Tax Code’s “String” Provisions: Expanding the Retained Interest Trap

Take-Away: While we are less concerned about federal estate tax liability these days, a working knowledge of the Tax Code’s ‘string provisions’ is critically important when individuals decide to make aggressive use of today’s large tax-free gifting opportunities presented by the 2017 tax law. That said, the IRS seems to be making headway in re-asserting the ‘string provisions’ in Tax Court cases in search of estate and gift tax revenues. Apparently in the view of the IRS and the Tax Court, a retained interest includes not only interests expressly retained by the transferor, but also an interest that may be exercised by someone who holds the power in a fiduciary capacity on behalf of the transferor.

Background: Often referred to as string provisions, three sections of the Tax Code can cause an individual’s estate to include the value of assets that the individual does not own at death. A fourth string can be said to be found in the special gift tax valuation sections of the Tax Code. Not only do the string provisions increase an individual’s federal and state estate tax liability, how those additional estate taxes are allocated due to the presence of the phantom assets that caused the additional transfer tax also can present confusion and litigation over whose inheritance is reduce to pay the tax on assets no longer owned or controlled by the decedent’s estate. As individuals begin to exploit the additional $5.0 million federal gift tax exemption, it is important to understand when, and how, the string provisions come into effect. With regard to the special gift tax valuation rule, that can come as a surprise to family members who do not even intend to make a gift.

• IRC 2036: This Code section applies to include in the value of the individual’s gross estate the value of all property that the decedent had transferred during lifetime over which the decedent retained for life the right, either alone or in conjunction with another person, to designate the person or persons who will possess or enjoy the property or the income from that property. Example: I transfer title to my house to my children, but I reserve (retained) the right to live in my house the rest of my life. My retained enjoyment of the transferred asset causes the value of the home to be included in my taxable estate, even though my children will hold title to the home immediately upon my death. Think of the conventional ladybird deed used by parents to effectively convey title to their home to their children on death while avoiding probate.
• IRC 2037: This Code section applies to include in the value of the individual’s gross estate all property transferred, by trust or otherwise, where the possession or enjoyment of the transferred property can, through ownership of such interest, exist only by surviving the individual. This is a cumbersome way  of the Tax Code to say that if the individual, immediately prior to his/her death, holds a reversionary interest in the transferred property that exceeds 5% of the value of the transferred property, then the property’s value will be included in the deceased individual’s gross estate. The reversionary interest is valued for purposes of IRC 2037 by taking into consideration (a) the mathematical chance, based on the transferor’s age, that the individual will survive the contingency upon which the reversionary interest rests; (b) the fact that the individual’s interest cannot take effect in any event until the contingency is fulfilled; and (c) the value of the transferred property. Example:  A 60 year old irrevocably transfers $500,000 stock to a trust. The trust directs the payment of all dividend income for life to the transferor’s neighbor, who is then age 55. Upon the neighbor’s death the stock returns to the transferor if he/she is then living, but if not living, the stock then passes from the trust to the neighbor’s spouse. The transferor dies 4 years later. The transferor’s reversionary interest in the trust assets will be valued as of the date of the transferor’s death by first determining the statistical likelihood that the transferor (now age 64) will survive the neighbor (now age 59) and then multiplying the resulting percentage by the discounted present value of the stock immediately before the transferor’s death. If that percentage is over 5%, then the value of all of the stock held in trust is included in the transferor’s taxable estate, as the transferor’s reversionary interest exceeded 5%.  Admittedly this string provision is infrequently encountered;  when it is more of a trap, since usually the retained reversionary interest attributed to the transferor results more from a mistake in the transfer document, e.g. the trust instrument, than by intentional design.
• IRC 2038: This Code section applies to include in the value of the individual’s gross estate the value of all property which the decedent had transferred during lifetime over which the decedent retained a power, exercisable either alone or in conjunction with another person, to alter, amend, revoke or terminate the transferee’s enjoyment of the transferred property, which power the decedent did not relinquish before death.  Example: I create and fund an irrevocable trust for my daughter’s benefit. But I retain the right to terminate the irrevocable trust at any time. My right to terminate the trust, and thus my daughter’s interest in the trust as a result of the trust’s termination, causes the value of the trust corpus to be included in my taxable estate. This power, whether or not exercised, is sufficient to cause the value of the trust’s assets to be taxed in my estate.
• IRC 2035(b): This stealth Code section applies indirectly when the individual releases their retained right or string power or reversionary interest prohibited under IRC sections 2036, 2037, or 2038 within three years of the decedent’s death. Example: I transfer title to my home to my children, but I retain a life estate in the deed (e.g. a ladybird deed.) After talking to my attorney, I learn of IRC 2036 and the problems that it will cause my taxable estate on my death, so I later release my retained life estate in the home that I previously had transferred to my children. If the release of my life estate interest occurs within three years before my death, the full fair market value of the home is still included in the value of my gross estate that is subject to federal estate taxation. Thus, the home which I no longer own, and the life estate that I previously enjoyed,  but I did not enjoy at the time of my death, still can cause additional federal estate tax liability for my estate, which is what I mean by a stealth tax provision.
• Estate Tax Surprises: Consider the IRC 2038 example. I create a trust for my daughter, reserving to myself the right to terminate the trust at any time. Due to IRC 2038 the full value of the trust’s assets are added to my estate (the value of the assets, not the assets themselves.) My estate plan leaves all of my wealth to my two children in shares of equal value. No special estate tax clause is included in my estate planning trust, the result of which is that my two children indirectly pay all estate taxes due on my death. My son will not be happy when he learns that the IRC 2038 trust added to that tax burden, of which he must pay 50% when he did not receive half of the IRC 2038 trust assets.
• Retained: The summary of each of these Tax Code sections is there must be (i) lifetime transfer (ii) where the transferor either retained the use and enjoyment of the transferred assets, or (iii) retained the ability to control who will enjoy the transferred assets, and that retained control is either when the transferor acts alone,  or only in conjunction with another person, e.g. the transferor’s attorney or accountant.

Exception for Bona Fide Sale for Adequate Consideration: None of these string provisions applies, however, if the transferor received fair and adequate consideration in money or money’s worth for the interest that is transferred. Example: I sell a life estate in my home to my neighbor, i.e. for my neighbor’s lifetime (not mine), and I receive full value for the life estate interest that is sold to the neighbor- the life estate is valued on his life expectancy applied to the fair market value of the home. I received full value for the life estate in my home sold to my neighbor. But I retained a reversionary interest in the home, should my neighbor die before me, when his life estate interest is terminated. The string provision  for estate tax inclusion applies but also including the consideration that I received from my neighbor for the purchase of the life estate  would result in ‘double counting’ the same asset twice in my taxable estate (the value of the home plus the value of the consideration that my neighbor paid to me.) This fair and adequate consideration exception was the subject of multiple litigation about 20 years ago, when family LLCs were created and used to transfer wealth to children and grandchildren, the transferor claiming that the LLC units received in exchange for the transferor’s assets transferred to the LLC was adequate consideration. Of course, adequate consideration is a concept that is subject to considerable debate among appraisers, and thus the source of much litigation in the Tax Court. In short, with the benefit of hindsight, if I did not receive full and adequate consideration for what was transferred by me, then the full value of the lifetime transferred assets are brought back into my estate for estate tax calculation due to the string provision, with maybe an offset for what I received in exchange, but there is no guaranty.

IRC 2703: The problem with the IRS asserting a string provision is that the government must wait until the transferor’s death in order to claim that an impermissible string existed, which obviously is intended to generate more federal estate tax. But if the IRS wants its tax revenues earlier in time, it will sometimes try to assert IRC 2703 as a means to generate current a federal gift tax liability. This comes into play when the subject of the lifetime transfer to a family member is an interest in a LLC, partnership, or corporation where the bylaws, partnership agreement, or LLC operating agreement contain provisions that indirectly result in retained rights by the transferor, which retained rights are intended to reduce the gift-tax value of the entity interest that is formally transferred to a family member.  IRC 2703 provides that the value of any transferred property interest  is determined without regard to the transferor’s retained option or agreement to acquire, use the property at a price that is less than fair market value of the property without regard to such option or agreement, or any restriction on the right to sell or use the transferred property. Example: I create an LLC and transfer to it marketable securities. As part of that LLC there is 1% voting membership interests and 99% non-voting interests in the LLC. I then gift the non-voting interests to my children. The LLC operating agreement says that there must be unanimous consent of all LLC members to liquidate the LLC. I assert aggressive valuation discounts to the transferred 99% non-voting interests since my children cannot force the liquidation of the LLC, nor can they control the LLC (which I retained in my 1% interest.) The IRS will claim that the restrictions in the LLC operating agreement can be ignored under IRC 2704, the result of which is that I am treated as gifting the entire value of the LLC’s assets (without any discounts nor with any value attributable to my 1% retained interest.) In sum,  the value of the interest in the entity retained by the transferor is valued at $0.00 when the value of gift to the family members is determined, which produces an immediate gift tax liability for the transferor. IRC 2703 thus acts as something of a backstop to the string provisions since it is intended to produce an immediate gift tax that is due, merely by valuing the transferor’s retained interest in the transferred entity at $0.00.

Recent IRS Arguments Regarding “In Conjunction With:” Each string provision applies and causes estate inclusion when the decedent could act either alone or in conjunction with any other person. An expansive view of in conjunction with ‘net’ is beginning to appear in the Tax Court, which is now causing taxpayers lots of transfer tax exposure.

• Regulations: The Regulations already provide an expansive view of  what in conjunction with: means: With respect to such a power, it is immaterial (i) whether the power was exercisable alone or only in conjunction with another person or persons, whether or not having an adverse interest; (ii) in what capacity the power was exercisable by the decedent or by another person or persons in conjunction with the decedent; and (iii) whether the exercise of the power was subject to a contingency beyond the decedent’s control which did not occur before his death (e.g. the death of another person during the decedent’s lifetime.) The phrase, however, does not include a power over the transferred property itself which does not affect the enjoyment of the income received or earned during the decedent’s life. (See, however, section 2038 for the inclusion of property in the gross estate on account of such a power.) Nor does the phrase apply to a power held solely by a person other than the decedent.  But, for example, if the decedent reserved the unrestricted power to remove or discharge a trustee at any time and appoint himself as trustee, the decedent is considered as having the powers of the trustee. Treas. Reg. Section 20.2036-1(b)(3). It is the underlined language that is now being stretched to include other persons acting alone but who may have some indirect fiduciary duty to the transferor.
• Powell Interpretation: The IRS successfully applied this much broader interpretation to that relatively benign phrase in each string provision when it searches for powers considered as retained by the decedent. What initially grabbed everyone’s attention was the Tax Court’s decision in Estate of Powell v. Commissioner, 148 T.C. 18 (2017) which expanded the reach of  the ‘ in conjunction with’ string to cause estate tax inclusion because the general partner of a partnership also was the transferor’s agent under a durable power of attorney. Powell was the case where the mother, shortly before her death,  transferred $10 million of assets to a family limited partnership. She held no general partnership interests, but she took back almost $10 million worth of 99% of the limited partnership interests. Her sons, who contributed nominal amounts  (via their promissory notes) took back the 1% general partnership interest. The mother then gifted her retained 99% limited partnership units to a charitable lead annuity trust (CLAT). When the mother died she held no interest in the limited partnership that her $10 million of assets had originally funded. Nothing was ‘retained’ by her at the time of her death. However, the Tax Court accepted the IRS’s arguments that the decedent’s son, the general partner of the limited partnership and also the agent who held his mother’s durable power of attorney, indirectly  gave to the decedent the retained right in conjunction with her son to designate the persons who could possess or enjoy the property that she had transferred to the limited partnership, or the income from the partnership, since as the general partner, he could terminate the partnership and thus ultimately control when other partners would enjoy the partnership assets. The decedent’s indirect retained right to control the partnership assets was through her son the general partner who also held her durable power of attorney. The son retained nothing, but his power was attributed to his mother because he had some fiduciary duty to her. I was troubled by the decision because the son, as agent, only had control over his mother’s assets that she owned. At the time of her death, she owned no partnership assets, but somehow the court attributed back to her the partnership interest that the son had purchased using his own assets. The estate tax notice in Powell explains the IRS’ interpretation of the ‘in conjunction with’ string:

It is determined that the decedent retained at her death the possession, enjoyment, or right to the income from the property she transferred to the [partnership] … or the right, either alone or in conjunction with any person [her son], to designate the persons who shall possess or enjoy the property or the income there from such that the property transferred to the partnership valued at $10,022,570 on the valuation date is includible in the gross estate under IRC 2036(a.) Alternatively, it is determined that the decedent retained at her death a power to change the enjoyment of property transferred to the [partnership] through exercise of a power by the decedent alone or in conjunction with any other person [her son] to alter, amend, revoke or terminate such that the property transferred to the partnership valued at $10,022,570 on the valuation date is includible in the gross estate under IRC 2038(a). Alternatively, it is determined that the decedent retained a her death a power to change the enjoyment of a 99% limited partnership interest in the [partnership] through exercise of a power held by the decedent alone or in conjunction with any person [her son] to alter, amend, revoke or terminate such that the value of the 99% limited partnership interest is includible in her gross estate under IRC 2038(a) at its fair market value of $10,022,570. The fair market value of the 99% partnership interest is determined without regard to certain rights and restrictions identified in IRC 2703(a.)

In summary, because the mother’s agent under a durable power of attorney was also the general partner who could  control the partnership, that ability to control the partnership via the agent-general partner roles was attributed to the agent’s principal, his mother, who was considered as holding the powers. This expansive interpretation of in conjunction with occurred even after the mother gave away her entire interest in the limited partnership, merely because her son held her durable power of attorney and he as general partner placed him in control to liquidate the partnership. It came as a surprise to many who viewed the in conjunction with clause in the string provisions as requiring a deliberate retention of control over the transferred asset, not a deemed or indirect control held by another (while also ignoring the general partner’s fiduciary duty to act in the best interests of the other partners in the partnership, not just his mother, his principal, under the durable power of attorney.) Apparently the Tax Court assumed that son-agent would at all times do his mother’s bidding over the partnership and its assets, triggering IRC 2036(a) on her death. One clear take-away from this case is that if family entity planning is a centerpiece of an estate plan, the transferor’s children should NOT hold their parent’s durable power of attorney.

• Cahill Argument: Last month the Tax Court was again called upon to interpret the phrase in conjunction with in Estate of Cahill v Commissioner, T.C. Memo. 2018-84 (June 18, 2018.) The facts in Cahill are too complex to discuss at length, but suffice it to say that it is a case that deals with a sophisticated split-dollar life insurance plan where the initial source of funds used to acquire $79.8 million life policy held in an ILIT on the life of the decedent’s child was a $10 million loan from the decedent. The decedent’s estate argued that only the fair market value of the promissory note the ILIT trustee gave to the decedent to document that loan was includible in the decedent’s taxable estate (around $184,000). The low value was because the loan did not come due until the insured’s death when the policy was paid off-recall that the insured is the transferor’s child, about 40 years younger, hence the long wait before the note would come due. The IRS argued that the cash surrender value of the life insurance policy held in the ILIT, $9.6 million, should be included in the decedent-lender’s taxable estate, not the $183,700 discounted present value of the note ( which only become due when the insured child died and the death benefit was paid to the ILIT). The decedent’s son was the trustee of the revocable trust that held the decedent’s promissory note from the ILIT. The son’s cousin and business partner was the ILIT trustee. The split dollar agreement said that the agreement could be terminated if both the holder of the note and the trustee of the ILIT agreed to terminate the arrangement. The IRS argued that the son, as trustee of the decedent’s revocable trust prior to death, held the ability to unwind the loan transaction and gain access to the life insurance policy’s cash surrender value which was offered as security for the ILIT’s note to the decedent because he could act ‘in conjunction with’ his cousin, the ILIT trustee. While not deciding the estate inclusion question directly, the Tax Court denied the estate’s motion for summary disposition when the estate asked for a determination that neither IRC 2036 nor 2038 applied to the split-dollar loan transaction, and that the restrictions contained in the split-dollar agreement along with the ILIT trustee’s fiduciary duties to beneficiaries (not the transferor or the son) should be disregarded as IRC 2704 would cause them to be ignored. Cahill relied upon the decision in Powell to hold that each of IRC 2036, 2038 or 2704 may apply to the split-dollar-loan arrangement with the strong possibility that the cash surrender value of the ILIT will be included in the decedent’s taxable estate. The Court’s decision seemed to suggest that the decedent’s son, as trustee of his revocable trust which entered into the split-dollar agreement with the trustee of the ILIT (his cousin and business partner), could have at any time mutually agreed, i.e. act in conjunction with, his cousin to terminate the split-dollar agreement and recover the cash surrender value. While Powell found an agent acting under a durable power of attorney to hold his principal’s retained string power, Cahill implies that the power of the trustee of a revocable trust can be attributed to the settlor who could agree with the trustee of the ILIT in order to find a string power to act in conjunction with another to control the split-dollar arrangement at the time of death and thus recover the cash surrender value of the policy. Again, fiduciary duties the of the ‘other person’ that might preclude participating in conjunction with the transferor were completely ignored by the court in reaching its conclusion.

Conclusion: Generally the string provisions are viewed as tax traps for estate tax calculation purposes (although they might be intentionally argued to be applicable to increase the income tax basis in the transferred assets now held in the hands of others.) Those long-standing traps may now be expanding if the string power is neither intentionally retained by the transferor, or it a power held by a third person [agent; trustee] can be deemed to be held by the transferor, even when that third person has to act in conjunction with yet another third person who has fiduciary duties to others, thus giving new and much broader meaning to a power or right that has been retained by an individual.