Mr. and Mrs. Stone owned 740 unproductive woodland acres in Cumberland County, Tennessee and wanted to gift the properties to their 21 children and children’s spouses and grandchildren. They met with counsel and he suggested they form a family limited partnership to avoid many deed transfers and eliminate the potential for partition actions.

In 1997 Mr. and Mrs. Stone formed the limited partnership under state law and each of them received a 1% general share and 49% limited shares.  Their real property was then transferred to the partnership. The partnership provided that it would hold and manage the real estate for the family members and provide for the health education, maintenance, and welfare for the family members. The partnership also provided that the limited partners could dismiss the general partners with a 67% vote.  The real property was appraised.  Mr. and Mrs. Stone made gifts of limited partnership shares to their family from 1997 through 2000.  By the end of 2000 Mr. and Mrs. Stone each held 1% general share and the family members held the 98% limited shares.  During this time the property was not developed and remained unproductive.  Since there was no income, real estate taxes were paid in some years personally by Mr. Stone.

Upon the death of Mrs. Stone, the IRS argued that section 2036 applied to the transfer of the property to the partnership as it was testamentary in nature.  Consequently, the IRS believed that all of the property should be included in the federal estate tax return of the decedent.  Section 2036 provides that the full value of the transferred property will be included in the decedent’s gross estate if the following conditions are met: (1) a decedent makes an intervivos transfer of property;  (2) for other than a bona fide sale for adequate consideration;  and (3) retains certain rights or interests in the property which are not relinquished until death.   In Stone, (1) Both parties agreed that an intervivos transfer was made. (2) The Tax Court followed established law that “the bona fide sale for adequate and full consideration exception is met where the record establishes the existence of a legitimate and significant nontax reason for creating the family limited partnership and the transferors received partnership interest proportional to the value of the property transferred.” The Tax Court’s analysis separated this issue into two parts: (a) whether the transaction qualifies as a bona fide sale, and (b) whether the decedent received adequate and full consideration.  

The Tax Court considered the taxpayer’s motive in its determination of whether the transfer to the partnership was a bona fide sale.   The Tax Court found two nontax motives.  One motive was to create a family asset which would later be developed and sold by the family.  The second motive was to protect the land from partition actions. The IRS argued that the only motive was to simplify the gift giving process.  The IRS claimed that gifting and elimination of the need to execute numerous deeds is a testamentary purpose and not a legitimate and significant non-business motive.  The IRS asserted further that since the Stones were transferors of the property and controlling general partners of the family entity that there was no arms-length transaction and thus no bona fide transfer.  The Tax Court did not agree with the IRS.  The Tax Court held that the taxpayers’ desire to have assets jointly held and managed by family members, even standing alone, is a legitimate and significant nontax motive for purposes of section 2036(a) (citing Estate of Mirowski v. Commissioner, T.C. Memo. 2008-74.  The Tax Court further held that testamentary objectives interwoven with other nontax motives will not defeat the underlying legitimate and significant nontax motives. (Estate of Bongard v. Commissioner, 124 T. C. at 121.) The Tax Court also found other facts to support legitimate and significant nontax motives.  For example, the Stones were financially independent and did not depend on distributions from the partnership; the real property was actually transferred to the partnership by deed;  there was no commingling of personal assets and partnership assets; and although the Stones were over age 70 at the time of the transfers to the partnership, their health was good.  It was also recognized that the partnership interest received by the Stones was proportionate to the property contributed by them.   Since there were legitimate and significant nontax reasons and the transaction occurred in a manner by which unrelated parties would deal with each other, the Tax Court held that a bona fide sale did occur.   

Regarding the full and adequate consideration issue, the IRS argued that there is no full and adequate consideration where the interfamily transaction merely attempts to change the form in which the property is held.  (This has been referred to as  “recycling of value”.) (see Estate of Gore v. Commisssioner, T.C. Memo. 2007-169.)  The Court held that the “recycling” argument fails where it is established that there is a “legitimate and actual” nontax purpose for establishing the partnership. As a result the Court found that Section 2036 did not apply and found in favor of the taxpayer and against the IRS.

 Many people in wealth categories should seek estate planning advice in the very near future regarding this matter.

The Tax Court Memo 2011 – 209 issued August 30, 2011, was an interesting case regarding the Estate of Turner. A limited partnership was created for the decedent and his wife and they transferred securities into the partnership. The Court found that management of securities is a legitimate nontax purpose if the assets involved required active management or special protection, or if it was stock of an operating business that required management. The Court found that the record failed to establish any meaningful activity of the marketable securities while in the partnership. The Court found that the decedent commingled personal and partnership funds and used partnership funds for personal gifts and personal bills. The Court found that the decedent, as general partner, had the right to amend the partnership agreement at any time without the consent of the limited partners. The Court found that the partnership was primarily testamentary and not for the active management of investments or business. In summary, the Court found that the transfer to the partnership was not for bona fide or adequate consideration as there were no significant nontax purposes and that the decedent expressly or implicitly retained the right to possess the transferred property as well as controlled which person would enjoy the transferred property. The Court included all the assets in the gross estate of the decedent under section 2036 of the Internal Revenue Code.

This decision is in favor of the taxpayer but we highly recommend that the insurance payment be made to the trust and the trust make the payment to the carrier, and the beneficiaries be notified of their withdrawal rights after each of the contributions to the trust are made.

Currently there is a $5 million estate tax exemption with a 35% rate until December 31, 2012, unless Congress extends. If Congress does not extend the law reverts to a $1 million exemption and a 55% rate. Some Democrats advocate a $3.5 million exemption and 45% rate and some Republicans suggest to keep the rate at 35%. The Administration’s 2012 budget proposal promotes a $3.5 million exemption and 45% rate. Some Republicans want the estate tax repealed altogether but that is unlikely. Yesterday Minnesota Gov. and Republican presidential hopeful Pawlenty said he would end the estate tax.

 It should provide an interesting debate if the issue is brought to the floor.

In this case the trust was an irrevocable trust and provided that upon the death of the Settlors the property is automatically transferred to the beneficiaries, and the Settlors could exchange and otherwise dispose of the property and may live in and enjoy the residence in question.

Section 1102–C.3(8.1) of the Realty Transfer Tax Act provides an exclusion for “A transfer for no or nominal actual consideration to a trustee of a living trust from the settlor of the living trust…”.  The Act further provides the definition of a “living trust” as “Any trust, other than a business trust, intended as a will substitute by the settlor which becomes effective during the lifetime of the settlor, but from which trust distributions cannot be made to any beneficiary other than the settlor prior to the death of the settlor.” The Commonwealth argued that the trust is not a “will substitute” because it was not a revocable trust but rather an irrevocable trust.

The three-judge panel reviewed the definition of “will substitute” in the Restatement (Third ) of Property which basically provides that the property transfers to the beneficiaries upon the death of the donors while preserving lifetime rights to the donors. The panel found that trust was a “will substitute” and that there was no transfer tax regardless that the trust was irrevocable. The Commonwealth Court agreed with the Order of the three-judge panel.

However, it is important to note that if the irrevocable trust did not allowed the Settlors to reside in and enjoy the property and have control on the sale or exchange of the property, the results would have been different and realty transfer tax would be imposed. It is also important to note that this issue of realty transfer tax is different than the law regarding death tax as such a transfer to an irrevocable trust would not be excluded from inheritance tax or federal estate tax because the settlors have the right to enjoy the property.

1. Use of the portable exemption new legislation requires an election that must be made on a timely filed estate tax return of his first spouse to die which computes the amount of unused federal exemption that the surviving spouse will receive. If the election is not made the portable feature is lost. Also, the election is irrevocable. We don’t have this problem with credit shelter trust .

2. If we use the credit shelter trust the appreciation on the assets contained in that trust will not be subject to estate tax on the second spouse to die. Whereas, if the first spouse provides in his or her Last Will that all of his or her assets shall be distributed to the surviving spouse and then the surviving spouse uses the federal estate tax exemption of both the first spouse and the second spouse, all of the appreciation that occurred in the estate of the surviving spouse regarding the assets of the first spouse will be subject to estate tax at the death of the surviving spouse. This results in a large advantage lost.

3. There is no portability with respect to the GST tax. To preserve the GST exemptions for both spouses the deceased spouse must be a transferor and therefore the marital reverse Q-tip trust is needed.

4. Credit shelter trusts provide many nontax benefits such as asset management, creditor protection and guaranteed disposition to lineal descendents.

5. Portability will last for only two years unless it is extended by Congress. If it is not extended then we need redo all the estate plans regarding those that did not utilize a credit trust. Use of the credit trust will avoid this exhausting reconstruction.

In Cepko Estate ,Vol.1, Third Series, Fiduciary Reporter, p.115, Westmoreland County, Pa., at issue was a joint account which remaining funds was specifically bequeathed to decedent’s daughter and the Court found that the account was controlled under section 6303 of the Pennsylvania Multiple-Party Account Act and the funds were contributed by the decedent and used both at his direction and also properly by his agent (his spouse) under his power of attorney.

In Private Letter Ruling 20944002 the IRS refused to rule whether the assets of the trust are included in the estate of Settlor under section 2036 where taxpayer created an irrevocable trust which benefited himself along with his spouse and descendents. The trust was created under a state law which provided that creditors could not reach Settlor if it the trust is a self settled asset protection trust. All the proper provisions where in place as the trustee was not a related party, it was a grantor trust with a substitution clause, the trustee was prohibited from reimbursing the taxpayer for income taxes paid by the taxpayer with respect to the trust income, and the IRS determined that the gift was a completed gift. However, the IRS refused to rule regarding the issue of whether or not the property is included in Settlor’s gross estate under section 2036 because the trustee had discretion to distribute income and principal to the grantor. Thus, self settled trusts remain questionable with respect to section 2036 inclusion.