Originally published on Forbes.com.
Estate planners will want to take a close look at the Tax Court decision in Estate of Sarah D. Holliday. It is an instance of the IRS attacking a family limited partnership discount and winning in a case where the execution of the plan was not really that weak. This decision makes me nervous about getting discounts for any family limited partnership that consists solely of marketable securities.
It Is All About The Discounts
I’m going to cut through the bovine excrement here and outright say that the reason for most family limited partnerships is to get substantial discounts in estate valuation. Of course for the plan to work you need other reasons which tend to be more in the nature of plausible excuses. Failure in that area is probably the reason for the Holliday estate failing to get its discount, but frankly I thought they had good enough facts to win. If you have an ounce of intellectual integrity you will admit that they deserve to lose, but so does just about everybody who fights these cases.
How Does It Work?
So you have $5,000,000 of marketable securities and you give away 1% of them. The remainder you might think is worth $4,950,000 and that is certainly a reasonable answer. But dress it up a little. Put the marketable securities into a limited partnership and make the 1% the general partner interest. True if you liquidated the thing you would end up with $4,950,000, but you are only a limited partner now. You can’t force a liquidation. Oh and there are restrictions on transferability so you can’t sell your limited partnership interest to just anybody. So when we value your limited partnership interest, there is a discount for lack of control and a discount for lack of marketability and maybe some other discounts. The limited partnership interest is worth maybe $3.5 million tops less if you are more aggressive creating substantial estate tax savings.
How It Went
In the Holliday estate, the IRS was seeking an additional $785,019 in estate tax by ignoring the transfer that Ms. Holliday had made to Oak Capital, a limited partnership in 2006. Ms. Holliday had been living in the Richard Place nursing home since 2003. She had granted her sons Joseph Holliday, referred to as Mr. Holliday and Dr. H. Douglas Holliday, referred to as Dr. Holliday powers of attorney. The impulse to fill the rest of the post with gunfight at the OK corral references borders on the irresistible, but I will resist – well mostly.
Also formed was OVL Capital Management LLC to serve as Oak Capital’s GP. Ms. Holliday sold OVL to Mr. Holliday and Dr. Holliday. They paid $2,954.84 each which worked out in total to the 0.1% of Oak’s capital owned by the GP. She also transferred a 10% limited partnership interest to a trust leaving her with 89.9%.
At July 7, 2009, the alternate valuation date for the estate, the assets in the partnership were worth $4,064,759. Ms. Holliday’s 89.9% interest was valued at $2,428,200. I make that to be a discount of 1/3 which is pretty middle of the road as these things go.
Reasons Not Good Enough
The IRS, of course, thought the correct discount was zero. They were not impressed by the “business” reasons for the formation of the partnership and the Tax Court went with the IRS.
We must determine whether decedent had a legitimate and significant nontax reason for creating Oak Capital. The estate argues that three significant nontax business purposes prompted its creation: first, to protect the assets from “trial attorney extortion”; second, to protect the assets from the “undue influence of caregivers”; and third, to preserve the assets for the benefit of decedent’s heirs.
As far as the “trial attorney extortion” went:
We are unconvinced that this was an initial motivation for Oak Capital’s formation. Decedent had never been sued, and, more importantly, she continued to hold significant assets that were not transferred to Oak Capital which would have been equally enticing for a person attempting to extort something from a wealthy elderly woman. As we have in other cases where a similar purpose was asserted, we agree with respondent that this was simply a theoretical justification and was not a legitimate and significant nontax reason for Oak Capital’s formation.
On the caregivers, the family had some horror stories to buttress the concern, but the Court was unimpressed:
Although it is possible for the elderly to be wrongfully targeted, the circumstances of this case do not persuade us that this was a legitimate and significant nontax reason for decedent’s transfer of assets to Oak Capital. We cannot accept that experiences with Mrs. Jones’ caregiver were a motivation in this case for the transfer of selected assets to Oak Capital. Decedent and Mrs. Jones were not similarly situated. Other than a grandson that lived over 1,000 miles away, Mrs. Jones had no immediate family. Decedent had two adult children who were both involved in managing her affairs, and Dr. Holliday visited her at least once a week. Mr. Holliday’s testimony about how his grandfather’s caregiver and his mother’s caregiver had stolen from their family is also unconvincing. Theft is distinct from undue influence, and simply changing the titleholder of assets will not necessarily protect them from theft.
The preservation of assets did not work either.
On the basis of the facts and circumstances we are unconvinced that the formation of Oak Capital was for a legitimate and significant nontax reason. Apparently, other structures were considered but were “quickly dismissed” because they would have been difficult to manage and use to “do certain things”. We find these reasons unconvincing, particularly in the light of the fact that Joseph H. Holliday, Jr.’s assets were held in trusts and there were no issues with the management of these assets. Further, decedent was not involved in selecting the structure used to preserve her assets. Dr. Holliday testified at trial that decedent was “fine” with whatever he, his brother, and the attorney decided on.
And That’s Not All
I indicated that the execution on this partnership was not that bad, but there were some more negatives cited by the Tax Court that would not have been hard to fix.
As respondent points out, decedent stood on both sides of the transaction. She made the only contribution of capital to Oak Capital and held, directly or indirectly, a 100% interest in the partnership immediately after its formation. Subsequently, on the same day decedent assigned her interest in OVL Capital to her sons in exchange for its fair market value. There was no meaningful negotiation or bargaining associated with the formation of the partnership.
I don’t know if it would have help a lot, but there could have been contributions in some amount by others besides Ms. Holliday on formation.
There were other formalities that were treated lightly.
Oak Capital also failed to maintain books and records other than brokerage statements and ledgers maintained by Mr. Holliday. The partners did not hold formal meetings, and no minutes were kept. As discussed above, despite the provisions of section 5 of Oak Capital’s limited partnership agreement, Oak Capital made only one distribution before decedent’s death. This was not the only portion of Oak Capital’s limited partnership agreement that was ignored. Section 9 of Oak Capital’s limited partnership agreement provides that “xcept as otherwise provided in this Agreement or a separate written document executed by all of the Partners, the General Partner, or any one (1) of them shall receive reasonable compensation for managing the affairs of the Partnership.” A separate written document was not introduced as evidence or discussed at trial, and no payments were ever made to OVL Capital.
Could It Have Worked?
The execution of this partnership could have been better, but compared to some it was not that bad. There was nothing like assets not being registered in the right name or distribution going the wrong way and the like. It is worth comparing this to the Purdue decision in January. The IRS attacked on the same basis, but the taxpayers prevailed. A couple of the differences were that the decedent and her husband had formed the partnership and that annual meetings with minutes and the like were held. Also there was some rental real estate in the partnership. Barbara Purdue’s husband had been the founding partner of a regional law firm, so the strong execution there is not surprising.
The Holliday decision does not make me despair when it comes to marketable security family limited partnerships, but advisors should really push for strong execution.I mean if you are saving near a million or more in transfer taxes, spring for a couple of thousand to get a good general ledger. Have a couple of meetings. And make sure you read that partnership agreement and do what it says.
Other Coverage
Lew Taishoff covered the case. His post was titled Boilerplate Is A Hazardous Substance referring to a detail in the decision, I passed over.
The late Sarah has a 99.9% limited partner’s interest in said FLP, and did get a check. Once.
Mox nix, argue Joseph H. and H. Douglas. “When asked at trial what he believed the term ‘operating needs’ meant, Mr. Holliday testified: ‘t seemed to me when I reviewed this document, when it was signed, that it was created, that this seemed to come from some sort of boilerplate for Tennessee limited partnerships, this sort of gave you broad powers to do anything you needed to do, including make distributions. But that wasn’t necessary. No one needed a distribution.” 2016 T. C. Memo. 51, at p. 10.
Sorry, Joseph H., that’s enough to sink you. ……
Takeaway—Remember the “TEN DOLLARS and other good and valuable consideration” blowing up a conservation easement deduction. Watch those boilerplate provisions. Boilerplate can be hazardous to your tax health.
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