Estate of Jorgensen and Estate Inclusion of Family Limited Partnership Interests Under Section 2036

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By Kathleen Ford Bay, Esq.
Potts and Reilly, L.L.P.., Austin, TX

Estate of Jorgensen v. Comr., T.C. Memo 2009-66, is yet another in a long list of reported cases that indicate the scrutiny, and yes, hostility, that the IRS devotes to limited partnerships when the partners are all members of the same family. Jorgensen is a blueprint showing attorneys and accountants what not to do and serves as a warning to deter the timid.

Colonel Gerald Jorgensen (the “Colonel”), who died in 1996, had a distinguished career in the Air Force, from bomber pilot, to attorney with the Judge Advocate General's office, to its diplomatic corps. After retirement, he served as an aide to a U.S. Congressman. Erma Jorgensen (“Mrs. J”) worked as a school teacher and then became a full-time mother of two and housewife. The Colonel and Mrs. J were frugal and the Colonel became a knowledgeable investor who adhered to a “buy and hold” strategy, with a portfolio of marketable securities and bonds worth over $2 million at his death. Mrs. J was not interested or involved in financial matters.

Enter the helpful experts. Estate Planning Attorney Number 1 (“Attorney No. 1”) helped the Jorgensens create revocable trusts and durable powers of attorney in 1994, with an amendment to Mrs. J's revocable trust in 1997. In 1995, the Colonel created Jorgensen Management Association (“JMA-I”) after consulting with Attorney No. 1. None of Mrs. J or their two children were involved in these discussions; although the Colonel and his children were the general partners and the Colonel, Mrs. J, the two children, and six grandchildren were the limited partners. Only the Colonel and Mrs. J contributed to JMA-I, about $230,000 each for 50% limited partnership interests. In a footnote regarding the interests listed as being owned by the limited partners, the Tax Court noted that while these interests are referred to as “gifts,” the use of that term is “for convenience only. We do not intend to imply that Colonel and Ms. Jorgensen's transfers of limited partnership interests were completed gifts for Federal tax purposes.”

The next part of the opinion shows that the Tax Court reviewed copies of letters from Attorney No. 1 to Mrs. J. Attorney No. 1 wrote Mrs. J that for the Colonel's estate, Mrs. J ought to take a 35% discount on the assets in JMA-I. (There is no indication that there was ever an independent appraisal.) Mrs. J followed Attorney No. 1's advice and funded the family trust with $600,000 of assets, including JMA-I assets at their value using the attorney-recommended minority interest and lack of marketability discounts. Everything else from the Colonel's estate went outright to Mrs. J.

Then Attorney No. 1 recommended that Mrs. J transfer her brokerage accounts to JMA-I, to get a discount both when she made gifts of partnership interests and in her estate. However, even though Attorney No. 1 wrote to Mrs. J, he only talked to her son, daughter, and son-in-law. Mrs. J's children and son-in-law decided to form a second entity (“JMA-II”). Attorney No. 1 wrote Mrs. J about this, explaining that low-basis assets would be in JMA-I, high-basis in JMA-II, and Mrs. J would give JMA-II interests to her children and grandchildren.

Mrs. J first contributed about $1.8 million to JMA-II in marketable securities and then shortly after that another $22,000 in marketable securities, money market funds, and cash, plus about $190,000 from the Colonel's brokerage account that she received upon his death. As Executor, Mrs. J also invested in JMA-II, with the result that she owned 79.69% and the Colonel's estate owned 20.31%. Although they did not contribute to JMA-II, Mrs. J's two children were listed as general partners and the children and grandchildren were listed as limited partners in the partnership agreement. Mrs. J started gifting interests in JMA-II to her children and grandchildren, using November 1996 values, even though the gifts were being made in mid-1997. Mrs. J did not file any gift tax returns, even though the values exceeded the then annual gift tax exclusion.

Enter Estate Planning Attorney Number 2 (“Attorney No. 2”). Mrs. J's daughter consulted Attorney No. 2 about Mrs. J transferring limited partnership interests in JMA-II equal to Mrs. J's estate and gift tax exemption, which was then $650,000.00. In October 1998, Attorney No. 2 wrote Mrs. J about discounts, noting that she would need to hire an expert appraiser “to have any chance of justifying the discounted value of a limited partnership interest if a gift or estate tax return is audited.” Later that month, Attorney No. 2 requested such an appraisal of a 1% interest in JMA-II, stating “[t]he partnership's sole activity is to hold and invest securities.”

There was little, if anything, done to keep the JMA-II separate from Mrs. J's personal matters. Even though she did not need the assets day-to-day, she used them as a fall-back for her personal affairs and to make gifts of cash to family members, and she had check-writing privileges on the accounts for both partnerships. The general partners did not reconcile checking accounts and one of them never even looked at check registers. (The son was apparently quite honest when deposed about his understanding or misunderstanding of the partnerships, his borrowings from them, and the like.) Attorney No. 2 billed partnership and personal legal work on one bill, not separately.

Mrs. J died in 2002. In 2003, her children paid the Federal and California estate tax liabilities (as they had calculated them) from JMA-II: $179,000 and $32,000, respectively. The IRS assessed a deficiency of nearly $800,000. After concessions, two issues were presented to the Tax Court: (1) whether the values of assets Mrs. J transferred to JMA-I and JMA-II were included in her estate under §2036(a), and (2) whether the estate should get “equitable recoupment” (an interesting issue, but one which had little financial effect, presumably, and is not discussed further in this analysis).

Factors that persuaded the Tax Court, using a preponderance of the evidence rule, to tax the value of the assets Mrs. J transferred to the two partnerships (63.124% in JMA-I and 79.69% in JMA-II) in Mrs. J's estate under §2036(a) are:

(1) The assets in each partnership consisted entirely of marketable securities, cash, and bonds. There was no active management.

(2) Mrs. J showed no interest in the partnerships' activities.

(3) Partnerships were not needed to help Mrs. J manage assets, were not needed for centralized control, because she had a revocable trust and a power of attorney, and management could easily be accomplished through these documents.

(4) Having the securities in partnerships did not result in an economy of scale pooling of assets, lower operating costs, less need for administrative compliance, and better attention from service providers. The government's attorneys called on the family's investment advisor, who testified that simply by linking investment accounts family members would have received the same attention. The court itself noted that “[w]e also doubt that giving securities to each of the children and grandchildren would have been less costly or complicated than creating two limited partnerships, each registered with the Commonwealth, requiring registered agent, annual report to the Commonwealth, and the filing of annual Federal income tax returns and Schedules K-1.”

(5) Partnership formalities were not followed - a requirement that pro rata distributions be made was ignored; the son, who was a general partner, borrowed for personal expenses (a home) and did not fully appreciate that partnerships were entities separate from the family and that gifts should not be made from them. Mrs. J, though not financially dependent on the partnerships for her day-to-day expenses, looked to them for distributions when she did not have enough cash to satisfy her gift-giving.

(6) All the non-tax reasons given for Mrs. J forming the partnerships were not given contemporaneously with their formation, and as to Mrs. J, could not have been, as she was not the one directing the lawyers. The relevant correspondence was written well after formation and funding “by [Attorney No. 2] preparing for potential litigation with respect to the gift. Thus, we give it little weight.”

(7) “The use of a significant portion of partnership assets to discharge obligations of a taxpayer's estate is evidence of a retained interest in the assets transferred to the partnership.” So, paying estate taxes out of JMA-II indicated to the Tax Court that Mrs. J retained possession and enjoyment of the assets representing those partnership interests.

There are several lessons to be learned from the Jorgensen case. If a client is a member of a family limited partnership, expect that the IRS is going to look closely at the valuation of the interests in that partnership. The client should also expect an estate tax audit, and should budget for the legal expenses. The attorney should expect that nothing in writing will be protected by the attorney-client privilege. It is also essential to let appraisers who are experts do their jobs and attorneys should not just say, “it looks like a 35% discount can be taken and then we'll negotiate it down if audited.”

In the planning stages, attorneys should not focus clients on discounts - discounts might be an ancillary result of the planning done by the family for other reasons, which the IRS will analyze. The partners should be involved in the planning process and not just sit idly by and sign when shown the signature line. The partners should discuss the business aspects of the partnership arrangement - whether it is an active business or not, focusing on the pros and cons of restructuring the way business and investment activities are currently being conducted and how they will change if a partnership is used. If other partners can actually contribute assets to the partnership rather than waiting to receive interests by gift, that also sits better with the IRS. Another practice point is that the attorney, accountant and financial advisors bill the partners and the entity separately, depending on who is receiving the advice.

There are also lessons to be learned about gifting. If gifts are made, the client should get a qualified appraiser to set the value of the gifts and file gift tax returns if the value exceeds the annual gift tax exclusion, and maybe even if the gift does not. This case also highlights that it is essential to observe the governing documents of the partnership - do not make non pro rata distributions if they are not allowed. Attorneys should analyze for the client if making gifts of partnership interests is going to be simpler than if undivided interests in the underlying assets are given. It is also essential to plan ahead whether having assets preserved through the partnership will aid in making monies available for the education of younger family members who are presumably limited partners or whether these assets should be maintained in another more easily accessible form of ownership for these eventual education needs.

The Tax Court has said, many times now, that “taxpayers often disguise tax-avoidance motives with a rote recitation of nontax purposes.” If an IRS officer looks at the partnership and does not immediately see and understand the nontax planning reasons for the partnership's existence, there will be a major difference of opinion and probably quite a fight. The Tax Court highlights that if there are other methods for the pooling of assets to save in investment fees, the partnership purpose of saving investment fees will be questioned. Also, a generic purpose of creditor protection will not be a persuasive partnership purpose if none of the partners have legitimate creditor concerns. Very general creditor protection concerns will not be sufficient. Of course, once a creditor is more than theoretical, fraudulent conveyance statutes may prohibit planning.

Clients who want to establish a limited partnership with family members should read the Jorgensen case (or another, but Jorgensen is quite readable) before going forward. Perhaps the client should have a “due diligence” check done on a regular basis, either by the general partner(s) or an outside accountant or lawyer, to make sure that the partners are using the partnership properly. Rest assured, the IRS will continue to challenge family limited partnerships.

For more information, in the Tax Management Portfolios, see Mezzullo, 812 T.M., Family Limited Partnerships and Limited Liability Companies, and in Tax Practice Series, see ¶6350, Estate Planning.