The Ninth Circuit affirmed a district court's holding that the full value of a grantor retained annuity trust (GRAT) was includible in a decedent's estate, not just the net present value of the unpaid annuity payments from the GRAT.
Patricia Yoder was married to Donald Yoder, a 50% partner in Y&Y Company, a family-run general partnership and property development company in southern California. After Donald's death in 1990, Patricia succeeded to his 50% partnership interest.
In February 1998, she created a GRAT to transfer the partnership interest in Y&Y to her daughters, Judith Badgley and Pamela Yoder. Patricia retained a right to an annuity to be paid from the GRAT for 15 years, equivalent to 12.5% of the date-of-gift value of the partnership interest for 15 years. Patricia died before the end of the 15-year annuity period. The estate tax return for her estate reported a total gross estate of $36,829,057, including the value of the assets held in the GRAT. Patricia's estate paid the reported taxes on the return of $11,187,475.
In 2016, Badgley, as executor of Patricia's estate, sought a refund of an overpayment of estate tax in the amount of $3,810,004. Badgley asserted that the overpayment resulted from the inclusion of the entire date-of-death value of the GRAT in the gross estate and that only the net present value of the unpaid annuity payments should have been included. The IRS did not respond to the refund request within six months, so Badgley filed a refund suit in district court.
Badgley argued in district court that the full value of the GRAT should not be included because Sec. 2036(a) did not apply to Patricia's GRAT and Regs. Sec. 20.2036-1(c)(2)(i) is overly broad and invalid to the extent that it applied to the GRAT.
The law and the district court's decision
Sec. 2036(a) provides:
The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death— (1) the possession or enjoyment of, or the right to the income from, the property ...
Thus, a decedent's 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. These three factors are referred to as "strings" tying the transferor to the property despite the transfer.
Regs. Sec. 20.2036-1(c)(2) includes the formula the IRS uses to calculate the portion of the property includible under Sec. 2036(a). The regulation interprets Sec. 2036(a) to provide that GRATs are includible in a grantor's gross estate when the decedent retains an annuity interest and dies before the expiration of the GRAT term, because they are sufficiently tied to the grantor.
The district court ruled in favor of the IRS (Badgley, No. 4:17-cv-00877 (N.D. Cal. 5/17/18)). It held that Patricia's retained annuity interest was both a retained right to income from and continued enjoyment of the property. Both "strings" tied the GRAT to Patricia, so the entire date-of-death value of the GRAT was includible in her gross estate. The court also concluded that Regs. Sec. 20.2036-1(c)(2), the Treasury regulation applying Sec. 2036(a)(1) to GRATs, was valid.
Badgley appealed the decision to the Ninth Circuit.
The Ninth Circuit's decision
The Ninth Circuit affirmed the district court's holding that the full date-of-death value of the GRAT was includible in Patricia's estate. It found that Patricia had retained the enjoyment of the annuity in the GRAT, so it was subject to Sec. 2036.
Badgley argued in the Ninth Circuit that Sec. 2036 did not apply because it did not expressly state that it applied to annuities or that it did not apply because Patricia did not retain possession, enjoyment, or the right to income from the GRAT as required under Sec. 2036(a)(1). She also again argued that Regs. Sec. 20.2036-1(c)(2) was an invalid regulation.
With regard to the first argument, the Ninth Circuit explained that in Sec. 2036(a)(1), Congress set forth three strings tying a grantor to property and instructed that courts look to the result — possession, enjoyment, or a right to income therefrom — rather than the form those strings take. It also noted that the Supreme Court and other appellate circuits had found that other interests such as reversionary interests, the power of appointment, and rent, also not specifically listed in Sec. 2036(a), were subject to it. The court therefore rejected Badgley's argument that because Sec. 2036(a) does not expressly mention annuities, the full value of the GRAT could not be included in Patricia's estate.
The Ninth Circuit next addressed whether a grantor retains possession, enjoyment, or a right to income from property as required by Sec. 2036(a)(1) of the annuity flowing from a GRAT. The Ninth Circuit found that the Supreme Court had held in a line of cases that to avoid the force of Sec. 2036(a), a grantor must completely divest himself or herself of possession, enjoyment, and income from the property, and the beneficiaries' interest must take effect prior to the grantor's death. The Court had further held that a grantor retained possession and enjoyment to property where the grantor retained a substantial present economic benefit to the property. In Clise, 122 F.2d 998 (9th Cir. 1941), a case outside the trust context, the Ninth Circuit had held that where an individual held annuity contracts that made payments to her for her lifetime, and to a second annuitant upon her death, the individual retained the economic benefit of the annuity payments and thus retained enjoyment of the property.
Therefore, the Ninth Circuit concluded that when a grantor derives substantial present economic benefit from property, he or she retains the enjoyment of that property for purposes of Sec. 2036(a)(1) and that an annuity was a substantial economic benefit. In this case, because Patricia's annuity was a "substantial present economic benefit," stemmed from a property interest placed in the GRAT, reserved to her the enjoyment of that interest during her lifetime, and was not transferred to the beneficiaries before her death, the annuity was required to be included in the GRAT's date-of-death value in the estate.
Finally, the Ninth Circuit addressed Badgley's challenges to Regs. Sec. 20.2036-1(c)(2), which includes the formula the IRS used to calculate the portion of the property includible under Sec. 2036(a). The Ninth Circuit concluded this argument was waived because of the cursory manner in which it was raised on appeal (two sentences in her brief to the court with two footnotes and no citations to legal authority). However, if the argument had not been waived, it would not apply in this case. Badgley contended 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, but that was not the case with this GRAT, so the IRS declined to address whether the regulation was valid.
Badgley tried to convince the court that there is 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 that Sec. 2036(a) applies only to the latter. The district court and the IRS acknowledged that there is no authority squarely equating a fixed-term annuity with a right to income or some other possession or enjoyment. However, both the district court and the Ninth Circuit embraced a substance-over-form approach to hold that an annuity results in some sort of possession, enjoyment, or right to income from the transferred property.
Badgley, No. 18-16053 (9th Cir. 4/28/20)