Formula Marital Deduction Clause Not a Guaranteed Estate Tax Shelter

Editor: Alan Wong, CPA

Estates, Trusts & Gifts

Estate plans often include a formula clause for calculating the amount of the bequest ultimately passing to the surviving spouse. The taxpayer desires to provide for the surviving spouse while minimizing, or even eliminating, estate taxes.

A pecuniary formula calculates an amount that is equal to:

• The optimal marital deduction, less
• The value of all other items includible in the gross estate that qualify for the marital deduction.

Alternatively, a fractional-share-of-residue formula calculates a fractional portion of the residual estate. The denominator of that fraction is the value of the entire residuary estate. The numerator is the same formula used in the pecuniary calculation:

• The optimal marital deduction, less
• The value of all other items includible in the gross estate that qualify for the marital deduction.

Both of these formulas should create a taxable estate equal to zero. The maximum tax-free amount goes to individuals other than the spouse and/or trusts, while any excess goes to the surviving spouse, either outright or in a marital trust.

FLP Inclusion

In Estate of Turner, T.C. Memo. 2011-209 (Turner I), the Tax Court originally held that the decedent’s inter vivos transfers of property to a family limited partnership (FLP) had to be included in his gross estate under Sec. 2036. The Tax Court found that the decedent’s lifetime FLP transaction did not meet the exception for a bona fide sale for adequate and full consideration in money or money’s worth under Sec. 2036(a). The court held that the assets the decedent had previously transferred to the FLP were includible in his gross estate under Secs. 2036(a)(1) and (2). According to the court, the decedent retained “the possession or enjoyment of, or the right to the income from, the property, and retained 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.”

In the decedent’s case, he had retained a general partner interest in the FLP. The court did not agree with the estate’s assertions that the decedent had any nontax motives for forming the FLP. In particular, the decedent transferred mainly securities and cash to the FLP and his investment strategies remained consistent with those before the transfers. The court found that there was no purposeful or active management of the assets once they were transferred to the FLP. The decedent also commingled personal assets with the FLP assets during his life.

Marital Deduction

Before the court brought the FLP assets back into the decedent’s estate, the estate did not owe any taxes because of the pecuniary marital bequest formula provision included in the decedent’s will. The formula provision specified that assets with a value equal to the unified credit amount passed to a credit shelter trust with the remainder of the assets passing to the spouse. The estate argued that, under this formula provision, it was allowed to claim an increased marital deduction if the partnership assets were included in the estate under Sec. 2036.

The Tax Court recently decided that the Turner estate could not increase its marital deduction for the FLP interests brought back into the estate under Sec. 2036 (Estate of Turner, 138 T.C. No. 14 (2012) (Turner II)). A Sec. 2036 inclusion can cause two distinct problems. First, the inclusion rule can cause problems for the marital deduction calculation. Second, the fact that the lifetime transfer was gifted to someone other than the spouse during life is a roadblock.

The first problem can arise because of the use of discounted values. Sec. 2036 pulls back the full value of the assets the decedent transferred to the FLP into the estate. In some cases, the IRS has taken the position that even when Sec. 2036(a) applies, the marital deduction is measured by the value of what actually passes to the surviving spouse, which is a discounted partnership interest, and not by the value of the underlying assets. This creates an incongruity between the values included in the gross estate and the calculation for purposes of the marital deduction. The Tax Court did not have to deal with this potential mismatch, however, because the IRS had allowed an increased marital deduction calculated on the basis of the value of assets transferred in exchange for the partnership interests that the decedent had held at death.

The second problem is at the heart of Turner II. The Tax Court refused to allow an increase in the marital deduction for the value of the FLP interests pulled back into the estate. Neither the FLP interests nor the underlying assets actually passed to the surviving spouse. An estate is only allowed a marital deduction for property that either passes or has passed to the surviving spouse.

The estate argued that Sec. 2036 was a legal fiction, and, therefore, the marital deduction should be increased to reflect that fiction. The Tax Court rejected this argument based on the statutory provisions for the marital deduction and the policy behind the marital deduction. Under Regs. Sec. 20.2056(c)-2(a), a property interest is treated as passing to the surviving spouse only if it passes to the spouse as beneficial owner. The marital deduction is not allowed for interests passing to the spouse merely as trustee or subject to a binding agreement by the spouse to dispose of the interest in favor of a third person. In Turner II, the decedent transferred the FLP interests during life to a combination of his children, grandchildren, and trusts set up to provide for his issue. Because the surviving spouse did not actually receive the benefit of any of the transferred interests, the estate was unable to take a marital deduction for those interests.

The Tax Court also reasoned that the policy underlying the marital deduction was simply a deferral of the taxes payable on those assets. The property passes estate tax free from the decedent to the surviving spouse. Theoretically, that property is then included in the future estate of the surviving spouse. Therefore, the taxes are not eliminated or even reduced; they are merely deferred to a later date. In Turner II, specifically, since the spouse did not receive any of the transferred interests, those interests would never be brought back into her estate because she was never considered their owner.

Conclusion

The Turner cases highlight the importance of properly transferring FLP interests during life in a way that avoids this trap of creating an estate tax when the decedent planned to have none. Transfers during life to an FLP must be done for a valid nontax reason if gifts to issue have any chance of avoiding inclusion in the transferor’s estate. All aspects of an estate plan should be carefully reviewed and considered as a whole.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.

For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.