THE TAX CONSEQUENCES OF RETAINED INTERESTS AND POWERS. Mary Ann Mancini / Steptoe & Johnson LLP. August, 2001

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1 THE TAX CONSEQUENCES OF RETAINED INTERESTS AND POWERS Mary Ann Mancini / Steptoe & Johnson LLP I. INTRODUCTION August, 2001 As it has oftentimes been stated /, it seems to be human nature to want to have your cake and eat it too. Although a client can easily understand the benefits of making gifts to family members, many will balk at actually transferring an asset if the end result of making such a gift means giving away all of the enjoyment and/or control associated with the asset. Satisfying the client s desire to retain control or enjoyment of the gifted assets, while achieving all of the benefits of making the gift, is the juggling act that every estate planning attorney must perform for his or her clients. Sections 2036, 2037, 2038, / as well as section 2702 are what keep a client from having, and eating, the whole cake in the estate and gift tax area. Furthermore, lest the estate planning attorney become too confident, he or she must also address the income tax consequences of interests and powers retained by the client, which can cause the inclusion of the income of the gifted asset in the client s income even after the gift was made. Sections 671 through 677 set forth the income tax consequences of certain retained interests and powers, some of which are easily avoided but others of which can be inadvertently (and sometimes deliberately) triggered. This outline will address the issue of retained interests and powers, first by analyzing sections 2036 through 2038 (which are estate tax provisions) and then section 2702 (which is a gift tax provision). Finally, the income tax provisions (sections 671 through 677) will be discussed, as they pertain to interests and powers retained by the transferor. II. RETAINED INTERESTS AND POWERS: SECTIONS 2036, 2037 AND 2038 Upon the death of an individual, all of the gifts the decedent made during his or her lifetime, must be reviewed. / If the decedent held any of the interests or powers set forth in sections over such gifted property (or held these powers at any time within the last three years of the decedent s death) then, notwithstanding the decedent s gift, such property (with certain exceptions) will be included, at its current fair market value, in the decedent s estate for federal estate tax purposes. A. Holding an Interest in or Power over Gifted Property When an asset is transferred from a donor to a donee for less than adequate and full consideration there are three possibilities for transfer tax purposes, as to what has occurred: 1. The gift can be completed, in which case:

2 a. unless it is eligible for the present interest annual exclusion, it is a taxable gift which will either utilize a portion of the donor s unified credit against gift taxes, or gift taxes will be payable, and estate. b. upon the donor s death it is not includable in the donor s taxable 2. The gift can be incomplete, in which case: a. although a gift tax return must be filed, / the gift is not a taxable gift, nor does it utilize the donor s present interest annual exclusion, and b. upon the donor s death it is includable in the donor s taxable estate, as though it had never been transferred. 3. The gift can be a completed gift, but the donor has retained or holds at the time of his or her death such control or enjoyment over the transferred asset that it brings the asset within the ambit of sections , in which case: a. the gift may be a taxable gift, / and: b. upon the donor s death, despite the completion of the gift (and the possible payment of gift taxes), it is includable in the donor s taxable estate (although any unified credit utilized at the time of the gift or any gift taxes paid will be credited against the donor s estate tax that arises as a result of the inclusion of the gifted property in the donor s estate). If property is includable in the decedent s taxable estate under sections 2036, 2037 and/or 2038, it is not the value of the right or interest held by the decedent that is includable in the estate but the value of the property (determined as of the date of the decedent s death, or alternative valuation date, as the case may be) over which such interest or power is held, that is includable in the estate. / The intent behind sections 2036, 2037 and 2038 is that estate tax should be imposed on property that was given away by a decedent during his or her lifetime when the decedent has either retained the economic benefit of the property (sections 2036(a)(1) and 2036(b)); or made what is essentially a testamentary transfer because the possession and enjoyment of the gift by the donee is deferred until the decedent s death (sections 2036(a)(2), 2037 and 2038). B. Sections 2036, 2037 and 2038: Common Elements 1. Inter Vivos Transfer a. The transfer must be a gift within the meaning of section 2511, which will include direct transfers, constructive transfers, transfers in trust, and indirect transfers, so long as the transfer was made for less than adequate and full consideration. /

3 b. Identity of Transferor: The difficulty raised by sections 2036, 2037 and 2038 is that many times the powers and interests described therein, are in and of themselves, not enough to result in the inclusion of the property in the holder s estate. However, if such powers and interests held by the decedent are over property originally gifted by the decedent, then sections may apply. Accordingly, determining the identity of the transferor is very important. For example, if an individual is given a right to receive the income of a trust but nothing more, then upon the individual s death, the trust fund is not includable in the individual s estate. On the other hand, if the same individual holding an income right had gifted the property, the entire trust fund is includable in the individual s estate under section 2036(a)(1). / c. Indirect Transfers: (1) Joint Tenancy. When joint tenancy property is transferred, state law will determine whether each joint owner (or only one of the joint owners) is the transferor for these purposes, depending on the rights of each joint tenant to the joint tenancy property prior to the transfer. If one of the joint tenants transferred the entire amount of joint property, and state law holds that the two joint tenants own 50% of the property, then the second joint tenant, even though he or she did not participate in the transfer, may be deemed to be the transferor to the extent of one-half of the transferred property. (2) Failure to Exercise Rights. (a) Whenever an individual has a right to an asset or an interest in the asset that is considered a general power of appointment under section 2041 and releases such right or interest, that individual would be considered the transferor of the property. (b) For example, when a person is given a right to withdraw principal from a trust for a period of time, such person is considered to hold a general power of appointment over such property and if that person waives the right to withdraw such property, the waiver or release of such right is considered a transfer by such person. / (c) If the individual allows such right to lapse (to fail through the passage of time or occurrence of a condition subsequent) then, to the extent the value of the property over which the individual had such a right was less than the greater of $5,000 or five percent of the fair market value of the property over which the individual could have exercised such right, such lapse will not be considered a release, and, to the extent a lapse is not deemed to be a release, the individual is not considered the transferor. / (d) If the individual s rights of withdrawal are subject to an ascertainable standard, / then the individual is not considered to hold a general power of appointment,

4 and even the release of such rights is not considered a transfer. / (3) Reciprocal Transfers. When two individuals transfer assets for the benefit of each other, they are usually trying to avoid sections 2036, 2037 and 2038 by making transfers in which the transferor does not retain or hold any powers or interests over the property transferred but receives such powers and interests from the other transferor, such as creating identical trusts for the benefit of each other. The Courts have addressed this issue by finding that, if the transfers were interrelated in that the transferors placed each other in approximately the same economic position as they would be had they transferred the asset for their own benefit rather than for the benefit of each other, then the transfers should be reversed. Courts achieve this by reversing the identity of the transferor of each transfer under the reciprocal trust doctrine. / Under this doctrine, the beneficiary of such a trust would be deemed to be the transferor of the transferred assets and, upon the death of the beneficiary, his or her rights and powers would be analyzed under sections 2036, 2037 and d. Non-Transfers: (1) Disclaimers. When a prospective donee or legatee refuses a gift or bequest, and such refusal is a qualified disclaimer within the meaning of section 2518, then such disclaimer by the donee or legatee is not considered a transfer for purposes of these sections. / (2) Gift-Splitting. When spouses gift-split pursuant to section 2513, and one spouse is not the owner of the gifted property, the non-owner spouse has not made a transfer for purposes of these sections. / (3) Community Property. When spouses own interests in community property, neither spouse is considered to have made a transfer of that half of such property which is the other spouse s community property interest. / 2. For Less than Adequate and Full Consideration a. When the transferor transfers property, and does not receive adequate and full consideration for the transferred property, the transfer is subject to sections 2036, 2037 and 2038, however an offset equal to any consideration received by the transferor is applied when the property is includable in the transferor s estate. b. When the transferor transfers the interests and powers described in sections 2036, 2037 and 2038 then the amount included in the decedent s estate is calculated differently, depending on whether any consideration was received by the transferor:

5 consideration: (1) If the transfer of such interest or power was made without (a) It would be a taxable gift of such interest or power. (b) If the gift occurred within three years of the transferor s death, the property over which the interest or power applied will be included in the decedent s estate (see discussion of section 2035 below). (2) If the transfer of such interest or power was for consideration (but less than full and adequate consideration): death: (a) (b) It would be a part-sale, part-gift If it occurred within three years of the transferor s (i) under section 2036 and 2037, the property over which the interest or power applied would be included in the decedent s estate with an offset for the consideration received for the interest or power; and (ii) under section 2038, that portion of the property over which the interest or power applied, to the extent the interest or power was transferred for consideration, would not be includable in the decedent s estate. Section 2038 allows the transferor to remove a proportionate amount of property (and its appreciation) allocable to the consideration received from the estate, rather than merely applying an offset to the entire amount of property (including appreciation) included in the estate. 3. Retention or Holding Requirement a. Even though sections 2036, 2037 and 2038 are found in the sections of the Code that address estate taxes and the tax consequences of these sections arise at the donor s death, the sections are only effective if there is a transfer for less than full and adequate consideration by an individual during his or her lifetime and the interests and powers described in each section are retained by that individual (or, in the case of section 2038, at one time the property was owned by the individual and after a prior transfer by such individual, certain powers are held by the individual at the time of the individual s death). / b. Without the retention language of sections 2036 and 2037 (or prior transfer language of section 2038), oftentimes the powers and interests described therein are generally not sufficient to result in the inclusion of the property over which such powers are held in an individual s estate. c. Therefore, the property subject to such interests and powers will be included in a decedent s estate if the interest and powers were retained (or, in the case of 2038, held) by the individual who actually transferred the property and by no other person, including the individual