For estate tax purposes, Internal Revenue Code Section 2036(a) includes in a decedent's gross estate the value of certain property transferred during life.¹ IRC Section 2036 generally applies when a taxpayer retains rights to the property transferred, the property's income² or the right to designate others who can receive the rights to the property or its income.³ The Internal Revenue Service frequently uses Section 2036 to include in a taxpayer's gross estate property that was transferred to legal entities — traditionally irrevocable trusts,⁴ but especially family limited partnerships⁵ and limited liability companies⁶ (collectively FLPs).

Section 2036 also applies to property transfers resulting in a tenancy in common (TIC), though it's construed more narrowly for two reasons. First, TIC owners have historically enjoyed unique state law property rights that form the basis of defense against Section 2036 inclusion. Second, in the 2010 case of Stewart v. Commissioner,⁷ the U.S. Court of Appeals for the Second Circuit held that if Section 2036 applies to TIC interests in real property at all, it only applies in proportion to the net economic benefit retained. These two factors make assessing and defending Section 2036 risks in a TIC context somewhat different from controversies involving FLPs.

The key is determining whether the value of the interest in the TIC property is includible in the estate, and if so, how much.

Section 2036

Section 2036 inclusion requires three elements:

1. The taxpayer must transfer property.⁸
2. The transferor must retain interests in or control over the property,⁹ such as “substantial present economic benefit”¹⁰ or “lifetime use.”¹¹
3. The interests or control must be retained for the transferor's lifetime or a period unascertainable without reference to his death.¹²

Section 2036 contains a “bona fide sale exception” for transfers made in exchange for full and adequate consideration.¹³ This exception typically involves selling assets at fair market value or contributing assets to an FLP for a significant and legitimate non-tax purpose in exchange for proportionate equity ownership. There are at least 11 cases in which taxpayers defeated the current version of Section 2036;¹⁴ 10 were FLP cases that hinged on the bona fide sale exception.¹⁵ The 11th was Stewart, which involved TICs. While the bona fide sale exception should also apply to sales of TIC interests, taxpayer victories involving TICs simply haven't needed to rely on it (see below).

The core concepts in assessing and defending against Section 2036 inclusion in a TIC context include: (1) the three statutory elements; (2) the scope of Section 2036's application, which typically depends on the existence of an “implied agreement” between the parties; (3) potential legal defenses such as the bona fide sale exception; (4) the type of property at issue, such as marketable securities or residential versus commercial real estate; and (5) sufficient factual development. The Second Circuit's Stewart decision provides a helpful road map of modern Section 2036 controversies in a TIC context.

TIC

TIC is a form of concurrent property ownership featuring unity of possession but separately held title.¹⁶ TIC owners typically enjoy certain state law rights. For example, California law gives TIC owners the right to occupy the property, to partition the property¹⁷ and to a pro rata amount of the rent and profits.¹⁸ This is relevant because, although federal law determines the tax consequences, state law defines the property rights being taxed.¹⁹ And, it's the existence of state law property rights that have historically defeated Section 2036 inclusion in the TIC context. The following four cases illustrate the evolution and modern landscape of this principle:

1. Trafton v. Comm'r.²⁰

   This 1956 case involved Section 2036's predecessor.²¹ The husband transferred marketable securities to himself and his wife as TIC owners under state law. Because the husband retained all income from the securities until his death, the IRS sought to include the wife's TIC interest in those securities in her husband's gross estate.²² The wife even testified that “she wouldn't dare to use any of the income” from her securities.

   The Tax Court ultimately held that the husband and the wife “each owned an undivided one-half of those securities and only the value of [the husband's] one-half interest is includible in his gross estate.” The husband's retention of the income was “of no significance” because one-half of the income legally belonged to the wife. Moreover, the wife had the state law right to partition the securities at any time and deprive her husband of her share of the income. The Tax Court held that — at most — the wife gifted her income to the husband.

   A modern court might interpret Trafton's facts as evidence of an “implied agreement” sufficient for Section 2036 inclusion. While the issue wasn't specifically addressed in Trafton, the Tax Court was certainly aware that “implied agreements” were central to inclusion under the predecessor to Section 2036. Judicial determinations of “implied agreements” appear as early as the Third Circuit's 1940 decision in Fox v. Rothensies,²³ which also involved Section 2036's predecessor. Note that the Treasury Department issued new regulations interpreting the modern version of Section 2036 in 1958 — two years after the court's ruling in Trafton. Since then, Section 2036 had been applied more broadly, particularly with regard to the determination of implied agreements.

   Trafton also contains a tangled discussion of gift and estate tax concepts. This complexity leads some to conclude the bona fide sale exception was responsible for excluding the wife's TIC interests from the husband's gross estate. But a careful reading reveals that the concept of “adequate and full consideration” only applied in the court's gift tax analysis. Section 2036 didn't apply for estate tax purposes because one of the statutory elements was missing — the husband didn't retain legally enforceable rights over the wife's TIC interests. The Tax Court later confirmed this interpretation in Powell v. Comm'r.²⁴

2. Powell v. Comm'r

   This 1992 case involved TIC interests in a personal residence. After moving to an assisted living facility, the decedent gave a 60 percent interest in the residence to her children, which created a state law TIC arrangement. Relying on Trafton, the Tax Court ruled that Section 2036 didn't include the 60 percent interest the taxpayer had transferred during life because “the rights of each cotenant are limited by the rights of others.”²⁵ The Tax Court found it immaterial that Powell involved a residence and Trafton involved securities. Absent an agreement trumping the parties' state law rights, Section 2036 simply didn't apply. Powell also clarified that the “Tax Court [in Trafton] did not rely on its determination that [the] wife had furnished full and adequate consideration for her interest” to determine that Section 2036 didn't apply.

3. Wineman v. Comm'r.²⁶

   This 2000 case addressed whether Section 2036 applied to TIC interests in mixed-use real property. The decedent gave a 24 percent TIC interest in a ranch to her children, which included two homes and grazing land subject to a lease. The IRS argued the decedent retained a life estate in the entire ranch because she continued living in one house and retained all lease payments.²⁷

   The Tax Court first held that life estates can be created by an express or implied agreement. But, the Tax Court found no agreement in Wineman because the other TIC owners weren't excluded from the property. The son ran a business on the ranch and his family lived rent-free in the second house.

   In Trafton, Powell and Wineman, the existence of state law property rights, held by the TIC owners, defeated Section 2036 inclusion without regard to the bona fide sale exception. This is in stark contrast to TIC owners in FLP cases, who typically rely on the bona fide sale exception as their sole defense.

4. Stewart v. Comm'r.²⁸

   The decedent owned 100 percent of a five-story building; she and her son lived on the first two floors and the upper floors were subject to commercial leases. The decedent transferred 49 percent of the property to her son six months before her death, creating a TIC under state law. The Tax Court determined there was an implied agreement because the decedent continued to retain all the rent and paid most of the property expenses. The Tax Court's decision in Stewart appears to be the first case in which Section 2036 inclusion applied to a gifted TIC interest.

   The IRS' victory in Stewart was temporary. In 2010, the Second Circuit reversed the Tax Court's²⁹ finding of an implied agreement that the decedent retained rights over the entire 49 percent interest transferred.³⁰ More specifically, the Second Circuit confirmed certain refreshingly fundamental aspects of Section 2036 law and its decision is distinctly important for three reasons.

   First, the Second Circuit articulated clear but differing Section 2036 inclusion standards for TIC interests in residential and commercial real property. Relying on an established body of case law pertaining to residential property,³¹ the Second Circuit held that an implied agreement exists when a decedent either retains exclusive possession or excludes other owners. In Stewart, the decedent did neither. Her son continued to live on and have access to the entire residential portion.

   For commercial property, the Second Circuit determined that some degree of implied agreement exists if significant economic rights are retained. But the Second Circuit only partially upheld the Tax Court's finding of an implied agreement with respect to the commercial portion of the real property, as discussed later, and remanded the case. This result is critically distinguishable from FLP cases in which, barring the bona fide sale exception, a finding of any implied agreement results in total Section 2036 inclusion.

   Next, the Second Circuit limited Section 2036 to the extent of the implied agreement. Stewart appears to be the first case in which Section 2036 was applied proportionally in a TIC context. This was a stunning modern twist on a “proportional” concept that had laid dormant in Section 2036 case law for over 50 years. The Second Circuit relied in part on the 1957 case of Uhl's Estate v. Comm'r,³² which interpreted the predecessor to Section 2036. In Uhl's Estate, the taxpayer had gifted a 100 percent interest in stocks and bonds to an irrevocable trust but expressly retained the right to $100 per month of the income — the result was that the decedent's estate included that portion of the stocks and bonds necessary to produce $100 per month. Building off this concept, the Second Circuit in Stewart held: “If the decedent retained or reserved an interest or right with respect to a part only of the property transferred by him, the amount to be included in his gross estate under Section 2036 is only a corresponding proportion of the amount.”³³

   The Second Circuit's interpretation is correct based on the “proportional” language in Uhl's Estate, the IRS' past rulings,³⁴ the regulations interpreting Section 2036³⁵ and the analogous modern regulations for inclusion of grantor retained annuity trusts and charitable remainder trusts.³⁶ Nevertheless, courts continue to apply a seemingly heightened “all or nothing” legal standard in Section 2036 FLP cases. For example, after Stewart, the Ninth Circuit decided Jorgensen v. Comm'r,³⁷ rejecting proportional application of Section 2036 to the FLPs holding stocks and bonds based on the facts of that case. It will be interesting to see if and how the concept of Section 2036 proportionality continues to develop, especially in the FLP context.

   Lastly, the Second Circuit held that the scope of the implied agreement (and thus Section 2036's proportional inclusion) hinged on the decedent's total net economic benefit (not gross). The Second Circuit remanded the case to the Tax Court because it lacked the totality of the facts and circumstances necessary to determine the “net net” economic benefit the decedent retained (that is, the aggregate net income from two properties). This included the net income and expenses from a second jointly owned property the Tax Court had largely ignored.

   The Second Circuit's approach, borrowed from the Seventh Circuit's decision in Uhl's Estate, produces a rational economic result that's well-rooted in the law. In contrast, absent the bona fide sale exception, Section 2036 appears to apply fully in FLP cases when an indeterminate number of poor facts exist.

   Practitioner Points

   Practitioners assessing and defending against Section 2036 risks in a TIC context should consider these points:

   • Develop the facts as early as possible, including the applicable state law rights. Section 2036 controversies are highly fact-driven and resolution early in the IRS' examination process is more practical and less costly than at trial;
   • When certain state law property rights exist, there's an argument that TIC interests have a complete defense to Section 2036 inclusion that, so far, hasn't been available in the FLP context;
   • The sale of TIC interests for full and adequate consideration should qualify for the bona fide sale exception, though no court appears to have specifically addressed the issue;
   • If Section 2036 applies to the transfer of a TIC interest, Section 2036 should only apply in proportion to the net economic benefit retained;
   • Because taxpayers generally have the burden of proof in litigation, it's generally the taxpayer's burden to disprove the existence of an implied agreement in Section 2036 cases;
   • Section 2036 is unlikely to apply proportionally unless the taxpayer is prepared to quantify the extent of any economic benefit retained;
   • The IRS continues to resist the Trafton line of cases and any proportional application of Section 2036;
   • Out of necessity, published decisions rarely contain all the facts and arguments that were presented to the court. Ascertain the cases most central to the issue at hand and then obtain the briefs for both parties; and
   • Remember the adage that an ounce of prevention is worth a pound of cure. Thoughtful planning and diligent operations can reduce the potential for Section 2036 controversies.

Endnotes

1. Internal Revenue Code Section 2036(a).
2. IRC Section 2036(a)(1).
3. IRC Section 2036(a)(2).
4. Jorgensen v. Commissioner, T.C. Memo. 2009-66, aff'd, 107 A.F.T.R. 2d 2011-2069 (9th Cir. 2011) (affirming Section 2036's application to family limited partnerships (FLPs)); Bigelow v. Comm'r, 503 F.3d 955 (9th Cir. 2007) (affirming Section 2036's application to an FLP).
5. Bongard v. Comm'r, 124 T.C. 95 (2005) (rejecting Section 2036 from applying to a closely held, multi-member limited liability company (LLC)); Mirowski v. Comm'r, T.C. Memo. 2008-74 (rejecting Section 2036 from applying to a single member LLC).
6. United States v. O'Malley, 383 U.S. 627 (1966) (applying Section 2036 to transfers in trust).
7. Stewart v. Comm'r, 617 F.3d 148, 165 (2d Cir. 2010).
8. IRC Sections 2036 (a) and (c).
9. Mahoney v. U.S., 831 F.2d 641, 646-47 (6th Cir. 1987), citing U.S. v. Grace, 395 U.S. 316, 320 (1969); IRC Sections 2036(a)(1) and (a)(2).
10. U.S. v. Byrum, 408 U.S. 125, 145 (1972).
11. Maxwell v. Comm'r, 3 F.3d 591, 593 (2d Cir. 1993).
12. IRC Section 2036(a).
13. Ibid.
14. See Compilation of cases relevant to FLPs and LLCs, by Stephanie Loomis-Price, Winstead PC, Houston (Aug. 31, 2011).
15. Black v. Comm'r, 133 T.C. 15 (2009); Estate of Bongard v. Comm'r, 124 T.C. 95 (2005); Keller v. U.S., 2009 WL 2601611 (S.D. Tex.); Kimbell v. U.S., 371 F.3d 257 (5th Cir. 2004); Miller v. Comm'r, 98 T.C.M. (CCH) 159 (2009); Mirowski v. Comm'r, 95 T.C.M. (CCH) 1277 (2008); Murphy v. U.S., 2009 WL 3366099 (W.D. Ark.); Schutt v. Comm'r, 89 T.C.M. (CCH) 1353 (2005); Schurz v. Comm'r, 99 T.C.M. (CCH) 1096 (2010); Stone v. Comm'r, 86 T.C.M. (CCH) 551 (2003).
16. Black's Law Dictionary 1465-66 (centennial ed.); Jack K. Levin and Elizabeth Williams, “Tenancy in Common Section 1,” 86 Corpus Juris Secundum (May 2010).
17. Cal. Civ. Proc. Code Section 872.210; Johns v. Scobie, 12 Cal.2d 618 (1939).
18. Garcia v. Andrus, 692 F.2d 89, 92 (9th Cir. 1982).
19. U.S. v. Irvine, 511 U.S. 224, 238 (1994) (following “the general and longstanding rule in federal tax cases that although state law creates legal interests and rights in property, federal law determines whether and to what extent those interests will be taxed”).
20. Trafton v. Comm'r, 27 T.C. 610 (1956).
21. Section 811(c)(1)(B) of the IRC of 1939.
22. Trafton, supra note 20.
23. Fox v. Rothensies, 115 F.2d 42 (3d Cir. 1940).
24. Powell v. Comm'r, T.C. Memo. 1992-367.
25. Ibid.
26. Wineman v. Comm'r, T.C. Memo. 2000-193.
27. Ibid. at 1096.
28. Stewart v. Comm'r, T.C. Memo. 2006-225.
29. Stewart v. Comm'r, supra note 7.
30. Ibid. at 165.
31. Spruill v. Comm'r, 88 T.C. 1197 (1987) Guynn v. U. S. 437 F.2d 1148, 1150 (4th Cir. 1971); Maxwell v. Comm'r, 3 F.3d 591(2d Cir. 1993); Reichardt v. Comm'r, 114 T.C. 144 (2000); Kerdolff v. Comm'r, 57 T. C. 643(1972); Linderme v. Comm'r, 52 T.C. 305 (1969).
32. Uhl's Estate v. Comm'r, 241 F.2d 867 (7th Cir. 1957).
33. Stewart, supra note 7, quoting 26 C.F.R. Section 20.2036-1(a)(1)(i).
34. Revenue Ruling 79-109, 1979-1 C.B. 297.
35. 26 C.F.R. Section 20.2036-1(c)(1)(i).
36. 26 C.F.R. Section 20.2036-1(c)(2).
37. Jorgensen v. Comm'r, T.C. Memo. 2009-66, aff'd, 107 A.F.T.R. 2d 2011-2069 (9th Cir. 2011) (stating the partnerships at issue were “inapposite” to the TIC interests in Stewart).

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Dennis I. Leonard and Alison Merino are attorneys at Ramsbacher Prokey LLP in San Jose, Calif.

SPOT LIGHT

Modern Times

“Réalités Nouvelles” (46 in. by 32 in.), painted circa 1948 by Paul Rouillier, sold at Christie's South Kensington Interiors Auction on Aug. 23, 2011 for $6,588. This oil on canvas, signed and inscribed, is from the Après Guerre (roughly translates to post-war) series painted during the Jeunesse period.