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Partnership Interest Was Includible in Gross Estate, Despite Transfer to Trust

(Parker Tax Publishing May 2020)

The Ninth Circuit held that the value of a grantor-retained annuity trust (GRAT) which held a 50 percent interest in a partnership and provided a decedent with an annuity for 15 years, was required to be included in the decedent's gross estate under Code Sec. 2036(a). The court found that the annuity reserved to the decedent the enjoyment of the partnership interest during her lifetime, and because she died before the termination of the GRAT, the property was not transferred to its beneficiaries before her death and therefore was required to be included in her gross estate. Badgley v. U.S., 2020 PTC 136 (9th Cir. 2020).


Patricia Yoder was married to Donald Yoder, a 50-percent partner in Y&Y Company, a family-run general partnership and property development company in southern California. After Mr. Yoder's death in 1990, Mrs. Yoder succeeded to his partnership interest. In February 1998, Mrs. Yoder created a grantor-retained annuity trust (GRAT) to transfer the partnership interest in Y&Y, valued at $2,418,075, to her daughters, Judith Badgley and Pamela Yoder. The interest was the only property placed in the GRAT. Mrs. Yoder retained a right to an annuity of $302,259 paid from the GRAT for 15 years, equivalent to 12.5 percent of the date-of-gift value of the partnership interest. In April 1999, Mrs. Yoder filed a gift tax return reporting the gift to her daughters of the GRAT's remainder interest and paid a gift tax of $180,606.

Mrs. Yoder was both the grantor and trustee of the GRAT, with her daughters serving as special trustees. The GRAT instrument provided that the special trustees could make additional distributions to Mrs. Yoder if requested. At the end of the 15-year annuity term or upon her death, whichever occurred earlier, the GRAT's corpus would pass to her daughters. Mrs. Yoder explained to them that if she did not outlive the 15-year annuity term, the partnership interest "would probably go back into her estate" for tax purposes. From 2002 to 2012, Y&Y made cash distributions to the GRAT ranging from $435,400 to $730,000. These cash distributions 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.

Mrs. Yoder died on November 2, 2012, shortly before the 15-year annuity period expired. The estate tax return included the GRAT's assets, consisting of the Y&Y partnership interest as well as the value of a bank account and an investment account, in the gross estate. The estate paid $11,187,475 in taxes. In 2016, Badgley, as executor of her mother's estate, sought a refund of an overpayment of estate tax in the amount of $3,810,004. She asserted that the overpayment resulted from the inclusion of the entire date-of-death value of the GRAT in the gross estate and argued that only the net present value of the unpaid annuity payments should have been included.

The IRS did not act on the refund claim within six months, so Badgley filed a refund action in a district court. The district court granted summary judgment for the IRS, holding that under Code Sec. 2036(a), Mrs. Yoder's retained annuity interest was both a retained right to income from, and continued enjoyment of, the property and therefore the entire date-of-death value of the GRAT was required to be included in her gross estate.

Badgley appealed to the Ninth Circuit, arguing that Code Sec. 2036(a) does not apply to annuities under the plain language of the statute. She also emphasize the distinction between income and principal and contended that because the GRAT's principal exceeded the annuity for several years of the 15-year term, the annuity could have been drawn from prior year distributions from the partnership and the interest earned on those distributions. Finally, she challenged the formula in Reg. Sec. 20.2036-1(c)(2) for calculating the portion of the property includable under Code Sec. 2036(a). Badgley contended that the formula is flawed because it assumes that the annuity payment will come entirely from the GRAT's income, rather than contemplating the amortization of principal.

Ninth Circuit's Analysis

The Ninth Circuit affirmed the district court's decision. The court found that in U.S. v. Est. of Grace, 395 U.S. 316 (1969), the Supreme Court explained that the purpose of the rule in Code Sec. 2036(a) is to include in a decedent's gross estate transfers that are essentially testamentary - i.e., transfers which leave the transferor a significant interest in or control over the property transferred during his or her lifetime. According to the Ninth Circuit, the gross estate includes the value of property transferred while the decedent was alive if the decedent retained possession of, enjoyment of, or the right to income from the property.

The court rejected Badgley's argument that annuities are excluded from the reach of Code Sec. 2036(a). The court found that interests such as reversionary interests, the power of appointment, and rent - which are also not expressly listed in Code Sec. 2036(a) - have been found to fall into one of the three categories of possession, enjoyment of, or the right to retain income from property. The court found that under Comm'r v. Church's Estate, 335 U.S. 632 (S. Ct. 1949), a taxpayer cannot escape the force of the rule in Code Sec. 2036(a) by hiding behind the legal niceties contained in devices and forms created by conveyances.

The court held that when a grantor derives substantial present economic benefit from property, she retains the enjoyment of the property for purposes of Code Sec. 2036(a). Applying this rule, the court found that Mrs. Yoder's annuity was a substantial present economic benefit because she received $302,259 per year for 15 years, and the partnership was the only property placed in the GRAT; therefore, the annuity stemmed from that property interest. According to the court, Mrs. Yoder reserved the enjoyment of the partnership interest during her lifetime, and because she died before the termination of the GRAT, the property was not transferred to its beneficiaries before her death. The court found that the issue of whether the annuity could have been drawn from prior year distributions from the partnership was irrelevant. The court reiterated that the only property in the GRAT was the partnership interest, and the annuity was drawn from the GRAT. Thus, the court found that any money received by Mrs. Yoder as part of the annuity came from the partnership interest and conveyed substantial economic benefit to Mrs. Yoder.

Observation: The court noted that the inclusion of a GRAT's corpus in the gross estate should come as no surprise to GRAT grantors. According to the court, a GRAT's risks are well-known, with the foremost being that the grantor may die before the GRAT's termination, and in setting up a GRAT, a grantor makes the decision that the potential benefits outweigh this risk. If the grantor does not die before the termination of a GRAT, the property passes to the beneficiaries free of the estate tax and with a gift tax that is diminished or even eliminated by the value of the retained annuity. This benefit exceeds that of either immediate transfer of the properties (which would result in the application of the gift tax to the entire value of the property) or a transfer at death (which would result in the application of the estate tax to the entire property).

The court also rejected Badgley's challenge to the formula in Reg. Sec. 20.2036-1(c)(2). The court found that the argument was presented in a cursory manner without any citations to legal authority and was therefore deemed waived. But the court said that it would reject the challenge even if it were not deemed waived. The court noted that while Badgley argued that formula was flawed because it assumed the annuity payment will come entirely from the GRAT's income, rather than contemplating amortization of principal, Badgley did not argue that Mrs. Yoder's annuity contemplated the amortization of principal, or even that the formula was flawed with regards to Mrs. Yoder's annuity. In the court's view, Badgley merely argued that the formula might be arbitrary if applied to a short-term GRAT that contemplates the amortization of principal as the primary source for the annuity payment, which was not the case here.

For a discussion of the estate tax treatment of retained annuity, unitrust, or other income interests in trusts, see Parker Tax ¶225,540.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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