May 22, 2017

The Estate of Powell1 is a case of aggressive estate planning that failed. While his mother, Nancy H. Powell, was “hospitalized and in intensive care,” her son, under a power of attorney formed a partnership, transferred $10,000,752 into a newly formed partnership, NHP Enterprises L.P. (NHP), in return for a 99% limited partner interest. Her two sons contributed an unsecured note payable to NHP in return for a general partner interest. On the same day as the formation of NHP, the mother’s 99% limited partner interest was transferred into a charitable lead annuity trust (CLAT) with her two sons receiving the remainder upon her death. She died seven days after the formation of the partnership and same-day transfer of her limited partner interest to the CLAT.

Importantly, this case was reviewed by a majority of the Tax Court.

IRS Arguments

The IRS provided the Court with three basic arguments. 1) Under Section 2036(a)(1) and (2), the decedent “retained at her death the possession, enjoyment, or the right to the income from the property she transferred to NHP … or the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income there from….” 2) Under Section 2038(a), the decedent “retained at her death a power to change the enjoyment of a 99% limited partnership interest in NHP … alone or in conjunction with any other person … to alter, amend, revoke, or terminate ….” 3) Under Section 2703(a), “the fair market value is determined without regard to certain rights and restrictions.” The arguments under 1) and 2) above were predicated on the fact that the decedent, in conjunction with the general partners, could unanimously agree to dissolve the partnership.

In regard to the transfer of the decedent’s limited partnership interest into the CLAT, the IRS pointed out that the power of attorney limited such transfers to the annual gift tax exclusion amount and was, therefore, invalid.

The Estate’s Response

The estate does not deny that decedent’s ability to dissolve NHP with the consent of her sons constituted a “right … in conjunction with … [others], to designate the persons who shall possess or enjoy the property [she transferred to the partnership] or the income therefrom,” within the meaning of section 2036(a)(2). Nor does the estate challenge respondent’s assertion that decedent’s transfer of cash and securities to the partnership was “not a bona fide sale for an adequate and full consideration in money or money’s worth.” The estate’s only response to respondent’s section 2036(a)(2) argument is that, upon her death, decedent did not retain her interest in NHP. The estate apparently reasons that, even if decedent’s interest in NHP gave her the right to designate the beneficiaries of the assets she transferred to the partnership, she did not retain that right for the remainder of her life (and the brief period for which she held the right was not ascertainable only by reference to her death). Consequently, the estate argues, section 2036(a)(2) does not apply to decedent’s transfer of cash and securities to NHP.

The Court’s Analysis

Because the taxpayer’s counsel did not argue that the transfer of the cash and marketable securities to NHP was “a bona fide sale for an adequate and full consideration in money or money’s worth,” the Court was simply left with the conclusion that the ability to dissolve the partnership, in conjunction with the affirmative vote of the general partners, was enough to bring the transferred assets back into the estate under Section 2036(a)(2).

The Court also concurred with the IRS’ interpretation of the power of attorney agreement that limited the amount that could be transferred to the annual exclusion amount. Thus, the Court concluded that the transfer of the decedent’s 99% limited interest to the CLAT was void.

Concurring Opinion

Apparently, complicating matters was the fact that this case was a response to a request for summary judgement. Therefore, it could only address issues that were not “genuine disputes over issues of material fact.” Judge Lauber wrote a concurring opinion, which stated:

There are compelling reasons to question whether a valid partnership was ever formed here. In comparison with the $10 million in cash and securities that the decedent relinquished for her alleged partnership interest, the other two supposed partners – her sons and heirs – contributed nothing more than unsecured promissory notes. Decedent’s contribution was made by one of her sons, ostensibly on her behalf as trustee of her revocable trust, a week before her death and while she was hospitalized and in intensive care. That son was essentially negotiating with himself: He signed the partnership agreement both as general partner of the partnership and for his mother as her trustee.

The partnership was an empty box into which the $10 million was placed. Once that $10 million is included in her gross estate under section 2036(a)(2), it seems perfectly reasonable to regard the partnership interest as having no distinct value because it was an alter ego for the $10 million of cash and securities.

Ruling on motions for summary judgment, the Court does not address this “partnership invalidity” theory, apparently because respondent did not clearly articulate it and because it could require resolving disputed issues of fact. Instead, assuming arguendo that the partnership was valid, the Court relies principally on section 2036(a)(2).

Section 2035(a)

The Court also noted that Section 2035(a) could be applicable to the transfer of the decedent’s NHP interest to the CLAT. Section 2035(a)(1) states that transfers “of an interest in any property, or [relinquishment of] a power with respect to any property, during the three-year period ending on the date of the decedent’s death” must be includable in the taxable estate.

Section 2043(a)

The Court seemed concerned that under the different conclusions reached, a result could be the double counting of the assets to be taxed when two different sections of the code were addressed, namely, Section 2036(a)(2) and Section 2035(a). “Applying section 2043(a) to limit the inclusion required by section 2036(a) simply prevents ‘double taxation of the same economic interest.’” Judge Lauber, in his concurring opinion, stated that “The Court’s exploration of section 2043(a) seems to me a solution in search of a problem.”

Valuation

While the topic of valuation was not addressed by the Court, it is interesting to note that the taxpayer’s expert had taken a 25% discount from the net asset value of the 99% limited partner interest. The IRS’ expert in its notice of deficiency had taken a 15% discount. Instead, the Court concluded that all of the assets transferred are to be brought back into the estate for estate tax purposes.

Summary and Conclusion

While the results of the Court’s decision seem appropriate, I remain concerned when Section 2036(a)(2) is raised. Section 2036(a)(2) states that the gross estate shall include any transfer where “the right, either alone or in conjunction with any person, to designate the person who shall possess or enjoy the property or the income therefrom” is retained. The clause “in conjunction with any person” can be interpreted quite broadly. The term “person” is interpreted by the courts to be plural, not singular. Where does the plurality of the term “person” end and where does it begin?  If I have a 1% interest, certainly I can combine with all of the other shareholders to control an entity. Does it make a difference that this case involves a 99% interest and not a 1% interest? These are questions that have not been directly addressed by the Courts. Instead, the Courts have adopted a two-part test: 1) significant non-tax reasons and 2) “bona fide sale for an adequate and full consideration in money or money’s worth.” The failure of this test then opens the door to Section 2036(a)(1) and (2).

It is interesting to contrast this case with the Estate of Barbara Purdue (December 2015) – which was a taxpayer win on the Section 2036 issues and illustrates a successful fact pattern to avoid 2036 inclusion.


1Estate of Nancy H. Powell – 148 T.C. No. 18 (May 18, 2017)