Estate and Gift Tax Effects of Selling a Remainder: Have D'Ambrosio, Wheeler and Magnin Changed the Rules?
Ronald H. Jensen
Pace University School of Law
Florida Tax Review, Vol. 4, Issue 8
Section 2036 requires that property transferred by a person during his lifetime be included in his federal gross estate if he retains a life interest in that property. The statute exempts bona fide sale[s] for an adequate and full consideration from this provision, but when is consideration "adequate and full"? If a person sells a remainder interest in his property but retains a life estate, is the consideration "adequate and full" if it merely equals the present value of the remainder on the date of sale, or must it equal the property's full fee value?
Until recently, the cases - with surprising uniformity - held that consideration was adequate only where it equaled the full fee value of the property. However, the Third Circuit in D'Ambrosio in 1996, the Fifth Circuit in Wheeler in 1997 and the Ninth Circuit in Magnin decided just last year rejected the seemingly settled law holding that consideration was adequate if it merely equaled the present value of the remainder. In light of these decisions, this article examines the proper test for determining adequacy of consideration in two situations: a sale of a remainder and a spousal election (traditionally called the "widow's election").
Sale of a Remainder
The amount received in the sale of a remainder should be considered adequate so long as it equals the present value of the remainder on the date of sale. Transfers for adequate consideration are exempted from the operation of section 2036 (and the other retained interest or power provisions), because such transfers do not diminish the size of the transferor's estate. Likewise, a sale of a remainder for its present value does not diminish the size of the transferor's gross estate. This is because the proceeds when invested at the interest rate used by the Government for valuing remainders will grow back over the course of the transferor's life expectancy to the property's fee value on the date of its sale. Indeed, holding such consideration inadequate causes an excessive amount to be included in the transferor's gross estate; for then the gross estate will not only include the value of the fee but also the consideration received for the remainder and all income that accumulates thereon.
The Spousal Election
Spousal elections (usually called "widow elections") occur in community property states. Typically husband H devises his share of the community property in trust with income payable to his wife W for life, remainder to their child C, but only if W at the same time transfers her share of the community property into the trust. If W acquiesces, her share of the community property may be included in her gross estate under section 2036 because of her retained life estate in the transferred property.
The cases traditionally view a spousal election as an exchange by W of a remainder in her share of the community property for a life estate in H's share. If the holdings in D'Ambrosio et al. extend to spousal elections, W's property will pass tax-free to C under this analysis where W's life estate in H's property exceeds in value the remainder she gives C. In that case, section 2036 will not apply since W will have received "adequate and full consideration" for her transfer. Thus the holdings in D'Ambrosio et al. may enable a couple to transfer one-half of the marital property to the next generation free of all transfer tax.
The article argues that this result is improper in the normal case. The defect in the above analysis lies in viewing a spousal election as simply an exchange by W of a remainder in her property for a life estate in H's property. Usually, H is also concerned with the nature of the interest W takes in her own property, and W is concerned with how H's property passes on her death. Because of H's concern for W's welfare, he may want her to place her property in trust so a professional trustee will manage it. H may want to limit W's interest in her property to that of a life income beneficiary because he fears that otherwise she will deplete the principal to her detriment. Or H may feel that the nature of the marital property (e.g., a closely-held business interest) requires unified management by a single trustee. Likewise, W is not only concerned with her receipt of a life estate in H's property. Normally, she also desires H to leave his property to C on her death. C is her child as well as H's.
Accordingly, a spousal election is better viewed, in most cases, as a transaction in which each party seeks a "package deal" from the other. H is disposing of his property in a manner calculated to induce W to dispose of her property in a certain way, and vice versa. Put more crudely, H is "buying and paying for" W's disposition of her property; and W is "buying and paying for" H's disposition of his property. So viewed, H should be treated under the reciprocal trust doctrine as the actual transferor of W's property, and W should be treated as the transferor of H's property. Consequently, when W acquiesces to the election, she should be treated as making a gift of the remainder in H's property to C. If her retained interest in H's property is not a "qualified interest," the taxable amount of the gift should be the entire value of H's property pursuant to section 2702. Likewise, the value of H's property will be included in W's gross estate when she dies under section 2036. For reasons explained in the article, W should not be entitled to a gift tax offset under section 2512(b) nor should her estate be entitled to an estate tax offset under section 2043.
Date posted: June 2, 2000