Badgley v. Commissioner
In Badgley, the United States Court of Appeals for the Ninth Circuit affirmed the District Court’s summary judgment in favor of the IRS, finding that a grantor-retained annuity trust (GRAT) is included in a decedent’s gross estate for purposes of the estate tax.
This case highlights some of the well-known risks in setting up a GRAT, including the risk that the grantor may die before the GRAT’s termination.
Donald Yoder owned a 50% interest in a family-run property development company in California called Y&Y Company. Mr. Yoder died in 1990 and his wife, Patricia Yoder, succeeded to his 50% partnership interest. In 1998, Patricia Yoder created a GRAT to transfer the partnership interest to her two daughters. The interest was valued at $2,418,075, and it was the only property placed in the GRAT. Ms. Yoder retained a right to an annuity of $302,259 paid from the GRAT for fifteen years.
At the earlier of the end of the annuity term or Ms. Yoder’s death, the GRAT’s corpus would pass to her daughters. From 2002 to 2012, Y&Y Company made cash distributions to the GRAT ranging from $435,400 to $730,000, which were sufficient to pay the annuity without decreasing the value of the partnership interest or requiring the sale of any of Y&Y’s holdings.
Ms. Yoder died in November 2012, before the termination of the GRAT. In 2016, Ms. Yoder’s estate sought a refund of an overpayment of estate tax in the amount of $3,810,004.
The issue on appeal is whether, under 26 U.S.C. Section 2036(a)(1), Ms. Yoder’s interest in the GRAT is a sufficient “string” that requires the Y&Y Company partnership interest to be included in Ms. Yoder’s gross estate.
I.R.C. Section 2036(a)(1) provides for the inclusion of property transferred during the decedent’s life in the decedent’s gross estate if the decedent retained possession of, enjoyment of, or the right to income from the property while the decedent was alive. These three factors – possession, enjoyment, and income – are referred to as “strings” connecting the transferor to the property despite the transfer. 2 To avoid the reach of Section 2036(a)(1), a grantor must “absolutely, unequivocally, and without possible reservations, part with all of his title and all of his possession and all of his enjoyment of the transferred property… [and the transfer] must be unaffected by whether the grantor lives or dies.”
In this case, Ms. Yoder’s estate argues that the decedent’s GRAT cannot be included in her gross estate because Section 2036(a)(1) does not expressly mention the term “annuity.” The Court disagreed, finding instead that Congress did not specify which property interests qualify, but rather intended for the result – possession, enjoyment, or right to income – to determine if the grantor remains tied to the property.
Ms. Yoder’s estate further contends that because the GRAT’s principal exceeded the annuity for several years, the annuity could have been drawn from prior year distributions from Y&Y Company and the interest earned on those distributions, and not from the GRAT’s principal. The Court declined to speculate about the parts of the trust from which the annuity could have been drawn, focusing instead on the fact that the only property in the GRAT was the partnership interest, thus any money received by Ms. Yoder as part of the annuity came from the partnership interest.
The Court, citing well-settled precedent, concluded that Ms. Yoder retained the enjoyment of the partnership interest for purposes of Section 2036(a)(1) because she derived a “substantial present economic benefit” from the annuity. She failed to completely divest herself of possession, enjoyment, and income stemming from the partnership interest, and her daughter’s beneficiary’s interest did not take effect until after her death. Thus, the statute requires inclusion of the entire GRAT’s date-of-death value in Ms. Yoder’s gross estate.
Finally, Ms. Yoder’s estate challenged 26 C.F.R. section 20.2036-1(c)(2), which contains the formula to calculate the portion of the property includable under Section 2036(a), asserting that the formula is flawed because it assumes the annuity payment will come entirely from the GRAT’s income rather than contemplating the amortization of principal. The Court, displeased with the cursory manner in which the argument was presented, declined to address the validity of the formula.
The Court’s decision that Ms. Yoder’s GRAT falls within the reach of Section 2036(a)(1), and is therefore included in her gross estate, is based upon her failure to divest herself of the enjoyment of the GRAT corpus from which her annuity payments were drawn. This is a risk that clients should be well aware of before established a GRAT and in selecting the term of the GRAT.
Frank Baldino is an estates and trusts attorney who helps people throughout the greater Washington, DC area protect assets for their families and future generations through careful estate tax planning. For more information, contact Frank at (301) 657-0175 or [email protected].