It Happens All The Time
A business owner dedicates every waking moment to the growth and well-being of the business. Invariably, the owner is motivated, in no small part, by the desire to provide for his or her family. After years of effort, and maybe some luck, the business succeeds. The owner and his or her spouse are able to accumulate wealth outside the business, or the business is sold for a significant amount.
At that point (belatedly, in my opinion), the owner and his or her spouse usually start to think about estate planning, including the reduction of estate taxes and maximizing the value of the assets that will pass to their family.
Where the estate plan is devised carefully, the owner and his or her spouse recognize that some loss of control over some of their assets may be necessary, and the plan is implemented properly and with sufficient time to “mature,” these goals may be attained.
Alas, too many business owners wait until it is too late to adopt and execute an effective estate plan that can also generate tax savings. This week’s post considers a recent example of one such situation.
The Limited Partnership
Decedent and her spouse owned a heating and air conditioning wholesale business and were involved in real estate development. They had accumulated substantial assets by the time the Decedent’s spouse died in 1999. His will directed that his assets be placed in three trusts. The income from two of those trusts was payable to Decedent on a regular basis, and the principal of all three could be used for her benefit. Further, at the time of her spouse’s death, Decedent had substantial assets of her own.
In 2003, Decedent moved to a nursing home, and granted her Son a power of attorney. Son attended to Decedent’s day-to-day financial needs and managed her financial assets using the power of attorney.
A few years later, Son and Decedent’s attorney devised an estate plan for some of her assets. Decedent was not involved in deciding how her assets would be held; she left this up to her Son and her attorney.
Decedent executed a certificate of limited partnership and a limited partnership agreement in November, 2006. The partnership agreement described the Partnership’s purpose in broad terms. However, one stated purpose was to provide “a means for members of the Family to acquire interests in the Partnership business and property, and to ensure that the Partnership’s business and property is continued by, and closely-held by, members of the [F]amily.” The agreement also provided that limited partners did not have the right or power to participate in the Partnership’s business, affairs, or operations.
On the same day, Decedent executed the articles of organization, and the operating agreement, of LLC, a limited liability company, with Decedent as the sole member. LLC was created for the primary purpose of being the general partner of Partnership.
In December, 2006, Partnership was funded with marketable securities transferred from Decedent’s account. A portion of this contribution was made “on behalf of” LLC. The gross value of Partnership’s assets at that time was almost $6 million. This was the only capital contribution made to Partnership. In consideration for her contribution, Decedent received a 99.9% interest as a limited partner, and LLC received a 0.1% interest as the general partner.
Subsequently, on the same day, Decedent assigned her interest in LLC to her Son in exchange for almost $6,000. The price paid by Son equaled the gross value of 0.1% of Partnership’s assets on that day, without discount. Son’s purchase of Decedent’s interest in LLC (the general partner) eliminated any formal control Decedent may have had over the assets she transferred to Partnership.
After Decedent’s transfer of her interest in LLC to Son, and still on the same day, she gave 10% of her limited partnership interest in Partnership to the Irrevocable Trust. Decedent executed this Trust on the same day that LLC and Partnership were formed. Following this transfer, Decedent held an 89.9% limited partnership interest in Partnership, which she held until her death.
At all times before Decedent’s death, Partnership’s assets consisted solely of investment assets, such as marketable securities and cash. Decedent held substantial assets that she did not transfer to Partnership.
In 2007, Partnership made a pro rata cash distribution to its partners. This was the only distribution Partnership made during Decedent’s lifetime.
When Decedent died in 2009, the fair market value of all of the assets owned by Partnership, without discount, was just over $4 million. The value of Decedent’s interest in Partnership was reported on her estate’s tax return as approximately $2.43 million as a result of discounts (over 30%) that were applied to her 89.9% limited partnership interest.
The IRS claimed that the assets of the Partnership should have been included in the Decedent’s gross estate, and issued a notice of deficiency in estate tax. Decedent’s Estate petitioned the Tax Court for relief.
Estate tax is imposed on the transfer of a decedent’s taxable estate. The taxable estate consists of the value of the gross estate after applicable deductions.
The Code requires the inclusion in a decedent’s gross estate of certain lifetime transfers that were testamentary in nature. Accordingly, a decedent’s gross estate includes the value of all property that the decedent transferred during life, but retained the possession or enjoyment of, or the right to the income from, for the decedent’s life, provided the decedent’s transfer was not a bona fide sale for adequate and full consideration.
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. In determining whether an implied agreement exists, the courts consider the facts and circumstances surrounding the transfer and the property’s use after the transfer. The taxpayer, of course, 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 Decedent’s “Retained” Interest?
The Estate denied the existence of an implied or oral agreement that allowed Decedent to retain control of the assets transferred to Partnership. The Estate asserted that after Decedent sold her interest in LLC to her Son, she did not retain possession or enjoyment of, or the right to income from, the assets that were transferred to Partnership. The Estate further contended that Decedent had no right to designate who would possess or enjoy the assets transferred to Partnership or the income from those assets.
The IRS, however, argued that Decedent did retain possession of the property transferred to Partnership and that she retained a right to income from that property. The IRS asserted that the distribution provision of the partnership agreement – which required the distribution of funds in excess of Partnership’s current operating needs – evidenced Decedent’s right to income from the assets transferred to Partnership.
The IRS also argued that there was an implied agreement that Decedent could access the income from the assets transferred to Partnership if necessary. Son’s testimony made it clear that had Decedent required a distribution, one would have been made.
On the basis of these facts and circumstances, the Court believed that there was an implied agreement that Decedent retained the right to “the possession or enjoyment of, or the right to the income from, the property” she transferred to Partnership.
Bona Fide Sale?
If Decedent’s transfer of the assets to Partnership was a bona fide sale for adequate and full consideration, the special inclusion rule would not apply. In the context of a family limited partnership, the record must establish a legitimate and significant nontax reason for creating the partnership, and that the transferor received partnership interests proportionate to the value of the property transferred. 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.
The Estate argued that three significant nontax business purposes prompted the creation of Partnership: first, to protect the assets from “trial attorney extortion”; second, to protect the assets from the “undue influence of caregivers”; and third, to preserve the assets for the benefit of Decedent’s heirs.
The IRS, however, asserted that the first two “purposes” were merely theoretical justifications, and not legitimate and significant nontax reasons for Partnership’s formation. The Court agreed.
The final proposed justification for the creation of Partnership was to preserve the transferred assets for the benefit of Decedent’s heirs. Though the partnership agreement explained Partnership’s purpose in extremely broad terms, it also stated that it was “formed for the purposes of providing a means for members of the [F]amily to acquire interests in the Partnership business and property, and to ensure that the Partnership’s business and property is continued by, and closely-held by, members of the [F]amily.” Son also testified that Decedent wanted to make sure that her assets were preserved for the benefit of the family.
The IRS contended that the facts surrounding the creation of Partnership showed that there was no significant nontax reason for its creation. The IRS emphasized that the transfer was not the result of arm’s-length bargaining, that Partnership held only cash and marketable securities, and that the terms of Partnership’s partnership agreement were not followed.
A Litany of Poor Planning
The Court was not convinced, on the basis of these facts and circumstances, that the formation of Partnership was for a legitimate and significant nontax reason. It found the reasons given unconvincing, particularly in the light of the fact that the assets of the Decedent’s spouse were held in trusts and there were no issues with the management of these assets. Further, Decedent was not involved in selecting the structure used to preserve her assets. Her Son testified at trial that Decedent was “fine” with whatever he and the attorney decided on.
Decedent stood on both sides of the transaction. She made the only contribution of capital to Partnership and held, directly or indirectly, a 100% interest in Partnership immediately after its formation. On the same day, Decedent assigned her interest in LLC to Son in exchange for its fair market value. There was no meaningful negotiation or bargaining associated with the formation of Partnership. In fact, the Son testified that during conversations about forming Partnership, Decedent would agree to whatever he and their attorney decided to do. This was not an arm’s-length transaction.
Partnership also failed to maintain books and records other than brokerage statements and ledgers maintained by Son. The partners did not hold formal meetings, and no minutes were kept. Despite the provisions of the partnership agreement, Partnership made only one distribution before Decedent’s death. Other portions of Partnership’s agreement that were also ignored.
Taking all of the facts and circumstances surrounding Partnership’s formation into account, the Court found that Decedent did not have a legitimate and significant nontax reason for transferring assets to Partnership. The Court also observed that Partnership held marketable securities that were not actively managed and were traded only on limited occasions. Despite the purported nontax reasons for Partnership’s formation, the Estate had failed to show that there were significant legitimate reasons.
On the basis of the foregoing, the Court held that the value of the assets Decedent transferred to Partnership should have been included in the value of Decedent’s gross estate.
Don’t Blow It At the End
Not planning properly for the transfer of one’s wealth– whether represented by a business or in the form of investments– is almost as bad as not planning at all. The tax savings are often the same: none. Witness the case above: poor planning and poor execution led to poor results.
That is why it behooves the “immortal” business owner and his or her all-too-mortal spouse to start planning early. That will require some difficult decision-making, first as to whether they should dispose of any of their assets during their lifetimes, and second, as to the disposition of their assets at their deaths. In both cases, they will have to address the questions of “to whom and how” their assets should be transferred. This is a responsibility that should not be abdicated to one’s children, as in the case above. It is a task that should be undertaken sooner rather than later.