• Fifth Circuit affirms Keller on funding of FLP and Graegin loan deductions—In Keller v. U.S., the U.S. Court of Appeals for the Fifth Circuit affirmed the U.S. District Court for the Southern District of Texas decision in favor of the estate of Maude O’Connor Williams (110 A.F.T.R.2d 2012-XXXX, Sept. 25, 2012). The issues on appeal were whether: (1) under Texas law, Maude had funded a family limited partnership (FLP) before her death when the assets weren’t actually transferred, and (2) interest paid by the estate on a loan to pay the estate tax was deductible under Internal Revenue Code Section 2053. The Fifth Circuit decided both issues in the affirmative. By including partnership interests (subject to valuation discounts) rather than the partnership assets in Maude’s taxable estate and allowing the deduction for the interest on the loan, the estate was entitled to a refund of $115,375,591.
The Fifth Circuit upheld the lower court’s decision that Maude’s intent to fund the partnership with particular assets was sufficient to cause those assets to be considered partnership property. Maude had signed all the partnership documents only a few days before her death. After she signed the documents, her advisors filed the necessary paperwork with the Secretary of State to form the entities. Schedule A to the partnership agreement, which was intended to show the partners’ capital contributions, was left blank, but extensive notes and a spreadsheet showed Maude’s intended contributions. However, on her date of death, her advisors hadn’t actually transferred the assets (bonds) Maude intended to contribute to the FLP. As a result, after she died, her advisors assumed that the FLP wasn’t funded. They treated the bonds as estate property, prepared and filed the estate tax return accordingly and paid $147 million in estate taxes.
Some time later, one of Maude’s advisors attended a continuing legal education (CLE) presentation that reiterated the common law rule in Texas that a partner’s intent is determinative in whether assets were considered partnership property. After realizing that the FLP had, in fact, been funded due to Maude’s intent, despite the failure to make the transfer on the books, the advisors formally transferred the bonds to the FLP, retroactively restructured the estate’s payment of the estate taxes as a loan from the FLP and issued a promissory note to the FLP at the applicable federal rate in effect at the time the estate tax was paid. The estate then filed a claim for refund, based on including partnership interests, rather than the partnership assets, in the estate, and deducting the interest accrued on the recharacterized loan.
The Fifth Circuit agreed with the district court that under Texas law, the partner’s intent was determinative of whether a contribution of property was made to an FLP. It noted that the issue of an initial funding of an FLP (as compared to an additional contribution to an existing partnership) hadn’t been raised before in Texas courts, but surmised that the Texas Supreme Court would apply the same rule to an initial funding as to any other capital contribution.
The IRS next argued that the loan lacked economic substance and wasn’t necessary (as required under Internal Revenue Code Section 2053 for the interest to be eligible for the estate tax deduction). It based its argument on a Tax Court decision, Estate of Black, in which the Tax Court denied a deduction for the accrued interest on a loan used by an estate to pay its estate tax. In Black, the decedent had conveyed almost all of his wealth, in the form of stock, to an FLP. After he died, his estate borrowed $71 million from the FLP and deducted the interest on the loan. The Tax Court denied the deduction, holding that the estate’s sole asset was the FLP interest and therefore, it had no way of repaying the loan without the FLP selling the stock and making a distribution to the estate or the estate selling its interest in the FLP. So, the loan structure was really an “indirect use” of the stock owned by the FLP. However, the Fifth Circuit distinguished Black from Maude’s estate, which owned sufficient other assets to pay back the loan. While these other assets were illiquid, they generated income that the estate used to pay the loan. Maude’s estate didn’t need to redeem the FLP interests or force a distribution of the FLP assets to pay the loan and, therefore, there wasn’t the same concern as existed in Black that the estate was “indirectly using” FLP assets by structuring a loan to obtain favorable tax treatment. Lastly, the Fifth Circuit refused to recharacterize the transaction as a distribution from the FLP to Maude’s estate.
Keller is an incredible example of how important state law property law rules are in the context of funding FLPs and how important it is to keep up with tax law developments and attend CLE seminars!
• Private letter ruling applies exception to transfer-for-value rule to grantor trust—In PLR 201235006 (released Aug. 3, 2012), the taxpayer sought rulings on the income tax consequences of a transfer of a life insurance policy between two trusts.
The taxpayer established two trusts for the benefit of his descendants. Trust A was a non-grantor trust. However, due to the taxpayer’s right to substitute the trust property with property of equal value, Trust B was treated as a grantor trust under IRC Section 675(4), assuming that the facts and circumstances indicated that he held the power in a non-fiduciary capacity. The ruling noted that it was a grantor trust to the taxpayer, regardless of the trust beneficiaries’ withdrawal rights under IRC Section 678(a).
Trust A planned to sell a life insurance policy it owned on the life of the taxpayer to Trust B. The purchase price would be the interpolated terminal insurance reserve value for the policy as of the date of sale, plus any amount of pre-paid premium payments covering the time after the date of sale. The taxpayer sought a ruling on how IRC Section 101(a) would apply when the death benefit was ultimately received. IRC Section 101(a)(1) provides that death benefits under a life insurance contract aren’t included in gross income, if they’re paid by reason of the death of the insured, subject to certain exceptions. One exception, known as the “transfer-for-value rule,” provides that if the policy is transferred for consideration, the exclusion from gross income is limited to an amount equal to the sum of the actual value of the consideration and the premiums paid by the transferee, unless the transferee is the insured (among others).
Revenue Ruling 2007-13 held that a transfer of a life insurance policy in exchange for cash between two grantor trusts isn’t a transfer for valuable consideration, because both trusts are treated as owned by the same grantor. The same revenue ruling also held that a transfer of a life insurance policy in exchange for cash from a non-grantor trust to a grantor trust would be a transfer for value, but that the transfer-for-value limitations wouldn’t apply, because the grantor trust acquiring the policy is treated for income tax purposes as owned by the insured, and, therefore, the transfer was treated as a transfer to the insured.
Applying the revenue ruling, PLR 201235006 held that the sale of the policy from Trust A to Trust B was a transfer for valuable consideration, but that because Trust B was a grantor trust to the taxpayer, the transfer of the life insurance policy was considered a transfer to the insured. Therefore, it qualified for the exception to the transfer-for-value rule and, on the death of the taxpayer, the death benefits wouldn’t be included in the gross income of Trust B.
Lastly, applying Rev. Rul. 2008-22, the IRS ruled that the taxpayer’s retained power to substitute trust property, as drafted, wouldn’t result in the taxpayer possessing incidents of ownership over the life insurance policy under IRC Section 2042.