07 - District Court Finds GRAT was Includible in Estate. Badgley v. U.S., (DC CA 5/17/2018) 121 AFTR 2d

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1 07 - District Court Finds GRAT was Includible in Estate Badgley v. U.S., (DC CA 5/17/2018) 121 AFTR 2d A district court has ruled against an Estate in a refund suit that sought to exclude the value of a grantor retained annuity trust (GRAT) from the Estate despite the fact that the decedent had died before the end of the GRAT's term. Background. Under Code Sec. 2702, in valuing interests in trusts held by the transferor or applicable family members after the transfer of an interest in trust to a member of the transferor's family, IRS tables that are ordinarily used to value trust interests are disregarded, and retained interests are valued at zero (the zero value rule) unless they take a form comparable to an annuity or unitrust interest. Thus, subject to the exception for an annuity or unitrust interest, Code Sec generally treats the grantor as making a gift of the full value of the property even though a child or other person will get the remainder only after a set number of years. A trust in which the grantor retains a "qualified annuity interest" is known as a grantor retained annuity trust (GRAT). A qualified annuity interest is any interest that consists of the right to receive fixed amounts payable not less frequently than annually, and that meets all the additional requirements of Reg (b) and Reg (d). For example, the GRAT's governing instrument must fix the term of the annuity interest, and the term must be (a) for the life of the term holder, (b) for a specified term of years, or (c) for the shorter (but not the longer) of those periods. The value of a qualified annuity interest may be subtracted from the value of property transferred to the trust in determining the amount of the taxable gift made by the transferor in establishing the trust (i.e., the annuity does not have to be valued at zero under the zero value rule of Code Sec. 2702). Reg (c)(2)(i) requires that transferred GRAT property be included in a decedent's gross estate under Code Sec where the decedent retains an annuity interest and dies before the expiration of the GRAT term. Under Code Sec. 2036, an individual's gross estate includes property he transferred during his life if he retained for life: (a) "the possession or enjoyment of the property, or the right to the income from the property," (Code Sec. 2036(a)(1)) or (b) "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." (Code Sec. 2036(a)(2)) In Helvering v. Hallock, (1940) 23 AFTR 1054 (dealing with the predecessor to the predecessor of Code Sec. 2036), the Supreme Court agreed that IRS correctly calculated the gross estate tax of several decedents to include trust 20

2 properties transferred inter vivos. The Court stated that the grantor's reservation of any interest, however remote, was sufficient to bring the conveyance within the Code's "possession or enjoyment" language. In C.I.R. v. Church's Estate, (1949) 37 AFTR 480 (dealing with the predecessor to Code Sec. 2036), the Supreme Court extended the "possession or enjoyment" language to apply to any trust transfer except by a bona fide transfer in which the settlor, absolutely, unequivocally, irrevocably, and without possible reservations, parts with all of his title and all of his possession and all of his enjoyment of the transferred property. After such a transfer had been made, the settlor must be left with no present legal title in the property, no possible reversionary interest in that title, and no right to possess or to enjoy the property then or thereafter. Looking to substance and not merely form, the Court concluded that the decedent in that case retained for himself until death a most valuable property right in certain stocks, the right to get and to spend their income. In Spiegel's Estate v. Comm., (1949) 37 AFTR 459 (dealing with the predecessor to Code Sec. 2036), the Supreme Court reaffirmed that the provision's applicability hinged primarily on the nature and operative effect of the trust transfer. The Court emphasized that the settlor's intent to retain a reversionary interest did not bear on the "possession or enjoyment" inquiry. Rather, the grantor's retention of any "absolute or contingent" "present or future interest" vitiated the complete kind of transfer required to show that the grantor had certainly and irrevocably parted with his possession or enjoyment. The Court emphasized that any requirement less than that would facilitate circumvention of the section, and thus frustrate Congress's legislative intent. In McNichol's Estate v. C.I.R., (CA ) 3 AFTR 2d 1838, the Third Circuit considered whether several income-producing real estate properties were properly included in a decedent's gross estate where the decedent had orally transferred the properties to his children, and his children understood that the decedent should retain for his lifetime the income from the real estate. The Court held that the decedent's receipt of rents from the properties in the trust constituted enjoyment of the transferred properties. The Court also found that "enjoyment" was synonymous with substantial present economic benefit. Facts. In '82, Patricia and Donald Yoder created the D&P Yoder Revocable Trust, which held Donald's interest in two family partnerships, Y&Y Company (Y&Y Co.) and Yoder and Yoder. Donald died in '90, and Patricia then became a one-half partner in each of these partnerships. On Feb. 1, '98, Patricia created the Patricia Yoder Grantor-Retained Annuity Trust (the GRAT), which she funded with her one-half partnership interest in Y&Y Co. Patricia placed three multi-tenant parcels of real estate that were owned by Y&Y Co. into the GRAT. The transfer was not a bona fide sale, and no consideration was given in exchange for the transfer. The GRAT stated that 21

3 Patricia Yoder was to receive annual annuity payments for the lesser of fifteen years or her prior death (paid quarterly) equal to 12.5% of the date-of-gift value of the property transferred to the GRAT. Under the GRAT, the Y&Y partnership interest was to pass to Patricia's two living daughters, Judith Badgley (who became Executor of Patricia Yoder's Estate) and Pamela Yoder, on the completion of Patricia's annuity payments. At least as early as 2002, the income generated by the Y&Y Co. partnership was sufficient to fund Patricia's quarterly annual annuity payments. Between 2002 and 2012, Y&Y Co. allocated half of its income to the GRAT; the GRAT's share of Y&Y Co. income was larger than Patricia's annual annuity of $302,259. Y&Y Co. also made cash distributions to the GRAT during this time that ranged from $435,400 to $730,000. Y&Y Co. distributions were paid to a bank account in the name of the GRAT. Patricia controlled the account and used the account to make quarterly annuity payments to her personal accounts. Patricia managed and invested the excess Y&Y Co. distributions after making GRAT annuity payments by transferring excess funds to other investment accounts. Patricia's involvement with Y&Y Co.'s affairs stayed the same after she transferred her one-half interest in the GRAT. On Nov. 2, 2012, Patricia died. She received her last annuity payment from the GRAT on Sept. 30, 2012, in the amount of $75,564. Her death was before the expiration of her GRAT term. The Estate reported a total gross estate of $36,829,057, which included the value of the assets held in the GRAT. Subsequently, the Executor filed a refund claim with IRS for $3,810,004 in estate tax alleged to have been overpaid by the Estate as a result of the inclusion of the full value of the GRAT. IRS neither allowed nor disallowed the refund claim, and the Executor brought this refund suit. Parties' positions. The Executor asserted that (1) Code Sec. 2036(a)(1) did not apply to the GRAT; and (2) Reg (c)(2)(i) was overly broad and invalid to the extent that it applied to the GRAT. She highlighted the absence of statutory or judicial authority expressly equating a fixed-term annuity with some possession, enjoyment or right to income, and that Congress could have stated that a right to income includes an "annuity" in Code Sec. 2036, if it so desired. She noted that there was a distinction between "a fixed annuity payment payable out of transferred property" on the one hand, and the retention of a "right to income" on the other, and contended Code Sec applied only to the latter. She reasoned that (1) income and a fixed annuity payment were distinct because the former fluctuated while the latter did not; (2) a right to income connoted an "ascertainable and legally enforceable power" to receive income, which Patricia lacked; and (3) Patricia's annuity could have been satisfied with income and 22

4 principal, or principal only. Accordingly, the Executor claimed that IRS improperly included the GRAT in calculating Patricia's gross estate, and the Executor was entitled to a tax refund. On the other hand, IRS moved for summary judgment, arguing that Code Sec applied to the GRAT and that Reg (c)(2)(i) was valid. IRS argued that Code Sec. 2036(a)'s "possession or enjoyment of" or "right to income" language applied to the GRAT for two alternative reasons: (i) because Patricia reserved a right to annual annuity payments from the GRAT, which she created with her one-half share in Y&Y Co.; and (ii) because Patricia possessed and enjoyed the property because she retained "other interests and powers" in Y&Y Co., including her control over and personal benefit from Y&Y Co. activities. In arguing that Patricia's fixed annuity qualifies as some possession, enjoyment, or right to income within the meaning of Code Sec. 2036(a)(1), IRS relied primarily on three cases: Church's Estate, Spiegel's Estate, and Hallock. Court's conclusion. The district court held that Code Sec applied to the GRAT, granting IRS summary judgment. Both parties acknowledged the lack of binding authority squarely addressing the issue presented here. But the district court reasoned that while IRS's authorities did not expressly equate a fixed-term "annuity" with a right to income or some other possession or enjoyment, the U.S. Supreme Court had adopted a substance-over-form approach that favored a finding that Patricia's annuity comprised some possession, enjoyment, or right to income from the transferred property. The district court found that, based on the Supreme Court's pragmatic approach to Code Sec. 2036's operative language, Patricia's right to a fixed-annuity payment from the GRAT brought her transferred property within the meaning of that section. The undisputed facts showed that: (a) Patricia funded the GRAT with her one-half interest in Y&Y Co.; (b) the three Y&Y Co. properties were placed into the GRAT; (c) Patricia's transfer of her one-half interest was not a bona fide sale, and no consideration was given; (d) the income generated by the GRAT each year was greater than Patricia's annual annuity; and (e) Patricia died before the GRAT's expiration. The Executor did not dispute, and there was no evidence to show, that any of the three properties constituting the original trust corpus were ever sold to fund Patricia's annuity. As a result, Patricia's annuity necessarily drew either from the GRAT's accumulated income (i.e., the principal) or the current income that flowed into the GRAT each year from the rents received through Y&Y Co. The Executor set out no legal basis for distinguishing these two funding sources within the meaning of Code Sec or its predecessors. In particular, the district court found the Third Circuit's decision in McNichol's persuasive, supporting a finding that Patricia's annuity provided her with some 23

5 possession, enjoyment, or right to income within the meaning of Code Sec The district court read the McNichol's opinion as constituting a sweeping and forthright declaration that technical concepts pertaining to the law of conveyancing couldn't be used as a shield against the impact of death taxes when in fact possession or enjoyment of the property by the transferor (and more particularly his enjoyment of the income from the property) ceased only with his death. The district court rejected the Executor's contention that Patricia could have no "right to income" because she did not have an "ascertainable and legally enforceable power" to receive income from the transferred property. She highlighted that Y&Y Co.'s income fluctuated while Patricia's annuity remained constant; but the district court determined that this argument failed. As a threshold, the argument assumed that income and annuity were distinct for the purpose of Code Sec. 2036, but the Courts had held otherwise. Also, the case law the Executor relied on for the interpretation of "right" was applicable to Code Sec. 2036(a)(2), but not necessarily to Code Sec. 2036(a)(1). Finally, the district court noted that the Executor admitted that an implied right to income can exist when annuity payments were no more than disguised payments of income. The district court found that this implied right existed here because: (1) Patricia created the original trust corpus with her one-half share in Y&Y Co. including the three multi-tenant parcels of real estate; (2) there was no evidence that any of these properties were ever sold off; and (3) Y&Y Co.'s income was always greater than Patricia's annuity payment. The income from Y&Y Co., whether accumulated or current, thus always funded Patricia's annuity. And Patricia expressly reserved that annuity right in the GRAT. The court also rejected the Executor's argument that, apart from whether Patricia enjoyed a "right to income" from the GRAT, Patricia's fixed-annuity could not constitute some other "possession or enjoyment." Specifically, the Executor asserted that enjoyment was equivalent to "right to income," which Patricia lacked, and that "possession" applied only where the property owner continued to possess or use the property for the remainder of her life. However, the district court determined that Patricia did enjoy a "right to income" within the meaning of Code Sec. 2036(a)(1). And even if Patricia lacked a right to income, she still enjoyed the property given her access to current and/or accumulated income from her interest in Y&Y Co. That was sufficient to bring the GRAT within the meaning of Code Sec Was the reg valid? To determine if Reg (c)(2)(i) was valid, the district court analyzed the reg under the two-part Chevron test. (Chevron U.S.A. Inc. v. Natural Resources Defense Counsel, Inc., (Sup Ct 1984) 467 U.S. 837) Under this approach, a court determines (1) if Congress has directly addressed the question at issue; and (2) if not, whether the agency's rule is a permissible interpretation, i.e., not arbitrary or capricious in substance, or manifestly contrary 24

6 to the statute. Here, the parties agreed that Code Sec did not expressly address whether annuity payments constitute some possession, enjoyment, or right to income from the transferred property. Applying Chevron's two-step framework, the district court also found that Reg (c)(2)(i) was a reasonable interpretation of Code Sec In drafting the reg, IRS relied principally on the binding authorities, including Church, Hallock, and Spiegel. IRS also drew on Code Sec. 2036's legislative history to devise the reg, observing that Congress amended the provision to include interests retained for a term of years. In addition, the court noted that IRS persuasively set out several of the reg's administrative benefits, including consistency with trust accounting regs under Code Sec The district court also found that the fact that Code Sec did not equate "income" with a fixedterm annuity in Code Sec did not mean that its interpretation of Code Sec was arbitrary or capricious. 25