Tax Law Update 2009-11-01 (1)Tax Law Update 2009-11-01 (1)

Victorious estate in FLP discount case — A district court in Arkansas ruled in favor of a decedent's estate and awarded it a refund of about $41 million. In Estate of Murphy v. United States, Case No. 07-CV-1013 (W.D. Ark. 2009), the court based its decision on valuation, estate inclusion and administrative expense deduction issues.

Charles H. Murphy, Jr. died on March 20, 2002, leaving an estate tax due (as calculated by his co-executors) of $46,265,434.

After the estate paid this amount, the Internal Revenue Service asserted a deficiency of $34,051,539 against the estate. The estate challenged the deficiency.

The issues central to the court's determination were:

Charles owned significant interests in Murphy Oil Corp., a publicly traded company started by his parents. His family also owned significant interests in timberland and banking enterprises, with members of the family serving in senior leadership roles in each entity.

In the early 1990s, Charles began turning over the management responsibility for the family assets to his children. Although Charles had four children, only two shared his desire to, as the court described, “hold the family's ‘Legacy Assets’ long-term and to grow those assets by actively participating in the management of [the] companies.”

In view of this family split, Charles decided not to leave his assets outright to his children and instead began working with his son Madison and an attorney to find a solution that would allow for the centralized management of the family's Legacy Assets, while also protecting them from dissipation. The solution was to create an FLP with an LLC as its general partner.

Charles discussed forming the FLP and LLC with Madison and with Charles' daughter Martha (who was represented by her own attorney). They decided Charles would hold a non-controlling 49 percent interest in the general partner LLC, while both Madison and Martha would each hold 25.5 percent interests. Additionally, ownership and transferability of the FLP interests were to be severely restricted and dissolution of the FLP would require a unanimous vote of the partners. Both the LLC and FLP were formed on Dec. 1, 1997, after which Charles invited his four children to contribute assets and participate in the FLP. Only Madison and Martha accepted Charles' invitation.

To fund the FLP, Charles contributed, on behalf of himself and as trustee of four trusts for his children, shares of Legacy Assets and other assets he and/or the trusts held which were worth $88,992,087. This amount represented about 41 percent of Charles' net worth at that time.

To fund the LLC, Charles simultaneously contributed shares of Legacy Assets worth $1,021,311.

Shortly thereafter, both Madison and Martha each contributed $526,195 of Legacy Assets to the LLC.

As planned, Charles began to gradually turn over the day-to-day management of the family's assets to Madison and Martha.

On Charles' estate tax return, his estate listed the value of its remaining 95.25365 percent interest in the FLP at $74,082,000 and its 49 percent interest in the LLC at $706,000.

The IRS issued a deficiency notice in the amount of $34,051,539, asserting that the FLP interest should have been valued at $131,541,819 (a $57,459,819 difference), the LLC interest at $1,903,000 (a $1,197,000 increase) and that the estate had overstated its interest expenses.

After paying the additional tax and interest and having its request for a refund denied, the estate brought suit for a refund of about $41 million.

Issue 1: Were the assets included in the estate?

The IRS asserted that the value of the property Charles transferred to the FLP and the LLC should have been included in his estate under IRC Sections 2036(a)(1) and (2).

Charles' estate, on the other hand, argued that the “bona fide sale for adequate and full consideration” exception applied.

The court noted that for this exception to apply, the transfer must have been made in good faith with a potential benefit other than only an estate tax savings. The court found that the FLP was indeed created for various non-estate tax purposes, “among them to pool the family's Legacy Assets into one entity to be centrally managed in a manner consistent with Mr. Murphy's long-term business/investment philosophy.”

Evidence of a non-estate tax purpose included the actions of the FLP in purchasing and managing additional properties (such as a plantation and a commercial building); the frequent business meetings of the LLC members; the fact that Charles retained significant assets outside the FLP (and was thus not dependent upon distributions from the FLP to support his lifestyle); that Charles refrained from commingling his personal assets with those of the FLP or treating the FLP assets as his own; and that Madison and Martha held active roles during the formation of the FLP and LLC.

The IRS argued that the FLP failed to have a legitimate non-tax purpose because Charles was aware of the potential tax advantages of the FLP. The IRS further argued that because the FLP continued to hold the Legacy Assets, it was not being actively managed and thus not operated for a legitimate non-tax purpose.

The court rejected these arguments, holding that the mere presence of tax advantages does not preclude a sale from being bona fide if the transaction is otherwise legitimate, and that the active management of assets does not necessarily imply their active trading. The court focused instead on the active role Madison took in managing the FLP's assets by serving on the boards of directors of the Legacy Asset corporations.

As for the “adequate and full consideration” part of the exception, the court found that Charles received partnership interests proportionate to his contributions, that the assets contributed by each partner were credited to their respective capital accounts, and that upon dissolution each partner was entitled to distributions equal to his or her respective capital account balance. Therefore, pursuant to the tests set forth in Estate of Kimbell, the court ruled that the transfer to the FLP had been made for “adequate and full consideration.”

Issue 2: Valuations

The court considered the various discounts and approaches set forth by both the IRS' and the estate's financial experts.

The court accepted the estate's expert's valuation discount as it applied to the valuation of the FLP's Legacy Assets, noting that the estate's expert considered such qualitative factors as volatility of the stock, actual price changes in the stock under differing market conditions, the current economic outlook for the company, the stock's price trend, the trend of the company's earnings, and the existence of any securities law resale restrictions. The IRS' expert failed to consider these factors in his valuation discount analysis.

To determine lack of control discount, both parties' experts first divided the FLP's assets into separate categories based on type of asset, determined a discount for each asset category, then constructed a weighted average discount with the results. Although both experts relied on data from closed-end funds, the court agreed with the estate's expert who also screened for funds with compositions similar to the FLP's.

To determine lack of marketability discount, although both experts examined studies of restricted stock transactions, the estate's expert also compared the data in the restricted stock studies to the holding period, relative risk, distribution policy and transfer restrictions that were unique to the Murphy FLP interests. The government's expert's analysis did not consider these additional factors. As a result, the court again sided with the discount put forward by the estate.

Issue 3: Deductibility of the Graegin loan interest

The IRS challenged the estate's deduction of the Graegin loan interest under IRC Section 2053(a), arguing that the interest was not “necessarily incurred” because it was the product of an unnecessary estate tax avoidance transaction that left Charles' estate with insufficient liquidity to pay the estate tax due. The IRS also claimed that the interest also was not “necessarily incurred,” because the estate could have elected to liquidate assets to pay the taxes due rather than borrow the funds.

The court rejected both these arguments. With respect to the first argument, the court observed that Charles had created the FLP in good faith and for legitimate and significant non-tax purposes and that, at the time of the transfer, Charles had retained substantial assets outside the partnership that were sufficient to provide for his support and to pay his estate taxes. That the estate had to borrow funds to pay the taxes, according to the court, was due solely to the value of non-partnership assets declining and not to any actions taken by Charles to “[deplete] his wealth to avoid taxes.”

With respect to the IRS' second argument, the court stated that “the executor of an estate is not required to set aside good business judgment when administering an estate. If the executor acted in the best interest of the estate, the courts will not second guess the executor's business judgment.”

Potential discount allowed in valuation of RMA — In Chief Counsel Advice 200941016, dated Aug. 26, 2008, the Office of Chief Counsel noted in an email that a valuation discount in a restricted management account (RMA) might exist for a potential breach of contract action.

The Chief Counsel's office noted that the relationship between an account owner and a financial institution was one of agency and that an account owner could unilaterally revoke the agency agreement, in addition to the agreement automatically being terminated upon the death of the principal. This ability to revoke exists regardless of any express or implied agreement between the parties that the contract is irrevocable, although such revocation might give rise to a breach of contract claim.

Although the IRS' typical position is that no discount for lack of control and marketability is warranted with regard to RMAs, due to the existence of such potential breach of contract claim, the counsel's office said that an “allowable discount, if any, should be limited to the potential damages… which would ordinarily be significantly less than the lack of control minority/marketability discounts claimed.”