Assets Transferred to Annuity Trust Included In Estate Under 2036
The Tax Court in Trombetta1 held that two rental properties transferred to an annuity trust were required to be included in the transferor's gross estate because the transfers to the trust were not bona fide sales for adequate and full consideration, and the transferor retained during her lifetime an interest in the transferred properties.
Helen Trombetta created an annuity trust with a term of 180 months, subject to her power to reduce the term of the trust. During the term of the trust, the trust would distribute to Trombetta an annual sum of $75,000 for the first 12 months with an increase of 4% at the beginning of each successive 12-month period. After the term of the trust, no further payments would be made to Trombetta from the trust and the trust assets would be distributed to Trombetta's children or grandchildren.
Trombetta and three of her children were co-trustees of the trust, and Trombetta was vested with 50% of the voting rights. The trust required that decisions of the trustees required a majority vote.
The trust agreement provided that if the income of the trust exceeded the annual required payment, the trust could distribute the excess income to Trombetta or permit it to accumulate in the trust. Trombetta transferred two rental properties that were subject to significant mortgages to the annuity trust. After the transfer of the properties to the trust, the trust paid the interest and principal owed on the mortgages although the trust never assumed the mortgages. Trombetta filed gift tax returns reporting the transfers to the trust.
After the properties were transferred to the trust, Trombetta negotiated with several banks to refinance the mortgage on one of the properties and executed the necessary mortgages. Trombetta was personally liable on the mortgages. During the term of the trust, the trust paid off the mortgage encumbering the other property.
Before the end of the trust term Trombetta was diagnosed with cancer, and she concluded she would not live until the end of the trust term. Therefore, Trombetta exercised the power granted to her pursuant to the trust agreement to amend the term of the trust to 156 months. Trombetta died approximately six weeks after the end of the amended trust term. Trombetta's estate filed an estate tax return, the IRS audited the return, and it issued a notice of deficiency.
Section 2036 includes the value of assets in a decedent's gross estate when:
- The decedent made an inter vivos transfer of property.
- The decedent's transfer was not a bona fide sale for adequate and full consideration.
- The decedent retained an interest or right in the transferred property that he or she did not relinquish before his or her death.
Whether a decedent retained an interest in transferred property depends on whether "there is an express or implied agreement at the time of transfer that the transferor will retain lifetime possession or enjoyment of, or right to income from, the transferred property." 2 To avoid characterization as a retained interest, the decedent must have "absolutely, unequivocally, irrevocably, and without possible reservations" parted with all of her title, possession, and enjoyment of the transferred assets. 3
The IRS contended that Section 2036 required that the two properties transferred to the annuity trust be included in Trombetta's estate. The estate on the other hand contended that Section 2036 was inapplicable for two reasons:
- The transfers were bona fide sales for adequate and full consideration.
- Trombetta did not retain during her lifetime an interest in the transferred properties.
Relying on Estate of Reichardt, 4 and Estate of Harper, 5 the estate argued that the transfers of the properties to the trust were bona fide sales for full and adequate consideration. The court rejected this argument, finding that Trombetta did not receive full and adequate consideration for the transfers to the annuity trust because the present value of the annuity payments were less than the value of the properties transferred to the trust. The court noted that Trombetta reported this difference as a gift on an IRS Form 709. The court also found that the transfers were not a "bona fide sale" because the court interpreted the phrase "bona fide sale" as synonymous with an arm's-length transaction.
The court found that Trombetta's estate planning attorney prepared the annuity trust agreement without any meaningful negotiation or bargaining with the other co-trustees or future beneficiaries. In addition, the court found that Trombetta and the estate planning attorney alone determined how the annuity trust would be structured and operated and which properties would be contributed to the trust. Finally, the court found that Trombetta stood on both sides of the transaction as the sole transferor and the sole beneficiary and also held 50% of the trust voting rights.
The estate, relying on Estate of Bigelow 6 and Estate of Bongard, 7 contended that the transfers to the annuity trust satisfied the bona fide sale exception because Trombetta had legitimate and significant nontax reasons for the transfers to the annuity trust. Specifically, the estate argued that Trombetta's purpose in transferring the properties to the trust was to relieve herself of the burden of managing the properties and to receive an assured income. Although the court recognized that cases have applied the legitimate and significant nontax reasons exception to find that the bona fide sale exception was satisfied, the court nevertheless distinguished those other cases because each of them arose in the context of a family limited partnership.
The court found that Trombetta's transfers to the annuity trust were not comparable to a transfer to a family limited partnership because no other individual received a present interest in the annuity trust and, therefore, the court refused to apply the legitimate and significant nontax reason exception. The court did go on to state that even if the court were to apply the legitimate and significant nontax exception, the evidence in this case did not establish that Trombetta had substantial nontax reasons for transferring the properties to the annuity trust. The court stated that Trombetta continued to manage the properties after they were transferred to the trust. For all of these reasons, the court held that the transfers to the trust did not qualify as bona fide sales.
The court next considered whether the decedent retained an interest in the properties transferred to the annuity trust. The court found that Trombetta made all decisions with respect to the properties owned by the annuity trust and that the other co-trustees generally acted on her recommendation. The court also found that Trombetta alone retained signatory authority with respect to the properties transferred to the annuity trust. The court, therefore, concluded that Trombetta retained de facto control over the properties transferred to the annuity trust.
In addition, the court noted that the annuity trust agreement provided that any additional trust income could be distributed to Trombetta at the direction of the trustees. Thus, the court held that because the trustees could make distributions of additional income to Trombetta when and in the amount they pleased, Trombetta maintained the same enjoyment of the properties and the income from the properties as she had before she transferred the properties to the trust. Furthermore, the court found that Trombetta received additional economic benefit from the trust because the trust used income from the properties to make payments on the loans encumbering the properties and the loans were personal obligations of Trombetta and not obligations of the trust. For all these reasons the court concluded that Trombetta retained an interest in the properties transferred to the annuity trust.
One may have assumed that annuity trusts were not includable in the gross estate if the requirements of 2702 and the regulations thereunder were complied with. This case illustrates that that assumption is not correct. If the IRS asserts a 2036 argument in the context of an annuity trust (or any retained interest trust for that matter) it may be difficult in light of the court's reasoning (other than in the context of a zero-out GRAT) to establish that the transfer to the trust was a bona fide sale for adequate and full consideration. In addition, in light of the court's reasoning regarding the legitimate and significant nontax reasons exception (which one may reasonably conclude is not completely sound), it may also be difficult to qualify for such exception. Therefore, it is very important for practitioners to ensure that the transferor not retain an interest in the assets transferred to the trust. For example:
- The transferor should not serve as a trustee.
- The transferor should not control or manage the assets of the trust.
- Careful and thorough valuations should be used.
- The trust should not pay the mortgages for property owned by the trust unless the trust is legally obligated to do so.
- The trust should not provide that the trustees may distribute additional sums to the transferor in excess of the required payment.
Practitioners would be well advised to meet with clients who have already established retained interest trusts, and trustees of such trusts, to advise them regarding the guidance provided by this case and to take the necessary remedial actions to avoid the adverse consequences of the court's holding while being aware of the applicability of Section 2035 to such remedial action. This same warning would also apply to sales to intentionally defective grantor trusts (IDGTs).
1 TC Memo 2013-234, RIA TC Memo ¶2013-234, 106 CCH TCM 416 .
2 Estate of Thompson, 94 AFTR 2d 2004-5764, 382 F3d 367, 2004-2 USTC ¶60489 (CA-3, 2004).
3 Estate of Church, 37 AFTR 480, 335 US 632, 93 L Ed 288 (1949).
4 114 TC 144 (2000).
5 TC Memo 2002-121, RIA TC Memo ¶2002-121, 83 CCH TCM 1641 .
6 100 AFTR 2d 2007-6016, 503 F3d 955, 2007-2 USTC ¶60548 (CA-9, 2007), aff'gTC Memo 2005-65, RIA TC Memo ¶2005-065 .
7 124 TC 95 (2005).
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets of high net worth individuals to minimize federal and state tax liability. For more creating and administering annuity trusts, contact Frank at (301) 657-0175 or email@example.com.
This article originally appeared in the February 2014 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.