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.