Gary T. Hurford passed away on April 8, 1999. He was survived by his wife Thelma and three children. Ms. Hurford passed away on February 19, 2001.
Mr. Hurford had a conservative estate plan consisting of a bypass trust (the Family Trust) and a qualified terminable interest property (QTIP) trust (the Marital Trust). While preparations for a more conservative estate plan for Ms. Hurford had been in the works since the prior summer, on February 22, 2000, Ms. Hurford dismissed her estate planner and hired a new one.
MS. HURFORD’S ESTATE PLAN
The estate planner separated the assets held by Ms. Hurford and the two Trusts into three groups: 1) cash and marketable securities; 2) Hunt Oil Company (Hunt) phantom stock; and 3) real property. Three FLPs were created to receive each group of assets. Ms. Hurford, Mr. Hurford’s estate, and the three children received an interest in each FLP. The children then purchased Ms. Hurford’s and Mr. Hurford’s estate’s interests in each FLP through a private annuity.
On February 24, 2000, the estate planner created three FLPs and three LLCs, with the LLCs serving as the general partner of the corresponding FLP (e.g., Hurford Management No. 1, LLC (HM-1) is the general partner of Hurford Investments No. 1, LTD (HI-1)). Each of the Hurfords received a 25 percent interest in each LLC, and Ms. Hurford was elected President of each. The FLP and LLC documents contained multiple drafting errors, including granting a limited-partner interest to a trust which did not exist, and listing HM-1 as the general partner of all three FLPs.
Transfers to Fund the FLPs
HI-1 was created to receive the cash and marketable securities, HI-2 the Hunt phantom stock, and HI-3 the real property. Numerous administrative and drafting errors and delays were present throughout the process of transferring the assets into the FLPs.
On April 5, 2000, Ms. Hurford and two of her children entered into a private annuity agreement where Ms. Hurford purported to sell a combined 96.25 percent interest in HI-1, HI-2, and HI-3 to them to provide a fixed annual income for life. However, the two agreed privately to give their brother a one-third interest at the time of death.
Valuing the Assets
The estate planner made serious errors when reporting the values for all three FLPs; such as not taking into account changes of asset composition, not utilizing the most recent information available, and not obtaining updated real estate appraisals. Furthermore, he never obtained a professional appraisal of the FLPs and applied his own unsubstantiated discounts.
Private Annuity Payments
Based on the values of the FLPs, the estate planner concluded that $80,000/month was an appropriate annuity payment. HI-1 assets were used to fund the payments. As payments for the annuity purchase were funded by the HI-1 assets, Ms. Hurford was essentially being paid with her own assets.
At the time of Ms. Hurford’s death, she was responsible for numerous tax returns either as an individual, executrix, trustee, partner, or member of an LLC. The returns were audited, and in November 2004 Ms. Hurford’s estate received notices of deficiency in regard to her 2000 estate tax and gift tax returns.
ISSUES AND DECISIONS
The primary issue for the Court to decide is what should have been included in Ms. Hurford’s gross estate. Specifically, were Ms. Hurford’s transfers to the FLPs and subsequent private-annuity transactions valid under section 2035, 2036, and 2038?
The Private Annuity
For the private annuity to not be included in Ms. Hurford’s estate, the transfer of Ms. Hurford’s interest in the FLPs for the private annuity must be bona fide and for adequate and full consideration. The Court holds that the private annuity agreement was not bona fide and was instead “a disguised gift or a sham transaction.”
The private annuity agreement transferred Ms. Hurford’s interest only to two of the children. The estate planner assumed, however, that they would ignore what he had drafted and they had signed, and instead carry out (as they ultimately did) Ms. Hurford’s true intentions. This rendered the private annuity a sham, nothing more than a substitute will leaving Ms. Hurford’s estate in equal shares to her children.
Secondarily, Ms. Hurford’s children did not use their own assets, or the income from the FLPs, to make the private annuity payments. Ms. Hurford’s children held the assets in the same form they were in before the private annuity, and then slowly transferred small amounts back to her in the form of monthly payments, planning to divide the remainder among themselves (including a share for their brother) after she died. To be bona fide, there must be proof that the transaction wouldn’t materially differ if the parties involved were negotiating at arms’ length.
When determining if Ms. Hurford received adequate and full consideration when transferring her assets for the private annuity, the key question is whether what she received is roughly equal to what she gave up. To meet section 2036(a)’s requirement, the estate planner should have determined the fair market value of the assets at the time of the transfer so that the value of the annuity received would be roughly equal to that of the property sold. He did not. Furthermore, Ms. Hurford maintained “enjoyment” of that property after the private annuity agreement. As previously mentioned, Ms. Hurford’s children made her monthly annuity payments with the very assets she supposedly sold to them. Ms. Hurford also continued to make deposits into the various FLP accounts, shifted assets between accounts, and otherwise treated them as if they were her own rather than actually transferred to the two children.
In regards to section 2038, Ms. Hurford’s estate must show that the transfer of property was not subject to any change through the exercise of a power to alter, amend, revoke, or terminate such transfer. Furthermore, Ms. Hurford may not maintain the power to change the enjoyment of the property. It is Ms. Hurford’s act of altering or amending the transfer of the property being used to pay for the private annuity which results in the property being pulled back into the gross estate.
The Court found that, under sections 2036 and 2038. all assets transferred in the private annuity transaction must be included in Ms. Hurford’s estate.
Similar to the private annuity, in order for the FLPs to not be included in Ms. Hurford’s estate, the exchange of property for interests in the FLPs must be bona fide and for adequate and full consideration.
For the transfers to be considered bona fide, a legitimate, non-tax business purpose must exist. The Court found that in this case, asset management and asset protection were not significant non-tax purposes. Further support for the decision is provided by Ms. Hurford’s financial dependence on the FLPs’ distributions, the comingling of her own funds with those of the FLPs, and the delay in transferring the property to the FLPs. Even if the transfers were bona fide, the Court found that they were not for adequate and full consideration.
Furthermore, the Court found that, under section 2035(a) together with section 2036(a)(1), the Hurfords are not entitled to any discounts on the FLP interests. As they were not entitled to any discounts when calculating the monthly annuity payments, they are not entitled to any discounts when determining the amount now includable in the gross estate.
The Family and Marital Trusts
The Court also found that the Family and Marital trusts are includable in Ms. Hurford’s estate and no discounts are applicable. Although the trusts were carefully crafted and imposed an ascertainable standard on withdrawals, Ms. Hurford negated these requirements by exercising “general power” when she distributed the trust’s assets to herself, and then sold those assets in the private annuity agreement.
It is safe to say that Hurford will not be viewed as a landmark in the ongoing debate over Sec 2036 and related tax law provisions. Like all the other “bad facts” cases, it is instructive primarily as an example of what not to do. As shown above, the estate failed several tests – all in an area of tax practice where a one-strike policy applies. The estate planner has been criticized here for not obtaining appraisals in support of his discounts. This is indeed a great error. However, with all the errors made in the planning and execution of the transactions, substantiating the discounts would have been a waste of effort and fees. That, of course, could be said for the entire estate planning effort in this case.