By, Caleb S. Sainsbury, Esq. of Morgan, Lewis & Bockius LLP
Citation: 145 T.C. Memo. 2015-249 (December 28, 2015)
Overview: This case addresses (1) whether the decedent retained an interest under §2036 of assets transferred to an FLP; (2) whether gifts of FLP interests qualify for the annual exclusion; and (3) whether interest on a loan to the estate to pay estate taxes may be deducted.
Summary of Facts: In 1995, the estate planning lawyer for Mr. and Mrs. Purdue advised them to establish an FLP and various trusts. In 2000, the Purdues acted on this advice and contributed $22 million of marketable securities, an interest in a commercial building worth $900,000, a $375,000 promissory note from one of their children and an $865,523 certificate of deposit in exchange for all of the FLP membership interests. The final agreement listed the following six reasons for establishing the FLP: to (1) consolidate the management and control of the property and improve efficiency in managing the property; (2) avoid fractured ownership; (3) keep ownership of the assets within the extended family; (4) protect assets from unknown creditors; (5) provide flexibility and management of assets not available through other business entities; and (6) promote the education and communication among extended family with respect to financial matters.
In addition, prior to the execution of the FLP, the estate planning attorney sent a memorandum to the Purdues summarizing five advantages of the structure. These advantages were (1) limited liability; (2) pass through income taxation; (3) minimum formalities; (4) appropriate entity for owning real estate; and (5) tax savings.
Prior to signing the documents, the Purdues had experienced some health issues. Mrs. Purdue had become semi-invalid due to a leg injury. She had also experienced stroke-like symptoms in October 2000, but did not have residual neurological impairment. Mr. Purdue was physically healthy at the time of the signing, but did experience symptoms of Alzheimer’s disease and was subsequently diagnosed with that disease.
Mr. Purdue died unexpectedly in August 2001 and his estate passed to a family trust and two QTIP trusts. From 2002 through 2007, Mrs. Purdue made gifts of the FLP membership interests to an irrevocable trust with beneficiary withdrawal rights. The trust made approximately $1.95 million of distributions to the children from 2001 to 2007, with the majority of the cash coming from the FLP interests contributed to the trust.
Upon Mrs. Purdue’s death in 2007, a dispute arose among her children on whether the FLP should make a distribution to pay estate taxes. Because the FLP operating agreement required unanimous consent, this gridlock resulted in funds from the FLP not being available to pay the tax. As such, some of the beneficiaries and the QTIP trusts loaned money to the estate to fund the estate tax payment. The estate deducted the interest on the loan on the estate tax return.
- §2036 Issues
The IRS argued that Mrs. Purdue had a retained interest in all assets transferred to the FLP. However, the Court reasoned that §2036 did not apply with respect to the transfers to the FLP for the following reasons: (1) the record established legitimate and significant nontax reasons for creating the FLP, (2) the Purdues were not financially dependent on FLP distributions, (3) FLP funds and personal funds were not comingled, (4) the FLP maintained its own records and formalities were respected, (5) the assets were transferred to the FLP in a timely manner, and (6) the Purdues were in good enough health at the time of the transfers.
- Annual Exclusion
To qualify as a gift of a present interest in the context of FLP interests, the donees must have the use, possession or enjoyment of the FLP interests or the income from those interests. Although the donees could not transfer the FLP interests without the consent of all members, the Court reasoned that the donees did receive income from those interests and this satisfied the present interest requirement. Therefore, the gifts did qualify for the annual exclusion.
- Deductibility of Interest
In order for the interest on a loan to the estate to be deductible on an estate tax return, the loan must be (i) bona fide, (ii) necessary and actually incurred in the estate administration and (iii) essential to the property settlement of the estate. See Treas. Reg. §20.2053-1(b)(2), §20.2053-3(a). The Court reasoned that the loan was necessary because the FLP members could not agree on whether to make a distribution to pay the estate taxes. Thus, the interest deduction was allowed.
Take Away Considerations: This case provides a roadmap for highlighting factors resulting in a positive result for the client. Particularly, advisors must take care to review the factors noted by the Court to avoid having the full value of assets transferred to an FLP included in the estate under §2036.