Bongard: Tax Court Incorrectly Expands Sec. 2036(a)’s Application

By Vinu Satchit, CPA, BDO Seidman, LLP, High Point, NC, and Member, AICPA Tax Division’s Trust, Estate and Gift Tax Technical Resource Panel

Sec. 2036(a) includes in a transferor’s gross estate the entire value of a lifetime transfer of property if he or she has retained, through explicit or implied agreements, one or more of the valuable economic benefits associated with property ownership (i.e., the right to possess or enjoy the property, the right to income therefrom or the right to designate the person(s) who would enjoy such rights (collectively, “prohibited rights”)). The statute does not apply to transfers that are bona fide sales for full and adequate consideration (bona fide sale exception).

Avoiding Estate Tax

Although enacted in 1931, Sec. 2036(a)’s underlying premise—that title, possession and enjoyment of property need to be transferred to avoid inclusion in the transferor’s estate tax base—had been present in the tax law since the early 1800s. In those days, taxpayers attempted to avoid the imposition of state inheritance taxes by transferring title to property while retaining the right to income from it. State inheritance tax provisions, enacted as early as 1826, frustrated such attempts by including lifetime transfers in the inheritance tax base if the “possession or enjoyment of the property was intended to take effect only at death.”

The 1916 Federal estate tax code also required the inclusion in the decedent’s gross estate of lifetime transfers intended to take effect, in possession or enjoyment, at death. From 1916–1930, Treasury treated transfers to trusts designed to distribute the corpus at the grantor’s death and which reserved a life income to the grantor as transfers “intended to take effect at death.”¹

The Supreme Court, however, took issue with such treatment in 1930. In May v. Heiner,² the taxpayer transferred assets to a trust that provided benefits to her husband for life, then to her for life, and then to her children. The Supreme Court, reversing the Third Circuit, concluded that the critical moment for determining whether property was includible in the gross estate was the point of passage of fee simple title. Because title had passed to the trust, the transfer was not includible in the gross estate. In response to the Supreme Court’s holding in Heiner and other cases, Sec. 2036(a)(1)’s predecessor was enacted in 1931.³

Sec. 2036(a) and FLPs

In recent years, the Tax Court has agreed in many cases with the Service’s argument that assets transferred to family limited partnerships (FLPs) were includible in the transferor’s estate under Sec. 2036(a). In determining whether a transferor has im-plicitly retained an economic benefit under Sec. 2036(a)(1), the courts typically look at all of the facts and circumstances surrounding the transfer and the subsequent use of the property. In all of the earlier cases involving Sec. 2036(a),⁴ analyses of the property’s subsequent use provided objective evidence that the taxpayer continued to possess and enjoy the property (or the income therefrom), as exhibited by one or more of the following facts:

• The income continued to be de-posited in the transferor’s accounts;
• The FLPs made disproportionate distributions and interest-free loans to meet the transferor’s living expenses;
• The FLPs paid the taxpayer’s personal expenses directly;
• The transfers were not properly recorded under state law; and
• The taxpayer continued to use the transferred property without paying rent.

Clearly, these facts evidence that while the decedents may have technically transferred title to the property to the FLP during life, they never actually parted with some or all of the valuable economic attributes associated with ownership (like the right to income or use). Thus, although the application might be clumsy, and the process fraught with technical hurdles⁵ (especially when applying the bona fide sale exception), the results are justified in these cases, because retention of possession or enjoyment of the transferred property is exactly the problem Sec. 2036(a) was enacted to address. In these cases, the taxpayers literally retained possession or enjoyment.

Bolstered by its many successes, the IRS has attempted in other cases to expand Sec. 2036(a)’s application to instances in which the use of the property after the transfer provided no evidence of the decedent’s retention of a valuable economic benefit. The Fifth Circuit turned down one such attempt in Kimbell,⁶ finding that the transfer met the bona fide sale exception. However, in Bongard,⁷ the Tax Court ruled that a decedent’s inter vivos transfers were includible in his estate under Sec. 2036(a)(1), even though he was relatively young and in good health at the time of the FLP’s formation (and at death), retained sufficient assets outside the partnership to maintain his lifestyle and did not engage in any of the transactions that typically evidence the retention of possession or enjoyment. The findings, based on an expansive and abstract (albeit flawed) definition of possession or enjoyment, have created controversy, for they are at odds with the statute’s plain meaning, its legislative intent and applicable Supreme Court precedent.

Bongard’s Facts

Wayne C. Bongard, the founder of Empak, Inc., a successful package design and manufacturing corporation, died unexpectedly on Nov. 16, 1998, at age 58. Two years before his death, he had owned 86.39% of Empak’s outstanding common stock; the remaining 13.61% was held by the Wayne C. Bongard Irrevocable Stock Accumulation Trust (ISA Trust), an irrevocable trust he created and funded in 1986 for his family’s benefit. On Dec. 28, 1996, the decedent and the ISA Trust transferred their Empak stock to a holding company—WBC Holdings, LLC (WBC)—in exchange for a proportionate number of WBC membership units.⁸ At that time, Empak was considering a private or public offering of its stock to raise additional capital; the stock transfer to the holding company was part of that plan.

A day later, the decedent and the ISA Trust set up the Bongard Family Limited Partnership (BFLP). The decedent documented the reasons (creditor protection, management of family assets, mechanism for gifting interests to children, limiting expenses in case of lawsuits and providing transfer tax benefits) in a letter to his children. Bongard contributed all of his WBC class B units for a 99% limited partnership (LP) interest in BFLP; ISA Trust contributed some of its WBC class B units for a 1% general partnership interest. All partnership formalities were observed in BFLP’s formation and subsequent administration.

During 1997, the decedent, in a series of transfers, gifted 51.38% of the WBC class A units to several trusts set up for the benefit of his children, grandchildren and wife. He also transferred a 7.72% LP interest in BFLP to his wife as part of a post-marital agreement. Thus, at death, he owned 49.28% of the WBC class A units and a 91.28% LP interest in BFLP. The estate tax return, filed in 2000, showed the value of the WBC units and the LP interest as approximately $4 million and $41 million, respectively. Asserting that Sec. 2036(a) applied to the transfer of Empak shares to WBC, and the subsequent transfers of WBC class B units to BFLP, the IRS issued a deficiency notice that included the 1996 transfer of Empak shares to WBC in the gross estate, increasing it by $96 million.⁹

Decision

The Tax Court, in an en banc decision,¹⁰ concluded that the transfer of Empak shares to WBC was not includible in the gross estate under Sec. 2036(a)(1), because the transfer met the bona fide sale exception. However, the court stated that the subsequent transfer of WBC units to BFLP did not meet that exception. Finding the existence of an implied agreement that allowed the decedent to retain enjoyment of the units after the transfer, the court concluded that the value of the WBC units he transferred to BFLP were includible in his estate (consequently, under Sec. 2035(a), the transfer to the spouse of the 7.72% LP interest was also includible).

The court’s analysis started with the bona fide sale exception. After reviewing prior decisions, it concluded that the exception is met “where the record establishes the existence of a legitimate and significant nontax reason for creating the family limited partnership, and the transferors received partnership interests proportionate to the value of the property transferred.” Because WBC was formed to position Empak for a corporate liquidity event, the court concluded that the bona fide sale exception was met.

As to BFLP, the court stated that the bona fide sale exception did not apply, due to a lack of legitimate and significant nontax reasons for its formation. It cited the facts that BFLP never (1) engaged in businesslike transactions, either before or after the decedent contributed his interest and (2) attempted to diversify its assets, as evidence that the transfer resulted in a mere “recycling of the value.” The estate argued that BFLP offered significant nontax benefits—creditor protection, mechanism for gifting interests to family members, facilitation of the decedent’s post-marital agreement and investment management—all of which the court dismissed as insignificant.

In all the Sec. 2036(a) cases, the courts have purported to test for the bona fide sale exception before, and independently of, testing for the retention of prohibited rights. However, the cases in which the exception was not met were also those in which prohibited rights were retained. This is not mere coincidence; the retention of prohibited rights has forced the Tax Court to find ways to overcome the bona fide sale exception in applying Sec. 2036(a) to FLPs. In this process, it created concepts such as “mere recycling,” “legitimate negotiations,” “pooling of assets” and “legitimate and significant business or nontax reasons” as essential to such inquiry. Unfortunately, these tests place undue emphasis on the taxpayer’s subjective motives, contrary to Sec. 2036(a)’s legislative intent.

For this reason, the Fifth Circuit’s decision in Kimbell rejected concepts such as mere recycling and legitimate negotiations, and instead created a three-prong test. While the third prong does scrutinize the transaction to make sure it is not a sham, the nature of the inquiry is limited to an examination of objective facts that would confirm or deny the taxpayer’s assertion that the transfer is bona fide or genuine. Thus, the presence of some potential benefit other than estate tax advantages should be sufficient to meet the third prong, as long as there is no factual evidence of the retention of prohibited rights. In the instant case, the Tax Court misapplied the bona fide sale exception, by dismissing the taxpayer’s reasons as not offering any potential benefit.

Retaining prohibited rights: Because the exception was not met, the next step of the Sec. 2036(a) inquiry was to determine whether the decedent retained any prohibited rights in the transferred property through explicit or implied arrangements.

The court noted that the decedent, as the chief executive officer and sole member of Empak’s board of directors, had the ability to determine the timing and magnitude of any redemption transactions as to Empak shares. Because BFLP could not transform its sole asset (the WBC class B membership units) into a liquid asset without a redemption, the court stated that the decedent, by not ordering any redemptions, exercised “practical control over BFLP and limited its function to simply holding title to the class B membership units.” Regardless of whether any redemption took place, the court concluded that the decedent’s “ability to decide whether that event would occur demonstrates the understanding of the parties involved that the decedent retained the right to control the units transferred to BFLP.” Such control, according to the court, equated to an implied agreement to continue to enjoy the property after the transfer; thus, Sec. 2036(a)(1) applied.

Dissent

In a part concurrence and stinging part dissent, Judge Chiechi (joined by Judges Wells and Foley) called the majority’s conclusion as to the application of Sec. 2036(a)(1) to the transfers to BFLP “factually, logically, and legally flawed.” The major weaknesses were well exposed in her dissenting opinion, which cited extensively from Byrum,¹¹ a Supreme Court case that shed light on Sec. 2036(a)’s limits.

Byrum facts: A decedent had transferred shares in three closely held corporations to an irrevocable trust for his children’s benefit, but retained the right to vote the transferred shares. That right, the IRS argued, resulted in the decedent retaining the right, under Sec. 2036(a)(2), to designate the beneficiary of the income from the transferred property. It reasoned as follows: by retaining voting control, the decedent retained the power to elect the majority of the corporations’ boards of directors. Be-cause the boards controlled dividend policy, he could use his influence over the directors he helped elect to control the timing and amount of dividends.

Alternatively, the Service also contended that the decedent had retained the right to enjoy the property under Sec. 2036(a)(1), because he had the power to determine when the corporations merged or liquidated and to influence his personal compensation and continued employment with the corporations. According to the IRS, “the cumulative effect of the retained powers and the rights flowing from the shares not placed in trust leaves the grantor in control of a close corporation and assures control for his lifetime.”

In ruling for the taxpayer, the Court noted that the term “right” connotes an “ascertainable and legally enforceable power,” and the purported rights Byrum retained—i.e., to unduly influence the three boards of directors in declaring dividends—“was neither ascertainable nor legally enforceable and hence not a right in any normal sense of that term.” It noted that the broad discretion the boards enjoyed over dividend policy was restrained by fiduciary responsibilities demanding that they act in the companies’ best interests. The Court also noted that alleged control over dividend policy, even if present, would only result in income distributions to the trust; only the corporate trustees could control the flow of income from the trust to the beneficiaries. Hence, the decedent did not have the power to designate the persons who would enjoy the income from the property under Sec. 2036(a)(1).

The Court also rejected the Service’s Sec. 2036(a)(1) argument as “conceptually unsound.” It ruled that the terms “enjoy” and “enjoyment,” as used in various estate tax statutes, “are not terms of art, but connote substantial present economic benefit.” It noted that the power to liquidate or merge is not a present benefit, but merely a “speculative and contingent benefit which may or may not be realized.” In addition, the power to influence personal compensation (and continued employment) was constrained by the boards’ fiduciary responsibilities.

In Bongard, Judge Chiechi noted that Sec. 2036(a)(1)’s language “plainly contemplates retention of an attribute of the property transferred—such as a right to income, use of the property itself, or a power of appointment with respect either to income or principal.” She noted that the analysis of the circumstances surrounding the transfer, and the subsequent use of the property, did not point to an implied agreement to retain such attributes.

In addition, the dissent noted that the Supreme Court had held the term “right” to connote “ascertainable and legally enforceable power,” and the term “enjoyment” to connote “substantial present economic benefit.” As to the alleged ability to control the redemption of Empak shares and the subsequent redemption of WBC units, the dissent noted that such alleged ability, even if it did exist, was neither an ascertainable and legally enforceable power, nor a right that showered substantial present economic benefit on the decedent. It was, at best, “a speculative and contingent benefit which may or may not” be realized and, thus, did not rise to the level of a prohibited right under Sec. 2036(a).

The dissent also pointed out that the “control” test, which formed the basis for the majority’s conclusion, had been explicitly rejected by the Byrum Court, because the term did not have a fixed and ascertainable meaning and, thus, the test was “too variable and imprecise to constitute the basis per se.” As the Supreme Court explained, although the right to vote more than 50% of the stock may give taxpayers control over electing the board of directors, it may not allow them to control certain corporate transactions. In addition, based on the corporation’s size and the concentration (or lack thereof) of ownership, a shareholder owning less than 50% may have “control,” in the sense of being able to influence the election of the board of directors.

Conclusion

The statute’s plain language and legislative intent, and the applicable Supreme Court precedent, are clearly at odds with the Bongard majority opinion that Sec. 2036(a)(1) applied to the transfers to BFLP. Perhaps the hesitancy to endorse multiple reductions in the value of assets through the formation of tiered entities played a part in the Tax Court’s conclusion; by transferring the Empak shares to WBC, the decedent was able to reduce the estate tax value of his holdings from $165 million to $108 million. If Sec. 2036(a) did not apply to the transfer of WBC units to BFLP, the result would have been significant further reduction in the gross estate’s value. This issue may have indirectly affected the court’s reasoning, but the ends do not always justify the means, especially when the interpretation upsets well-settled estate law concepts. The Eighth Circuit (if the case is appealed) should overturn the Tax Court’s decision. In the meantime, existing FLPs should continue to comply carefully with state law formalities, and the FLP agreement’s terms, in the yearly administration process.