Texas District Court respects decedent's unfunded FLP for estate tax purposes. A case out of Texas sure enough shows it pays to know the law. In this case, clients saved about $40 million.

In Keller v. United States, No. V-02-62 (S.D. Texas Aug. 20, 2009), the U.S. District Court for the Southern District of Texas ruled in favor of the taxpayer, holding that the estate of Maude O'Connor Williams was entitled to a refund based on the value of family limited partnership (FLP) interests owned by two trusts that were includible in Maude's estate. The FLP had not been formally funded before Maude's death. But the court held that, under Texas law, Maude's intent to fund the partnership with particular assets was sufficient to cause those assets to be partnership property.

Maude, a 90-year-old legally blind widow and, as the decision put it, a “frugal businesswoman and shrewd heiress,” actively worked to protect her family's wealth and assets. She had a particular concern about losing control over family assets due to her heirs' possible divorces. Maude's family advisors, Rayford Keller and Lane Keller, in conjunction with Maude, had been drafting the documents and planning to fund the FLP since early 1999. The FLP was to be owned by two trusts (49.95 percent each) and a general partner limited liability company (LLC) (1 percent). One trust was a qualified terminable interest property (QTIP) marital trust from her late husband. The other trust owned property belonging to Maude (presumably a revocable trust). Maude was the trustee of both trusts and would be the sole owner of the LLC. Maude was going to fund the LLC with $300,000 and the FLP was to be funded by the trusts with nearly $250 million of bonds. Maude also planned to sell LLC interests to other family members.

Maude was diagnosed with cancer in March of 2000 but her doctors did not believe her death was imminent. The process of revising the partnership documents proceeded, and Maude signed the partnership and LLC agreements and formation documents in her hospital room in the late evening of May 9, 2000. She signed as trustee of the two trusts and as the president of the general partner LLC. Within the next two days, the Kellers applied for tax identification numbers for the FLP and LLC and filed the FLP's certificate and the LLC's articles to form the entities. The schedule to the partnership agreement showing the initial capital contributions of the partners, however, was blank. The Kellers testified that the schedule was left blank because they were uncertain of the exact value of the assets (and the interest accrued on the bonds) being transferred to the FLP. These values would be dependent on the date of transfer.

Maude died six days later, on May 15, 2000, before the assets were transferred. After Maude's death, the Kellers stopped working on the FLP transaction entirely.

And here's where this story gets really interesting: More than a year later, Lane Keller was attending an estate-planning seminar and learned that, under Texas law according to Church v. United States, 2000 WL 206374 (W.D. Texas Jan. 18, 2000), the FLP might, in fact, have been validly created and funded before Maude died.

The advisors then made the asset transfers and completed the other FLP formalities.

Three months after filing the estate tax return that reported a $143 million estate tax liability, the estate filed a claim for a refund of about $40 million, plus interest.

The IRS failed to respond to the claim. The estate filed suit.

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The court held that Maude's estate was entitled to an estate tax refund. Under Church, Maude's intent to form the FLP was sufficient to consider the FLP valid and fully formed before her death and the securities she planned to transfer to the FLP were beneficially owned by the FLP at her death. Similarly, her intent to capitalize the LLC was sufficient to consider it funded and her estate had a fiduciary and contractual, legal obligation to follow through on the sale of her LLC interests. In other words, the court treated the LLC interests as having been sold to her children before her death.

The court held that the FLP assets were not included in Maude's estate under Internal Revenue Code Sections 2036(a) or 2038(a), because the transfer was a bona fide sale for adequate and full consideration. The court relied on several factors:

  1. Maude was actively involved in the plans for the FLP and had several meetings regarding the FLP agreement and funding;
  2. Maude's goal of protecting family assets from depletion by her descendants' potential divorces and facilitating the administration of significant family assets was a legitimate and significant non-tax purpose in forming the FLP; and
  3. the FLP agreement provided for the partners' percentage interests, capital accounts and liquidation rights to be in proportion to the partners' respective contributions to the FLP.

In addition, the court noted that Maude's retention of $110 million in assets indicated that she had sufficient assets to support herself and that there was no implied agreement that she would retain possession or enjoyment of the FLP assets. These circumstances distinguished her situation from that in the famous Strangi case, T.C. Memo 2003-145 (May 20, 2003).

The fact that Maude, as trustee of the trusts and the sole contributor to the LLC, was on all sides of the transaction was not mentioned by the court.

Lastly, the court agreed with the estate's experts that lack of control and marketability discounts applied in valuing the FLP interests. The opinion does not detail what discounts were applied by the estate's expert, but did note that the IRS expert failed to correctly apply the hypothetical willing buyer and willing seller rule by considering the actual identities of the parties, speculating as to events after the valuation date, and aggregating the interests of the different owners.

Maude's consistent efforts to prevent her own family's wealth from being dissipated by divorce, daily involvement in the details of her estate planning, and retention of significant assets outside the FLP won the day and overrode the fact that the documents were signed only a few days before her death. But the key to the taxpayer's success was the unusual rule under the Church case, causing the assets to be considered partnership property without being formally transferred.

As a result, this case probably does not have much impact for those of us outside of Texas and the purview of the Church case.

But it's certainly an impressive win for a taxpayer.

And it does remind all advisors how important it is to keep current on the intricacies of their state's laws.