Code Section 2036 and Retained Interest Rules

When an individual passes away, their assets are tallied to determine if any federal estate tax is owed. This calculation starts with the “gross estate,” which includes property owned at death and the value of certain assets given away during their lifetime. The Internal Revenue Code specifies that certain transfers can be pulled back into the gross estate. This rule prevents individuals from avoiding estate tax by giving away property while continuing to benefit from it.

Transfers with Retained Enjoyment

A primary rule that can pull transferred assets back into an estate is found in Internal Revenue Code Section 2036. This provision targets situations where an individual gives away property but keeps the ability to use, possess, or receive income from it. If this retained benefit lasts for the transferor’s lifetime or a similar period, the entire date-of-death value of the property is included in their gross estate. The rule is designed to address transfers that function like a will by allowing the transferor to enjoy the property until death.

The concept of “possession or enjoyment” is broad and does not require a legally enforceable written agreement. For instance, if a parent gifts a family vacation home to their children but continues to use it for extended periods without paying fair market rent, the IRS can argue there was an implied understanding. This suggests the parent retained the benefit of the property, and its full value could be included in their estate.

Similarly, retaining the right to the income from a transferred asset triggers the same consequence. A clear example is an individual who transfers a portfolio of dividend-paying stocks into a trust for a beneficiary but stipulates in the trust document that all dividends must be paid to them for life. In this scenario, the full market value of the stocks on the date of the individual’s death would be included in the gross estate.

This rule also applies to the retention of voting rights in a controlled corporation. If a person transfers stock in a controlled corporation but retains the right to vote those shares, they are considered to have retained the enjoyment of the property. A controlled corporation is generally defined as one where the decedent and their family owned or had the right to vote at least 20 percent of the total combined voting power of all classes of stock at any time within the three-year period ending on the date of death.

The inclusion is based on the fair market value at the time of death, meaning any appreciation in the asset’s value is captured in the estate. The existence of an implied agreement is a factual determination, where the IRS will look at the circumstances surrounding the transfer and the subsequent actions of both parties to determine if a retained benefit existed.

Retained Power to Control Beneficial Enjoyment

Separate from retaining personal use of an asset, the tax code provides another trigger for estate inclusion. This part of the code focuses on the transferor’s retained power to control who will ultimately possess or enjoy the property or its income. This rule applies even if the transferor cannot personally benefit from the asset, as the authority to alter the distribution of benefits is what matters.

A common illustration involves the creation of an irrevocable trust. If a grantor establishes a trust for their children, names themselves as trustee, and retains the power to decide how much income each child receives, this is a “sprinkle power.” This retained right to designate who enjoys the income is the type of control this provision targets.

The power does not need to be held by the transferor alone. The rule is triggered if the power is exercisable “in conjunction with any person,” meaning even if the grantor must get a co-trustee’s consent, the power is still considered retained. The capacity in which the power is held is also irrelevant; it does not matter if the grantor holds the power as a trustee or in any other role.

This provision underscores that giving up ownership is not enough to remove an asset from one’s estate if significant control over its benefits is kept. By retaining this authority, the transferor has not fully relinquished their connection to the property. The tax code treats the transfer as incomplete for estate tax purposes until their death.

Application in Common Estate Planning Structures

The principles of retained enjoyment and control affect common estate planning tools like Family Limited Partnerships (FLPs). In a typical FLP, a senior family member transfers assets to a partnership and then gifts the limited partnership interests to their children. The IRS often challenges these arrangements, arguing an implied agreement existed for the senior member to retain enjoyment of the assets. Evidence can include using partnership funds for personal expenses or commingling funds.

Irrevocable trusts can also fall within the scope of these rules. If the grantor appoints themselves as a trustee, they must be careful about the powers they hold. For this reason, grantors are often advised not to serve as the sole trustee of a trust they create if that trust contains discretionary distribution powers.

A Qualified Personal Residence Trust (QPRT) is a specific trust designed with these rules in mind. A QPRT allows an individual to transfer their home into a trust, retaining the right to live in it for a specified number of years. If the grantor survives the term, the house passes to the beneficiaries and is not included in the grantor’s estate. To continue living in the home after the term ends, the grantor must pay fair market rent to the trust to avoid estate inclusion.

The Bona Fide Sale Exception

The retained interest rules do not apply to all transfers. The statute provides an exception for a “bona fide sale for an adequate and full consideration in money or money’s worth.” This exception has two distinct components that must be satisfied. If a transfer meets this standard, the property will not be included in the estate, even with a retained interest.

The first component is that the transaction must be a “bona fide sale.” In the context of family transactions, this means the transfer must be made in good faith. For transfers to an entity like an FLP, courts generally require a “legitimate and significant non-tax reason” for creating it, such as managing family assets or protecting them from creditors.

The second component is the requirement of “adequate and full consideration.” This means the transferor must receive back property that is roughly equal in value to the property they transferred. For example, when assets are transferred to an FLP, the partnership interests received must be equivalent in value to the assets contributed.

This exception is often the focal point in litigation involving FLPs. The estate must prove that the formation of the partnership was motivated by legitimate business or financial purposes, not just a scheme to generate tax discounts. Failing to demonstrate a significant non-tax purpose can cause the structure to be disregarded for tax purposes, bringing the assets back into the estate.