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Musings On Current Events

Partnership Recognized Although Not Formally Funded Before Decedent’s Death; Interest on Recharacterized Loan From FLP Loan to Pay Estate Taxes and Other Obligations is Deductible For Estate Tax Purposes

Steve R. Akers
Bessemer Trust
300 Crescent Court, Suite 800
Dallas, Texas 75201
October 2012

Brief Synopsis

The decedent signed a partnership agreement but did not formally fund the FLP prior to her unexpected death. About a year after her death, the planners heard at a seminar about the Church case, which recognized that under Texas law a partnership could be funded impliedly based on the intent of the decedent prior to his death. The decedent had planned to transfer a large bond portfolio to the partnership, and the estate took the position in this estate tax refund case that FLP actually owned the bonds at the decedent’s death (although the parties did not know that at the time of her death) and that the estate’s interest in the FLP should be valued at a discount. The district court ultimately upheld that position and valued the estate’s limited partnership interest at a 47.5% discount. (The court accepted the estate’s appraiser’s value, finding that the government’s appraisal violated several of the tenets of the hypothetical willing buyer-willing seller valuation principle, including considering the true identities of the buyer and seller, speculating as to future events, and aggregating the interests of the various owners.) In addition, when the estate realized that it had improperly sold the bonds that it did not really own to be able to pay estate taxes, the estate retroactively documented that it owed the FLP a loan of about $114 million. The district court concluded that nine years of interest payments on that loan were deductible as necessary expenses of the estate.

Several subsequent district court cases addressed a variety of issues primarily dealing with what administration expenses could be deducted.

The IRS appealed to the Fifth Circuit Court of Appeals as to two legal issues: (i) whether under Texas law the partnership was created and funded prior to the decedent’s death, because of the decedent’s intent to fund the partnership; and (ii) the deductibility of interest on the retroactively structured loan from the FLP. The Fifth Circuit Court of Appeals affirmed the lower court as to both issues, recognizing the FLP based on the decedent’s intent that it own the bond portfolio and allowing an estate tax deduction for nine years of interest payments on the recharacterized loan from the FLP to the estate.

Brief Summary of Lower Court Cases

In this estate tax refund case (the original opinion was published about 2 years after a four-day trial), the decedent signed a partnership agreement and expressed the intent to fund the partnership with a specifically identified bond portfolio and cash, but the funding did not formally occur before her death. The decedent died unexpectedly, so the planner put the funding on hold for about a year until one of the planners heard about the Church case, which had recognized a partnership that similarly had not been formally funded at the decedent’s death. The planners completed the formal funding transfers and the estate filed an estate tax return reporting the partnership interests (without a discount) and reporting about $143 million of estate tax. The estate later filed a claim for refund for about $40 million of estate tax. The court concluded that the decedent had expressed the clear intent to fund the partnership with the identified assets, and under Texas law that caused the assets to become partnership assets. The bona fide sale exception to 2036 and 2038 applied because the partnership was genuine, there was a legitimate business purpose for the partnership (protecting family assets from divorce proceedings and facilitating the administration of family assets) and because she retained significant assets outside the partnership. The taxpayer’s valuation expert’s value was accepted, representing a 47.5% discount. (The IRS’s expert’s opinion was rejected because it violated several of the tenets of the hypothetical willing buyer-willing seller valuation principle, including considering the true identities of the buyer and seller, speculating as to future events, and aggregating the interests of the various owners.) The estate borrowed $114 million from the partnership to pay estate taxes and other debts. The interest on the 9-year loan was deductible for estate tax purposes because the interest expense was actually and necessarily incurred in the administration of the estate. 104 AFTR 2d 2009-6015 (S D. Tex. Aug. 20, 2009). The author of this overview summary published a detailed summary of the facts and analysis of that case following its issuance in 2009.

There have been various subsequent decisions of the district court. The district court refused the government’s motion to alter or amend the finding of facts and conclusions of law (regarding the validity of the loan and the deductions for interest on the loan from the FLP). Among other things, the government argued that the interest was paid from the decedent’s revocable trust and testamentary trusts, and that those were non-probate assets so any payments made after the three-year period of limitations on assessments of estate tax could not be deducted as a result of 2503(b). However, the court reasoned that 2503(c)(2) makes no distinction between probate and non-probate assets, but it merely limits deductions for expenses exceeding the value of property subject to claims at the decedent’s death. The decedent’s will in this case explicitly stated that administration expenses were to be paid from the revocable trust or the residuary estate, so payments made from the revocable trust could be deducted even if they were paid after the three-year period on limitations of assessments of estate tax. The case cites other consistent cases and rulings. Estate of Snyder v. U.S., 84 AFTR 2d 99-5963 (Fed. Cl.); PLR 9123024. 106 AFTR 2d 2010-6309 (S. D. Tex. Sept. 14, 2010).

The next day, the district court addressed the taxpayer’s proposed calculation of deductions including loan interest, attorneys’ fees, executor/trustee fees, and miscellaneous administrative expenses including courts costs, accountants’ fees and appraisers’ fees. Most of the expenses were allowed as deductions, except for a $9.47 million contingency fee paid to the attorneys regarding the estate tax refund claim and $12 million of executor/trustee fees paid to three family members. The court allowed a deduction for $3 million of executor/trustee fees paid to the accountant, who actually performed the role of the executor. The court observed that the payments to the decedent’s daughter ($6 million) and two grandchildren from another child of the decedent ($3 million each) represented “a perfect split based on their lineage,” agreeing with the IRS’s argument that the payments to the family members were “a disguised distribution to heirs” rather than “necessary” administration expenses. The IRS also argued that Texas law limited executor fees in this case to about $745,000. However, the court observed that there was no such limit on the determination of “reasonable” trustee fees and that the balance of the $3 million paid to the accountant for executor/trustee services could be deducted as a reasonable trustee fee. 106 AFTR 2d 2010-6343 (S.D. Tex. Sept. 15, 2010).

The district court subsequently considered (and generally rejected) arguments by the estate regarding various administration expenses. The estate argued that the IRS was precluded from objecting to the deduction of the $12 million paid to family members as executor/trustee fees because the IRS’s answer to an interrogatory was that “[t]he United States does not at this time” assert that executor/trustee fees should not be deductible. The estate did not present any testimony at trial regarding the services performed by the family members because it believed the deductibility of the fees was not at issue. However, the court concluded that the fees were not paid until after the government’s interrogatory response and the government could not have raised its “necessity” objection in its response. Also, the government’s language “at this time” preserved its ability to object to the expenses at a later time. In addition, the estate claimed additional interest deductions under an extended promissory note (extending the due date from February 2010 to February 2013). The IRS viewed this as “simply another attempt to create more 2053 interest deductions for the estate,” and noted that interest deductions had already been allowed for nine years. The court had set a February 10, 2010 cut-off date for calculating deductions for administration expenses (observing that it had to “determine a cut-off for its involvement in the calculations at issue”) and refused to allowed deductions for expenses beyond that date.

Brief Summary of Fifth Circuit Court’s Analysis

The IRS appealed to the Fifth Circuit Court of Appeals as to two legal issues (but not any of the fact issues). Those two legal issues were (i) whether under Texas law the partnership was created and funded prior to the decedent’s death, because of the decedent’s intent to fund the partnership, and (ii) the deductibility of interest on the retroactively structured loan from the FLP. The Fifth Circuit Court of Appeals affirmed the lower court as to both issues.

Creation and Funding of Partnership Based on Intent. The Fifth Circuit determined that under Texas law intent (either express or implied) determines whether property is owned by the partnership or by a partner individually, regardless of who has legal title. The Texas cases specifically addressed property acquired by an “already-formed partnership,” but thought that the Texas courts would rule similarly as to whether “property passed to the FLP contemporaneous with its formation.” The court rejected technical arguments that various provisions of the Texas Limited Partnership Act required a different result, and observed that its holding was consistent with the Church case, which was affirmed by the Fifth Circuit. 85 AFTR 2d 2000-804 (W.D. Tex. 2000), aff’d, 268 F.3d 1063 (5th Cir. 2001). The court also rejected the government’s argument that the FLP ceased to exist at the decedent’s death, because her death triggered the termination of the trusts that were the limited partners, reasoning that the limited partnership statute provides four exclusive methods of dissolving a limited partnership, and the circumstance causing the alleged termination was not one of them. The Fifth Circuit concluded, as to this issue, that the decedent transferred to the FLP the bond portfolio prior to her death “and the district court correctly applied the relevant discount reflecting the encumbrance on the partnership interests.”

Deductibility of Interest on Loan from FLP. In addition, the Fifth Circuit affirmed the deductibility of the loan interest, reasoning that the loan was “actually and necessarily incurred” despite the government’s assertion that the loan “could have as easily be retroactively characterized as a distribution.” The court distinguished Estate of Black, 133 T.C. 340 (2009), which disallowed an interest deduction for a loan from an FLP to a decedent’s estate where the FLP’s “only meaningful asset” was stock in Erie Indemnity Company (of which the Black family was a large shareholder). In Black, the estate had no ability to pay off the loan without receiving assets from the partnership, and indeed the Erie stock was ultimately sold. The Tax Court viewed the loan structure as an “indirect use” of the Erie stock in the FLP to generate a tax deduction. The Fifth Circuit reasoned that the key was “Black estate’s essential insolvency vis--vis the $71 million loan without resort to the sale of stock or partnership units.” The Keller estate is different because it had other illiquid assets that eventually could be used to repay the loan without “redeeming partnership units or distributing the FLP’s assets.”

As to the argument that the estate could have recharacterized the use of the partnership assets as a distribution rather than a loan, the Fifth Circuit reasoned (very briefly) that this position “takes Black too far.” The government also argued that the estate’s and FLP’s common control between related entities renders “the chosen financing structure little more than a legal pretense or an indirect use.” The Fifth Circuit noted that when the estate realized that it had improperly disposed of bonds that really belonged to the FLP, it was forced “forced to rectify its mistake using the assets it had available — largely illiquid land and mineral holdings.” Instead of liquidating those assets, the estate borrowed from the FLP. The Fifth Circuit did not seem to find that to be an unreasonable business decision (though it did not state that explicitly). The court just concluded that it refused “to collapse the Estate and FLP to functionally the same entity simply because they share substantial (though not complete) common control.”

The Fifth Circuit case presumably ends the saga of this case that resulted in a very large valuation discount for municipal bonds held in an FLP, and that allowed nine years worth of interest deductions on retroactively created loans from an FLP that had been created and implicitly funded by the decedent shortly prior to her death.

Copyright © 2012 Bessemer Trust Company, N.A. All rights reserved.

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