred but in which he retained a proscribed interest. If the decedent retained an interest in only a part of the transferred property, only the value of that portion will generally be includible in the decedent's estate.

Example 4: X transfers a remainder interest in real estate, retaining a life estate for himself. Under Sec. 2036, on X's death 100% of the value of the property in trust will be includible in his estate.

If, instead, X has a life estate in only 50% of the real estate (with the other 50% to go to G}, only 50% of the value of the property in trust will be includible in X's gross estate.

Planning Options

Unlike the traditional estate freeze or buy-sell agreement, the planning techniques for contending with Sec. 2036(a} have as their chief objective the avoidance of estate inclusion, rather than the minimization of the value accorded an asset includible in an estate. Of concern in evaluating the desirability of using any of these techniques is the possible application of Secs. 2701-2704, added by the RRA. In this regard, new Sec. 2702 holds particular importance to a number of Sec. 2036in] planning options, e.g., private annuities, grant orretained income trusts (GRITs} and joint purchases. If caution is not used, and the transaction is deemed subject to Sec. 2702, the transferor may well incur an unexpectedly substantial gift tax, while still possibly being vulnerable to Sec. 2036{a] estate inclusion.[12] The new provisions of Sec. 2702 are generally effective for transfers made after Oct. 8, 1990.

Several techniques exist to enable the possible retention of lifetime enjoyment of an asset, or obtaining payments as a result of disposing of an asset, while keeping the asset within the taxpayer's family, but without including the asset in the transferor's estate. One such maneuver involves retaining a life estate and releasing the interest in the property before death. Urfortunately, the risk then exists that the interest will be includible in the decedent's estate under the three-year rule of Sec. 2035. Under Sec. 2035, when a taxpayer releases property or an interest or right therein that would be includible in the taxpayer's estate under Sec. 2036 were it held at death, within three years of death for less than full and adequate consideration, that interest will be includible in the decedent's gross estate.

A safer alternative is to have another person acquire the asset and establish a life estate in the taxpayer with remainder to another designated person. Arguably this transaction would generally avoid both Sec. 2036 and Sec. 2033, as the taxpayer does not retain an interest in property transferred by him nor have any control or interest surviving him at death. As a practical matter it is unlikely that this scenario would often arise as, generally, the person acquiring an asset would prefer to use it himself. Should the acquisition and transfer be characterized as part of a prearranged plan funded by the taxpayer, the transaction would be vulnerable to characterization as a purchase and retention of a life estate by the taxpayer subject to possible inclusion under Sec. 2,036.

A taxpayer's principal options for possessing a life estate while avoiding inclusion of the asset in his gross estate might include the following.

[] Selling the remainder interest.

[] Transferring the asset pursuant to a private annuity or installment sale with a self-canceling installment note.

[] Employing a grantor retained annuity trust

(GRAT) or grantor retained unitrust (GRUT).

[] Undergoing a gift-leaseback or sale-leaseback.

[] Engaging in a joint interest purchase of the asset.

The sale option

Sec. 2036(a) expressly excludes transfers of property made for full and adequate consideration in money or money's worth. This provision has been interpreted as requiring that the consideration be sufficient to replace the amount that would have been includible in the decedent's estate had the life estate been retained until death. Recent decisions indicate that similar treatment will apply to the sale of the remainder interest.[13]

Private annuities

Sec. 2039 prescribes the general rule governing the inclusion of an annuity in an estate. Typically, the acquisition of a straight life annuity covering the annuitant's life will not give rise to an estate inclusion. This results because no interest in the annuity remains on the annuitant's death. In contrast, a joint and survivor annuity will typically give rise to an inclusion in the estate of the first of the annuitants to die. Likewise, an annuity for a term of years runs the risk of resulting in estate inclusion should the annuitant die within the annuity period.

While most annuities are acquired from a commercial company, e.g., a life insurance company, a private annuity arrangement may also be available. A private annuity is an arrangement in which the annuitant transfers an asset to a noncommercial entity, generally a relative, in return for periodic payments of a given amount. The private annuity arrangement has potential estate planning merit as it gets the asset and its future appreciation out of the transferor-annuitant's estate, while providing the transferor with an established return and keeping the transferred asset within the family unit.

The tax ramifications of a private annuity are spelled out in Rev. Rul. 69-74.[14]

[] The transferor will have a gain realized equal to the amount by which the present value of the annuity exceeds the transferor's basis in the property transferred.

[] The amount by which the fair market value (FMV} of the property transferred exceeds the present value of the annuity payments constitutes a gift.

[] Gain attributable to the private annuity is to be reported ratably over the period of years measured by the annuitant's life expectancy and only from that portion of the annual proceeds that is includible under Sec. 72.

[] The annuitant's basis in the asset transferred constitutes the annuitant's investment for purposes of determining the Sec. 72 exclusion ratio. Example 5: Father F transfers to D, his daughter, unimproved real estate that has been held for investment, in which he has a basis of $100,000, and which has an FMV of $200,000. In return, D agrees to provide F with a lifetime annuity of $12,000 a year payable on December 31 of each year. According to IRS prescribed tables, F has a 20-year life expectancy and the present value of the annuity payments is $164,136. Based on these facts, is deemed to have made a gift of $35,864 $200,000 FMV of the assets transferred - $164,136 present value of annuity payments). In addition, F will have capital gain of $64,136 ($164, 136 present value of annuity payments - $100,000 basis in the capital asset transferred) and ordinary income of $75,864 I$240,000 total amount of annuity payments - $164,136 present value of annuity payments). Since the annuity will terminate on F's death, the annuity payments do not appear to be derived from the property transferred and F does not enjoy possession, enjoyment or control of the asset transferred, no estate inclusion should arise under Sec. 2036 or 2039 due to the annuity.

Perhaps the most critical pitfall attached to a private annuity is that it often resembles a transfer of property by the annuitant, with a retention of a life estate in the income therefrom. This characterization would seem to fall within Sec. 2036. To protect the transaction from this treatment, the annuity payments should be a specified fixed amount that is reasonable with regard to the value of the asset transferred by the annuitant, and should not be specified as coming merely from income produced by the asset transferred by the annuitant.

The amount to be received by the annuitant should generally be determined using actuarial tables. The Est. of Fabric[15] case indicates that a departure from the use of actuarial tables in determining a reasonable amount to be paid the annuitant is justified only when the annuitant's death is clearly imminent at the time the annuity is entered into.

In Fabric, the decedent established a foreign trust with which she entered into an agreement for a lifetime annuity. The agreement was made five days before she underwent open heart surgery. The decedent's family had a history of heart attacks; the decedent herself had a history of hypertension, kidney problems and ulcerative colitis, and suffered severe chest pains for months before the surgery. The decedent's physician estimated her chances of survival before surgery at 60% to 75%. A few weeks later, the decedent had a pacemaker inserted. Subsequently, her cardiologist expected her to live several more years. However, the decedent died one year and five months after the bypass operation. The property transferred for the annuity was not included in her estate.

The Service challenged this treatment, contending that the decedent had retained a life estate in the transferred property, as the annuity did not reflect full and adequate consideration.

Despite the Service's claims, the Tax Court found for the estate. The amount to be received by the annuitant was determined by the tables in Regs. Sec. 20.2031-10. According to the court, such a determination of the amount to be received would be upheld absent death being clearly predictable or imminent at the time the annuity agreement was entered into.

* Self-canceling installment note As an alternative to using a private annuity, consideration should be given to making an installment sale of an asset to a family member, with any balance of the installment note automatically canceled on the seller's death. According to the Tax Court in Est. of MOss,[16 ]the termination of an installment note due to the death of the seller will not result in an estate inclusion. The court reached this decision based on the fact that the transaction giving rise to the note was bona fide and for adequate and fair consideration. While estate inclusion may be available, Rev. Rul. 86-72[17] indicates that the unpaid balance of the installment note will constitute income in respect of a decedent. Whether this also constitutes cancellation of indebtedness income to the purchaser is likely but uncertain.

Unlike a private annuity, no gift will be found when a bona fide installment sale involving a selfcanceling note is used, so long as the payments to be received are reasonable in light of the value of the asset sold. To protect the recognition of the sale and avoid possible gift tax or estate inclusion, consideration should be provided for the self-cancellation feature in the form of an increased sales price or increased interest rate to be paid.

When an installment sale with a self-canceling note is entered into, a gift may be found to the extent the FMV of the asset sold unreasonably exceeds the agreed on sales price. Unlike the private annuity, the taxation of installment payments will be determined under the Sec. 453 installment sale rules. The special related party rules of Sec. 453(e) are applicable when the sale is made between related parties.

Example 6: Father F makes an installment sale of raw land to his son, S. The land has a basis of $100,000 and an FMV of $200,000. The sales price is $200,000, along with adequate stated interest, payable in 20 equal annual installments. Included in the sales price is a $20,000 premium, which S agrees to pay in order to be discharged from paying the balance of the sales price outstanding should F die within the 20-year payment period. Despite the disparity between the sales price {excluding the premium) and the FMV of the asset sold, no gift tax will likely result, as the sales price (excluding the premium) constituted adequate and fair (reasonable} consideration. The treatment of amounts received by F will be governed by Sec. 453, with 50% of each payment of sales price received {$100,000/ $200,000) being accorded capital gain treatment and any interest received treated as ordinary income.

Often the line distinguishing a private annuity from an installment sale is blurred. Clearly the parties' stated intent and the documentation regarding the transaction are helpful in determining the nature of the transaction. Also significant for making this distinction are guidelines prescribed in GCM 39503?

1. The right to receive periodic payments for life with no monetary limit suggests an annuity.

2. The existence of a maximum stated payout, which is to be accomplished over a period less than the transferor's life expectancy, indicates an installment sale.

3. The stated maximum payout period ending at the transferor's death suggests an annuity.

If properly structured, neither the private annuity nor the installment sale with self-canceling note should give rise to the finding of a gift or estate inclusion of the asset transferred. Even if a disparity exists between the value received and transferred, Sec. 2702 does not appear applicable unless the transferor retains an income interest in the asset transferred. While this would arguably be the case when payments are being made to the transferor out of income produced from the property transferred, it is uncertain whether attribution of payments to the property will be alleged when they come from some other source. Even if Sec. 2702 were applicable, the structure of the payments made to the transferor would probably be considered a qualified interest held by the transferor.

* Transfer-leaseback

The often attractive, but usually risky, sale or giftleaseback of an asset should probably not be used to avoid Sec. 2036. The very nature of the transaction invites parallels to the retention of an interest in the property transferred. In addition, it may be attacked as abusive as it not only removes the transferred asset from the transferor's estate, but also removes additional amounts through the making of lease payments. A claim might be made that a gift-leaseback should avoid Sec. 2036 as it involves the payment of fair and adequate consideration, e.g., the rental. This claim would not seem to protect the transfer from Sec. 2036 treatment, however, because Sec. 2036 seems to assume that consideration goes to the transferor rather than from him.

A properly structured sale-leaseback has a better chance for success. To prevail, however, the transaction should reflect arm's-length terms, regarding the sales price and rentals. Thus, although the sale-leaseback gives the taxpayer continued use, there is still a risk of large estate inclusion, as the amounts received or receivable as the sales price must generally be included.

A transfer-leaseback is significantly more vulnerable to new Sec. 2702 than is a private annuity or installment sale. This results because by its very nature the transfer-leaseback involves the retention of some interest in the asset transferred. It is also likely that such interest will constitute a term interest, as it will usually be a life estate or a term of years. Therefore, should the consideration received be less than the value deemed transferred, Sec. 2702 may come into play. If Sec. 2702 does apply, a particular problem may be encountered in determining whether the transferor has retained a qualified interest to be able to mitigate the amount of the gift deemed made. Arguably, if fixed amounts of the sales price are paid at least annually, the transferor will be found in possession of a qualified interest for Sec. 2702 purposes.


The appeal of using a grantor retained income trust (GRIT) has been reduced because of the unlikelihood that a retained interest will be considered a qualified interest. In contrast, the appeal of a grantor retained annuity trust (GRAT) and a grantor retained unitrust (GRUT) has been substantially enhanced: because these trusts constitute qualified interests, the value of their retained interests can be taken into account in valuing the gift amount. In comparing the consequences of these transfer arrangements it is critical to bear in mind the required rate of return, the rate of return (discount rate) used in the relevant Treasury tables and the term of the retained interest.

As a general rule, the higher the return or discount factor and the larger the period of the retained interest, the smaller the value accorded the gift. While using these factors to minimize the amount of the gift appears to be an attractive means of reducing current taxes and, thus, bears time value of money advantages, certain critical drawbacks exist. Care must be taken to avoid the term being for life or so long that the transferor will likely die within it, `esulting in a Sec. 2036(a) estate inclusion. In addition, with regard to increasing the required rate of return, the larger the return, the larger the consequent receipts by the transferor and the potential estate inclusion.

In comparing the use of a GRAT with a GRUT, it is important to consider whether the security of receiving a stable fixed amount (GRAT) is preferable to receiving what may be considered a hedge against inflation (GRUT). The respective methods of valuing the two types of transfers should also be taken into account. Given similar data, different transfer tax valuation and consequences can ensue from each method.

Examination and application of the tables reveal that when the required rate of return is less than the appropriate Treasury rate, a GRUT will produce a smaller gift valuation; and when the required rate of return exceeds the appropriate Treasury rate, a GRAT will produce the smaller gift valuation.

* Joint purchase

The joint purchase has long held promise as a means for the taxpayer to enjoy a life estate in property, while avoiding inclusion of the property in his estate. Unlike the options previously mentioned, under the joint purchase option, the taxpayer does not make a transfer of an interest in the asset. Instead, a joint purchase typically involves the purchase of a life estate by the taxpayer from a third person, and a purchase of the remainder interest in such property by someone else (usually a relative of the taxpayer)from a third person. Since the only interest the taxpayer arguably held in the asset was a life estate, and the taxpayer lacked any dispositive powers over the remainder interest, on the taxpayer's death his entire property interest should be considered terminated, and no inclusion in his estate should arise under either Sec. 2036 or 2033.

Under the new rules a joint purchase is treated as including an acquisition of the entire asset by the term holder followed by a transfer of the remainder interest for whatever consideration has been provided by the remainderman.[19] The language of Sec. 2702 and the Gradow20 decision make uncertain whether the remainder interest will be valued at the full FMV as of the time of the purchase. While the provisions of Sec. 2702 and the apparent lack of a transfer by the term holder to the remainderman suggest that a joint purchase will not give rise to an estate inclusion under Sec. 2036(a), care should be taken to avoid falling prey to such inclusion under a substanceover-form argument. This argument would be based on facts supporting recharacterizing the transaction as a transfer for Sec. 2036(a)purposes from the term interest holder to the remainderman. Vulnerability to this type of argument would appear to exist, for example, when the term interest holder either directly or indirectly funded the remainderman's consideration or when the term interest holder provided a substantially disproportionate amount of the purchase price.


Transferring an interest in an asset while retaining an interest in it holds both gift and estate tax implications. Substantial gift tax consequences may result from the application of new Sec. 2702 and estate tax consequences from Sec. 2036. To mitigate the amount of the gift deemed made under Sec. 2702, the transferor should retain a qualified interest in the property. By doing so, the value of the remainder interest transferred will generally be its present value as determined under the appropriate table, rather than the entire value of the asset. In addition, numerous planning options exist for the potential avoidance of Sec. 2702 and/or Sec. 2036.
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Author:Segal, Mark A.
Publication:The Tax Adviser
Date:Aug 1, 1992
Previous Article:Buy-sell agreement with a twist.
Next Article:Indirect methods of income reconstruction.

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