Wealth Management Update - 2010 Year-End

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FAMILY LIMITED PARTNERSHIPS AND LLCS

Tax Court Finds Transfers of FLP Interests Do Not Qualify for the Gift Tax Annual Exclusion Because Gifts Were Not of Present Interests – Price v. Commissioner, TC Memo 20102

This Tax Court decision provides guidance on the availability of the annual exclusion from gift tax under Section 2503(b) for gifts of interests in family limited partnerships. It is an important case for anyone who plans to engage in this kind of gifting, and it calls for a careful review of the provisions of the partnership or LLC agreement.

In 1976, Walter Price started a company, Diesel Power Equipment Company ("DPEC"), which distributed and serviced heavy equipment. Some time later, Mr. Price made the decision to sell the business. In 1997, he formed Price Investments Limited Partnership as a limited partnership and contributed to it the stock in DPEC and three parcels of commercial real estate. When it was formed, the partnership was owned 1% by its general partner, Price Management Corp., 49.5% by the Walter Price Revocable Trust and 49.5% by Mr. Price's wife's revocable trust. Price Management Corp. was owned by Mr. and Mrs. Price's revocable trusts.

In 1998, the partnership sold the DPEC stock and invested the proceeds in marketable securities. Over the next several years, each of Mr. and Mrs. Price gifted interests in the partnership to their children such that by 2002 the children's cumulative interest in the partnership was 99%. Gift tax returns were filed properly for each year, reporting zero gift tax because of the use of annual exclusion and unified credit amounts. Valuation reports were attached to the gift tax returns indicating substantial discounts for lack of control and marketability (which the IRS stipulated were reported correctly).

The IRS issued the Prices deficiency notices disallowing the use of the gift tax annual exclusion under Section 2503(b) with respect to the transferred partnership interests on the ground that the gifts were of "future interests in property." The Prices argued that their gifts were of present interests because (i) the donees could freely transfer the interests to one another or to the general partner and (ii) each donee had immediate rights to partnership income and could freely assign income rights to third persons. Relying on Hackl, the IRS argued that the transferred partnership interests were future interests because the partnership agreement effectively barred transfers to third parties and did not require income distributions to the limited partners.

The Tax Court agreed with the IRS and applied the methodology of Hackl in concluding that the Prices failed to show that their gifts conferred upon the donees the immediate use, possession or enjoyment of either (i) the transferred property or (ii) the income therefrom.

In its analysis of the "transferred property" prong, the court focused on the terms of the partnership agreement. Specifically, the court notes that the donees have no unilateral right to withdraw their capital accounts; that their rights to transfer and assign partnership interests are restricted; and that a transferee is a mere assignee rather than a substitute limited partner. The Tax Court, citing Hackl, states that transfers subject to the contingency of approval cannot support a present interest characterization.

In its analysis of whether the gifts of the partnership interests afforded the donees the immediate use, possession or enjoyment of "the income therefrom," the court held that (1) the partnership would have needed to generate income at or near the time of the gifts; (2) some portion of that income would have to have flowed steadily to the donees; and (3) the portion of income flowing to the donees had to be readily ascertainable. The Court found that the partnership's income did not flow steadily to the donees since there were no distributions in certain years. Furthermore, the court found problematic the fact that neither the partnership nor the general partner had any obligation to distribute profits, and distributions were secondary to the primary purpose of the partnership in achieving a reasonable, compounded rate of return on a long-term basis.

Tax Court Holds Loan from FLP to Surviving Spouse's Estate Not "Necessarily Incurred" and Interest thereon Not a Deductible Administration Expense; Transfer to FLP Escapes Estate Inclusion under Consideration Exception – Estate of Black v. Commissioner, 113 T.C. 15 (2009)

In this case, the Tax Court objected to a Graegin-type loan arrangement between related entities. It is an important decision to review if you are considering such a loan. This case also considered whether certain transfers of FLP interests are includible in a decedent's estate.

Estate of Black involves the estates of Samuel and Irene Black. Samuel Black owned a large amount of stock in Erie Indemnity Company. In 1993, at the age of 91, Mr. Black, his son and two trusts for Mr. Black's grandchildren contributed their Erie stock to an FLP in exchange for partnership interests proportionate to the fair market value of the Erie stock each contributed. The transaction was initiated to implement Mr. Black's buy-and-hold philosophy with respect to the family's Erie stock, and concerns about his son's marriage and the possibility that his grandsons would sell the stock when their trusts terminated. At the time the FLP was formed, Mr. Black was in good health and retained approximately $4 million in assets outside the FLP.

Mr. and Mrs. Black died within five months of each other, with Mr. Black dying first. There was a liquidity shortfall to pay estate taxes, so the Executor (who was their son) approached several banks about a loan but he did not like the terms, and the banks did not want FLP interests as collateral. The Executor also approached the Erie Company about a loan, but was turned down. Ultimately, the Blacks' son, as general partner of the FLP, undertook a secondary offering of approximately one-third of the FLP's Erie stock. The FLP and Mrs. Black's estate worked out a loan whereby the FLP would lend the estate approximately $71 million to pay, among other things, estate taxes, a charitable legacy and certain expenses in connection with the secondary offering. The interest was payable in a lump sum on a date more than four years from the date of the loan, and the estate had no right to prepay interest or principal, being patterned on the loan approved in the Graegin case.

The Executor computed the interest on the loan to be $20,296,274 and deducted that amount on Mrs. Black's estate tax return, in full, as an administration expense of her estate. The IRS assessed large estate tax deficiencies in both estates, denying the deductibility of the interest paid, and arguing for the inclusion in Mr. Black's estate, under Section 2036, of the Erie stock Mr. Black transferred to the FLP.

The taxpayer won on the 2036 issue, with the Tax Court finding that there was a substantial nontax reason for forming the FLP and that Mr. Black's transfer of the stock to the FLP in exchange for the partnership interest was a bona fide sale for adequate and full consideration in money or money's worth. With respect to the deductibility of the loan interest, the estate argued that the loan was bona fide and similar to the loan blessed by the Tax Court in the Graegin case. The Tax Court ruled for the IRS, holding that the loan was not "necessarily incurred" (and thus not a deductible administration expense) since the FLP could have distributed Erie company stock in redemption of the estate's partnership interest in an amount that could have covered the estate tax, charitable legacy and other expenses. The Tax Court also was troubled by the fact that the Blacks' son effectively stood on both sides of the loan transaction, as general partner of the FLP and as Executor of Mrs. Black's estate.

Tax Court Finds Transfer of an Interest in a Limited Partnership and Timberland to an FLP Was Not Includible in the Decedent's Gross Estate Under Section 2036(a) Because the Transfer Was a Bona Fide Sale For Adequate And Full Consideration – Estate of Shurtz v. Commissioner, TC Memo 201021 (February 3, 2010)

This Tax Court decision provides another Section 2036 victory for the taxpayer by holding that assets transferred to an FLP were not includible in the decedent's gross estate under Section 2036(a) because the transfer was a bona fide sale for adequate and full consideration. This case is particularly taxpayer friendly because the Tax Court focused on the nontax purposes for forming the FLP and was able to overcome several bad facts.

The Decedent, Mrs. Shurtz, died in California in 2002. She was survived by her husband and children. The Decedent and her siblings grew up in Mississippi where their family owned and operated a timberland business.

By 1993, many family members held separate interests in the business. On the advice of counsel, the family formed a limited partnership, Timberlands LP, to manage and operate the business. A corporation was formed which owned a 2% GP interest in Timberlands LP. The Decedent and her two siblings each owned one-third of the stock of the GP and the Decedent owned a 16% LP interest.

After Timberlands LP was formed, the Decedent and her siblings raised concerns about protecting the family business from "Jackpot Justice" in Mississippi. They were concerned that they could be sued and a judgment entered against them and they could lose control of the business. To avoid this problem, their attorney recommended that each family hold its Timberland LP interest in a separate limited partnership. This recommendation was followed so that the active timber business was held in Timberland LP and the equity ownership was held in several new FLPs, one of which the FLP created by the Decedent.

The Decedent also wanted to give her children and...