Transfers to Family Partnership Includable in Estate
The Tax Court, in Estate of Holliday, 1 held that marketable securities transferred to a family limited partnership were includable in the transferor's gross estate because there was an implied agreement that she retain the right to the possession or enjoyment of, or the right to the income from, the transferred property. In addition, the court found that the decedent did not have a legitimate and significant nontax reason for transferring the assets to the partnership.
In November 2006, Sarah D. Holliday formed a limited partnership and a limited liability company (LLC) that served as the general partner of the limited partnership. Sarah was the sole member of the LLC. On the same day, she formed an irrevocable trust.
In December 2006, Sarah transferred to the limited partnership marketability securities from her account. On the same day, Sarah sold her interest in the LLC to her two sons and transferred a 10% interest in the limited partnership to the irrevocable trust. After the gift to the trust, Sarah owned an 89.9% interest in the limited partnership.
Sarah died in January 2009, and at that time the fair market value of all of the assets of the limited partnership was valued at $4,064,759. On Sarah's estate tax return, her 89.9% interest in the limited partnership was valued at $2,428,200 after the application of a discount of approximately 33%. Following an audit, the IRS issued a notice of deficiency based on its position that the assets of the limited partnership were includable in Sarah's gross estate pursuant to Section 2036.
Section 2036 is intended to include in a decedent's gross estate inter vivos transfers that were testamentary in nature. Under Section 2036 , a decedent's gross estate includes the value of all property that the decedent transferred but retained the possession or enjoyment of, or the right to the income from, for the decedent's life. This rule, however, does not apply in cases where the transfer was a bona fide sale for adequate and full consideration. Section 2036(a) applies if the following three conditions are met:
(1) The decedent made an inter vivos transfer of property.
(2) The decedent retained an interest or right enumerated in Section 2036(a) or (b) in the transferred property, which the decedent did not relinquish before death.
(3) The decedent's transfer was not a bona fide sale for adequate and full consideration.
The parties did not dispute that Sarah made an inter vivos transfer of property, but the parties disagreed whether the second and third conditions were met.
The court began its analysis by considering whether Sarah retained possession or enjoyment of the transferred property. An interest or right is treated as having been retained or reserved if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred on the transferor. This principle applies even if the retained right is not legally enforceable. In determining whether an implied agreement exists, courts consider the facts and circumstances surrounding the transfer and the property's use after the transfer. The taxpayer bears the burden of proving that an implied agreement or understanding did not exist at the time of the transfer. This burden is particularly onerous when intra-family arrangements are involved.
The partnership agreement in this case provided that the limited partners did not have the right or power to participate in the business, affairs, or operations of the partnership. The estate denied that there was an implied or oral agreement that allowed Sarah to control the assets of the partnership. The estate also contended that Sarah had no right to designate who would possess or enjoy the assets she transferred to the partnership. The estate asserted that after Sarah sold her interest in the general partner to her sons, they alone controlled the partnership.
The court rejected the estate's arguments and focused on a provision of the partnership agreement that provided: "to the extent that the General Partner determines that the Partnership has sufficient funds in excess of its current operating needs to make distributions to the Partners, periodic distributions of Distributable Cash shall be made to the Partners on a regular basis according to their respective Partnership Interests." Based on its reading of this provision, the court found that the partnership agreement unconditionally provided that Sarah was entitled to receive distributions from the partnership under certain circumstances.
The court therefore held that there was an implied agreement that Sarah retained the right to the possession or enjoyment of, or the right to the income from, the property. Consequently, the second condition for the application of Section 2036(a) was satisfied.
The court next turned to a consideration of whether the transfer by Sarah of the marketable securities to the partnership was a bona fide sale for adequate and full consideration. If the transfer by Sarah was a bona fide sale for adequate and full consideration, Section 2036 would not apply. The court stated that in the context of a family limited partnership, the record must establish a legitimate and significant nontax reason for creating the family limited partnership, and that the transferors received partnership interests proportionate to the value of the property transferred.
The court noted that the objective evidence must indicate that the nontax reason was a significant factor that motivated the partnership's creation. A significant purpose must be an actual motivation, not a theoretical justification. Furthermore, the court pointed out that intra-family transfers are subject to heightened scrutiny.
The estate argued that three significant nontax business purposes prompted its creation:
(1) To protect the assets from trial attorney extortion.
(2) To protect the assets from the undue influence of caregivers.
(3) To preserve the assets for the benefit of the decedent's heirs.
The IRS, however, contended that the facts surrounding the creation of the partnership showed that there was no significant nontax reason for its creation. In addition, the IRS argued that the transfer was not the result of arm's-length bargaining, that the partnership held only cash and marketable securities, and that the terms of the partnership agreement were not followed.
The court was not convinced that protection from trial attorney extortion was an initial motivation for the formation of the partnership. The court observed that Sarah had never been sued, and, more importantly, she continued to hold significant assets that were not transferred to the partnership which would have been equally enticing for a person attempting to extort something from her. The court concluded that this was simply a theoretical justification and was not a legitimate and significant nontax reason for the formation of the partnership.
With respect to the claim that the partnership was formed to protect the assets from the undue influence of caregivers, the members of the Holliday family did in fact have unfortunate experiences regarding caregivers stealing from them. However, the court distinguished the situation of those other family members from that of Sarah because Sarah had two sons who were involved in managing her affairs, and one of her sons visited her at least once a week.
More important to the court was that no one had discussed with Sarah the concept that her possibly being taken advantage of was a reason for transferring some of her assets to the partnership. Therefore, the court concluded that there was no evidence that the transfer by Sarah of assets to the partnership was motivated by her own concern that she would become subject to the undue influence of a caregiver. The court found that this was a theoretical justification for the transfer, not a legitimate and significant nontax reason.
The final alleged justification for the creation of the partnership was to preserve the transferred assets for the benefit of Sarah's heirs. One of Sarah's sons testified at trial that Sarah stated she was fine with whatever he, his brother, and her lawyer decided. The court therefore concluded that Sarah was not involved in selecting the structure used to preserve her assets. As such, based on the facts and circumstances, the partnership was not formed for legitimate and significant nontax reasons.
The court also pointed to other facts supporting its conclusion that the partnership was not formed for legitimate and significant nontax reasons. Sarah stood on both sides of the transaction. She made the only contribution of capital to the partnership and held, directly or indirectly, a 100% interest in the partnership immediately after its formation. There was no meaningful negotiation or bargaining associated with the formation of the partnership. The partnership also failed to maintain books and records other than brokerage statements. The partners did not hold formal meetings, and no minutes were kept.
Despite the provisions of the partnership agreement permitting periodic distributions of cash to the partners, the partnership made only one distribution before Sarah's death. This was not the only portion of the partnership agreement that was ignored. Section 9 of agreement provided that except as otherwise provided in this agreement or a separate written document executed by all of the partners, the general partner, or any one of them would receive reasonable compensation for managing the affairs of the partnership. However, a separate written document was not introduced as evidence or discussed at trial, and no payments were ever made to the general partner. The court also noted that the partnership held marketable securities that were not actively managed and were traded only on limited occasions.
The court therefore held that the value of the assets transferred by Sarah to the partnership should be included in the value of her gross estate pursuant to Section 2036(a)(1).
This case presented several bad facts, as the court enumerated. Advisors should use those enumerated "bad facts" as a checklist when working with clients so as to avoid following the same pattern when forming family limited partnerships.
One aspect of the decision, however, is somewhat troubling. The court, in reaching its conclusion that the decedent retained a right to the income of the property transferred to the partnership, relied on a standard provision contained in partnership agreements that permitted the general partner to make distributions of cash to the partners. This type of provision is usual and customary in partnership agreements, including those entered into by unrelated parties.
1 TCMemo 2016-51
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets his clients have accumulated and minimizing federal and state tax liability. These clients range from homeowners whose property has appreciated to people with significant investment, retirement, business, and real estate holdings. For more on forming family limited partnerships, contact Frank at (301) 657-0175 or email@example.com.
This article originally appeared in the August 2016 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.