Tax Law Update 2009-05-01 (1)Tax Law Update 2009-05-01 (1)

Family limited partnership assets were included in a decedent's estate under Internal Revenue Code Section 2036(a)(1). Once again, the IRS has triumphed over a family limited partnership (FLP) — this time in a fight over the estate of a war hero's widow, Estate of Erma V. Jorgensen v. Commissioner, T.C. Memo 2009-66 (March 26, 2009).

Erma Jorgensen died in 2002, owning interests in two FLPs. The first, JMA-1, had been formed back in 1995 by Erma and her husband, Colonel Gerald Jorgensen. The Colonel had had a 30-year career with the U.S. Air Force. He was a highly decorated bomber pilot, seeing active combat in both World War II and the Korean War. When he stopped flying, he joined the Judge Advocate General's office as an attorney. The Colonel later served in the Air Force's diplomatic corps in Ethiopia and Yugoslavia.

Erma and the Colonel each contributed marketable securities to JMA-1. In exchange, Erma received limited partnership interests and the Colonel received limited and general partnership interests. In addition, even though their children and grandchildren did not make any contributions, the children were listed as general partners and grandchildren were listed as limited partners. The Colonel organized the formation of JMA-1 independently of the other family members — Erma and the children were not involved in negotiating the terms of the partnership — and he managed the partnership assets exclusively without any involvement of the other general partners.

After the Colonel's death, Erma established a second FLP, JMA-II. Erma contributed her own marketable securities and cash and, as executor, marketable securities and cash from the Colonel's estate, in exchange for partnership interests. Again, the children and grandchildren made no contributions but were listed as general partners and limited partners respectively. Evidently, the children and grandchildren received these partnership interests by gift, but Erma never filed gift tax returns to report them (some of the gifts exceeded her gift tax annual exclusions).

The FLPs continued to own only cash and marketable securities. Neither Erma nor her children actively managed the FLPs. The partners did not keep formal books or records, and there was no oversight over the accounts (for example, no one reconciled the partnership bank account statements). Erma withdrew funds and wrote checks from the partnership accounts even though, as a limited partner, she had no authority to do so, and the partnership agreements required pro rata distributions. Partnership funds were used by Erma to pay her income taxes and other personal expenses. Partnership funds also were used to pay administration expenses and taxes for Erma's estate and the Colonel's estate.

Notwithstanding the Colonel's service to the country, the Tax Court held against his widow's estate and in favor of the tax authorities. The Tax Court ruled that the assets Erma had transferred to the FLPs were to be included in her gross estate under IRC Section 2036(a)(1) because:

The court held that the transfers to JMA-I and JMA-II were not bona fide sales, because there was no legitimate and significant non-tax reason for the transfers. Indeed, correspondence between Erma and her attorney indicated that valuation discounts were a primary reason for establishing the FLPs, so the estate was unable to convince the court that legitimate and significant non-tax reasons actually motivated the transfers and not just a rote recital.

The court concluded that the estate's “management succession,” “financial education of family members,” and “perpetuation of an investment philosophy or participation in the partnerships” were not convincing non-tax reasons. The FLPs owned only passive investments, no active management was required under a professed “buy and hold” strategy, and, if and when any sales of securities were made, such transactions were executed by the Colonel during his life or the third-party investment advisor after his death.

The court disregarded claims that the FLP “pooled assets” as there was no change in the management of the assets by transferring the assets to the FLPs.

The court also was not convinced that the FLP facilitated gift giving, because it would have been equally easy to make gifts of securities instead of partnership interests.

Evidence of the FLP's asserted creditor protection was likewise unpersuasive.

In addition, the court noted that the bona fide sale exception should not apply because the transactions were not at arms-length and partnership formalities were disregarded.

Lastly, the court held that Erma had retained possession and enjoyment of the partnership assets. Erma had not retained sufficient assets for her gift-giving plans, and FLP assets were used to pay her personal obligations. Non-pro rata distributions were made in violation of the partnership agreement.

And so, with the case of the Colonel's widow, the Tax Court reaffirmed that there must be a significant non-tax reason for forming an FLP and that FLPs holding only marketable securities are most at risk. Also, lax administration of FLPs may be very costly later.

Once again, we are all reminded that it pays to ensure a partnership is properly run and its formalities observed.

Extension of time for S corporation elections with unusual comment on Section 675 substitution power. Private Letter Ruling 200910008 (March 6, 2009) appears at first blush to be a standard S corporation fix-up ruling in which the Service grants an extension of time to make an S corporation election under IRC Section 301 and characterizes several transactions as inadvertent terminations under IRC Section 1362(f). The corporation in the ruling elected S corporation status but then went through several reorganizations, which included a conversion to a partnership. In addition, stock was owned by trusts that never made timely elections to be treated as electing small business trusts (ESBTs). All of these errors the Service forgave, granting extensions to avoid termination of status as an S corporation.

But there was an interesting part of the ruling, focusing on several trusts that owned the S corporation stock. In the recital of facts, the Service describes the trusts as grantor trusts (and therefore permissible S corporation stockholders) due to the power of the grantor to reacquire assets of the trusts by substituting property of equivalent value under IRC Section 675. Yet, later, in its conclusion, the Service ruled that the trusts were grantor trusts because “the power to reacquire assets of the trust by substituting property of equivalent value affects beneficial enjoyment… under 674(a)” (emphasis added).

Last year, Revenue Ruling 2008-22 confirmed that the grantor's power to substitute assets of a trust in a non-fiduciary capacity will not, by itself, cause inclusion in the grantor's estate under IRC Section 2036 if:

In PLR 200910008, however, the Service states that the substitution power over these trusts affects beneficial enjoyment under IRC Section 674(a).

Without further information about the trusts' provisions, it is not clear whether the trust agreements failed to satisfy the requirements of the revenue ruling that protects against shifting benefits among the trust beneficiaries, if the Service is changing course on Rev. Rul. 2008-22, or if the reference to Section 674 was simply an oversight on the part of the Service.