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In Estate of Adler, Section 2036 Trumps Fractional Interest Discounts

By : Ori Bash, ASA

In Adler v. Comm’r, TC Memo 2011-28, the IRS prevailed in a Section 2036 attack, and eliminated fractional interest discounts applied to an estate with a ranch property.

On December 8, 1965, Axel O. Adler (Adler) transferred undivided one-fifth interests (to his five children) in his 1,100-acre Rancho Aguila property in Carmel, California. After the transfers, Adler continued to use the property rent-free, and paid all expenses associated with the property, including taxes, upkeep, and maintenance.  In addition, Adler was not required to and did not seek the children’s permission to alter or improve the property.  In 1991, Adler’s daughter transferred her one-fifth interest back to him via a quitclaim deed in exchange for cancellation of debt she owed him. The fee simple interest for Rancho Aguila on Adler’s date of death of June 20, 2004 was stipulated $6,390,000.  At issue was whether the gross estate should include the undiscounted value of a fee simple interest in Rancho Aguila, or several fractional interests in Rancho Aguila with applicable fractional interest discounts. The respondent argued for the former under a Section 2036 attack, while the petitioner argued for a combined discount of 42.9 percent for the estate (32 percent marketability discount and 16 percent minority discount), and a combined discount of approximately 34.5 percent (22 percent marketability discount and 16 percent minority discount) for the four blocks gifted during the decedent’s life.

Court Discussion
Under Section 2036, the inter vivos transfer of a remainder interest with a retained life estate is treated as a testamentary transfer of the entire property. In forming its opinion, the Court looked to answer whether the decedent gratuitously transferred a remainder interest and retained a life estate.  Specifically, the fact pattern showed that Adler retained the “possession or enjoyment of, or the right to the income from, the property” for life and “controlled the property”, after he transferred the interests.  Interestingly, the court cited Mellinger , a case in which a husband died and left his interest to a qualified terminable interest property trust for the lifetime benefit of his wife. When the wife died, she still owned her one-half interest in the stock, the value of which was included in the value of her gross estate under Section 2033. In Mellinger, the interests were treated as two separate 50 percent blocks with applicable discounts since at “no time did the wife possess, control, or have any power of disposition over the interest held in the trust.”  In summary, the Court concluded that the Rancho Aguila property “should be considered to have been split up at Adler’s death” under Section 2036, and therefore is not subject to any fractional interest discounts.   

In Adler, the fact pattern clearly points to a Section 2036 ruling.  From a tax perspective, the Adler estate would have been better served had Adler, after transferring the fractional interests, given up control of the subject property and paid rent to his children.  We note that, had the discounts been allowed as reported, the subject interests would have been valued at approximately $4,080,000 .

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