Transferred Assets Were Subject to Estate Tax

The U.S. Tax Court has held that the value of investment assets that a decedent transferred to a limited partnership had to be included in the value of her estate. Reason: She kept control of the funds after she transferred them and had no reason to create the partnership aside from the tax benefits.

The court determined that the decedent didn’t have a legitimate and significant nontax reason for transferring assets to the limited partnership and that there was an implied agreement that she retain the right to the possession or enjoyment of, or the right to the income from, the transferred property. (Estate of Sarah D. Holliday et al. v. Commissioner)

Under the tax code, if a decedent had transferred property but still retained its possession or enjoyment, the value of the property is included in the estate.

In this case, the decedent formed three entities in one day:

  1. A limited partnership (LP),
  2. A limited liability company (LLC), and
  3. A family irrevocable trust.

The LP agreement stated that one of its purposes was to provide “a means for members of the (decedent’s) family to acquire interests in the partnership business and property, and to ensure that the partnership’s business and property was continued by and closely-held by members” of the family. The LLC was created for the primary purpose of being the LP’s general partner.

Marketable Securities

The decedent funded the LP with nearly $6 million in marketable securities, with a portion of this contribution being made “on behalf of” the LLC. In return, she received a 99.9% interest in the LP as a limited partner, and the LLC received a 0.1% interest as a general partner.

Under the LP’s limited partnership agreement, limited partners didn’t have the right to participate in the business but the partnership could make periodic distributions of cash.

The decedent also assigned her interest in the LLC to her two sons for $2,960 each. This price equaled the gross value of 0.1% of the LP’s assets on the day of the transaction.

The decedent also gave 10% of her limited partnership interest in the LP to the family irrevocable trust. She then held an 89.9% limited partnership interest in the LP, which she maintained until her death.

She left decisions about how her assets would be held to her two sons and her attorney.

Estate Tax Deficiency

When the decedent died, the fair market value of all of the assets owned by the LP was approximately $4 million. The value of the decedent’s interest in the LP was reported on her estate’s tax return as $2.4 million. The IRS audited the return and found an estate tax deficiency of $785,019.

The question before the court was whether the value of the assets the decedent transferred to the LP should be included in the value of her gross estate. The court said yes.

The court believed there was an implied agreement that the decedent retained the right to “the possession or enjoyment of, or the right to the income from, the property.” Although the LP only made one pro rata distribution of $35,000 to its partners before the decedent’s death, the limited partnership agreement unconditionally provided that the decedent was entitled to receive distributions in certain circumstances. Moreover, one of the sons testified at trial that if the decedent had required a distribution, one would have been made.

According to the court, the decedent didn’t have a legitimate and significant nontax reason for transferring assets to the LP and there wasn’t a bona fide sale. The court also observed that the LP held marketable securities that weren’t actively managed and were traded only on limited occasions.

Rejected Arguments

The court rejected the estate’s arguments that three significant nontax business purposes prompted the LP’s creation:

  1. To protect the assets from “trial attorney extortion,”
  2. To protect the assets from the “undue influence of caregivers,” and
  3. To preserve the assets for the benefit of the decedent’s heirs.

The concerns over unscrupulous trial attorneys and caregivers were merely theoretical justifications, the court reasoned. The decedent had never been sued, and because she lived in a nursing home, her risk of being vulnerable to trial attorney extortion was minimal.

While one of the sons testified as to instances of improper conduct by caregivers toward family members, he also testified that he didn’t discuss with his mother that he feared she might be taken advantage of and that was a reason to transfer the assets. Accordingly, the court determined there was no evidence that the transfer was motivated by the decedent’s own concern that she would become subject to the undue influence of a caregiver.

The decedent wasn’t involved in selecting the structure used to preserve her assets, the court noted, adding that one of the sons testified that she was fine with whatever he, his brother and the attorney decided. They had considered other structures but they were “quickly dismissed” because they would have been difficult to manage and use to “do certain things.” These reasons were unconvincing, the court said, particularly in the light of the fact that their father’s assets were held in trusts without any issues

Not Arm’s Length Transactions

In conclusion, the court determined that these weren’t arm’s length transactions. There wasn’t any meaningful negotiation or bargaining associated with the formation of the partnership. The decedent made the only contribution of capital to the LP and held, directly or indirectly, a 100% interest in the partnership immediately after its formation. On the same day, she assigned her interest in the LLC to her sons in exchange for its fair market value.

Moreover, the LP failed to maintain books and records other than brokerage statements and ledgers maintained by one of the sons. The partners didn’t hold formal meetings, and no minutes were kept.