Through a combination of hard work, savings, and investments, an army colonel and his wife amassed a tidy portfolio of marketable securities worth roughly $2 million. When it came time to preserve and pass on their wealth, the couple established two family limited partnerships, one before his death in 1996 and one afterward. When the widow died in 2002, the IRS assessed roughly $800,000 in deficiencies against her estate.
At trial, the U.S. Tax Court (J. Haines) considered the following non-tax, business reasons for forming and funding the FLP, which the taxpayer argued pursuant to I.R.C. Sec. 2036(a)(1) demonstrated that it was a “bona fide sale for adequate consideration,” sufficient to keep the asset’s discounted value out of the widow’s gross estate:
- Management succession. The colonel’s widow specifically deferred any responsibility for choosing or investing the securities to her grown children, the FLP’s limited partners. However, they deferred most decisions to their investment advisors, failing to take an “active or efficient” management role, enough to fulfill this purpose.
- Financial education and family unity. There was little evidence that the colonel actually taught his two children about investing, and promotion of unity was “no more than a theoretical purpose,” the court said.
- Perpetuation of investment philosophy. Under these facts, the “perpetuation of a ‘buy and hold’ strategy is not a legitimate or significant nontax reason for transferring the bulk of one’s assets to a partnership.”
- Pooling and gifting of assets. Although pooling the assets might have cut expenses when it came to gift-giving, the donees could have received the investment accounts directly without adding any costs, especially in light of the expense of forming the FLPs in the first place. Finally, gift giving, alone, does not constitute a significant business purpose.
Even though the colonel and his wife had not discounted the value of any transfers during his lifetime, the Tax Court found that the widow and her children failed to treat the FLPs as formal, independent partnership entities, and pulled their full value back into the estate in Estate of Jorgensen v. Commissioner, T.C. Memo. 2009-66 (March 26, 2009).
Some believe that the court may have gone too far in Jorgensen v. Commissioner. At least one commentator, Owen Fiore, says that the court “in reality is taking IRC Sec. 2036(a) to the extreme, making it virtually impossible to have a passive investment, asset-holding FLP or LLC qualify as having the prerequisite real and significant non-tax purpose(s) to avoid treating [the] transfer of assets into the entity followed by gifts, etc. as testamentary in nature and [avoided] for estate tax purposes!”
For more of Fiore’s comments, see his current newsletter; and for a full write-up—including all of the facts and the court’s findings—see the forthcoming (July 2009) Business Valuation Update™. The full text of the Tax Court’s decision will be available at BVLaw™.
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