When Is Transferred Property Pulled Back Into the Estate At Death? Be on Your Bongard!

Overview

When the federal estate tax exemption was much lower than it is now, gifting property played a much greater role in estate planning than it does now.  That gifting could consist of either an outright gift of property or a gift of an interest in an entity.  In either situation, the basic idea was to transfer value away, typically to other family members to keep the transferor’s estate at death beneath the level of the available estate tax exemption at death so that federal estate tax could be avoided. 

However, if a transfer isn’t done correctly, it runs the risk of being pulled back into the decedent’s estate and subjected to federal estate tax at death. 

Avoiding transferred property being included in a decedent’s estate at death – it’s the topic of today’s post.

Tax Code Provision and Tax Court Test

Under I.R.C. §2036, the value of a decedent’s gross estate includes the value of all property to the extent that the decedent had an interest in the property at the time of death.  That includes property that the decedent transferred but retained for life, or for any period of time tied to the decedent’s death the possession or enjoyment of the property.  I.R.C. §2036 also catches a retained right to receive income from the property or the right to designate who possesses the property or the income from the property.  The same is true for a retained right to vote stock of a corporation the decedent controls. 

When will a transfer be respected so that the transferred property will not be included in the transferor’s estate at death?  In Estate of Bongard v. Comr., 124 T.C. 95 (2005), the Tax Court set forth the standard concerning how to determine whether I.R.C. §2036 pulls property back into a decedent's estate. According to the Tax Court, transferred property will be pulled back into the decedent’s estate if the decedent made a transfer of property during life that was not a bona fide sale for adequate and full consideration, and the decedent retained an interest or right in the transferred property.  A sale is bona fide only if the evidence establishes the existence of a legitimate and significant nontax reason exists for the transfer.

Recent Case

The Tax Court’s Bongard standard was at issue in another Tax Court case decided earlier this year.  In Estate of Moore, T.C. Memo. 2020-40, the decedent, at age 88 in late 2004, started negotiations with prospective buyers for the sale of his farm.  However, before he could get the farm sold, he suffered a heart attack and was diagnosed with congestive heath failure.  Doctors told him that he wouldn’t live longer than six months.  Within a week after being discharged from the hospital, and while in in-home hospice care, the decedent worked with an attorney to formalize an estate plan – something he really hadn’t done up to this point in time.  His primary goal was to eliminate potential estate tax.  However, he also wanted to maintain control.  Those two goals can prove difficult to satisfy simultaneously. 

Ultimately, the attorney created various trust for the decedent – a revocable living trust; a charitable lead annuity trust; a trust for his children; a management trust; an irrevocable trust (also for the benefit of his children); and a family limited partnership (FLP).  The management trust (which made a nominal contribution to the FLP upon its formation) held a 1 percent general partner interest in the FLP.  The decedent held a 95 percent limited partnership interest in the FLP.  Each of his four children held a 1 percent limited partner interest. Purportedly, the purpose of the FLP was to provide protection against liability; protection against creditors; bad marriages; and to bring together a dysfunctional family.  Under the terms of the FLP agreement, no single partner could transfer any interest unless all partners agreed.

The decedent transferred all of his property (the farmland and his personal property) to the revocable living trust.  The trust contained a formula that transferred a part of the trust assets to the charitable trust with the goal of causing the least amount of federal estate tax to the estate.  Everything else, after payment of taxes and claims and distributions of specific bequests were specified to pass to the trust for the children.  The management trust held a 1 percent interest as a general partner in the FLP and, upon the decedent’s death, that interest was to be distributed to the trust for his children.  The decedent then transferred (via the revocable living trust) an 80 percent interest in his farmland and $1.8 million worth of assets to the FLP. 

Five days after forming the FLP, and within two months of his death, the decedent sold the farm for almost $17 million.  The FLP and the revocable trust transferred their respective interests in the farmland to the buyer.  The terms of sale allowed the decedent to continue to live on the farm and operate it (in accordance with his capability) until his death. 

After the sale, the decedent directed the FLP to transfer $500,000 to each of his four children in return for a five-year promissory note at a 3.6 percent interest rate per annum.  However, there was no amortization schedule for any of the notes, and none of the children made any payments.  Also, the FLP never attempted to collect on the notes, and the attorney that prepared the estate plan told the children that they didn’t have to pay on the notes.  The FLP then distributed (purportedly a loan) $2 million to the revocable living trust, that the decedent used to pay expenses, including the balance of the $320,000 attorney fee charged to set up all of the trusts and the FLP, and the tax obligation on the sale of the farm. 

Additionally, in late February 2005, the living trust transferred $500,000 to the irrevocable trust, which was treated as a $125,000 gift to each of the four children. Lastly, in early March 2005, the living trust transferred its entire limited interest in the FLP to the irrevocable trust in return for $500,000 cash and a note for $4.8 million. The decedent died in late March of 2005.

The decedent's federal estate tax return reported $53,875 for the management trust's 1% general partnership interest in the FLP; $4.8 million for the note receivable from the irrevocable trust; claimed a $2 million deduction for the debt owed to the FLP and a $4.8 million deduction for a charitable contribution to the charitable trust.  It also reported $1.5 million in taxable gifts; and $475,000 deduction for attorneys' fees associated with the administration of the decedent's estate (reported on Schedule J (the form where estate administration deductions are claimed), which was in addition to the $320,000 charged for establishing the estate plan).

The estate also filed a federal gift tax return for 2005. The return reported gifts of $125,000 for each of the decedent's children in the form of the $500,000 transfer to the irrevocable trust earlier that year.

The IRS issued a notice of deficiency to the estate determining a deficiency of nearly $6.4 million. Additionally, the IRS issued a notice of deficiency determining a gift tax liability of more than $1.3 million for the 2005 tax year.  While the Tax Court was tasked with addressing numerous legal/tax issues, a primary one was whether the value of the farm should be included in the decedent’s estate for tax purposes. 

The Bongard Application

Business purpose.  As noted above, one of the tests established by the Bongard decision is whether a transfer was made for a nontax business purpose.  That is usually evidenced by active management of the transferred asset(s).  But here, the Tax Court noted, the decedent sold the farm days after he transferred it to the FLP.  That meant that there was no business for the children to manage.  Only liquid assets remained in the FLP that the children did not manage.  Instead, and investment advisor was hired to manage the liquid assets.  Also, based on the evidence, there was no legitimate concern about creditor claims (another legitimate purpose for creating the FLP). In addition, the entire estate plan (including the formation of the FLP) was done in the imminence of death as part of a scheme to avoid tax.  The whole plan reeked of being testamentary in nature.

Retained interest.  Also, part of the Bongard test is that the decedent must not retain an interest in the transferred property.  But the Tax Court determined that the decedent had at least an implied agreement to retain possession or enjoyment of the farm property.  Indeed, he continued to live at the farm and made management decisions up to his death and treated the other FLP assets as his own by paying personal expenses (including attorney fees) with them and using FLP assets for making loans to his children.  In essence, he treated the FLP as his pocketbook. 

The retained possession or enjoyment of the transferred property along with the lack of a substantial nontax purpose caused inclusion of the farm property in the decedent’s gross estate at death.  The amount included in the estate was calculated as the value of the farm as of the date of death less the funds that left the estate between the time of the sale and the date of death.  I.R.C. §2043.

Other Issues

The Tax Court also determined that the “loan” from the FLP to the revocable living trust was not really a loan, thereby wiping out an estate tax deduction for the $2 million loan. There was nothing that indicated that it was a loan – no note; no interest; no collateral; no maturity date specified; and no payments were made or demanded. 

The Tax Court also agreed with the IRS that the “loans” to the children were gifts.  Again, like the purported loan from the FLP to the revocable living trust, there was nothing to indicate that the transfers to the children were anything other than gifts.  Those total gifts of about $2 million caused the additional gift tax to be included in the decedent’s estate as gifts within three years of death.  I.R.C. §2035(b). 

Conclusion

The Moore case is an illustration of what not to do.  Of course, the emphasis on avoiding federal estate tax was bigger at the time the planning was engaged in than it is now.  The federal estate tax exemption equivalent of the unified credit was only $1,500,000.  That’s a far cry from the current level of the exemption.  But, for those with large estates that face the potential of federal estate tax, the case clearly points out the peril that unplanned estates face in a rush to tidy matters up before time is up.

In addition, “death bed” estate planning is particularly not good when the planning tries to get too “cute.”  Formalities of entities and transfers must be followed and, when an FLP is involved, the transferor must retain sufficient assets personally to pay living expenses, etc.  Any use of the FLP assets after transfer to the FLP, must be via an agreement that clearly denotes that the assets belong to the FLP and that an appropriate amount is paid for the assets’ usage.  Retained possession and enjoyment of transferred assets is a big “no-no.”