Remainder Sales: Still a non-abusive tool

A View on Remainder Sales - Still a useful, non-abusive tool
The Fifth Circuit Court of Appeals decision in Wheeler, 116 F. 3d 749 (5th Cir. 1997), resulted in the affirmation of what was previously a somewhat controversial estate planning technique. The decision implanted the following principles into our jurisprudence: The exchange of a remainder interest in property for other property of equal value is a transfer for adequate and full consideration for purposes of federal gift and estate tax law. At death, the life interest retained in the exchange is not includable in the gross estate, and IRC §2036 has no application.

Wheeler was decided seven years after the enactment of the new §2702. But the remainder sale in Wheeler occurred years before the enactment of §2702. Congress clearly intended to terminate the use of remainder sales used for the purpose of insulating the entire value of a retained life estate from the reach of the taxing statutes. However, close analysis of the language of the statutes suggests that Congress left alive the opportunity to sell a remainder interest coupled with a marital gift of the life estate. If constructed properly, the front-end-loading effect of §2702 is not activated.

What §2702 does:

This provision operates to create a “deemed” gift of the entire value of a retained life estate. Assume the same situation as in Wheeler. Dad sold the remainder interest in his land to his sons and carried the note. The price was equal to the appraised value of the land multiplied by the appropriate factor promulgated in IRS Publication 1457 based on the §7520 interest applicable to the date of the transaction (plus another $10,000 just to be sure the price was adequate and full). Thus, Dad received absolutely full and adequate consideration for the value of the remainder that was transferred. The sons paid off the debt. According to the Fifth Circuit, the retained life estate was not part of the Dad’s estate.

The government had argued that “adequate and full consideration” had to be the value of the entire fee – i.e., that a price reflecting only the value of a remainder interest was not adequate and full consideration. Clearly, the concern was that the life interest portion still possessed at Dad’s death would completely escape taxation. Rejecting that argument, the Fifth Circuit reasoned that the decision is driven by the function and purpose of the actuarial rules. It was reasoned that under the valuation scheme mandated by the law, the investment of the remainder-sale proceeds at the then-applicable §7520 rate would actuarially restore the value of the life interest to the gross estate. Thus, it could be fairly said, that if both the actuarially-restored value was taxed in addition to the value of the retained life interest, value would be taxed twice.

When §2702 operates upon facts presented in Wheeler, a different result arises. Now, where Dad sells the remainder to sons and retains for himself the life estate, the statute deems that the transaction resulted in the transfer of the entire fee; and, since the value received only equal the price of the remainder portion, the value of the life interest is deemed to have been transferred as a gift. Thus, Dad’s sale is taxed as part sale (the remainder portion) and part taxable gift (the life interest portion). But §2702 is not applicable where Dad does not retain a life interest. §2702 only operates where there is a retained interest. See, Treas. Regs. §25.2702-2(d) example 3. Still remaining is the issue of whether Dad can simultaneously sell the land to sons for the value of the remainder only, and still make a gift to Mom that qualifies for a marital deduction.

Marital Deduction for gift of life estate?

The policy of the federal taxing statutes is to not tax gratuitous transfers to a spouse. That way, when the values are accumulated in the spouse’s estate they are taxed upon the spouse’s demise. So, where assets that will be included in the spouse’s estate are transferred gratuitously (either inter vivos or testamentary) the law provides a marital deduction so that the value transferred in not taxed at the time of transfer. And in general, that is why a gift of a terminable interest such as a life estate is not thought of as being eligible for a marital deduction. A common view is that if the asset transferred will be excluded from the spouse’s estate, then there should be no marital deduction at the time of the gift.

However, the statute that precludes a marital deduction for a gift of a life interest followed by a remainder to any person contains a clear and unequivocal exception. Under §2523 it is provided that no marital deduction shall be allowed where the donor retains or else transfers an interest that will become possessory upon the death of the donee-spouse. But, there is a big parenthetical exception to that rule. Under §2523, there is no deduction if the donor transfers the remainder to any person other than the donee spouse for less than an adequate and full consideration. Based on the language of the statute there is reason to conclude that where the donor gives the life interest to the donee-spouse and sells the remainder to the children, the gift to the donee-spouse qualifies for a marital deduction.

Tax outcomes:

The tax consequences would appear to be favorable to the taxpayer. First, because the donor transfers both the life interest and the remainder, retaining no interest in himself, the provisions of §2702 are not applicable. Second, the sale of the remainder must be taken into account for the seller’s income tax return. Third, the value of the life estate gifted to the donee-spouse qualifies for the marital deduction provided under §2523(a) because the interest that succeeds the donee-spouse’s life interest was transferred for an adequate and full consideration. Fourth, when the donee-spouse dies, the life interest will not be includible in the gross estate.

Not abusive – Wheeler is supportive: Such a transaction should not result in the taxation of the gratuitous transfer of the life interest to the donee-spouse when the reasoning of Wheeler is brought into the analysis. According to that judicial pronouncement, the mathematical assumption underlying the federal valuation scheme is that the proceeds from the sale can grow at the rate presumed by the law for the balance of the seller’s actuarially-presumed life expectancy. Over that period, the growth will compound its way right back to the full equivalent of the value of the entire fee. It’s as though it is to be presumed that is what will happen – that the proceeds will in fact compound to that equivalent value. Thus approached, the value of the life estate should not be taxed because its equivalent value will have been restored to the estate. And not a single authority has challenged or sought to displace that formulation at any time since Wheeler was decided. To the contrary, the reasoning has been expressly adopted and reinforced in the Ninth Circuit. It seems that it is probably unshakably part of our law: the actuarial-based valuation scheme presumes that the proceeds will grow to the point of completely restoring the whole value of the entire fee in the seller’s estate.

In the Fifth and Ninth Circuits there would be no economic basis for asserting that a marital deduction should not be allowed. The assumption is that the proceeds of the remainder sale will appreciate for the balance of the seller’s life and completely restore the value of the life interest to the seller’s gross estate. It will be taxed in that estate. Therefore, there is no economics-based reason to tax the value of the gift to the spouse. Rather, under Wheeler one is compelled to conclude that to do so would result in the unjust taxation of the same value twice – once upon transfer to the spouse and again when the appreciated value from the remainder sale is taxed in the donor-seller’s gross estate.

Tension between 2523 and 2702?:

While §2702 would tax the value of a retained life interest upon sale of the remainder to members of the seller’s family, it would tax it as a deemed gift to the remaindermen. And if the buyer of the remainder is the seller’s spouse, §2702 would require that the transaction be treated as also including a transfer of the value of the life interest – a deemed transfer of the whole. But the application of §2702 should not produce any taxable transfer because the value of the whole should be deemed transferred to the donee-buyer-spouse in this family-only transaction. And since the remainder is not transferred to any person other than the spouse, it is clear that a marital deduction shall be allowed under §2523. There is nothing in §2702 that would conflict with allowance of a marital deduction where a life estate is actually or “deemed” transferred to a spouse. Treas. Regs. §25.2702-2(d) example 3 seems to support that view.

Letter Rulings: None of the letter rulings I have been able to find dealing with issues under §2523 express any thought concerning the parenthetical “consideration-based exception” provided in §2523(b)(1). The rulings briskly pass by the matter because the facts presented do not involve transferring the remainder to other persons in a genuine sale for adequate and full consideration. Of course, that does not unequivocally establish the proposition that the IRS might attempt to deny a marital deduction even where the remainder is sold for an adequate and full consideration to persons other than the donee-spouse. But that is where the reasoning applied in Wheeler seems to constitute such strong support for the proposition that the transaction should be treated as a sale of the remainder (having immediate income tax consequences to the seller-donor) and a tax-deductible gift to the donee spouse.

Wheeler adopted as correct in Magnin (9th Circuit):

Just before Wheeler was published, the Tax Court published its opinion in Magnin, TCMemo 1996-25. There, the Tax Court held that a sale of a remainder is a transfer for less than adequate and full consideration where the value received is less than the value of the entire property. Shortly after the Tax Court released that opinion, the Fifth Circuit published Wheeler which announced a rule that was completely contrary to the Tax Court’s position in Magnin. According to the Fifth circuit’s analysis, every time property removed from a transferor’s estate is joined by receipt of property that has equal value, the transfer is for adequate and full consideration. That set the stage for the appeal of the Magnin case to the Ninth Circuit where there was presented the unequivocal conflict between the Tax Court and the fifth Circuit.

Though Wheeler involved the sale of a remainder in realty and Magnin involved the relinquishment of the remainder interest in closeheld stock in exchange for a life interest in the same closeheld stock owned by the transferor’s father, the Ninth Circuit relied upon and followed the sound reasoning of Wheeler and rejected the principle expressed by the Tax Court in its opinion in Magnin, 184 F. 3d 1074 (9th Cir. 1999). Since that flurry of activity from 1996 to 1999, the issue has never again been raised in any court. Perhaps the government knows that Wheeler – wholly adopted and followed in the Ninth Circuit – expressed the correct view of the law: an exchange of equally valued things is always a transfer for adequate and full consideration.

The clear governing principle that must be met is that the remainder must be sold for a price that is absolutely the full value. Both courts correctly point out that the actuarial tables are built upon the presumption that there the property received for the life estate grows at the rate prescribed under §7520, then the growth reproduces exactly the same value includable in the gross estate that would have been included if there had been no transfer.

Caveat:

Seller-financed sale creates an interest: Where the seller carries the purchase-money note secured by liens against the property, there exists the contingent possibility that the seller-donor might again become the owner in the event of default and foreclosure. It is possible that the existence of that contingent interest is sufficient to remove the transaction from the scope of the parenthetical exception based on transfer for adequate and full consideration. The language of the statute seems to require that whoever owns the remainder must be a person who purchased it for full value, thereby completely cutting off the seller-donor’s interests in the property. For that reason, to make use of this remainder-sale/marital gift technique, it seems quite advisable to arrange for third-party financing by some means.