Valuation Discount Despite Failure to Fund Partnership
Keller, 10-41311JONES20120925CA5,110 AFTR 2d 2012-6061, 697 F3d 238, 2012-2 USTC ¶60653 697 F.3d 238, 110 AFTR2d 2012-6061 (CA-5, 2012).
In Keller,1 the Fifth Circuit affirmed the decision of a district court permitting a 47.5% discount for partnership interests for estate tax purposes despite the fact that the partnership was not actually funded until after the decedent's death. The court held that under applicable state law, the decedent's demonstrated intent to fund the partnership was sufficient. The court also permitted interest deductions for a Graegin loan2 between the partnership and the estate.
Maude Williams formed a limited partnership in May 2000. Prior to the formation of the partnership, Maude's accountant had prepared for her a spreadsheet listing specific assets that were to be transferred to the partnership. The assets were to come from two trusts with respect to which Maude was the sole trustee. While Maude did not memorialize in writing her agreement with the spreadsheet, she gave her accountant implicit approval to prepare a flowchart showing how the partnership would be funded with bonds and cash amounting to $250 million. Maude died before the partnership was actually funded. Her advisors initially believed that they failed to fully create and fund the partnership before Maude's death and ceased attempts to activate the partnership. In February 2001, Maude's estate paid over $147 million in estate taxes.
One of Maude's advisors reconsidered the partnership in May 2001 and formally transferred the bonds to the partnership. Once the partnership was funded, the advisors realized that although the estate had actually paid the estate taxes, it legally lacked the liquid assets to make the $147 million estate tax payment because the assets used to pay the estate tax actually belonged to the partnership. Consequently, the advisors retroactively structured a $114 million loan from the partnership to the estate effective as of February 2001 at the applicable federal interest rate. The estate filed a claim for a refund with the IRS in November 2001 on two grounds:
- The estate's initial fair-market value assessment of Maude's assets failed to discount appropriately the value of the partnership interests, thereby leading to an initial overpayment.
- The estate had accrued interest on its loan from the partnership to pay estate taxes, entitling the estate to a deduction.
After six months passed without IRS action, the estate filed a complaint in the U.S. District Court for the Southern District of Texas. In the district court, the estate argued that under Texas law, Maude's intent to transfer the bonds to the partnership transformed those bonds into partnership property notwithstanding her failure to complete the partnership documents. The estate also argued that the transfer to the partnership by Maude necessarily rendered the tax payment a loan from the partnership to the estate and thereby entitled the estate to an interest deduction as an expense of administering the estate. The government raised several objections to the estate's argument, including these:
- Maude failed to create the partnership at all.
- Texas law required Maude to have committed her transfer of assets to the partnership in writing.
- Any purported loan between the estate and the partnership was a sham transaction.
The district court rejected the government's arguments. Reviewing Texas law, the court held that Maude's intent to transfer the bonds to the partnership was sufficient to transfer the bonds regardless of record title or the absence of a writing confirming that transfer. Moreover, because the bonds sold to satisfy estate taxes were in fact partnership property, the transfer from the partnership to the estate was actually and necessarily incurred in the administration of the estate, entitling the estate to a corresponding deduction for the interest on the loan. The district court therefore granted the estate a refund of approximately $115 million. The IRS appealed the decision to the Fifth Circuit.
The court began its opinion by stating that with respect to existing partnerships, well-established Texas law provides that the intent of an owner of an asset to make that asset partnership property causes that asset to become the property of the partnership. The Texas courts have long held that ownership of property intended to be a partnership asset is not determined by legal title, but rather by the intention of the parties as supported by the evidence. The court recognized that the facts of this case were different from those of prior Texas decisions, because rather than addressing property acquired or used by an already-formed partnership, the question here was whether title to property passed to the partnership contemporaneous with its formation. In addition, another difference from prior cases is that the partnership in question was a limited partnership formed under the then-applicable Texas Revised Limited Partnership Act (TRLPA), rather than under general partnership laws.
The government did not challenge the district court's factual finding that Maude intended to transfer the bonds in question to the partnership; instead, it invoked provisions of TRLPA that assertedly prohibit the conclusion that a transfer occurred. The government's first argument relied on the statute of frauds, under which a promise by a limited partner to make a contribution to a limited partnership is not enforceable unless in writing and signed by the limited partner. The court rejected this argument, finding that the government's argument ignores the fact that under Texas law, Maude transferred the bonds to the partnership immediately on forming the partnership and executing the partnership agreement with the intent that the bonds were partnership property. Under Texas law, this intent regarding forming the partnership and transferring the bonds immediately conferred equitable title to the partnership.
The government's second argument was that TRLPA required Schedule A of the partnership agreement, which was to describe the initial capital contribution of each partner to the partnership, to be filled out before Maude's death in order for the bonds to be transferred to the partnership. The court rejected this argument, believing that this provision should be more sensibly construed as a mandatory record keeping provision, the breach of which may give rise to suit for violating duties between partners rather than as a provision invalidating noncompliant property transfers.
Both the estate and the court pointed out that at least one federal district court has applied Texas law to resolve a formation-stage problem in a family limited partnership. In Church,3 a decedent and her children executed documents to form a family limited partnership for estate-planning purposes and transferred both a ranch and valuable securities to the partnership. The family fully executed the documents before the decedent's death, but failed to form the partnership's corporate general partner, to file the certificate of limited partnership with the Texas Secretary of State, and to transfer legal title of the securities to the partnership prior to the decedent's death.
The court in Church nonetheless sustained the requested estate valuation discounts. Despite several defects in forming the partnership, the partnership was in substantial compliance in good faith with TRLPA. Furthermore, the actual possession of legal title to the securities was not determinative because the decedent's intention to transfer the property to the partnership was sufficient.
The government's final argument was that the partnership ceased to exist on Maude's death because her death triggered immediate termination of the two trusts that were the limited partners of the partnership and the assignment of their limited partnership interests to the trust beneficiaries. The court rejected this argument because TRLPA sets forth the three events that result in the dissolution of a limited partnership, and the assignment of a limited partnership interest is not one of those listed event.
Having rejected each of the government's arguments, the circuit court held that the district court correctly concluded that Maude's intent on forming the partnership was sufficient under Texas law to transfer ownership of the bonds to the partnership. The court, therefore, upheld the valuation discount.
The court turned next to the issue of whether the interest paid on the loan between the estate and the partnership was deductible. An estate may deduct for tax purposes expenses that are actually and necessarily incurred in the administration of the decedent's estate.4 These expenses include interest on loans taken to pay debts of an estate, such as estate taxes, if those loans are necessary to pay estate debts. Courts have permitted interest deductions on loans between an estate and closely related business entities, typically because any revenue-raising alternative to the loan threatened to diminish asset value.5
The government relied on Estate of Black,6 where the Tax Court denied a deduction for accrued interest on a loan between a family limited partnership and a decedent's estate. In Black, the taxpayer established a family limited partnership and conveyed to it substantially all of his assets in exchange for partnership interests. After his passing, the estate borrowed $71 million from the partnership and sought a deduction for the interest paid on the loan. The Tax Court denied the interest deduction. The Tax Court observed that the partnership interest owned by the estate was the only meaningful asset of the estate. It was therefore impossible for the estate to repay the loan without resort to the assets of the partnership. In other words, the estate would eventually be required to sell partnership assets or its partnership interest to satisfy the loan, and its financing structure merely was an “indirect use” of the assets of the partnership to generate a tax deduction. The Tax Court concluded that the “indirect use” of the assets of the partnership distinguished the case from other cases in which loans from a related family-owned corporation to the estate were found to be necessary to avoid forced sales of illiquid assets or to retain an asset for future appreciation.
The court distinguished the Black case from the present case. In Black, in order to satisfy the loan to the partnership, the assets of the partnership would have to be sold and distributed to the estate because the estate had no asset other than the partnership interests. The court noted that in this case, the estate did not face a similar outcome because it did not need to resort to redeeming partnership units or distributing partnership assets to repay the loan eventually. Rather, the estate's assets (excluding the partnership interests) included over $110 million in ranch and mineral holdings which, while illiquid, could be used to repay the loan.
The government also argued that the loan between the estate and the partnership could have been characterized as a distribution from the partnership to the estate, thereby rendering the loan unnecessary. Without analysis, the court stated that the government's argument takes the decision in Black too far. The government also argued that the fact that the beneficiaries of the estate and the partners of the partnership were similar rendered any potential economic distinctions between the estate and the partnership as well as the chosen financing structure little more than a legal pretense. The court stated that it refused to collapse the estate and the partnership to functionally the same entity simply because they share substantial (although not complete) common control. The court therefore concluded that the district court correctly permitted a deduction for the interest on the loan from the partnership to the estate.
This case is a major victory for the taxpayer. The court's decision regarding the funding of the partnership was supported by applicable Texas law. Advisors, however, should be cautious in relying on the court's holding unless they are certain that the laws of their state support the conclusion that mere intention to fund is sufficient to fund a partnership. In addition, even if the laws of one's state support such a conclusion, best practices dictate that taxpayers actually transfer legal title of property to the partnership in order to avoid audits or expensive litigation with the IRS.
1 110 AFTR 2d 2012-6061, 697 F3d 238, 2012-2 USTC ¶60653 (CA-5, 2012).
2 See Estate of Graegin, TC Memo 1988-477, PH TCM ¶88477, 56 CCH TCM 387 .
3 85 AFTR 2d 2000-804, 2000-1 USTC ¶60369 (DC Tex., 2000), aff'd 88 AFTR 2d 2001-5352, 268 F3d 1063, 2001-2 USTC ¶60415 (CA-5, 2001).
4 Reg. 20.2053-3(a).
5 See Estate of Graegin, supra note 2.
6 133 TC 340 (2009).
This article originally appeared in the February 2013 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.