Regular Sophisticated Planning Techniques Fail due to Poor Implementation

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By Kathleen Ford Bay, Esq.  

Richards Rodriguez & Skeith LLP, Austin, TX

In Estate of Trombetta v. Commissioner, T.C. Memo
2013-234, the Tax Court held that properties transferred to a
qualified personal residence trust (QPRT) and a grantor retained
annuity trust (GRAT), respectively, were includible in the gross
estate of the decedent-beneficiary who died during the term of the
annuity and retained use terms because the decedent had a retained
interest under §2036(a). The Tax Court also ruled against the
decedent's estate with respect to a purported charitable deduction.
This case demonstrates how well-established, sophisticated planning
techniques may not produce the desired tax results where the
techniques are not implemented well.

The Trombettas lived in California, had four children, and
invested in rental properties. When they divorced in 1992, Mrs. T
received some rental properties, including a 27-unit apartment
building (Black Walnut) and a 79-unit apartment complex (Tierra
Plaza), and a personal residence. Both Black Walnut and Tierra
Plaza were mortgaged and she and Mr. T were personally liable for
these mortgages (and she agreed to hold him harmless). Also, in
1992, Mrs. T hired an attorney and an accountant to assist her with
her estate planning objectives, naming to (1) have a monthly cash
flow of about $10,000, (2) have an emergency cash reserve of
$100,000, (3) reduce her management responsibilities, (4) reduce
her financial risk, and (5) facilitate the disposition of assets to
her children while minimizing estate and gift taxes. As a result of
a "comprehensive and integrated estate plan," in 1993, at age 72,
Mrs. T executed a will, a revocable living trust, a GRAT and a
QPRT. She also formed a limited partnership and transferred all
rental properties except Black Walnut and Tierra Plaza to the

Mrs. T was the sole beneficiary of the GRAT, which was to last
180 months unless she exercised her power to reduce the term. She
was one of four trustees, the other three being her children. She
had 50% of the voting rights, with the other trustees splitting the
rest; decisions could be taken by majority vote of all trustees.
The annuity was $75,000 for the first 12 months, plus a four
percent increase at the beginning of each new 12-month
period.  Her three children agreed to be jointly and severally
liable for required annuity payments if the trust did not have
sufficient funds.  If the trust income was greater than the
required payments, the co-trustees had the power to either
distribute the excess to Mrs. T or accumulate it. At termination,
the trust went to her descendants. After the transfer to the GRAT,
the GRAT paid the mortgages on the properties, but it never assumed
the mortgages.

Mrs. T's basis in Black Walnut and Tierra Plaza, the only
properties transferred to the GRAT, was approximately $1.3 million;
together the debt was about $2.9 million. Mrs. T reported on her
gift tax return for 1993 a net value of approximately $1.4 million,
a retained interest of approximately $900,000, and a gift of
approximately $504,000.

By 2001, the mortgage on Black Walnut was paid off, but Mrs. T
was remained personally liable on the Tierra Plaza mortgage. She
was also personally liable on a promissory note secured by Black
Walnut and Tierra Plaza.

In March 2005, Mrs. T was diagnosed with cancer.  In August
2006, Mrs. T reduced the term of the GRAT from 180 to 156 months.
When she died, the GRAT owed her about $122,000, which was paid to
her estate that month and two months later. The debt on Tierra
Plaza was about $2.2 million, and the leased fee value of the trust
about $4.3 million.

Mrs. T was the sole Trustee and beneficiary of the QPRT; it was
to last 180 months, subject to her power to reduce the term. Her
basis in the home was about $400,000. On her 1993 gift tax return,
she reported that the property had a net worth of $150,000, a
retained interest of approximately $92,000, and a gift of
approximately $58,000.

In August 2006, Mrs. T reduced the term of the QPRT and updated
her Will to provide that after she died, the residence would pass
not to her descendants but to a (CRUT) with her estate as the
beneficiary of the unitrust payout during the term of years. 
Mrs. T died on September 16, 2006. In December 2006, one of her
daughters as successor trustee of the QPRT created a unitrust to
pay the estate about 20% of the fair market value of the trust for
five years, with the remainder passing to charities. In 2007, the
successor trustee petitioned to reform the QPRT to provide that the
retained term terminated on the last day of the month before Mrs.
T's death on the grounds that the QPRT was not intended to be
includible in her estate and the reformation would permit this
result. The court entered a reformation order effectively
terminating the QPRT as of August 31, 2006.

The estate tax return for Mrs. T's estate did not include the
properties held in the GRAT and QPRT in Mrs. T's gross estate. The
estate also claimed a charitable deduction with respect to the
transfer of the residence to the CRUT and claimed a deduction of
$2.2 million for the mortgages on the properties transferred to the
GRAT. The IRS issued a notice of deficiency challenging each of
these positions.

As to the GRAT, the taxpayer's position was that its assets
should not be included in Mrs. T's estate because (1) Mrs. T's
transfers of the Black Walnut and Tierra Plaza were bona fide sales
for adequate and full consideration; or, alternatively, that (2)
Mrs. T did not retain during her life an interest in the
transferred properties. Section 2036(a) generally provides that the
value of transferred property in which a life estate is retained
must be included in a decedent's gross estate. Section 2036(a) does
not apply, however, if there was a bona fide sale, meaning an
arm's-length transaction with full and adequate consideration.
Citing Estate of Bongard v. Commissioner, 124 T.C. 95
(2005), the taxpayer argued that the essential question in whether
a bona fide sale occurred is whether the taxpayer had legitimate
and significant, non-tax reasons for entering into the transaction.
The taxpayer asserted that there were significant, non-tax reasons
for the transfers to the GRAT because the transfer were made to
relieve Mrs. T of the burden of managing the properties and provide
steady income flow. First, the Tax Court pointed out that
Bongard and the other cases cited in support involved
transfers to family limited partnerships, not to a grantor trust.
Second, the Tax Court concluded that the taxpayer had not
established a significant non-tax purpose because Mrs. T continued
to manage the property as a trustee with her co-trustees only
acting on her recommendation, and the transaction was undertaken as
part of the tax planning for her overall estate plan. The Tax Court
also noted that she retained 50% of the voting rights, and together
with her children had the ability to distribute excess income to
herself so she retained enjoyment of the properties after the
transfer in the same manner as before the transfer. Finally, the
Tax Court noted that the transaction was not a bona fide sale
because she was the grantor and, at the time of the initial
transfer, the sole trustee. 

The taxpayer also asserted that the reduction in the term of the
annuity trust was not the relinquishment of a power within three
years of death under §2035(a). Section 2035(a) operates to include
in the gross estate the value of property that would have been
includible under §2036 or §2038 but for the decedent relinquishing
a power with respect to that property within three years of death.
The Tax Court concluded that in reducing the term of the GRAT Mrs.
T had relinquished her power to receive periodic distributions and
excess income distributions, and, therefore, had relinquished a
power within the meaning of §2035(a).

The Tax Court then looked at what value should be included in
Mrs. T's gross estate. The taxpayer argued that only the value of
the annuity trust needed to fund the required payments should be
included in Mrs. T's estate, not the entire amount, relying
primarily on Rev. Rul. 82-105, 1982-1 C.B. 133, made obsolete as of
July 14, 2008, by T.D. 9414, 2008-35 I.R.B. 454. The Tax Court held
that, unlike the situation in Rev. Rul. 82-105, Mrs. T had more
than just the right to the annuity in the trust because she
retained voting control the right to distribute excess obligations
and the right to use trust income to satisfy personal loan

The Tax Court concluded, however, that since the full value of
both Black Walnut and Tierra Plaza was included in Mrs. T's gross
estate and because she was personally liable, Mrs. T's estate could
deduct the mortgages on the properties.

With regard to the QPRT, the Tax Court concluded that the fair
market value of the residence must be included in Mrs. T's gross
estate because she retained the right to live in the residence
until her death regardless of the reformation. In reaching this
conclusion, the Tax Court rejected taxpayer's contention that Mrs.
T's s gross estate must include only an amount equal to the rental
value of the home for the residence trust term as "without
persuasive reason or authority".

The Tax Court then turned to the question of whether Mrs. T's
estate was entitled to a charitable deduction for the portion of
the QPRT that passed to the CRUT. Section 2055 provides a
charitable contribution deduction for amounts transferred by a
decedent during life or by Will for qualified charitable use.
Citing Estate of Engleman v. Commissioner, 121 T.C. 54
(2003), the Tax Court stated that a charitable contribution
deduction is not permitted where the amount passing to charity
depends on the actions of a personal representative. The Tax Court
concluded that because of the judicial reformation the residence
was not directed to the CRUT by the Will but rather by an action of
the successor trustee of the QPRT. Therefore, the Tax Court
concluded that no charitable deduction was allowed.

For more information, in the Tax Management Portfolios, see
Lischer, 52 T.M.
, Incomplete Lifetime Transfers: Retained
Beneficial Interests Under Section 2036(a)(1) and
2037, and in Tax Practice Series, see ¶6250, Pre-Death
Transfers - Sections 2035, 2036, 2037 and 2038.