Tax Law Update 2010-04-01 (1)Tax Law Update 2010-04-01 (1)

Tax Court rules in favor of taxpayer in family limited partnership case, noting the marital deduction — In Estate of Charlene B. Shurtz v. Commissioner, T.C. Memo 2010-21, the Tax Court held for the taxpayer that assets transferred to a family limited partnership (FLP) were not included in the decedent's gross estate under Internal Revenue Code Section 2036.

Charlene Shurtz, along with her two siblings, inherited from her parents interests in a family business that managed timberlands in Mississippi. Charlene and her husband, Reverend Richard Shurtz, were religious and charitable — spending time abroad as missionaries and donating almost $1 million to charity. As the family grew and more individuals owned interests in the business, it became increasingly difficult to manage the property. The family decided to streamline management and form a limited partnership to operate the business: C.A. Barge Timberlands, L.P. (Barge) was formed on June 25, 1993 and funded with 45,197 acres of Mississippi timberland.

However, Charlene, her siblings and in-laws still had concerns about how to protect the family business from what they regarded as the litigious and “jackpot justice” society of Mississippi. They were advised that each sibling should set up a second limited partnership for his or her family to hold their interests in Barge. As a result, potential creditors wouldn't have a right to the underlying timberlands, but only to the distributions actually made by Barge. Charlene also still directly owned almost 750 acres of timberland that she wanted to give to her children and grandchildren. Since the difficulties in managing property with multiple owners was already clear from past experience, Charlene decided to contribute these lands as well as her interests in Barge to her new “upper tier” partnership.

Charlene wanted to establish a partnership (which requires more than one member) but she owned all the assets to be contributed. So Charlene gave Richard a portion of her interests in the timberlands. Charlene and Richard then contributed the timberlands and interests in Barge to a new FLP: Doulos L.P. Charlene and Richard each received a 1 percent general partnership interest and Charlene received a 98 percent limited partnership interest. The partnership prohibited outsiders from becoming partners without the consent of the general partners and required outsiders who received partnership interests through involuntary transfers and spouses who held interests after the divorce or the death of an existing family member to sell such interests back to the partnership. Charlene gifted limited partnership interests to her children and grandchildren over the years as annual exclusion gifts (interestingly, the gifts appear to have qualified for the annual exclusion even in light of Hackl v. Commissioner, 118. T.C. 279 (2002) and Price v. Comm'r, T.C. Memo 2010-2, both discussed in the March 2010 Tax Law Update column).

On Charlene's death on Jan. 21, 2002, she owned a 1 percent general partnership interest and an 87.6 percent limited partnership interest in Doulos L.P. The Internal Revenue Service argued that the value of the assets Charlene contributed to the partnership, rather than the partnership interest, should be included in her gross estate under IRC Section 2036.

IRC Section 2036(a) states that “the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth) under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death (1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right… to designate the persons who shall possess or enjoy the property or the income therefrom.”

The court held that the transfers to the FLPs met the bona fide sale exception of IRC Section 2036(a). Under Estate of Bongard v. Comm'r, 124 T.C. 95 (2005), the bona fide sale exception is met if (1) there is a legitimate and significant non-tax reason for creating the partnership that actually (not theoretically) motivated the taxpayer to form the partnership, and (2) the taxpayer received full and adequate consideration in exchange for his contribution to the partnership in an arm's length transaction. The court cited Estate of Mirowski v. Comm'r, T.C. Memo 2008-74 and held that as long as estate tax savings is not the predominant reason for establishing the partnership, a finding that the taxpayer was motivated to reduce estate tax does not preclude the exception from applying.

The court found that Charlene and her family had legitimate and significant non-tax reasons for establishing the partnership. First, they sought to protect the family business from intra-family creditors and potential lawsuits. In addition, in light of Charlene's intent to give partnership interests to her children and grandchildren, forming the FLP would streamline the management of the property, which required active management. The court noted that management efficiency may be a legitimate and significant non-tax reason for establishing a partnership even if only a portion of the partnership property requires active management. Lastly, although reducing estate tax was a motivating factor, it was not the predominant factor.

The court found that Charlene had received full and adequate consideration in exchange for her interest because Charlene and Richard received interests in the partnership proportionate to the property they contributed, the assets each contributed were properly credited to their capital accounts, and later distributions reduced each partner's capital account accordingly (even though distributions had been made that were not pro rata and make-up distributions were made afterwards). The partnership was formed in a manner similar to the way in which ordinary parties in a business transaction would deal with each other, that is to say, at arm's length. The bona fide sale exception applied and only the value of the partnership interests were included in Charlene's estate.

The IRS had also asserted that not only should the value of the assets contributed to the partnership be included in Charlene's estate, but also the marital deduction for the partnership interests that passed to Richard should be limited to the discounted value of those interests. A “mismatch” would result because the value of the deduction (the value of the limited partnership interests, subject to applicable discounts) would be less than the value of the corresponding partnership assets includible in the estate and subject to tax. Therefore, due to the reduced deduction, estate tax would be due. However, since the court ultimately held that only the value of the partnership interests was included in Charlene's taxable estate, there was no mismatch and no estate tax was due.

The Shurtz case is particularly interesting for two reasons. First, the court has interpreted Bongard to mean that estate tax savings, as long as it's not the predominant factor, can be a factor motivating the formation of the partnership and will not necessarily prevent the formation of the partnership from qualifying for the bona fide sale exception. Second, while facilitating gift giving may not be a legitimate and significant non-tax reason, if a gift-giving program would create a difficult management situation for property that requires active management, improved management efficiency could still be a convincing legitimate and significant non-tax reason.

Tax Court holds New York property conveyed by ambiguous deed is to be owned by couple as tenants-by-the-entirety and includible in the surviving spouse's estate — In Estate of Oscar Goldberg v. Comm'r, T.C. Memo 2010-26, the Tax Court found that the taxpayer had not overcome the presumption under New York law that property conveyed to a husband and wife is conveyed to them as tenants-by-the-entirety.

Oscar Goldberg received partial interests in two New York properties from his mother: an 11.66 percent in one property and a 12.5 percent interest in the other property. In 1977, Oscar transferred his entire interest in each property to himself and his wife, Rachel. The deed for one of the properties conveyed it “to Oscar Goldberg and Judith Goldberg, as wife” and the other deed conveyed the other property “to Oscar Goldberg and Judith Goldberg, his wife.” Judith died, and Oscar, as her executor, transferred “all of her interests” in the properties to a trust. Other than the original transfers in 1977 to himself and his wife, Oscar never attempted to otherwise convey any of his interests in the properties.

After Oscar's death, the executor of his estate reported one-half of the original interest in each property as includible in Oscar's estate. His executor took the position that Oscar's original deed to himself and his wife conveyed a 50 percent tenants-in-common interest to each of them. However, the IRS asserted that Oscar had conveyed the property to them as tenants-by-the-entirety, a form of joint ownership with a right of survivorship. As a result, the IRS argued, on Judith's death, Oscar owned all of the interests himself and on his death, the full interest in each property should be included in Oscar's estate and subject to tax.

The Tax Court looked to New York law to analyze how Oscar and Judith held the property. By state statute, a transfer of real property to a husband and wife creates a tenancy-by-the-entirety unless it's expressly stated to be a joint tenancy or a tenancy-in-common. The estate sought to introduce parol evidence showing that the couple had intended to own the properties as tenants-in-common but the court held such evidence inadmissible. The estate also argued that the couple had converted their ownership to a tenancy-in-common but could not provide any evidence of the conversion. Therefore, the Tax Court held that the New York statute's presumption of a tenancy-by-the-entirety was not overcome and that the full value of the interests was includible in Oscar's estate.

Tax Court values life insurance policy without regard to surrender charges; taxpayer recognizes income from resulting bargain sale of policy — In Matthies v. Comm'r, 134 T.C. No. 6 (Feb. 22, 2010), the Tax Court agreed with the IRS that the value of a life insurance policy distributed to the taxpayers from a profit-sharing plan should be determined without reduction for surrender charges. As a result, the taxpayers recognized income equal to the amount by which the value of the insurance policy distributed exceeded the consideration paid in exchange.

In 1998, Karl and Deborah Matthies consulted an estate-planning attorney who introduced them to his son, an insurance agent. Together, the attorney and insurance agent recommended a strategy called the Pension Asset Transfer Plan, which would involve using qualified pension assets to purchase an insurance policy and then selling the policy to the taxpayers at a very low cost due to the policy's high surrender charges.

The taxpayers followed the suggestion. First, the taxpayers established an S corporation and a profit sharing plan for the corporation, of which they were the sole trustees and committee members, and obtained a favorable determination letter from the IRS for the profit sharing plan. Second, the profit sharing plan purchased a survivorship policy on the taxpayers' lives with a death benefit exceeding $80 million. The taxpayers then made two transfers of $1.25 million to the profit sharing plan that used all of the contributed funds to pay insurance premiums. Third, after holding the policy for just under 2 years, the profit sharing plan sold the policy to the taxpayers for about $300,000, which was the cash value of the policy reduced by a surrender charge of over $1 million (the surrender charge decreased each year until it was fully phased out after 20 years). Last, in December 2000, the taxpayers transferred the insurance policy to an irrevocable trust and the trustee of the trust exchanged the policy for a variable survivorship policy with a death benefit of over $19 million. The insurance company issuing the new policy to the trust waived the surrender charges and accepted the full $1.3 million cash value as payment for the single premium due on the new policy. No further premiums on the replacement policy would ever be due.

New regulations under IRC Section 402(a) regarding distributions from tax-exempt employees' trusts to an employee were promulgated in 2005. While the taxpayers and the IRS disagreed over whether such regulations indirectly applied to the case at hand, the Tax Court only looked at the law as in effect at the time of the transactions.

The Tax Court first looked to whether the value of the policy that exceeded the consideration paid should be included in the taxpayers' gross income. Generally, an arm's length bargain doesn't give rise to income. However, citing to Supreme Court precedent, the Tax Court highlighted that income results from a bargain sale when there is a special relationship between the parties (such as stockholders or employees), which indicates that the sale is not arm's length and was entered into pursuant to a prearranged plan. Comm'r v. LoBue, 351 U.S. 243 (1956). Because the transaction by the taxpayers was pre-arranged solely for tax purposes and clearly not arm's length, the Tax Court held that the taxpayers recognized income to the extent that the transaction was a bargain sale.

The Tax Court then turned to whether the value of the life insurance policy should be reduced for the applicable surrender charges. IRC Section 402(a) provides that the distribution of property to an employee from an employees' trust is taxable to the employee under IRC Section 72. Treasury Regulations Section 1.402(a)-(1)(a)(2), as in effect prior to Aug. 29, 2005, provided that in the case of an insurance contract distributed to an employee, the “entire cash value” of the insurance contract is taxable to the employee. The regulations did not define “entire cash value” but the Tax Court noted that the term was revised from the original term “entire value” which was used in the proposed regulations. Under IRC Section 72, which governs the income taxation of annuities and distributions under IRC Section 402(a), the cash value of the contract is determined without regard to any surrender charges. As a result, the court construed “entire cash value” under IRC Section 402(a) to mean cash value without reduction for any surrender charges. The taxpayers were therefore held to have purchased the insurance policy in a bargain sale since the value was over $1.3 million and they paid just over $300,000. The court noted that its holding was supported by the fact that the replacement policy was issued by crediting the trust the full cash value of the original policy without reduction for the surrender charges.

As noted above, the transactions in the Matthies case predated final regulations under IRC Section 402(a) that were issued in 2005. Current regulations provide that the “fair market value” of the life contract (rather than the “entire cash value”) is taxable to the employee and guidance on bargain sales. Matthies shows that under either the new or old regulations, the Tax Court may see through prearranged plans to transfer life insurance at a depressed value due to surrender charges.