Estate of Liljestrand v. Commissioner, T.C. Memo 2011-259; 2011 Tax Ct. Memo LEXIS 251 (Nov. 2, 2011)
Here’s yet another case that proves the simple point that hiring an accredited appraiser can make a huge difference in estate planning.
After retiring in 1978, a doctor exchanged his interest in a Hawaiian hospital for several real property holdings, including condominiums and a shopping center in California, a warehouse in Oregon, a Florida strip mall, and a medical building in Arizona. Just about six years later, the doctor formed a revocable trust to hold the real property, naming his eldest son as trustee and also paying him to manage the property.
FLP to ensure son’s employment. By 1996, the doctor wanted to plan his estate on behalf of all his four children, but also wanted to make sure that his eldest son kept his position managing the real estate businesses, in which none of his siblings showed an interest. In addition, he was concerned that if he gifted the property while it remained in trust, then local (Hawaiian) law would allow his other children as beneficiaries to seek judicial partition of the property and oust him as manager.
To alleviate these concerns, an estate planning attorney suggested that the father form a family limited partnership (FLP), funded with the trust-owned properties. Accordingly, the attorney formed the FLP in 1997, naming the father as the 99.8% general partner and giving the son a small Class A limited partnership (LP) interest. Within six months, the father transferred all his real property investments, appraised at roughly $6 million, to the FLP.
Over the next two years, he gifted Class B LP units to four trusts established for each of his grown children. Based on the underlying real property values, an appraisal firm valued the Class A LP units at $2.14 million and the Class B units at $5.91 million, as of the date of FLP formation (1997). However, according to court records, the parties “ignored” the formal appraisal. Instead, they valued the FLP’s general partnership units at $59,000, and its LP units at $310,000 (Class A) and $2.0 million (Class B). “It is unclear how the interests were valued,” the court observed.
The parties also ignored the formalities of the FLP and its operations. For instance, they continued to treat the father’s former revocable trust as owner of the real estate, depositing the operational income into the trust’s bank account until 1999, when they finally created a bank account for the FLP. The family’s accountant also reported the real estate income on the father’s personal tax returns in 1997 and 1998. After discovering her mistake, the accountant began keeping appropriate books and records for the FLP, and filed its return in 1999; but rather than go back and amend the prior returns, she decided (along with the father and his attorney) to treat the FLP as commencing operation in 1999. Similarly, the FLP did not execute a formal management agreement with the eldest son until 2001.
Since the father had contributed all but his personal residence to the FLP, the FLP made disproportionate distributions, larger than those provided by the partnership agreement, to pay his living expenses and debts as well gifts to his grandchildren. The FLP also “loaned” money to the eldest son, but he never wrote a promissory note or repaid the loans. When the father passed away in 2004, the FLP refinanced certain properties and used the proceeds to pay the father’s estate taxes of $2.3 million.
In 2008, the IRS assessed a $2.6 million deficiency, based on including the entire fair market value of the father’s real estate holdings in his estate pursuant to IRC Section 2036(a), and the taxpayer petitioned the court for a determination of liability.
FLP asserts three business purposes. To qualify the FLP transfers for the 2036(a)(1) exception as bona fide sales for full and adequate consideration, the estate claimed that the FLP had at least three legitimate, non-tax business purposes, and the Tax Court examined each in turn:
1. Ensured son’s continued employment. By preventing the conflict of interest that formerly existed when the son was acting both as trustee of the revocable trust that held the real properties and their manager, the FLP form made sure he could continue his management role, the estate argued.
But the formation of the FLP simply changed the nature of the trust’s holdings, from directly owning the real property to owning FLP interests, the court observed. The son was still trustee of the trusts that held the partnership interests; and he was the FLP’s general partner. As a result, the FLP “did not resolve [the son’s] conflict of interest…nor did it change [his] his roles with respect to the trust,” the court found
2. Protect the FLP assets from partition. Most of the properties were located outside of the state, beyond the reach of Hawaiian trust laws. Further, the father’s estate planning attorney never researched the application of trust laws in those other states. “The lack of such basic legal research is telling as to the significance of [the threat of] partition in the decision to form” the FLP, the court observed. In any event, the Hawaiian partition laws would not have applied to the trust-owned properties, and the father had left his personal residence to the children as joint tenants, without any apparent “fear of partition” or any evidence that they wanted to partition the FLP properties. Thus the “threat of litigation” did not serve a legitimate business purpose, the court held, declining to apply Estate of Shurtz v. Commissioner, T.C. Memo 2010-21 (litigious atmosphere in Mississippi sufficient non-tax purpose to form FLP)(available at BVLaw).
3. Protection from creditors. Likewise, the court was “skeptical” that the father formed the FLP to protect the assets from creditors, since the estate “failed to name a single” potential claim or “even establish a pattern of activity by the partners” that could expose them to liability.
So, despite some minimal changes to the FLP assets and operation between the time of formation and the father’s death (opening a checking account in 1999, for instance, and minimizing the payouts to the father and the son), the “partnership served primarily as a testamentary device through which [the father] would provide for his children at his death,” the court held. In light of all the other factors in the case, the court included the full, fair market value of the FLP assets in the father’s gross estate, pursuant to Section 2036, and denied the estate’s petition.