828 / When are gifts with a life interest retained by the donor includable in the donor’s gross estate under IRC Section 2036?

IRC Section 2036 is one of the three sections (2036, 2037, 2038) dealing with lifetime transfers whereby the donor retained some rights over the property given. IRS Section 2036 brings into the gross estate lifetime transfers of property where the decedent retained the use of the property or the income from the property for life. Included are transfers made directly to a donee and transfers made to an irrevocable trust for designated beneficiaries, and transfers made to entities such as a partnership, if the decedent retained the prohibited “strings.”

Specifically, IRC Section 2036 requires any property which an individual gratuitously transfers during lifetime to be included in the gross estate if he retains “for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death,” either:

“(1)   the possession or enjoyment of, or the right to 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 IRS asserts the decedent’s retention of possession or enjoyment of, or the right to income from, property may be evidenced by an agreement, or by prearrangement, or merely by circumstantial evidence.¹

In November 2011, the IRS finalized regulations regarding the includability of property (including property held in trust) in the grantor’s gross estate under Section 2036 where the grantor retained: (i) the use of the property; (ii) the right to an annuity or unitrust; (iii) a graduated retained interest; or (iv) other payment from the property.

Excepted from the scope of IRC Section 2036 is a transfer of property by way of “a bona fide sale for an adequate and full consideration in money or money’s worth.”² This exception to Section 2036 is often referred to as the “bona fide sale exception.” Courts have wrestled with the interpretation of this exception in “widow’s election” cases. Typically, a married decedent leaves certain property (and/or certain community property) in trust for his children, with all income to the surviving spouse for her lifetime, on the condition that the surviving spouse transfer certain of her property (or community property share) to the trust. The surviving spouse thus has her choice between what has been provided for her in the will and her statutory (intestate) share (or community property share). If the widow elects to take under the will, and transfers the agreed-upon property to the trust in exchange for a life income from all the trust assets, what has she transferred for purposes of IRC Section 2036? Has she transferred the entire property, or has she transferred only a remainder interest? If she is considered to have transferred the entire property, and the value of property transferred exceeds the value of the life income interest she receives in return, then she has not made a “bona fide sale for an adequate and full consideration” and the entire value of the property she transferred is includable in her gross estate under IRC Section 2036. If, however, she is considered to have transferred only a remainder interest, and that interest is of less value than the value of her life income from trust assets in excess of the value of the property she actually transferred, then she will have received adequate and full consideration for the transfer, and none of the property she actually transferred will be includable in her estate under IRC Section 2036. Case law appears to support the former
interpretation.³

For purposes of analyzing the bona fide sale exception to contributions/transfers to family entities, such as LLCs or limited partnerships, courts analyze whether a “legitimate and significant,” non-tax purpose existed for the formation of the partnership and whether the decedent received a share in the entity proportionate to her contribution.⁴ If these conditions are satisfied, Section 2036 does not apply and the gross estate includes the value of the decedent’s interest in the entity at the time of death (after gifts of interests, etc.). If, on the other hand, Section 2036 does apply (bona fide sale exception not satisfied and decedent retained prohibited rights), the gross estate includes the value of the assets contributed (without consideration of the entity, discounts applicable to ownership of an interest in the closely-held entity, or gifts made during life of interests).⁵