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By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
Est. of Jorgensen v. Comr.,1 is a virtual textbook case of how not to implement a family limited partnership for estate planning purposes.
In March of 2009, the Tax Court, in a memorandum opinion,2 held that Erma Jorgensen's estate included assets that she transferred to family limited partnerships. There was no bona fide sale, and she retained control over the assets transferred. The decision was affirmed on appeal to the Ninth Circuit in a memorandum opinion (not for publication) that may not be cited as precedent.
Erma Jorgensen ("Decedent") died testate in California on April 25, 2002. She was the widow of Colonel Gerald Jorgensen, who was described by the court as a knowledgeable investor, and over the years the couple's portfolio of marketable securities grew to over $2 million through implementation of a "buy and hold" strategy.
Prior to Decedent's death, Colonel Jorgensen, in consultation with the family's investment advisor ("Arntson"), decided that he and his wife would form a family limited partnership. Neither Decedent nor her children ("Son" and "Daughter") were involved in any of these discussions. On May 15, 1995, Colonel Jorgensen, Decedent, Son and Daughter signed the Jorgensen Management Association (JMA-I) partnership agreement. The JMA-I partnership agreement states that the parties desired to pool certain assets and capital for the purpose of investing in securities.
On June 30, 1995, Colonel Jorgensen and Decedent each contributed marketable securities valued at $227,644 to JMA-I in exchange for 50% limited partnership interests. Son and Daughter, along with their father, were the general partners. Colonel Jorgensen and Decedent had six grandchildren, each of whom, with Son and Daughter, were listed as limited partners and received their initial interests by gift. Neither Son, Daughter, nor any of the grandchildren made a contribution to JMA-I, although each was listed in the partnership agreement as either a general or a limited partner. During his lifetime, Colonel Jorgensen made all decisions with respect to JMA-I. He died on November 12, 1996.
On January 29, 1997, Arntson wrote to Decedent regarding Colonel Jorgensen's estate tax return and her own estate planning. Arntson recommended that Colonel Jorgensen's estate claim a 35% discount on his interest in JMA-I. The estate's interest in JMA-I passed into Colonel Jorgensen's family trust. The family trust was funded with $600,000 of assets including JMA-I interests valued using minority interest and lack of marketability discounts. All amounts over $600,000 went to Decedent. Arntson also recommended that Decedent transfer her brokerage accounts to JMA-I, which, as he explained on more than one occasion: …will allow your estate to qualify for the discount available to ownership of interests in limited partnerships and at the same time, facilitate your being able to make annual gifts to your children and grandchildren. This is important if you wish to reduce the amount of your own estate which will be subject to estate taxes.
Although Arntson wrote to Decedent, he did not personally meet with her to discuss additional contributions to JMA-I. Instead, all planning discussions were among Arntson, Daughter, Daughter's husband, and Son. On the basis of these discussions, they decided to form JMA-II. On May 19, 1997, Arntson wrote to Decedent regarding the formation of JMA-II. He explained: To a certain extent we are trying to reorganize your assets and those of Colonel Jorgensen into two different groups—one grouping Jorgensen Management Associates Two (JMA2) will hold basically high basis assets and the second grouping (JMA) will hold basically low basis assets. In the future, you would primarily make gifts to your children and descendants from JMA2 which will hold high basis assets.
JMA-II was formed on July 1, 1997, when Decedent's children filed a certificate of limited partnership interest with the Commonwealth of Virginia. On July 28, 1997, Decedent contributed $1,861,116 in marketable securities to JMA-II in exchange for her initial partnership interest. In August 1997, she contributed $22,019 to JMA-II, consisting of marketable securities, money market funds, and cash. Also in August 1997, in her role as executrix of Colonel Jorgensen's estate, Decedent contributed $718,530 from his brokerage account, consisting of marketable securities, money market funds, and cash. Of the contribution, $190,254 was attributable to Decedent as it was Decedent's marital bequest from Colonel Jorgensen. After these contributions were completed, Decedent held a 79.6947% interest in JMA-II, and Colonel Jorgensen's estate held a 20.3053% interest. The children and grandchildren did not contribute to JMA-II. Son and Daughter were general partners, and Son, Daughter, and the grandchildren were listed as limited partners in JMA-II's partnership agreement. They received their interests by gift from Decedent.
Neither JMA-I nor JMA-II operated a business. They held passive investments only, primarily marketable securities. Daughter maintained the checking accounts for the partnerships, but they went unreconciled, and Son never looked at the check registers. Neither of the partnerships maintained formal books or records.
In July 1999, Son borrowed $125,000 from JMA-II to purchase a home. On July 25, 2001, Son made his first interest payment to JMA-II of $7,625. On August 7, 2002, he made a second and final interest payment of $7,625. Daughter believed that if Son did not repay the loan, she would take it out of his partnership interest. However, each of the partnerships required that all distributions be pro rata. After Decedent's death, on April 25, 2002, Son was advised to repay the loan in order to "clean up" the partnership in the event of an audit.
Although the partnership agreements stated that withdrawals shall only be made by general partners, Decedent was authorized to write checks on the JMA-II checking account, and she wrote checks on both the JMA-I and JMA-II accounts. In 1998, she signed several checks on the JMA-I account, including cash gifts to family members. On December 27, 1998, Daughter's husband wrote, and Decedent signed, a $48,500 check drawn on Decedent's personal account to purchase a Cadillac for Son. The parties characterized it as a loan which was forgiven in January 1999. However, the gift was not reported on a gift tax return in 1998 or 1999. On January 10, 1999, Decedent wrote a $48,500 check, drawn on the JMA-I account, to Daughter because Decedent wished to make an equalizing gift but did not have sufficient funds in her personal checking account. The gift to Daughter was not reported on a gift tax return.
Decedent also used the JMA-I account to pay her 1998 quarterly estimated federal taxes of $6,900 and her California state taxes of $2,290. The record does not indicate that these amounts were returned to the partnership, although the estate contends that JMA-I's federal tax return shows the amounts as due from Decedent. She also paid a portion of Colonel Jorgensen's estate's administration funds from the JMA-II account, as well as expenses relating to the filing of gift tax returns for 1999 and 2002.
On January 24, 2003, JMA-II paid Decedent's $179,000 federal estate tax liability and $32,000 California estate tax liability (as calculated by the estate).
In 2003 through 2006 JMA-I and JMA-II sold certain assets, including stock in Payless Shoesource, Inc., and May Department Stores Co., which Decedent had contributed to the partnerships during her lifetime. In computing the gain on the sale of those assets, the partnerships used Decedent'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 Decedent's date of death that would have been available had the assets been included in Decedent's gross estate. The JMA-I and JMA-II partners reported the gains on their respective individual income tax returns, and paid the income taxes due. Between April 6 and 9, 2008 (after the federal estate tax audit), the JMA-I and JMA-II partners submitted to respondent untimely protective claims for refund of 2003 income taxes paid on the sale of the assets Decedent contributed to the partnerships.
On these facts, the Tax Court determined, and the Ninth Circuit affirmed, that the assets Decedent transferred to the partnerships were includible in her gross estate for federal estate tax purposes under §2036(a) because: there (i) was no "bona fide sale for adequate consideration;" and (ii) Decedent retained an interest in the transferred property during her lifetime.
a. No Bona Fide Sale. The Tax Court and the Ninth Circuit both noted that the bona fide sale exception is not applicable where the facts fail to establish that the transaction was motivated by a legitimate and significant nontax purpose. In this case, observed the court, the reasons given by the estate for the transfers to the partnerships (management succession, financial education of family members, perpetuation of investment philosophy, pooling of assets, spendthrift concerns and providing equally for descendants) were either illusory, or could have been achieved through other, pre-existing, means. What little contemporaneous evidence in existence concerning the reasons for Decedent's transfers to the partnership indicated that "reducing the value of Decedent's taxable estate, and thus tax savings" was the primary reason for the transfers.
The Ninth Circuit also noted that the type of assets transferred (marketable securities) "did not require significant or active management, there was some disregard of partnership formalities, and the nontax justifications are either weak or refuted by the record (including formation of a second family partnership to hold higher-basis assets for gift-giving purposes, purportedly for the same nontax justifications that the original partnership could have already served)."
Both courts also cited the failure to maintain books and records, the unreconciled checkbook, the use of partnership assets to pay personal expenses and for gift giving as indications that the transfers were not motivated by a legitimate and significant nontax reason. The lack of an arm's-length relationship between the parties was also cited as an indication of no bona fide sale.
Notably, the government did not contend that the transfers were not made for "full and adequate consideration," having apparently given up, after several losses, on its "gift on formation" theory of partnership transfers,3 (perhaps in favor of its arguably more successful "step transaction" theory).4
b. Retained Interest. The Tax Court also concluded that Decedent retained the possession or enjoyment of, or the right to the income from, the property she transferred to JMA-I and JMA-II. This was evidenced in part by the use of partnership assets to pay Decedent's pre-death and post-death (estate taxes) obligations.
On appeal, the Estate did not contest the fact that Decedent retained some benefits in the transferred property (because she had written checks on partnership accounts to pay some personal expenses and make some family gifts), but argued - as it did not in the lower court - that these amounts should be considered de minimis or that the application of the section should be limited to the actual amount accessed by Decedent.
The Ninth Circuit found this argument to be "without merit." Citing Strangi v. Comr.,5the appellate court stated that "[w]e do not find it de minimis that decedent personally wrote over $90,000 in checks on the accounts post-transfer, … and the … partnerships paid over $200,000 of her personal estate taxes from partnership funds."
The appellate court also found it compelling that Decedent in effect had unlimited access to the partnership's accounts. The fact that she did not take advantage of her access to the fullest extent should not impact the result under §2036(a).
c. Equitable Recoupment. The Tax Court allowed the estate to recoup income taxes paid on the assets included in Decedent's gross estate that were attributable to the carryover basis of those assets, despite the technical running of the statute of limitations on the filing of a refund claim. The doctrine of "equitable recoupment" prevents "an inequitable windfall to a taxpayer or to the Government that would otherwise result from the inconsistent tax treatment of a single transaction, item, or event affecting the same taxpayer or a sufficiently related taxpayer." This issue apparently was not appealed by the government and was not addressed by the Ninth Circuit.
For more information, in the BNA Tax Management Portfolios, see Mezzullo, 812 T.M., Family Limited Partnerships and Limited Liability Companies, and in Tax Practice Series, see ¶4095, Family Business Entities.
3 See, e.g., Holman, Jr. v. Comr., 130 T.C. 170 (2008), Est. of Jones v. Comr., 116 T.C. 121 (2001), and Church v. U.S., 2000-1 USTC ¶60,369 (W.D. Tex. 2000), aff'd without published opinion, 268 F.3d 1063 (5th Cir. 2001).
5 417 F.3d 468, 477 (5th Cir. 2005). See also Est. of Bigelow v. Comr., 503 F.3d 955 (9th Cir. 2007); Est. of Erickson v. Comr., T.C. Memo 2007-107; Est. of Korby v. Comr., 471 F.3d 848 (8th Cir. 2006); Est. of Rosen v. Comr., T.C. Memo 2006-115; Est. of Thompson v. Comr., 382 F.3d 367 (3d Cir. 2004); Est. of Reichardt v. Comr., 114 T.C. 144, 151-152 (2000).
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