Poor Planning by the Taxpayer Yields Victory for the Tax Collector in Forming Family Limited Partnerships and Family Limited Liability Companies
Two recent cases: one by the United States Tax Court and the other by the Pennsylvania Commonwealth Court, demonstrate that deathbed estate planning and lacking nontax purposes in transferring assets to family limited partnerships or limited liability companies are perilous. Family limited partnerships and limited liability companies are formed for a variety of business and estate planning purposes. However, one goal of those that form these entities is to reduce estate and gift taxes by transferring partnership interests or limited liability company memberships instead of transferring direct interests in the property that will be owned by the these entities. This reduction is obtained as a result of minority, marketability and other discounts that can be established in the valuation of limited interests for gift and estate tax purposes as opposed to the direct ownership of property. This is similar to a closed end stock mutual fund where the per-unit price of the fund is almost always less than the proportionate share of the total value of the underlying assets in the fund. The investor is paying for management and diversification but does not have direct control over the assets.
In order for transfer of the family interests to achieve the discounts and have the partnership or limited liability company recognized for tax purposes, it cannot be a sham. There must be nontax reasons for forming the partnership or limited liability company, and the transfers must result in the transferees (generally the children of the transferor) have having rights not inconsistent with ownership of the interests they received. Deathbed creation of limited interests raises the question of whether there is a nontax purpose for the partnership or limited liability company. If not, it will be disregarded by the tax collector as a sham. Yet, discounts are based on the fact that the owners of the limited interests are locked in and cannot readily dispose of their interests; so there is a balancing act between providing the normal attributes of ownership and restricting the interests sufficiently in order to achieve the desired discounts.
In the Estate of Hilde E. Erickson the United States Tax Court found there was no nontax purpose in forming the family limited partnership. Mrs. Erickson, the decedent, was diagnosed at age 86 with Alzheimer’s decease on March 5, 1999, and her physical health deteriorated after this. The partnership agreement was not signed until May of 2001, and it was signed on behalf of Mrs. Erickson by her daughter, Karen, who acted under a power of attorney in managing her affairs. The partnership was not funded until September 28, 2001, two days before Mrs. Erickson died on September 30, 2001, while in the hospital and her death was expected. The delay in transferring assets both from Mrs. Erickson and her children as agreed indicated that the parties were not following the formalities of the partnership. Also the contribution to the partnership of virtually all of Mrs. Erickson assets leaving nothing to support her or to pay the estate’s liabilities indicated an implied agreement for her continued use of the assets and thus kept them in her estate for tax purposes under section 2036(a)(1) of the Internal Revenue Code. The estate was not able to establish any management purpose for the partnership in that Karen already had management authority under the power of attorney. There was also evidence of commingling of partnership’s funds with that of the partners. As the court saw it, this family limited partnership was merely changing the form of the investment in the assets and was a mere asset container without a legitimate nontax purpose. Thus, the court held the assets were still in Mrs. Erickson’s estate and found in favor of the Internal Revenue Service.
The Erickson case demonstrates how important it is to avoid delaying the implementation of an estate plan until death is imminent and to follow the formalities of the partnership formed to carry out the estate plan. Seeking tax and estate planning advice before it is too late to act avoids a disastrous tax such as occurred in this case. Planning in advance not only fortifies any tax position, but also gives time for the donor to weigh the various options while he or she is able to do so.
In the Estate of Helen H. Berry, the Pennsylvania Commonwealth Court disregarded the partnership even though it was established and funded more than three years before the decedent’s death and even though the Internal Revenue Service had recognized it for Federal Estate Tax purposes and allowed the discounts the estate sought for lack of control and marketability. Pennsylvania currently does not have any regulations or statutory provisions specifically governing family limited partnerships or similar entities. Athough the Commonwealth Court agreed that the Federal regulations governing the Federal Estate Tax apply, the court held that neither the Pennsylvania Department of Revenue nor the court was bound by the determination of the Internal Revenue Service. Instead, the court followed the Third Circuit in the Estate of Thompson v. Commissioner which held in a Federal Estate Tax case decided under section 2036(a) of the Internal Revenue Code that for an inter vivos transfer of assets to a family limited partnership to be recognized, the partnership had to have a “valid functioning business enterprise.” Just as the Third Circuit found in the Thompson case, the Commonwealth Court found that the partnership did not engage in business outside the family and the decedent received no benefit from the transfer other than saved tax dollars and continued to receive most of the economic benefits of the partnership by distributions for her personal use and the bestowal of gifts. Therefore, court denied the discounts. The Commonwealth Court may have overstated the holding of the Thompson case in following the literal language of that case in requiring a business purpose, because the facts in the Thompson case clearly evidence a lack of virtually any purpose except tax savings. The United States Tax Court in the Estate of Bongard v. Commissioner, a decision reviewed by the entire court, has cited the Thompson case as only requiring increased scrutiny in the case of a transfer to a closely held entity to determine if there are bona fide nontax purposes to justify recognition of the partnership or other entity. The Tax Court noted that cases have recognized nontax “business reasons” including, among others, the protection of the taxpayer from personal liability with regard to the properties contributed, the pooling of all of the decedent’s assets to provide greater financial growth than splitting the assets up, and the establishment of a centralized management structure. The Berry case is now on appeal to the Supreme Court of Pennsylvania; so the Pennsylvania law remains in a state of flux.
In planning, creating and operating a family limited partnership or limited liability company, the prospective donor needs to consult with counsel to review the particular facts involved in the family affairs and what the donor seeks to accomplish. The counsel in turn in advising the donor needs to compare carefully the facts involved with the facts in the above cases as well as in those cases where the partnership or other closely held entities were recognized and the discounts sustained. Contact Mr. Kogan for further advice concerning these types of entities and assistance in forming new business entities.