Valid Transfers Excluded From Gross Estate

BY SHARON BURNETT AND DARLENE PULLIAM

Under IRC section 2036(a) and Treasury regulations section 20.2036-1(a) there are two exceptions that prevent transfers from being included in a decedent’s gross estate. First, if a transfer is a bona fide sale for adequate and full consideration, it is not part of the gross estate. Second, the transfer also can avoid inclusion if the decedent did not retain possession, enjoyment or rights to the transferred property or the right to designate who would possess or enjoy the property.

In 1991 Ruth Kimbell transferred the bulk of her estate to a revocable living trust. In January 1998 the trust and Mrs. Kimbell’s son David and his wife formed a limited liability corporation (LLC) with the trust holding a 50% interest. David was the LLC’s sole manager. Later that month, the trust and the LLC formed a limited partnership (LP) to which the trust contributed $2.5 million, receiving a 99% limited partnership interest. The LLC contributed $25,000 and received a 1% general partnership interest. At the LP’s inception, approximately 11% of the assets were working interests in oil and gas properties.

On March 25, 1998, Mrs. Kimbell died, leaving a will. In December her estate filed a federal estate tax return claiming a 49% discount on the value of Mrs. Kimbell’s interests in the LP and LLC based on lack of control and marketability of the LP. The IRS subsequently audited the Kimbell estate, determining that the transfers to the LP and LLC were subject to section 2036(a) and that the value of the assets transferred should be included in the gross estate. The estate paid the additional tax and filed for a refund. A district court agreed with the IRS determination and the estate appealed the decision to the Fifth Circuit Court of Appeals.

Result. For the taxpayer. The Fifth Circuit first determined the transfer to the LP (by far the larger and more important) was for full and adequate consideration. To reach this conclusion, the court focused on three main points: (1) the trust and LLC received partnership interests proportionate to the assets each contributed; (2) the partnership accounts were properly credited; and (3) the partnership agreement required distributions on termination or liquidation according to the partner’s capital balances.

The Fifth Circuit then determined the transfer to the LP was a bona fide sale based on four factors: (1) Mrs. Kimbell had had sufficient assets outside the partnership to support her personal needs; (2) all partnership formalities were satisfied and the transferred assets were actually assigned to the partnership; (3) most of the assets transferred did require active management; and (4) non-tax-objective business reasons existed for the transfer to a partnership that the trust could not satisfy. (Perhaps the most compelling reason was that the LP provided personal legal protection for Mrs. Kimbell from possible environmental issues related to the working oil and gas interests.)

The bona fide sale determination was particularly important since the district court had decided transfers between related parties by definition could not be bona fide sales. The Fifth Circuit rejected this argument and said that while related party transactions should be scrutinized at a higher level than those between unrelated parties, related party status should not automatically disallow the transaction.

The Fifth Circuit thus decided the transfer to the LP met the first exception of section 2036(a) and the assets were not included in Mrs. Kimbell’s gross estate. The court then turned its focus to the transfer from the trust to the LLC. It decided the second exception to section 2036(a) applied since Mrs. Kimbell only had a 50% interest in the LLC and David Kimbell had sole management powers. Therefore, Mrs. Kimbell had not retained the right to enjoy or designate who would enjoy the LLC property. The Fifth Circuit remanded to the district court the determination of whether Mrs. Kimbell’s interest in the LP was an assignee or limited partner interest for valuation purposes.

Based on the outcome of this important case, CPAs should make clients doing estate planning aware of the two exceptions under section 2036(a) and its regulations and emphasize the IRS and the courts probably will ask these questions about property transfers:

Was the transfer for full and adequate consideration, based on the three main points mentioned earlier?

Was the transfer a bona fide sale based on the four factors described above?

If the answer to either question was no, did the transferor give up all rights of possession, enjoyment or ownership of the assets as well as the right to designate who would possess or enjoy the transferred property?

Kimbell v. United States, 93 AFTR2d 2004-2400, 05/20/2004.

Prepared by Sharon Burnett, CPA, PhD, assistant professor of accounting, and Darlene Pulliam, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.

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