Estate of Erma V. Jorgensen, (CA 9 5/4/2011) 107 AFTR 2d ¶2011-793
The Court of Appeals for the Ninth Circuit has affirmed a Tax Court decision that assets transferred by an individual to two family limited partnerships (FLPs) were includible in her gross estate under Code Sec. 2036. The overall facts of the case, including that FLP funds were used to pay a significant portion of the decedent's personal income taxes, showed that she retained the economic benefits of such property and that the transfer wasn't a bona fide sale for adequate consideration.
Observation: Individuals typically transfer assets to FLPs in the hope of achieving large estate tax discounts for the assets that would not otherwise be available if the assets were retained in outright ownership. The huge discounts, in turn, could result in substantial estate tax savings. However, in order to achieve the desired results, a number of hurdles must be overcome. In this connection, IRS's Appeals Settlement Guidelines for FLPs can help a practitioner overcome the hurdles. By carefully reviewing the Guidelines and the pro- and anti-taxpayer cases examined in them, a practitioner should be in a position to craft an FLP that will achieve a desired level of discounts for a client's estate.
Background. An individual's gross estate includes property he transferred during his life if he retained for life the possession or enjoyment of the property, or the right to the income from the property. (Code Sec. 2036(a)(1)) This requirement is met if there is an implied agreement among the parties to the transaction at the time of transfer that the transferor may retain the possession or enjoyment of, or the right to the income from, the transferred property.
No inclusion is required if the transfer was a bona fide sale for an adequate and full consideration in money or money's worth. (Code Sec. 2036(a))
Facts. Erma V. Jorgensen (Ms. Jorgensen) was a resident of California when she died with a will on Apr. 25, 2002. In’95, Ms. Jorgensen and her husband, who died a year later, formed an FLP called the Jorgensen Management Association (JMA-I) by each contributing marketable securities valued at $227,644 in exchange for 50% limited partnership interests. Other family members were given interests in the partnership.
A second FLP, JMA-II was formed by Ms. Jorgensen on July 1,’97 when she contributed about $1.8 million of marketable securities in exchange for her initial partnership interest. Children and grandchildren received interests in JMA-II. Because the value of each of these interests exceeded the then available $10,000 annual exclusion, gift tax returns should have been but weren't filed.
Neither JMA-I nor JMA-II operated a business. The FLPs held passive investments only, primarily marketable securities, and neither maintained formal books or records.
Although the partnership agreements stated that withdrawals could only be made by general partners, Ms. Jorgensen was authorized to write checks on the JMA-II checking account, and she wrote checks on both the JMA-I and JMA-II accounts. Some withdrawals were used to make gifts, some of which should have been but weren't reported on gift tax returns.
In 2003 through 2006, JMA-I and JMA-II sold certain assets, including stock that Ms. Jorgensen had contributed to the partnerships during her lifetime. In computing the gain on the sale of those assets, the partnerships used Ms. Jorgensen's original cost basis in the assets, as opposed to a step-up in basis equal to the fair market value of the assets on Ms. Jorgensen's date of death under Code Sec. 1014(a). The JMA-I and JMA-II partners reported the gains on their respective Forms 1040 and paid the income taxes due.
Tax Court's decision. The Tax Court determined that Ms. Jorgensen's estate included the value of the securities which she contributed to both of the FLPs. The Court rejected the estate's argument that the transfers of securities weren't “transfers” under Code Sec. 2036(a), concluding that this term encompassed any inter vivos voluntary act of transferring property, including the transfers at issue. The estate's claim that the transfers were bona fide sales for full and adequate consideration, because Ms. Jorgensen had several nontax reasons for making the transfers, including management of her assets and financial education of family members, was belied by overall facts and circumstances surrounding the formation, funding, and management of the partnerships.
The Court also concluded that there was an implied agreement at the time of the transfers that Ms. Jorgensen would retain the economic benefits of the property, even if the retained rights were not legally enforceable. However, the Court partially upheld the estate's equitable recoupment claim for income taxes paid by Ms. Jorgensen's children and grandchildren (JMA-I and JMA-II partners) on sales of stock that occurred in 2003 through 2006, the values of which the Tax Court held were properly included in the value of Ms. Jorgensen's gross estate.
Ninth Circuit affirms. The Court of Appeals for the Ninth Circuit agreed with the Tax Court's decision to include the transferred amounts in Ms. Jorgensen's estate. The estate argued on appeal that, although Ms. Jorgensen retained some benefits in the transferred property, the amounts for which benefits were retained should be considered de minimis or should be limited to the actual amount accessed by decedent. However, the Ninth Circuit rejected these arguments, finding that the $90,000 in checks personally written by Ms. Jorgensen and the use of $200,000 FLP funds to pay her personal estate taxes weren't de minimis.
The Ninth Circuit also agreed with the Tax Court's conclusion that there was an implied agreement that Ms. Jorgensen could have accessed any amount of the transferred assets, and the fact that she only accessed a specified amount doesn't undermine that conclusion. Additionally, it found no clear error in the Tax Court's conclusion that the transfer wasn't a bona fide sale for adequate consideration. Noting that transfers to FLPs are subject to heightened scrutiny, the Ninth Circuit agreed that the nontax reasons advanced by the estate were either weak or refuted by the record.
References: For the retained enjoyment rule, see Federal Tax Coordinator 2d ¶R-2400; United States Tax Reporter Estate & Gift ¶20,364; TaxDesk ¶764,000; TG ¶40750.