In Estate of Hilde E. Erickson, TCM 2007-207 (April 30, 2007), the IRS determined a $734,599 Federal gift tax and a $718,320 Federal estate tax deficiency of the estate of Mrs. Hilde E. Erickson. The taxpayer petitioned the Court to decide if property of the decedent transferred to a family limited partnership shortly before her death should be included in her gross estate under section 2036.
Mr. Erickson’s will left most of his assets to Mrs. Erickson. Mr. Erickson’s will also set up a credit trust for Mrs. Erickson’s benefit, intended to provide for her care in the event she depleted her own assets. Any remaining funds in the credit trust after Mrs. Erickson’s death would pass to their daughters (Karen and Sigrid) free of estate tax.
Mrs. Erickson and Karen were the initial trustees of the credit trust, and Sigrid became a successor trustee years later. Mrs. Erickson granted Karen a durable power of attorney in 1987 and again in 1994, and around 1999-2000 Karen began dealing with the credit trust on her mother’s behalf, managing the credit trust’s investments. The credit trust had over $1 million in assets, consisting of marketable securities and a Florida condominium purchased as an investment.
Mrs. Erickson, at the age of 86, was diagnosed with Alzheimer’s disease on March 5, 1999 and as her health declined, the family decided it was best for her to move to a supervised living facility. After Mrs. Erickson’s diagnosis, Merrill Lynch Financial Foundation prepared a report regarding her financial situation, and presented planning alternatives and recommendations.
The report indicated Mrs. Erickson desired to maintain a $100,600 annual budget and to minimize estate shrinkage. Also, the report estimated the estate would owe over $500,000 in Federal estate taxes and advised consulting with a tax and estate professional.
The Family Limited Partnership
Aware that a family limited partnership would have estate tax advantages due to valuation discounts that apply to the partnership interests, a limited partnership agreement (the “Agreement”) for the Arthur and Hilde Erickson Family Limited Partnership (the “Partnership”) was signed in May 2001. Karen acted on behalf of her mother and herself, and as co-trustee of the credit trust in forming the Partnership.
The agreement provided that Karen and Sigrid were both general partners and limited partners, while Mrs. Erickson (acting through Karen) and Chad (Karen’s husband) were limited partners. The limited partnership agreement provided that Mrs. Erickson contribute securities and a Florida condominium in exchange for an 86.25 percent interest in the Partnership, the fair market value of both being about $2.1 million.
The limited partnership agreement also provided that Sigrid contribute two partial interests in her Colorado investment condominium in exchange for a general and limited partnership interest representing 2.8 percent of the entire Partnership, while Karen and Chad, respectively, would contribute partial interests in their Colorado investment condominium (equaling a 100 percent interest in the Colorado condominium they jointly owned) in exchange for a general and limited partnership interest, and a limited partnership interest representing 1.4 percent of the Partnership each.
Lastly, the limited partnership agreement provided that the credit trust contribute a Florida condominium in exchange for an 8.2 percent limited partnership interest.
The credit trust also owned $1 million in marketable securities, but Karen and Sigrid opted to exclude those securities from the Partnership because they were not subject to estate taxes. Unlike Mrs. Erickson’s personal assets, they would receive the credit trust assets free of estate tax after their mother’s death.
Although the Agreement contemplated that the partners’ assets would be contributed to the Partnership concurrent with the signing of the Agreement, no transfers to the Partnership occurred upon its execution. Instead, the transfer of assets began about two months later. In July 2001, Karen instructed Merrill Lynch and Wells Fargo to transfer over $1.5 million of Mrs. Erickson’s assets into the Partnership’s account. No other transfers occurred before September 2001, other than the execution of quitclaim deeds relating to the Colorado investment condominiums.
Everything changed, however, on September 27, 2001, when Mrs. Erickson was hospitalized due to pneumonia and a decreased level of consciousness, causing Karen to scramble and transfer assets the following day while her mother’s health was failing.
Acting on behalf of Mrs. Erickson, Karen executed a deed transferring Mrs. Erickson’s Florida condominium unit to the Partnership. Acting as co-trustee of the credit trust, she also signed a trustee’s deed transferring the credit trust’s Florida condominium to the Partnership on the same day. Karen also finalized Mrs. Erickson’s gifts to her three grandchildren by giving limited interests in the Partnership to three trusts for their benefit, reducing her mother’s 86.25 percent Partnership interest to just 24.18 percent. Finally, the most substantial reduction in Mrs. Erickson’s interest occurred shortly before her death when Karen, acting as her attorney-in-fact, transferred over $2 million of her mother’s assets to the Partnership. Most of the retained personal assets, including the substantially reduced retained partnership interest, were illiquid. Mrs. Erickson died two days later.
After Mrs. Erickson’s Death
The family continued to operate the Partnership after Mrs. Erickson’s death. The condominiums in Florida and Colorado were both managed by the same onsite management companies and the marketable securities the Partnership held continued to be managed by investment advisers at Wells Fargo and Merrill Lynch after they were contributed to the Partnership. Over time, the Partnership became less invested in bonds and more heavily invested in real estate. The Partnership made three loans, two of which were to its partners. The Partnership lent $140,000 to Sigrid to enable her to purchase a Florida condominium. It also lent Chad $70,000. Both loans were repaid in a timely manner.
Karen was appointed the personal representative of the estate pursuant to Mrs. Erickson’s will. Finding that the estate was unable to meet its liabilities for estate and gift taxes, , Karen engaged in two transactions. First, she sold Mrs. Erickson’s home to the Partnership for $123,500. Second, the Partnership gave Mrs. Erickson’s estate cash totaling $104,000. The parties characterized the $104,000 disbursement as a redemption of some of Mrs. Erickson’s partnership interests.
The IRS issued deficiency notices after examining the estate’s gift tax and estate tax returns. The parties stipulated the fair market values of the assets Mrs. Erickson contributed to the Partnership and stipulated the fair market values of the partnership interest Mrs. Erickson retained after making the grandchildren’s gifts of partnership interests. The IRS argued that Mrs. Erickson retained the possession, enjoyment of or the right to income from the transferred assets. Further, the IRS determined that the assets were not transferred in a bona fide sale for adequate and full consideration.
The Courts found the rationale for the Partnership and timeliness of the transfers to be self-serving and not credible. Accordingly, the Court concluded that the estate had not met the requirements of Section 7491 because the estate had not introduced credible evidence, so it denied the estate’s motion to shift the burden of proof under Section 7491.
The Court then focused on whether the transferred assets were included in the gross estate. If a decedent makes an inter vivos transfer of property (other than a bona fide sale for adequate and full consideration) and retains certain specific rights or interests in the property that are not relinquished until death, the full value of the transferred property will generally be included in the decedent’s gross estate.
Under Sec. 2036(a), the three requirements for the property to be included in a decedent’s gross estate are:
- The decedent must have made an inter vivos transfer of property,
- The decedent must have retained an interest or a right specified in section 2036(a) (1) or (2) or (b) in the transferred property that he or she did not relinquish until death, and;
- the transfer must not have been a bona fide sale for adequate and full consideration.
The factors the Court considered important in the assessment of whether a decedent implicitly retained the right to possession and enjoyment of the transferred assets included the commingling of funds, a history of disproportionate distributions, testamentary characteristics of the arrangement, the extent to which the decedent transferred nearly all of his or her assets, the unilateral formation of the partnership, the type of assets transferred and the personal situation of the decedent. The delay in transferring the assets to the Partnership suggested that the parties did not respect the formalities of the Partnership. The record reflected that the partners were in no hurry to alter their relationships to their assets until the decedent’s death was imminent.
The Partnership also had to provide the estate with funds to meet its liabilities. First, disbursing funds to the estate is tantamount to making funds available to Mrs. Erickson (or the estate) if needed. Second, although the estate designated the funds disbursed to the estate as purchase of Mrs. Erickson’s home and a redemption of units rather than a distribution, the estate received disbursements at a time that no other partner did. These disbursements provided strong support that Mrs. Erickson (or the estate) could use the assets if needed. Finally, the Partnership had little practical effect during Mrs. Erickson’s life, particularly because the Partnership was not fully funded until days before she died.
Indeed, the Partnership was mainly an alternate method through which Mrs. Erickson could provide for her heirs. Karen, acting on behalf of Mrs. Erickson, transferred substantial amounts of her partnership interests in making the grandchildren’s gifts two days before she died. Moreover, Mrs. Erickson was in declining health for some time. The transaction represents the decedent’s daughters’ last-minute efforts to reduce their mother’s estate tax liability while retaining for the decedent the ability to use the assets if she needed them.
Under the bona fide sale exception, transfers a decedent makes before death are not included in the decedent’s gross estate if the transfers are bona fide sales for adequate and full consideration in money or money’s worth(Sec. 2036(a)). The bona fide sale exception applies if the record shows that a family limited partnership was formed for a legitimate and significant non-tax reason and that each transferor received a partnership interest proportionate to the fair market value of the property transferred.
No Legitimate Non-Tax Purposes
The Court identified several factors Court indicating that a transaction was not motivated by a legitimate and significant non-tax purpose. These factors included the taxpayer’s standing on both sides of the transaction, the taxpayer’s financial dependence on distributions from the partnership, the partner’s commingling of partnership funds with their own, and the taxpayer’s failure to transfer money to the partnership.
There is no significant non-tax purpose where a family limited partnership is just a vehicle for changing the form of the investment in the assets, a mere asset container. The estate argued that the forming of the Partnership allowed the family to centralize the management responsibilities to Karen, and that the Partnership afforded greater creditor protection, as well as facilitating Mrs. Erickson’s gift-giving plan. The Court held that the Partnership was mainly a collection of passive assets intended to assist Mrs. Erickson’s tax planning and benefit the family, and consisted primarily of marketable securities and rental properties that remained in the same state as when they were contributed.
According to the Court, Mrs. Erickson’s age and health at the time of the transaction strongly indicated that the transfers were made to avoid estate tax. Mrs. Erickson’s age and declining health weigh against a finding that the parties formed the Partnership for any reason other than to help reduce Mrs. Erickson’s estate-tax liability.
The Court concluded “that the estate failed to show a legitimate and significant non-tax purpose for the Partnership, and, therefore, Mrs. Erickson’s transfer of assets to the Partnership was not a bona fide sale. The estate failed to identify any legitimate non-tax purpose, and the objective facts indicate that no such legitimate non-tax purpose existed. Therefore, the exception to Section 2036 for bona fide sales for adequate and full consideration did not apply. The implied agreement existed under which Mrs. Erickson retained possession and enjoyment of the assets she transferred. Accordingly, Section 2036(a) (1) applies, and the property Mrs. Erickson transferred to the Partnership is included in her gross estate.”
It is hard to believe even the IRS thinks any major new ground was broken with this decision. Clearly, it was another loss for the taxpayer, but the Court’s rationale in Erickson is now so well established that it should no longer be controversial. The following circumstances are ones in which any taxpayer would do well to settle when given almost any reasonable offer from the Service, rather than fighting it out in Tax Court:
- Deathbed formation and gifting.
- The decedent, or the estate, using family entities as their own personal piggybanks.
- Pro-forma transfers to family entities that do little or nothing to change the nature of the transferred assets, or their management.
As to the “bona fide sales” test, much more economic substance is required than what was evidenced here. The Court is clearly looking for evidence from the participants’ actions, not just, in the Court’s words, “a theoretical justification.” In other words, as has been established before in cases like Kimbell, Stone and Schutt, the family needs to do something with the transferred assets – and from past cases, it appears the threshold for economic substance can often be quite low.
For example, if there is some change in the management of a property, or significant rebalancing of a portfolio, or similar acts that indicate that assets are being managed by the partnership for clear and discernable reasons, this may be enough economic substance. Of course, with only months or even days until death, it would be difficult to produce a paper trail to show evidence of such management.