Tax Court Slams FLP Planning

Estate of Powell v. Commissioner, 148 T.C. No. 18 (May 18, 2017).

Hold on to your seat!  This case has a huge impact on Family Limited Partnership (FLP) planning.  And yes, it creates a new “doughnut hole.”

For the very first time, the Tax Court held that where a decedent owned only limited partnership interests, they are brought back into the donor’s estate under IRC §2036(a)(2).  It also raises the specter of a possible double tax as partnership assets may be included under §2036 and under §2033.

The case has what most estate planning lawyers would call “bad facts.”  It was death bed planning done for a decedent, Nancy Powell, by her son Jeffrey, acting as an agent under a power of attorney.  The estate tax deficiency was $5.88 million.  There was also a gift tax deficiency of $2.96 million. 

Using his power of attorney, decedent’s son transferred $10 million of decedent’s securities to a FLP in exchange for a 99% limited interest.  The two sons contributed notes and receive a 1% general partnership interest.  The general partner had sole discretion to determine the amount and timing of distributions.  The same day, the son, acting as agent, transferred decedent’s 99% limited interest to a charitable lead annuity trust. (One other thing -  the document naming Jeffrey  as agent for his mother Nancy did not include the power to make gifts to anyone other than Nancy’s issue so how could the transfer to the CLAT be valid?)  The remainder in the CLAT was valued with a 25% discount for lack of control and marketability.  This is the source of he gift tax deficiency.

Nancy Powell died 7 days after the day that this transaction was completed by her son.

As if it wasn’t bad enough, the taxpayer in this case didn’t even bother to argue that §2036(a)(2) wasn’t applicable, or to argue that the full consideration exception applied.

The Tax Court held that §2036(a)(2) applied saying that the decedent in conjunction with the other partners could dissolve the partnership (isn’t that always the case?)  and the  decedent through her son Jeffrey who was the general partners and her agent, could control the amount and timing of distributions.  They found the fiduciary duty to be “illusory.”

What ever happened to Byrum?  That was a U.S. Supreme Court case (United States v. Byrum, 408 U.S. 125 (1972)) holding that retaining voting rights to shares of stock in a corporation that decedent had transferred to a trust did not require that the shares be included in his estate under §2036(a)(2)?  Why isn’t that controlling?

For the double tax specter, the court came up with a new concept – the “doughnut hole.”  They held that any consideration received in return for the contribution of securities to the FLP (here the receipt by Nancy of the 99% limited partnership interest)  is subtracted under IRC Section §2043 from the amount included in the gross estate under §2036.

But remember, the discount will be disallowed and the whole value included under 2036(a)(2) for inclusion purposes, but for consideration received, the 99% limited interest received as consideration will be discounted.  Hence, the doughnut hole.

The case can be appealed to the 9th Circuit.  Let's hope it is.

No Deduction for Interest on Loan to Pay Estate Tax

In Koons v. Commissioner  Case No. 16-10646 (4/27/2017) the 11th Circuit denied the interest deduction for interest on loan to pay estate tax.

Decedent’s revocable trust included a 70% interest in an LLC which had over $200 million in liquid assets.  The estate’s liquid assets were insufficient to pay the estate tax.  The executors refused the offer of a distribution from the LLC to pay taxes and instead, borrowed $10,750,000 from the LLC at 9.5% interest to pay the tax.  No payment was due for 18 years and the principal and interest were scheduled to be repaid in 14 installments between August 2024 and February 2031.  No prepayments were permitted.

The projected interest was $71,419,497 which was taken as a deduction on the estate tax return.

The IRS claimed a $42,771,586.75 estate tax deficiency and a $15,899,463 generation-skipping tax deficiency.

The estate relied on the Estate of Graegin v. Commissioner, 56 T.C.M. (CCH) 387 (1988)  which permitted interest deductions, holding that  “expense incurred to prevent financial loss to an estate resulting forced sale of its assets to pay estate taxes are deductible administration expenses.”

In Koons, the 11th Circuit held that the interest deduction is properly denied if the estate can pay its tax liability using the liquid assets of an entity but elects to obtain a loan from the entity and then repay the loan using those same liquid assets.

Rauschenberg's "Canyon" now belongs to MoMA

A couple of months ago we wrote about the IRS' s ridiculous position on the estate tax value of this piece of art featuring an "illegal eagle."

The case has been setlled - finally.  A charitable contribution was made to the Museum of Modern Art where it joins others of its ilk.  It spent the last few decades on loan at the Metropllitan Museum of Art.

Eric Gibson writes fo the Wall Street Journal:

"On Wednesday last week, New York's Museum of Modern Art unveiled its most recent gift, and one of the most significant in its history: Robert Rauschenberg's "Canyon" (1959). Rauschenberg was among the leading American artists of the post-World War II era, and "Canyon" is a "combine," a kind of large-scale, three-dimensional collage that includes photographs, pieces of wood, a mirror, a pillow and a stuffed bald eagle.

The arrival of "Canyon" at MoMA is the culmination of a five-year absurdist farce—one tinged more by Kafka than Feydeau—that involved the IRS, the U.S. Fish and Wildlife Service and the heirs of art dealer Ileana Sonnabend. It might have been laughable, except that the stakes were so high. "

Read the rest of his article.

P.S.  For you arty types - check out this blogpost and compare "Canyon" to Rembrant's "Rape of Ganymede."

Estate Tax Marital Deduction Allowed for Same Sex Couple

Read Charles Rubin's blogpost:  click here

The U.S. District Court for the Southern District of New York "found the DOMA provisions unconstitutional under the lower “rational basis” standard which requires only that a law have a rational basis for its classifications to withstand an equal protection clause challenge. The court determined that the purposed bases of protection of the institution of marriage, protection of childrearing and procreation, consistentcy and uniformity of federal benefits, and conserving the public fisc were not rationally served by the DOMA provisions. The court thus ordered that the refund be paid."

Windsor v. U.S., 109 AFTR 2d ¶ 2012-870 (DC N.Y. 6/6/2012)

Form 8939 Filing Deadline Extended

Hat Tip to Dean Mead:  Form 8939 Filing Deadline Extended

There's nothing like prolonging the agony.

Seminar on the New Tax Act

Don't Touch That Dial(ysis)

2010 is the year with no federal estate tax. George Steinbrenner died in July 2010. His family will be saving about $500 million in estate tax and won’t have to sell the Yankees to pay the tax. Forbes says 5 billionaires died so far in 2010, and the tax their estates would have owed totals $8.7 billion.

Under the tax cut legislation, the estate tax exemption increased to $3.5 million and then in 2010 the estate tax was repealed for the year. If nothing changes, the estate tax will be back January 1, 2011 with a $1 million exemption.

The year with no estate tax was the year to "throw mamma from the train." This year’s estate planning techniques included one-way tickets to Switzerland where euthanasia is legal. Congressman Richard E. Neal, quoted in the New York Times when asked about the expiration or the estate tax in 2010 said, "If you’re at the checkout counter, you might want to expedite things."

Three states - Oregon, Washington and Montana - allow versions of the practice of euthanasia or assisted suicide. Oregon's law took effect in 1997, and Washington enacted a similar one in 2009. Montana's Supreme Court recently ruled that nothing in the state constitution prohibited doctors aiding patients with dying, but voters haven't yet specifically authorized it. Some countries, such as Switzerland and the Netherlands, have long allowed physicians to aid patients in dying. But only Switzerland extends this benefit to foreigners.

In a recent news story in Wyoming, Representative Cynthia Lummis claimed some of her Wyoming constituents are so worried about the reinstatement of federal estate taxes that they plan to discontinue dialysis and other life-extending medical treatments so they can die before Dec. 31. She didn’t name names, but gave the example of a rancher on dialysis seriously considering termination of treatment to let the end come and, thus, escape the estate tax due to come back two months hence.

This news article generated page after page of comments on the internet. Many took the approach that if a person has enough money to have to pay federal estate tax, they ought to be able to pay a professional to minimize or even eliminate the transfer taxes at death. True, good planning can minimize the impact of taxes, but it can’t eliminate them.

Some commentators advocated stealth gifts to the family, or selling the farm to the kids for one hundred dollars. These approaches don’t work. These are do-it-yourself techniques that just create problems. The IRS is anything but naive. A transfer of a $5 million dollar ranch in a $100 dollar sale is really a $4.999900 million gift. Doing this could actually result in more tax due, not to mention penalties and interest. The gift tax exclusion is only $1 million, but the estate tax exclusion might be as much as $5 million next year.

All this said, one enlightened responder to the posting, an estate planning lawyer named Emil Blatz quoted a study showing this "hurry up and die" mentality to be a recurring phenomenon. He quotes research stating that "academic researchers have known for years that death rates are influenced by major changes in estate-tax law. A 2003 paper published in the prestigious Review of Economics and Statistics looked at 13 major estate-tax changes in the U.S. - following the creation of the tax in 1916 - and found they had a small but statistically significant effect on death rates. "Among those wealthy enough to be affected by the changes, the chance of dying increased slightly in the two weeks before rates went up and decreased in the two weeks after an estate-tax cut, a phenomenon the authors have dubbed death elasticity."

As one elderly gentleman put it, with sardonic humor, "In 2010 I’m not going to linger too long at the top of any stairways."

Legacy for One Billionaire: Death, but No Taxes

David Kocieniewski reports for The New York Times: (click here for full article)

"A Texas pipeline tycoon who died two months ago may become the first American billionaire allowed to pass his fortune to his children and grandchildren tax-free, The New York Times’s David Kocieniewski reports.

Dan L. Duncan, a soft-spoken farm boy who started with $10,000 and two propane trucks, and built a network of natural gas processing plants and pipelines that made him the richest person in Houston, died in late March of a brain hemorrhage at 77.

Had his life ended three months earlier, Mr. Duncan’s riches — Forbes magazine estimated his worth at $9 billion, ranking him as the 74th wealthiest in the world — would have been subject to a federal tax of at least 45 percent. If he had lived past Jan. 1, 2011, the rate would be even higher — 55 percent.

Instead, because Congress allowed the tax to lapse for one year and gave all estates a free pass in 2010, Mr. Duncan’s four children and four grandchildren stand to collect billions that in any other year would have gone to the Treasury."

BUT DON'T FORGET ABOUT CARRY-OVER BASISNew Carry-Over Basis Rules for 2010

The fact that there is no estate tax is only half of the story.  The heirs will have to take over the decedent's basis in all assets and income tax liabilities will be huge on liquidation of assets.  Its not the free pass it appears to be at first blush.

Senators Bicker Over Estate Tax Fix

 "Nero Fiddled While Rome Burned"

And now - what on earth are they thinking in Congress?  They really want to create more litigation, don't they?

See this excellent update at The Trust Advisor BlogBickering Senators Delay Estate Tax Fix.


What happens if the sun sets?

Here we are four months into 2010 and there has been no change to the gift and estate tax law.  Most observers were surprised that a patch to continue the law as it stood in 2009 was not enacted.  Now there is talk of such a patch or even a new law that would accomplish it retroactively.  But the first truly rich American has died, a multi-billionaire who was number 74 on the world wealth rankings.  His estate has plenty of money to spend fighting any retroactive tax law as well as a lot of money to be saved if it prevails.  But what if nothing happens?

As a refresher, if the estate tax law of 2001 is allowed to expire then everyone’s estate can pass $1,000,000 free of federal estate tax. Above that, the estate is taxed on a rising bracket scheme until the top bracket of 55 percent is reached.  There is a surtax on estates over $10 million until the benefits of bracketing are gone and the estate is taxed at a flat 55 percent.  Also, the state tax paid is allowed as a credit, not just a deduction.  There is a table that shows what the IRS will accept as state death tax credit. It starts after $60 thousand and moves up in brackets until it reaches 16 percent.  This is the ultimate in revenue sharing because what you pay to your state is reduced dollar for dollar from your federal estate tax.  It was phased out in the four years following 2001 but would reappear if the current law is allowed to reach “sunset”.

Every state used that table as part of or all of their estate tax assessment.  It was called the state estate tax, or the slack tax, or the pickup tax.  When it was phased out, some states (the “time machine” states) adjusted their laws to levy tax as if the IRS law in effect before 2001 was still in effect.  Others, the “philosophical” group, just shrugged, apparently saying, “Easy come, easy go.”  Pennsylvania tried the “time machine” approach, but bracketed tax violates the state constitution, so it begrudgingly had to join the “philosophical” group.  While the state estate tax was always unconstitutional in Pennsylvania, it was never challenged in court because no one was injured by it (except maybe the IRS) and so there was no cause of action.  When credit for it started vanishing from the IRS credit list, a cause of action was created and thus the trip to the back of the “philosophical” line for Pennsylvania.

If sunset occurs, the states are ready to enjoy the benefit again.  Since U.S. Senators and Congressmen are well aware of their state’s financial problems, it seems they all have a motive to allow the “sun to set”.  But the federal government needs money too, so wouldn’t this cause an income problem for the U.S. Treasury?

The answer is yes and no, but mostly no.  Consider what Pennsylvania and the IRS collect on an estate under the 2009 regime and again under the 2011 sunset rules.  Assume the decedent is the second of a couple to die. There is almost never any tax for the first to die thanks to the unlimited spousal exemptions in both the federal and state tax law.  Assume all the estate will go to children or parents, for whom the state inheritance rate is 4.5 percent.

With an estate of $6 million, both the state and the US would end up with about twice as much income.  At $10 million, the state does about 2.4 times better, while the U.S. still does better but only by a factor of 1.37.  At $30 million, the factors are 3.16 and 1.05.  At $40 million, the factors are 3.26 and 1.01.  At a net estate of $44,337,107, the factors are 3.29 and 1.0.  The IRS actually takes in the same dollar amount.  Above this level, the state factor keeps getting better, but with a limit, while the IRS factor drops below 1.0.  At $250 million, the factors are 3.51 and 0.92.  At $1 billion, the factors are not much different, being 3.54 and 0.91.

Both taxing authorities improve their income in the ten million dollar range.  The state continues to improve until it collects about three and a half times more in the billion dollar range.  The IRS drops to break even at about $44 million and collects less than before above that amount but never dropping below 90 percent of what it had collected.  Estates pay more, since 55 percent is more than 45 percent.  But, more of the revenue stays in the state, which is a motive that could leave us seeing the sun set in 2011.

Family Limited Partnerships - Make It a Real Deal

The biggest challenge for estate planners is how to reduce estate and gift taxes but allow the client to retain control over his assets. Family limited partnerships (FLPs) provide a solution to this problem.

When you place investments, a business, or real estate holdings in a FLP, you retain control of the assets while at the same time making gifts of limited partnership interests to your beneficiaries so that they own part of the equity. Because the limited partnership interests that are given to the beneficiaries are not marketable, they are valued at a discount which maximizes the amount of the underlying assets that can be transferred free of gift taxes. The family limited partnership also provides other benefits for asset protection from creditors and providing for centralized control and management.

How does it work? The older generation members ("Mom and Dad") form a partnership and contribute assets to the partnership. The contributed assets now belong to the partnership. Mom and Dad are the general partners and control the partnership. Mom and Dad make gifts of the limited partnership interests to children, grandchildren, trusts for grandchildren, as they wish.

What can a child or grandchild do with the limited partnership interest? Nothing. The interest can’t be transferred, can’t be sold, doesn’t give the owner decision making authority or authority to exercise control over the partnership assets. It is documentation of an interest in the partnership which entitles the owner to partnership distributions if they are made, and to liquidation proceeds if the partnership is liquidated. The terms of the partnership agreement restrict the limited partners’ ability to transfer or, otherwise, enjoy the asset.

A FLP gives a two-fold benefit: (1) Mom and Dad stay in control even though they have made gifts, and (2) because of the restrictions placed on the limited partnership interest by the partnership agreement, the value of the gifts is much less than a pro rata value of the underlying assets. Thus, Dad can transfer more property by making gifts of limited partnership interests than by making outright gifts of the assets. Both the psychological goal of retained control and the estate planning goal of a reduced taxable estate are reached.

The gift and estate tax savings are a function of gaining IRS acceptance of the discount. Let’s say you form a FLP and claim a 45% discount on the gifts of limited partnership interests. The IRS objects and, rather than go to litigation, you agree on a 25% discount. What do you call that? I call that "victory." You won a 25% discount. (If you think that losing the whole 45% is failure, a family limited partnership is not for you.)

There are things you need to do to make your case for a discount compelling. The FLP has to be a "real deal." It must be operated as a genuine partnership with a business purpose. It is not just a document. It is an operating entity, and the entity must be respected.

Some tests of whether or not it is a real entity are: Do you follow the partnership’s requirements for votes, meetings, contemporaneous records, and other requirements set forth in the document? Do you file a Form 1065 - Partnership Income Tax Return? Does the partnership have its own bank accounts and investments, contracts for services and pay its own bills? Does the FLP maintain books and records? Also, make sure that there are sufficient assets outside of the FLP. Don’t use the partnership as your own personal piggy bank. It cannot be stressed enough that FLPs have to be planned, documented, implemented and operated.

Next, make sure you have the best possible valuation appraisals from a qualified appraiser. Two appraisals are required, at two different levels. One appraisal is for the assets owned by the partnership. The second appraisal is for the value of an interest in the partnership. The valuations are key to defending the discount, so they are not something to stint on.

There are considerable non-tax advantages as well. The partnership can protect property against claims. Creditors that may sue the partnership cannot reach the personal assets of the limited partners and the general partner (if the general partnership is a limited liability company or corporation). Creditors of the partners themselves may be more willing to settle than be saddled with limited partnership interests and non-controlling general partnership interests that will cause them to have income tax liability, but no guarantee of distributions with which to pay the taxes.

The partnership property can be managed through one account, thus consolidating and simplifying the management of the family’s investments. The partnership simplifies the manner in which you make gifts to your beneficiaries. Instead of being required to select and give several securities or other assets, you simply could transfer limited partnership units.

FLPs are not for everybody; but if you can abide by the constraints of the entity, this estate planning technique is an important one that can provide significant benefits.



Your Estate Plan May Need a Band-aid

Thanks to Congress’s failure to act to "fix" the estate tax by the end of 2009, your estate plan may have a serious problem. If your estate plan divides your assets by use of a formula that refers to the estate tax, your plan could be in trouble.

Many people have this type of plan. It goes by various names. Some call it an A-B Trust, some call it credit shelter trust planning, some refer to it as by-pass trust planning. Whatever you call it, the salient feature is a word formula that directs part of the decedent’s assets to a trust and part to the surviving spouse (or to a trust usually for his or her benefit). These formulae were put into your plan so that your plan could adapt to changes in the federal estate tax, like the increasing exemption amount, and to take account of gifts you may make in your lifetime.

The formula divides the assets by reference to the federal estate tax law. Since we don’t have a federal estate tax right now, these formulae don’t work - they are either meaningless gibberish or they produce a bad result. (Thank you Congress.)

On December 31, I sent out letters to all my clients who had such formula provisions in their wills or revocable trusts. Many of them have been in to sign codicils or amendments already. If your plan has a formula, you really should get it fixed up for 2010.

One example of a formula would direct the distribution of the maximum portion of your estate amount that can pass free of estate tax to the credit shelter (or by-pass) trust. Since there currently is no estate tax, the maximum amount that can pass free of estate tax is 100% of your estate. Thus, if you died now, all of your assets would go to that trust; and your surviving spouse would not receive anything (except that he or she may have some interest in that trust). This is probably not what was intended when you signed the document.

Another example of a formula is one which provides that an amount passes to the spouse which is the whole estate minus an amount equal to the amount the federal exemption equivalent which is directed to the credit shelter (or by-pass) trust. Using this formula, if you died now, since there is no estate tax in 2010, 100% of your estate would pass to the surviving spouse, and nothing would go to the trust. Again, this is probably not what was intended when you signed the document.

With neither formula do you get the result that was intended when you signed your estate plan. Thanks to our venerable Congress’s failure to act with regard to the estate tax prior to the end of 2009, your plan now has a serious problem.

Remember, this type of planning was done to save estate taxes, specifically to use both spouses’ exemptions from the federal estate tax. In most cases, the only purpose of including a by-pass or credit shelter trust was to save estate taxes. It would not be good to saddle your surviving spouse with a trust to administer when the trust was completely unnecessary to save taxes and was funded only because of Congress’s current shenanigans.

The solution is to amend the formula provision. There is not sufficient time to revisit your whole plan. As an immediate "band-aid" fix, if your plan contains a formula division, you should contact your attorney to make a simple codicil to your will or amendment to your trust. The codicil or amendment should provide that if you die in 2010 when the estate tax and generation-skipping tax do not apply to your estate and if these taxes are not retroactively reinstated by Congress, any computations required to apply the formulae in your plan shall be made as if the Internal Revenue Code in effect on December 31, 2009 is then in effect.

If you make a change like this, your plan will be the same as when you signed it. That may or may not be good for you. Depending on when you created the plan, the federal exemption may have been $600,000. In 2009 it was $3.5 million. That’s a big difference. Maybe you don’t really want to direct up to $3.5 million where you had directed $600,000 before. If that is the case, you need a complete review of your plan, not just a band-aid fix.

The objective is to make sure your plan works and makes sense in 2010 until Congress acts, if it does. Don’t delay. This needs attention.

Gift Tax Paid Within 3 Years of Death

In 1981 with the passage of the Economic Recovery Tax Act (ERTA), Section 2035 of the Internal Revenue Code was amended so that most gifts made within three years of death were no longer pulled back into the estate.  The 3-year rule was not eliminated completely, however.  Transfers of life insurance within three years of death can still cause inclusion of the death benefit in the estate and transfers of the "strings" under IRC Sections 2036, 2037 and 2038 that cause estate inclusion can cause a pull back. 

Also, any gift tax paid within three years of death is pulled back into the estate.   The reason for this gift tax rule is that the federal estate tax is a tax inclusive tax and the gift tax is a tax exclusive tax.  These examples illustrate the point:

Gift:         Donor has $150; transfer tax rate is 50%. Donor can give $100 to donee and pay $50 gift tax.

Bequest:       Decedent dies with $150; transfer tax rate is 50%. Decedent can leave $75 to beneficiaries and pay estate tax of $75. 

Without the 3-year pull back for gift tax paid with 3 years of death, one could cut the federal transfer tax payable by 1/3 simply by transferring everything days or moments before death.  OK.  So, decedent made taxable gifts and paid gift tax within three years of death.  Gift tax is brought back into the estate.  Who pays the estate tax on the gift tax?

See Gary Freidman's blogpost about  Matter of Rhodes, __ Misc.3d __, __ N.Y.S.2d __, 2008 NY Slip Op 28472 (Sur. Ct. Westchester Co. 2008), where the issue was whether donees of gifts made within three years of death are responsible for paying estate tax attributable to the inclusion of the gift tax paid on such transfers.

The Court held that the donees of the gifts made within three years of decedent's death are responsible for paying their ratable share of the estate tax attributable to the inclusion of the gift tax paid.  Ouch!  

Here is what the tax clause in the will said:

All inheritance, succession, transfer and estate taxes . . . payable by reason of my death in respect of all items included in the computation of such taxes which shall have passed under the provisions of this Will, shall be paid by my Executors as follows:
(A) All taxes with respect to property passing under this Will shall be apportioned in accordance with the law of New York, notwithstanding the foregoing, I direct that any such taxes resulting from the bequests under Clauses SECOND, THIRD and FIFTH of this Will shall be paid by my Executor out of my residuary estate, without apportionment or reimbursement from any beneficiary.
(B) I intend that all taxes described in paragraph (A) of this Clause with respect to property passing outside of the provisions of this Will shall be apportioned in accordance with the law of New York . . ..
(D) I wish to record that I have given great consideration as to how I have directed that the taxes described in paragraph (A) of this Clause are to be paid with respect to property passing under and outside my Will and to whom I have burdened with the payment of such taxes. I believe that the provisions which I have arrived at are equitable for all of my family members.

Looks like the decision is correct.  The gift tax paid certainly didn't "pass under the terms of the will."   Another reminder to be very careful with tax clauses.