Decedent Had Implied Retained Estate for Partnership Established Solely for Tax Reasons, So Entire Value Included in Her Taxable Estate

The most successful method the IRS has developed to attack claimed discounts in family limited partnerships continues to be to claim the transactions, as actually undertaken by the decedent and the family members, ran afoul of the provisions of IRC §2036(a).  In the case of Estate of Holliday v. Commissioner, TC Memo 2016‑51 the IRS again succeeded in bring the assets back into the decedent’s estate using this same provision of the law.

IRC §2036(a) reads:

(a) General rule

The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—

(1) the possession or enjoyment of, or the right to the income from, the property, or

(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

The courts have interpreted this section to require two things to be true for the value of the property to come back into the decedent’s estate:

  • The transfer must not have been a “bona fide sale” with an emphasis on the actual existence of significant non-tax reasons for establishing the partnership to show it was “bona fide” and
  • The decedent must have retained the right to the income of the property, most often via an implied life estate.

In this case the decedent had funded the partnership with marketable securities of just under $6 million.  She sold her interest in the general partnership (which held a 0.1% interest in the entity) to her two sons for just under $6,000 and then later gifted portions of the limited partnership interests she retained to an irrevocable trust.

Just over two years later the decedent died.  In those two years the partnership had made a single pro-rata distribution of $35,000, not exactly a huge number for a partnership with a portfolio of $6,000,000.  This was despite a clause in the partnership agreement which 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.

At trial one of the brothers (the holders of the general partnership LLC that was to make the determination of operating cash need) was asked about this issue.

When asked at trial what he believed the term “operating needs” meant, Mr. Holliday testified: “[I]t seemed to me when I reviewed this document, when it was signed, that it was created, that this seemed to come from some sort of boilerplate for Tennessee limited partnerships, this sort of gave you broad powers to do anything you needed to do, including make distributions. But that wasn’t necessary. No one needed a distribution.”

The IRS argued that the partnership was formed solely for tax purposes and that the decedent and her sons had an implied agreement that she would retain the use of the income of the assets in the partnership to the extent she needed the funds.

The estate argued that there were three separate legitimate non-tax reasons for establishing the partnership, creating a bona fide transaction. 

The estate’s first claim was one that is often recited by such documents—establishing the partnership would insulate the decedent from legal liability should a personal injury attorney come after her.  Of course at the time the partnership was set up the decedent was living in a nursing home and had, in fact, never been sued.  The Court agreed that it seemed highly unlikely that there was any real risk the elderly lady would somehow be put in a position to be subject to risk of large legal liability claims. 

And, in any event, she continued to hold substantial assets outside the partnership—so there was still plenty available for the theoretically nasty personal injury attorney to come after.  Thus the Court found that this was not an actual legitimate non-tax reason why this entity was formed.

The estate also raised the often recited claim that the structure was created to preserve the assets for the decedent’s heirs and to make management of the assets easier.  The Court noted that before the partnership was created the assets were already being held in a trust which would provide for centralized management,   As well, one brother testified that his mother was “’fine’ with whatever he, his brother and the attorney decided upon” for the structure—indicating that the decedent clearly wasn’t involving in selecting the structure based on her desire to insure the assets remained held as a whole by the family.

Finally the estate claimed the structure was chosen to prevent the undue influence of caregivers that could have caused a loss of assets.  One of the sons testified at trial that the decedent’s cousin-in-law had been subject to such undue influence by a caregiver who had, per the brother’s testimony, unfairly exploited the cousin-in-law for financial gain due to her dependence on the caregiver.  As well, after the sons’ grandfather had passed away they discovered a caregiver had stolen heirloom silverware.  And one of the decedent’s own caregivers had failed to show up for work but continued to bill for work done.

However the Court noted that the decedent’s situation was nothing like her cousin-in-law, a lady who had no immediate family nearby, unlike the decedent who had both sons nearby and was visited weekly by them.  The Court noted that putting assets into the partnership would not protect them from theft.  Finally, the Court noted that the sons admitted they had never actually discussed the potential protection from undue influence with their mother when she was deciding to form the partnership.

The Court noted additional factors suggested this wasn’t a bona fide transaction.  There was no meaningful bargaining in setting up the partnership among the parties, with the decedent assenting to whatever her sons and the attorney came up with. 

As well, the Court noted the partnership agreement was effectively ignored:

Oak Capital also failed to maintain books and records other than brokerage statements and ledgers maintained by Mr. Holliday. The partners did not hold formal meetings, and no minutes were kept. See Estate of Jorgensen v. Commissioner, T.C. Memo. 2009-66. As discussed above, despite the provisions of section 5 of Oak Capital’s limited partnership agreement, Oak Capital made only one distribution before decedent’s death. This was not the only portion of Oak Capital’s limited partnership agreement that was ignored. Section 9 of Oak Capital’s limited partnership agreement provides that “[e]xcept as otherwise provided in this Agreement or a separate written document executed by all of the Partners, the General Partner, or any one (1) of them shall receive reasonable compensation for managing the affairs of the Partnership.” A separate written document was not introduced as evidence or discussed at trial, and no payments were ever made to OVL Capital.

Thus without a bona fide sale the remaining issue was whether there had existed an implied life estate allowing the decedent enjoyment of the income of the assets for her life.

In this case the IRS asserted the distributions clause, cited above, and the partnership’s own actions showed that she retained the right to income for her life.  The Court agreed, noting:

Section 5 of Oak Capital’s limited partnership agreement unconditionally provides that decedent was entitled to receive distributions from Oak Capital in certain circumstances. Further, Mr. Holliday’s testimony makes it clear that had decedent required a distribution, one would have been made. On the basis of the facts and circumstances surrounding the transfer of assets to Oak Capital, we believe 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 Oak Capital. See sec. 2036(a)(1). Accordingly, the second condition necessary for section 2036(a) to apply has been met.

Advisers must counsel clients who are looking at using a family limited partnership as part of an estate plan of the issues that must be dealt with to insure that the entity will be recognized by the courts.  As was noted above, one key issue is that the entity must actually be respected by the family if there is any chance it will be respected by the Courts.  As well, non-tax reasons for establishing the partnership must be actual issues that address real concerns of the person transferring the assets to the partnership, not merely a boilerplate recitation of possible reasons.