The Fifth Circuit in Keller v. United States (Docket No. 10-41311) has affirmed the district court's ruling (Docket No. 6:02-cv-00062) that assets of a family limited partnership (FLP) were established before the decedent's death, even though no assets had actually been transferred by that time. As a result, the estate was entitled to a refund of estate taxes based on valuing the FLP interests with discounts of approximately 47.5%. It further determined that interest on a loan from the FLP was deductible under Section 2053.
The case revolved around the decedent's intentions at the time of her death. Following her husband's death in January 1999, the decedent had spent considerable time with her advisers regarding various options for the protection and disposition of some of the assets in two trusts. One trust, for which a qualified terminable interest property election had been made upon her husband's death, consisted of his separate property and his one-half interest in their community property. The other trust consisted of the decedent's separate property and her one-half interest in their community property. The discussion centered on the possibility of creating a series of FLPs for the purpose of holding some or all of the family's real estate, mineral interests and investment assets, with one FLP to be established for each class of assets.
The first FLP was to be formed with approximately $250 million of community property bonds. Each trust was to contribute approximately one-half of that amount in exchange for a 49.95% limited interest in the FLP. A corporation to be formed by the decedent with an initial cash contribution of $300,000 was to own the 0.1% general partner's interest. The decedent intended to sell her interest in the corporation to family members. Various drafts of the documents were circulated during the fall of 1999. In March 2000, the 90-year-old decedent was diagnosed with cancer, but her death was not believed to be imminent. On May 9, 2000, her adviser took the paperwork to her hospital room, and she signed the FLP agreement and various papers for the corporate general partner. The FLP agreement had blanks for the amounts contributed. Her adviser testified that the blank amounts would be filled in when the bonds were actually transferred to the FLP and the values on that date ascertained. He applied for Taxpayer Identification Numbers (TINs) for the FLP and the corporation, discussed opening brokerage accounts for the FLP assets and cut a check for $300,000 which the decedent was to sign. The decedent, however, died on May 15, 2000, before the TINs were received, before the brokerage accounts were opened, before assets were transferred to the limited FLPs and before the decedent signed the check to fund the corporation.
After her death, all action regarding the FLP ceased until May 2001, when her adviser attended an estate planning seminar and heard a discussion about Estate of Church v. United States, (85 A.F.T.R.2d 804), which was affirmed by the Fifth Circuit (268 F.3d 1063). In Church, the courts recognized the validity of a partnership even though the certificate of limited partnership was not filed until shortly after the decedent's death and the corporate general partner was not organized until several months after her death. Buoyed by the success of the estate in Church, the adviser and the family members moved quickly to complete the remaining matters necessary to complete the formation of the FLP and the transfer of the bonds to the FLP.
In February 2001, the estate filed a request for an extension to file the estate tax return and remitted a payment of $147 million. In August 2001, the estate filed an estate tax return showing estate tax liability of $145.5 million. The return, however, did not reflect proper discounts for the FLP interests held by the estate.
Having completed the FLP transaction, the adviser realized that they lacked liquid assets to issue the February 2001 estate tax payment of $147 million. Consequently, the estate retroactively restructured part of the payment as a $114 million loan from the FLP effective at the time the estate tax return was filed.
In November 2001, the estate filed a claim for refund for $40.5 million properly reflecting discounts for the FLP interests held by the estate and a $30 deduction for interest on the loan. After not hearing from the IRS, the estate filed a petition with the Tax Court alleging (1) the estate's initial value of the decedent's assets failed to appropriately discount the value of the FLP initial overpayment and (2) the estate accrued interest on its loan from the FLP, which it was entitled to deduct.
Creation of FLP
Following the rationale in the Church case, the district court determined that under well-established principles of Texas law, the intent of an owner to make an asset partnership property will cause the asset to be property of the partnership irrespective of whether legal or record title to the property has yet been transferred. Because the estate established that the decedent intended to transfer the community property bonds to the FLP at the time she signed the FLP agreement, the FLP was a valid limited partnership before her death, so that the assets are considered FLP property before her death.
The district court then turned to the application of Section 2036. In general, Section 2036(a)(1) includes in a decedent's gross estate for estate tax purposes the value of transfers made by a decedent during the decedent's lifetime when the decedent has retained certain rights regarding the possession of, enjoyment of or income from, the transferred property. Section 2036(a) includes an exception to its application if the transfer is a bona fide sale for adequate and full consideration in money or money's worth (the "bona fide sale exception"). The court concluded that the decedent's transfer of the community property bonds to the FLP was a bona fide sale based on the lengthy discussions that went into creating the FLP, the primary purpose for creating the FLP to protect from depleting family assets during divorces and the existence of significant other resources available to the decedent (well over $100 million). In addition, the court determined that the decedent's transfer was made for full and adequate consideration because the FLP agreement provides that the percentage interests of the partners are proportionate to their respective contributions, the capital accounts are to be credited with the contributions, and upon liquidation the partners are to receive their capital accounts according to their percentage interests.
On appeal, the IRS did not challenge the district court's finding that the decedent intended to transfer the bonds to the FLP. Instead, the IRS argued that certain provisions of the Texas Revised Uniform Limited Partnership Act (TRULPA) prohibit a conclusion that a transfer occurred. After reviewing various sections of the TRULPA cited by the IRS supporting its argument, the Fifth Circuit rejected them all, concluding that none of the IRS's challenges defeated Texas's overarching rule that intent determines property ownership. The court affirmed the district court's ruling that an FLP had been created and the FLP interests in the decedent's estate were entitled to a discount.
Deductibility of interest on loan
Section 2053 allows an estate tax deduction for administration expenses. To be deductible, an administration expense must be actually and necessarily incurred in the administration of the decedent's estate. If a loan incurred by the estate to pay the estate tax liability avoids the forced sale of estate assets, the loan generally will be considered to be reasonable and necessary in administering the estate.
The district court summarily determined that the loan from the FLP was actually and necessarily incurred because the deemed transfer rendered the estate illiquid. The Fifth Circuit, however, gave the issue more attention. The IRS challenged the district court's findings on two grounds: (1) by reiterating its challenge to the initial transfer of the bonds to the FLP (which would have made the estate liquid) and (2) arguing that the loan could have as easily been retroactively characterized as a distribution from the FLP.
Regarding the first ground, the Fifth Circuit dismissed it because of its finding that the bonds had been transferred to the FLP under Texas law. Regarding the second ground, the Fifth Circuit noted that the Tax Court permitted deductions under Section 2053(a)(2) on loans between an estate and a closely held entity in which it holds an interest when the estate generally held illiquid assets. It has also found in other instances, however, that where the estate had liquid assets, such loans were unnecessary and, therefore, the estate has been denied a deduction. In particular, in Black v. Commissioner (133 T.C. 340), the Tax Court denied an interest deduction for a loan from an FLP that held marketable assets, determining that it was inevitable that the stock would need to be sold to pay the estate's tax liability and that the only reason the FLP was formed was to obtain the interest deduction. The Fifth Circuit distinguished the Black finding by noting that the decedent's estate faced no such inevitable outcome because it did not need to resort to redeeming partnership units or distributing the FLP's assets to repay the loan. It noted that, excluding the FLP interests, the estate had more than $110 million in other assets from which the loan could be paid.
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