Scott E. Vincent
Vincent & Fontg LLC
Kansas City

A recent Tax Court decision highlights the risks of a retained life estate in estate planning. In Disbrow Estate v. Commissioner, T.C. Memo 2006-34 (2/28/06), the Tax Court held that a residence transferred by a decedent to a family partnership was includible in the decedent's gross estate because she continued to live in the residence paying less than fair rental value until her death pursuant to an understanding with her family members.

Factual Background

The decedent passed in 2000 at the age of 78. She left her estate by will to her five children in equal shares. The estate consisted primarily of cash, stocks, bonds, and annuities, and did not include the residence in question. The decedent had acquired sole ownership of the residence upon her husband's death in 1993, and the residence was her principal residence until she died. In 1993, a comparative market analysis valued the residence at $350,000.

Also in 1993, when the decedent was almost 72 years of age, she executed a general partnership agreement forming a family partnership. The decedent had a 28% interest in the family partnership with the balance of the interests divided among her children and their spouses. None of the partners of the family partnership contributed any assets upon formation of the entity.

After formation of the family partnership, the decedent transferred her entire interest in the residence to the family partnership for no consideration. When the decedent was transferring the residence to the family partnership, the other partners (all family members) assured the decedent that she could continue to live at the residence as long as she furnished the funds necessary to maintain it. Following these transfers and agreements, the decedent gave her 28% interest in the family partnership to her children and children-in-law.

The family partnership agreement stated that the entity was "created to establish and conduct the business of real estate ownership and management" and that its place of business was the address of the residence. However, the family partnership conducted no business and apparently was not operated with an intent to make a profit. The only assets of the family partnership were the residence and a checking account. The decedent, after she was no longer a partner, handled various transactions with respect to this family partnership checking account.

The decedent's lawyer had recommended formation of the partnership to keep the residence out of her estate. Her lawyer did prepare annual lease agreements under which the family partnership rented the residence to the decedent for each year from January 1, 1994 through December 31, 2000. The rental amount in these annual lease agreements changed from year to year, but the rental amounts were all significantly below the residence's fair rental value.

The decedent did not accurately follow the terms of the lease agreements. She did not regularly pay her rent, she did not always pay the amount of rent stated in the lease agreements, and she often paid her rent later than the time required by the lease agreements. The family partnership never mailed the decedent notices demanding her rent, nor did the family partnership ever send a notice of eviction.

The family partnership filed partnership tax returns for each year from 1994 through 2000. These returns stated that the principal business activity of the family partnership was "rental" and that its principal product or service was "real estate." The tax returns reflected rent and related expenses, depreciation, and net losses.

The decedent always had the exclusive use and enjoyment of the entire residence, and she always had the right to use the entire residence. When she died in February 2000, the fair market value of the residence was $400,000. In November 2000, the family partnership sold the residence to one of the decedent's sons for $350,000.

Holding and Analysis

The Tax Court held that the fair market value of the residence was includible in the decedent's gross estate because, until her death, she retained the "possession" and "enjoyment" of the residence within the meaning of § 2036(a)(1).

Section 2036(a)(1) provides that "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 . . . under which he has retained for his life . . . the possession or enjoyment of, or the right to the income from, the property. . . ."

The Tax Court concluded in this case that the decedent's transfer of the residence to the family partnership was done with a retained lifetime possession and enjoyment of the residence pursuant to her understandings and agreements with the donees. The court also noted that the decedent paid less than fair rental value for the exclusive possession and enjoyment of the residence, and that the annual lease agreements were a subterfuge to disguise the testamentary intentions of the parties.

Further, the court found that the family partnership was not a business operated for profit, but a testamentary device to remove the residence from the decedent's gross estate. In this regard, the court noted that the residence was transferred to the family partnership on the advice of counsel to minimize tax on the decedent's estate.

Finally, the court stated that the parties did not treat the residence as leased property following its transfer to the family partnership and that the decedent was not treated as a tenant of leased property.

The court found that these factual circumstances triggered the application of § 2036(a)(1) and that the residence was includible in the decedent's estate.