Beware of the whipsaw effect on an estate when a valuation discount of family limited partnership assets isn't respected in a decedent's gross estate
In the ongoing family limited partnership (FLP) battle between taxpayers and the Internal Revenue Service, taxpayers have been able to achieve some significant victories over the past two years in the Tax Court, particularly in the face of IRS challenges under Internal Revenue Code Section 2036(a). In these recent cases, the IRS has argued that all of the assets contributed by a decedent into an FLP during his lifetime should be included in the gross estate under a Section 2036(a) retained interest theory. Six recent cases, however, have demonstrated that it's possible for a taxpayer's estate to successfully defend a Section 2036(a) challenge by satisfying the “bona fide sale for an adequate and full consideration” exception to that statute.1 These recent cases have been a positive indication that FLPs, if formed and administered correctly, are still viable estate-planning vehicles, and have clarified that the bona fide sale exception can be satisfied by showing that an FLP was created for “legitimate and significant non-tax reasons.”
However, two of the recent taxpayer victories also have a darker lining. In these cases, the IRS raised an issue revolving around a “marital deduction mismatch.” The IRS has raised this issue in the past and, most recently, in Estate of Black v. Commissioner and Estate of Shurtz v. Comm'r.2 In both cases, the court found that the marital deduction mismatch issue was moot because the taxpayers' estates prevailed in convincing the Tax Court that Section 2036(a) didn't apply because the transfers into the FLPs satisfied the bona fide sale exception. Despite the victories achieved by the decedents' estates in these cases, they should, nonetheless, serve as a warning that this thorny issue exists and is currently on the IRS' radar in its challenge of FLPs. If the IRS' position is correct, there's a potential for unintended estate tax consequences that are often given little attention by estate practitioners when structuring and administering these vehicles.
The Marital Deduction Mismatch
So what is the marital deduction mismatch and why should estate practitioners and taxpayers care? FLPs can provide a number of benefits to a taxpayer and his family members by providing a vehicle for consolidation and management of assets, asset protection and possible valuation discounts. An FLP is often viewed as a “nothing ventured, nothing gained” proposition with little, if any, downside, other than set-up and administrative costs. Many view FLPs as valuable planning vehicles that, in addition to the non-tax benefits, have the potential to provide valuation discounts to reflect minority interest and lack of marketability for estate and gift tax purposes. The conventional wisdom is that if a valuation discount claimed on a decedent's estate tax return isn't respected, perhaps the discount would be reduced on audit or, at worst, the assets contributed by the taxpayer would be included in his estate as if the taxpayer had done no planning. The assumption is often made that if the contributed assets are brought back into the taxpayer's estate, then, if there is a surviving spouse, those assets will pass either outright to the surviving spouse or into a trust that qualifies for the marital deduction so that federal estate taxes will be deferred until the surviving spouse's death. Historically, the worst-case scenario was presumed to be that the taxpayer's estate is in the same position as if he never formed the FLP, but in no worse a position except for the transaction costs. The position taken by the IRS in Black and Shurtz demonstrates that such a tidy result may not necessarily be the case.
If sustained, the IRS' position as raised in Black and Shurtz would cause a valuation “whipsaw” effect whereby Section 2036(a) causes the inclusion of underlying FLP assets in a decedent's gross estate at their fair market value (that is, with no valuation discount); but the estate is only eligible for an estate tax marital deduction for the discounted value of the partnership interests that actually pass to or for the surviving spouse. If the value of the FLP's assets included in the gross estate exceeds the value of the limited partnership (LP) interests actually passing to or for the spouse, the IRS' position is that the difference in value is subject to estate tax, without an offsetting marital deduction. If, for instance, the taxpayer dies owning only LP interests or non-voting interests in a limited liability company (LLC), the amount of the marital deduction would be determined based upon a value that is discounted for lack of marketability and minority interest. The end result would be that the marital deduction to which the decedent's estate would be entitled for property passing to the spouse or a marital deduction trust could be substantially less than the value of the FLP's assets included in the decedent's gross estate.
If the IRS is successful in this argument, the amount of the mismatch (that is, the difference between the value of the assets included in the gross estate and the value of the assets qualifying for the marital deduction) would be subject to federal estate tax at the death of the first spouse, thereby producing dramatically unexpected consequences to the estate. To the extent that the decedent dies in a year in which the estate tax applies, and to the extent to which the decedent has any remaining estate tax exemption, the amount of the marital deduction mismatch could “soak up,” or more accurately, “waste,” a portion or all of the decedent's estate tax exemption, effectively rendering any “credit shelter” estate planning undertaken by the decedent moot. Adding insult to injury, if the amount of the mismatch exceeds the amount of the decedent's remaining estate tax exemption, federal estate taxes will be imposed on such excess. In that event, assuming that estate taxes are payable out of the taxpayer's residuary estate, each dollar of estate tax paid to the IRS will not qualify for the marital deduction and will trigger its own estate tax liability. This “tax on tax” will result in a substantial amount of first death estate taxes unexpectedly being paid out of the decedent's estate to the IRS, with a significantly smaller amount of assets passing to the spouse or marital trust. In short, the marital deduction mismatch issue, if applicable, has the potential to wreak havoc on an estate plan.
The recent Black and Shurtz cases, while ultimately taxpayer victories, should serve as fair warning to practitioners and clients that the potential for this mismatch exists if the IRS prevails on this issue. In Black, the decedent transferred shares of stock in an insurance company to an FLP. His son and grandsons, to whom he had previously gifted shares in the insurance company, also contributed their shares to the FLP. Following the decedent's death, the IRS argued that under Section 2036(a) the underlying shares he contributed to the FLP, rather than the partnership interests, should be included in his gross estate. The IRS further argued that the marital deduction, however, should be determined based upon the value of the discounted partnership interests actually passing to or for the surviving spouse. Ultimately, the estate prevailed on the Section 2036(a) argument so that the decedent's gross estate was valued based upon the partnership interests, and not the underlying shares of stock contributed to the FLP. Since the court held that the bona fide sale exception was supported based upon a “buy and hold” investment plan with respect to shares of stock in a closely held company, the court didn't address the marital deduction mismatch issue. It stated “[b]ecause we have decided that the fair market value of Mr. Black's partnership interest in Black LP, rather than the fair market value of the [stock] that he contributed thereto, is includible in his gross estate, the marital deduction to which Mr. Black's estate is entitled under Section 2056 must be computed according to the value of the partnership interest that actually passed to Mrs. Black, not according to the underlying [stock] apportionable to that interest. Therefore, the marital deduction issue is moot.”3
If, however, the IRS had been successful in its Section 2036(a) argument, the decedent's gross estate would have included the full value of the shares contributed by the decedent to the FLP and may only have been eligible for a marital deduction for the lesser, discounted value of the FLP interests that actually passed to the decedent's spouse. To illustrate the mismatch issue, in Black the decedent's interest in the FLP was valued at approximately $165 million while the pro rata portion of the contributed stock was worth approximately $250 million. If the IRS had prevailed on the Section 2036(a) challenge and on the mismatch argument, then the estate's interest would have been valued at $250 million, not $165 million, which would have caused $85 million to be unexpectedly included in the gross estate. In such case the difference wouldn't have been eligible for the marital deduction, thereby generating a first death estate tax liability of roughly $38 million (assuming for these purposes an estate tax rate of 45 percent). That $38 million of estate tax liability would be paid from the residuary estate, thereby generating its own estate tax liability of roughly $17 million, which would also be paid out of the residuary estate and lead to an additional estate tax. Ultimately, if the IRS had prevailed on both its Section 2036(a) and marital deduction mismatch arguments, this “tax on tax” could have resulted in roughly $70 million in first death estate tax to account for the additional $85 million of “phantom” value that would have been included in the taxpayer's gross estate.
In Shurtz, the decedent transferred an interest in an operating business and timberland to an FLP. She subsequently made 26 gifts of FLP interests, utilizing the gift tax annual exclusion, to her children and grandchildren. At her death, the decedent's interest in the FLP had been reduced to an 87.6 percent LP interest and a 1 percent general partnership (GP) interest. The IRS argued, under Section 2036(a) as well as Section 2035(a), that the underlying partnership assets contributed by the decedent to the FLP were fully includible in her gross estate. It further argued that the marital deduction under Section 2056(a) was limited to the discounted value of the LP interests that actually passed for the benefit of the surviving spouse. Even with some bad facts, ultimately, the estate was able to satisfy the bona fide sale exception to Section 2036(a) based upon a business purpose for creating the FLP to hold and manage timberland property. Therefore, as in Black, the court didn't have to address the issue of the mismatch. Citing to Black, it stated “[b]ecause we conclude that a bona fide sale for an adequate and full consideration in money or money's worth occurred, the fair market value of the contributed property is not includable in the value of the decedent's gross estate. Consequently, we need not address whether decedent retained an interest or right enumerated in section 2036(a)(1) or (2) in the transferred property. In sum, the fair market value of decedent's partnership interest in [the FLP], rather than the fair market value of the contributed property, is includable in the value of her gross estate.”4
The mismatch issue potentially has worse implications if the taxpayer has given away significant interests in the FLP during his lifetime so that the estate doesn't actually own the partnership interests at death, but is still liable for payment of estate tax on the assets that the taxpayer transferred to the FLP during his lifetime. In such case, the mismatch would be caused not only by the difference in valuation between the underlying assets included in the estate versus the discounted partnership interests, but also due to the fact that the gross estate would include assets contributed to an FLP by the decedent where he has rid himself of legal ownership of some or all of those partnership interests. Thus, the estate could not even look to the partnership interests as assets in the estate with which to satisfy the estate tax liability.
Not New Issue
This mismatch issue is not new to the IRS. The IRS has issued rulings on at least two occasions that resulted in a marital deduction mismatch where a “phantom asset” was included in the gross estate and wasn't eligible for the marital deduction. In Private Letter Ruling 9050004, the IRS ruled that where the decedent owned 100 percent of a corporation of which 49 percent passed to a marital trust for his spouse, the estate was only entitled to a marital deduction for a discounted minority interest to reflect lack of control. In PLR 9403005, the decedent held common and preferred stock that together constituted a controlling block. The preferred stock, which represented a non-controlling interest, passed into a marital deduction trust. The common stock that passed to a credit shelter trust was also a minority interest. The IRS ruled that the decedent's estate was only eligible for the marital deduction for the discounted value of the minority interest and that the decedent's gross estate included a premium reflecting the controlling block; however, such control didn't exist with respect to the stock passing to the marital deduction trust such that a lesser marital deduction was applicable.5
In the FLP context, the Tax Court has yet to squarely address the application of the marital deduction mismatch issue. The Tax Court did make reference to the issue in the Estate of Bongard v. Comm'r.6 In Bongard, the Tax Court held that partnership assets attributable to a 7.72 percent LP interest that the decedent transferred to his wife within three years of his death were included in his estate under Section 2035(a). This was because the underlying assets the taxpayer transferred to the FLP (membership interests in a newly formed LLC) were included in his estate under Section 2036(a)(1) due to a finding of an “implied agreement.” Because the partnership interests the decedent gave to his wife consisted of a portion of the property that caused the application of Section 2036(a)(1) (that is, because the decedent had a retained interest in the underlying assets of the transferred FLP interests under Section 2036(a)(1)), the court found that Section 2035(a) was applicable to the decedent's transfer of the 7.72 percent LP interest in the FLP. Thus, the decedent's gross estate included the value of the underlying partnership assets held by the FLP on the decedent's death in proportion to his 7.72 percent LP interest. On the mismatch issue, the court indicated in a one-sentence footnote that the decedent's estate may be entitled to a marital deduction for gifts included in a decedent's gross estate by reason of Section 2035(a) if they were made to the decedent's spouse.
Pending legislation with respect to the proposed elimination of valuation discounts may, in the case of certain “bad fact” FLPs, provide an unintended “fix” to this issue.7 If the assets transferred into an FLP are fully included in the decedent's estate at death due to the application of legislation enacted in the future that might value the FLP's underlying assets in the estate and disregard the existence of the FLP for valuation purposes, such a “look-through” approach would presumably also apply in determining the value of the assets passing to the surviving spouse or a marital deduction trust. However, such legislation may not provide relief against the marital deduction mismatch in all circumstances. For instance, in a situation in which the decedent has made gifts of LP interests or sold LP interests during his lifetime, yet retained sufficient strings so as to cause all of the contributed assets in the FLP to be included in his estate under 2036(a), a mismatch could still occur. In such a case, while the contributed assets would still be fully included in the estate, even if the partnership interests in the estate were valued without valuation discount as a result of such legislation, only those assets that were still actually owned by the decedent's estate would be available to pass to the spouse or marital deduction trust. A mismatch could therefore still occur, in such case, not as the result of application of valuation discounts for interests passing to or for the spouse, but, rather, as a result of assets being included in the estate for gross estate purposes but not for property law purposes.
At this point, the Tax Court has yet to address directly the merits of the FLP martial deduction mismatch issue. Therefore, it can't be said with any degree of certainty whether the IRS' argument would hold. As mentioned above, the closest guidance that appears to exist on this issue in the FLP context is the Tax Court's reference to the issue in Bongard that the taxpayer's estate “may” be entitled to an offsetting marital deduction in the event of the inclusion of a phantom asset in the estate where the property is brought back into the estate after it was gifted to a spouse within three years of death. The Black and Shurtz cases, however, are a clear indication that the mismatch issue is a new arrow in the IRS' quiver in its ongoing challenge of FLPs.
Minimize the Risk
Estate practitioners can take measures to try to minimize the risk of unintended estate-tax consequences arising from the mismatch issue.8
First, the practitioner and client would both be well served when creating and administering an FLP to strive to satisfy the bona fide sale exception to Section 2036(a). As mentioned above, six recent Tax Court cases, as well as prior cases, have provided additional guidance as to what the courts consider “legitimate and significant non-tax business purposes” within the meaning of the exception. To the extent that this exception can be satisfied, such that Section 2036(a) wouldn't apply, the marital deduction mismatch issue would be moot. Of course, the practical difficulty with presuming that this exception will necessarily apply is that such a determination would only be made following the decedent's death and in the context of an estate tax audit. Additionally, it can't be said with any certainty what standard the Tax Court will apply in the future with respect to this argument. Certainly, adhering to a standard of “best practices” with respect to the formation and administration of an FLP, such as respecting the formalities of the entity and establishing legitimate and significant reasons for the creation of the partnership is always a good idea.
In addition, clients might consider divesting themselves of all ownership in an FLP during the client's lifetime to minimize a potential argument that any “strings” were retained by the taxpayer in the FLP. To the extent that the client transfers his partnership interest during his lifetime by way of a gift, there is the added risk that Section 2035 may apply so as to impose a three-year requirement to completely divest the taxpayer of the partnership interest from an estate tax standpoint. Alternatively, a taxpayer might consider selling his remaining partnership interests in exchange for cash or a promissory note. In such case, it is recommended that a qualified appraisal be obtained to establish the purchase price so as to support the position that the sale has been made for “adequate and full consideration” in the event of a further challenge under Sections 2035 or 2036(a).
In the absence of completely divesting oneself of ownership in the FLP during life, a taxpayer might consider owning both the GP and LP interests (or voting and non-voting interests in an LLC) while both spouses are living and coordinating the estate plan to ensure that both interests will pass to or for the benefit of the surviving spouse at death. In such case, perhaps the GP or voting interest could later be sold. Such an approach, however, would also need to be considered in connection with Section 2036(a)(2) “control” issues.
While the recent Black and Shurtz cases were resolved favorably for the taxpayer, and these cases are considered to be positive from an FLP viability standpoint, practitioners should take note of the lurking mismatch issue on which the IRS appears to be focusing.
— The author thanks Marissa Dungey, an associate at the firm, for her valuable contribution to this article.
- Mirowski v. Commissioner, T.C. Memo 2008-74 (March 26, 2008); Miller v. Comm'r, T.C. Memo 2009-119 (May 27, 2009); Keller v. United States, 2009 U.S. Dist. LEXIS 73789 (Aug. 20, 2009); Murphy v. U.S., 2009 U.S. Dist. LEXIS 94923 (Oct. 2, 2009); Black v. Comm'r, 133 T.C. No. 15 (Dec. 14, 2009); Shurtz v. Comm'r, T.C. Memo 2010-21 (Feb. 3, 2010).
- Black, supra note 1 at p. 72.
- Shurtz, supra note 1 at p. 29.
- See also DiSanto v. Comm'r, T.C. Memo 1999-421 (Dec. 27, 1999) (for marital deduction purposes, a discount applied to a minority interest in company shares passing to a surviving spouse after she disclaimed certain shares; however, the decedent's gross estate was valued based upon a control premium).
- Bongard v. Comm'r, 124 T.C. 95 (March 13, 2005).
- The Certain Estate Tax Relief Act of 2009, H.R. 436, 111th Cong. (2009); Office of Management and Budget, Executive Office of the President, Budget of the United States Government, Fiscal Year 2011 (2010).
- For a good discussion of possible solutions to the mismatch issue see Kevin Matz, “Family Limited Partnerships: Special Concern in FLP Planning Where Both Spouses are Living,” Estate Planning, January 2007.
N. Todd Angkatavanich is a partner in the New York, Greenwich and New Haven, Conn. offices of Withers Bergman LLP
Jean Metzinger's oil on canvas “Femme au chapeau,” about 17 inches by 14 inches, painted in 1906-1907, sold for $1,650,500 at Christie's Property from the Collection of Mrs. Sidney F. Brody sale in New York on May 4, 2010.