05/01/2007 E-alert – IRS Uses Payment of Estate Tax to Win Family Limited Partnership Case
Estate of Erickson v. Commissioner, T.C. Memo 2007-107, was another “bad facts” case in which the IRS convinced the Tax Court to disregard the existence of the Family Limited Partnership because of application of IRC § 2036. The Service was thereby able to pull all of the partnership assets back into the estate at full value for estate tax purposes.
The facts of the Erickson case were as follows:
1. At the time she created her Family Limited Partnership, the decedent was in poor health and in her 80s.
2. The decedent had also been diagnosed with Alzheimer’s Disease prior to the date the partnership was created.
3. There was a delay in transferring assets to the partnership, including scurrying to fund interests in several condominiums on the decedent’s deathbed.
4. The decedent had two daughters, one of whom managed the decedent’s affairs under a power of attorney.
5. The daughter, acting as agent under the power of attorney, created and funded the FLP and made gifts of partnership interests on the decedent’s deathbed.
6. The other daughter (who was also a partner) testified that she did not understand anything about the particulars of the partnership except that it was supposed to save estate taxes.
7. The partnership was funded with almost all of the decedent’s liquid assets (including $2,000,000 of marketable securities) and interests in several condominiums.
8. The decedent’s pre-deceased husband left his assets in a credit shelter trust, which had approximately $1 million in it at the time of the decedent’s death.
9. Two days before the decedent died, the daughter (acting under the power of attorney) scrambled to convey the various interests in condominiums to the partnership and to make gifts to the decedent’s grandchildren, reducing the decedent’s percentage of the partnership from 86% to 24%.
10. The partnership assets had the same managers of the investment portfolio and the same management company managing the condominiums as before the partnership was created.
11. After the decedent’s death, partnership funds were used to pay part of the decedent’s estate and gift taxes. The estate sold the decedent’s home to the FLP for $123,500 and the partnership redeemed some of her partnership interests for $104,000. The estate used this money from the Sale to the partnership to pay part of the estate and gift taxes.
The Court pointed to the following factors, among others, to conclude that the bona fide test under IRC § 2036 is not satisfied:
- The partnership consisted mainly of passive assets (including marketable securities and rental properties).
- The assets were managed by the same managers before and after the creation of the Family Limited Partnership.
- Loans were made to family members on favorable terms.
- The Partnership was planned unilaterally by one daughter.
- The same law firm represented all partners in the creation and funding of the partnership.
- The court viewed the delay in funding and last minute transfer of assets as evidence of testamentary motivations.
- The estate used $227,000 of partnership assets to pay estate taxes.
Of special interest is how the court emphasized that the partnership provided funds for payment of the estate tax liabilities. (The only liabilities mentioned in the case were gift and estate tax liabilities.) The court viewed that as tantamount to making funds available to the decedent. Although the disbursement was implemented as a purchase of assets from the estate and a redemption, “the estate received disbursements at a time that no other partners did. These disbursements provide strong support that Mrs. Ericsson (or the estate) could use the assets if needed.”
This is the first case to focus on the use of partnership assets to pay estate tax liabilities. (The Fifth Circuit Strangi case addressed use of partnership assets to pay estate liabilities, but did not focus on the payment of estate and gift tax liabilities.) Apparently, there were no distributions from the partnership to the decedent during her lifetime – there was approximately $1 million in a credit shelter trust that presumably provided income, and potentially distributions of principal for the decedent’s health, education, maintenance and support.
In light of this case, conservative estate planning attorneys may plan for the client to retain sufficient assets outside the Family Limited Partnership to pay for living expenses, and at least a significant portion of the anticipated estate taxes. That said, it is impossible to know if the court would have ruled the same way if the case had not been surrounded by so many other bad facts.