Erickson: IRS Wins Another §2036 Case

On April 30, 2007, the United States Tax Court issued a Memorandum decision & opinion in Estate of Hilde E. Erickson, Deceased, Donor, Karen E. Lange, Personal Representative, T.C. Memo 2007-107 (PDF, 30 pages). The issue, which related to the amount of federal estate & gift taxes owed, was framed by that court, as follows:

. . . [W]e are asked to decide whether property Hilde E. Erickson (decedent or Mrs. Erickson) transferred to a family limited partnership shortly before her death is included in her gross estate under section 2036(a)(1). We hold that it is.

The text & legislative history of Section 2036 is provided (unofficially) by the Tax Almanac. It notes that section's placement in federal law: under Part III ("Gross Estate"), of Subchapter A ("Estates of Citizens or Residents"), of Chapter 11 ("Estate Tax"), of Subtitle B ("Estate and Gift Taxes"), of Title 26 ("Internal Revenue Code"), of federal statutes.

The effect of Section 2036, very generally, is to bring back into the "gross taxable estate", for purposes of federal estate and gift tax calculations, any "retained interest" in property. A "retained interest" occurs when a transferor retained some interest in property that was transferred. Such a "retained interest " can be based in documentation, on rights, or from an expectation or understanding.

The "general rule" of Section 2036, is stated in its subsection (a):

The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death -

1. the possession or enjoyment of, or the right to the income from, the property, or
2. the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

The Erickson decision is the latest in a string of recent litigation successes for the Internal Revenue Service in its reliance on Section 2036 to tax assets previously transferred to a limited partnership (often a "family limited partnership") or a limited liability company.

Steve R. Akers, Esq., Esq., a Managing Director & Associate Fiduciary Counsel of Bessemer Trust Company, N.A., in Dallas, Texas, sent to me a brief article about the Erickson ruling, with "planning pointers". I repost it with his permission (thereby preserving copyright in him).

Tax Court Extends §2036 to Using Partnership Funds to Pay Decedent’s Estate Taxes: Erickson v. Commissioner

Estate of Erickson v. Commissioner, T.C. Memo 2007-107, is another §2036 victory for the IRS in a “terrible facts” case.

The case is particularly interesting in that the retained enjoyment of the partnership was the use of $227,500 of partnership funds to pay a portion of the decedent’s gift and estate taxes (albeit through the purchase of an estate asset and a redemption of part of the estate’s interest).

Indeed, there was also a $1.0 million credit shelter trust for the decedent that had been created at her husband's prior death and that could have been used to provide her living expenses without the necessity of withdrawals from the partnership. However, the case was surrounded with other facts that made readily apparent that the only purpose of the partnership was to try to secure an estate tax discount.

Planning Pointers from Erickson:

1. The partnership involves a transfer of all liquid assets from an Alzheimer's patient in her 80s and in poor health by her daughter acting under a power of attorney, with some transfers and gifts being made on her deathbed. Expect an IRS attack in these kinds of “wounded animal” cases.
2. Conservative planning would suggest, in light of this case, that the client should retain assets outside the partnership for living expenses, and at least a significant portion of the anticipated estate taxes. (However, it is impossible to know if the court would have ruled the same way if the case had not been surrounded by so many other terrible facts. This is the first case that has focused on the use of partnership funds to pay estate taxes as the §2036(a)(1) retained interest. In fact, in at least one prior case, the judge refused to allow the IRS to present evidence of cash flows from the partnership—including for payment of estate taxes—as evidence of retained enjoyment. Now that the IRS has won a §2036 case based on the use of partnership funds to pay estate taxes, we might expect to see the IRS make the argument more widely in the future.)
3. The question often arises as to how best to pay estate taxes if the estate does not have sufficient liquidity without using partnership assets. In this case, structuring the transaction as a purchase of an estate asset and as the redemption of the estate’s interest in the partnership did not avoid the §2036(a)(1) taint. Using a loan, purchase, or redemption would still seem far preferable to merely having the partnership make a large distribution to the decedent’s estate to get cash to the estate for paying estate taxes. If possible, it would be preferable for the estate to borrow the needed funds from a third party or from the beneficiaries.
4. Management activities for some assets contributed to the partnership should change if centralized management is a nontax purpose of the partnership.
5. This is yet another case mentioning a lack of negotiations, the fact that one partner planned the entire transaction, and that the same law firm represented all parties. Give all partners (and anticipated future partners) opportunity for meaningful input as to the terms of the partnership during the planning stage.

For another excellent analysis of the Erickson decision, see: "Estate of Erickson v. Commissioner, T.C. Memo. 2007-107. Is anyone reading Strangi, Rosen, Bongard, or Shepherd?", by James P. Dawson, Esq., posted May 6, 2007, on the "Florida Tax Litigation" blog, published by Fox Rothschild, LLP.

This remains an evolving area of federal tax law -- but an area far too complex for dabbling.