Originally published on Forbes.com.
When one of the founding partners of a regional law firm has the firm’s estate group handle his planning, they are likely to do a pretty good job. That may well be the moral in the Tax Court decision in the case of the Estate of Barbara M. Purdue. I look at the case as another illustration of Reilly’s Fourth Law of Tax Planning – Execution isn’t everything, but it’s a lot.
The IRS was looking for over $4 million in estate and gift tax from Mrs. Purdue’s estate. She died at the age of 95 in 2007 and had some colorful items in her biography. During WWII she was a Red Cross hospital aide on the USS Comfort, the only hospital ship ever struck by a Kamikaze. Her husband Robert, one of the founders of Seattle law firm Montgomery Purdue Blankinship & Austin PLLC died in 2001. They had five children and in the words of the decision “multiple grandchildren and great-grandchildren”. As of 1999, their net worth was approximately $28 million mostly marketable securities and also an interest in a commercial building in Hawaii (the Hocking Building).
The Plan
Mr. and Mrs. Purdue had engaged Alan Montgomery to work on their estate plan in 1995. In the decision they are referred to as “the parents”. Montgomery’s recommended a family limited partnership to centralize management and take advantage of valuation discounts. In 2000, PFLLC was created and capitalized with $22 million in marketable securities and some other assets including the interest in the Hocking Building valued at $900,000
Also in 2000, PFT, a trust was formed. The trust beneficiaries were the descendants and their spouses. The agreement provided the beneficiaries with Crummey withdrawal rights. From 2002 till 2007 Mrs. Purdue made annual exclusion gifts of interests in PFLLC to PFT based on the number of beneficiaries on January 1 of each year and additional gifts on December 31 if there were more beneficiaries or the LLC value had dropped. At the time of her death Mrs. Purdue owned about 25% of the LLC, 42% was in a QTIP, 5% in a Bypass Trust, 7% owned outright by the children, and 21% by PFT.
Conflict
The problem with family limited partnerships is that they involve, you know, families. The five siblings had some issues to work out when it came time to pay the taxes.
Mr. Montgomery sent a letter to the Purdue children dated August 18, 2008, explaining the options for paying the estate tax liabilities, including a $6,245,744 loan from the PFLLC to the estate and the QTIP Trust or a $9,863,571 dividend from the PFLLC. The Purdue children’s rights were limited. The members of the PFLLC could not transfer their interests without unanimous consent by the other members. Beverly refused to approve a PFLLC dividend sufficient for the estate and the QTIP Trust to pay their estate tax liabilities with their proportionate shares in order to induce her siblings to approve a large lump-sum PFLLC dividend that she wanted but that they opposed (deadlock). For the same reason, she also refused to approve PFLLC dividends necessary for the QTIP Trust and the Bypass Trust to pay their income tax liabilities. The $5,040,090 of combined PFLLC dividend shares of the estate and the QTIP Trust was insufficient to pay their estate tax liabilities. The remaining distributees aggregated their distributions and made loans totaling $1,233,897 to the estate and the QTIP Trust.
The IRS challenged the estate’s deduction of $20,891 in interest on the loan. The Court allowed the deduction.
IRS Attack
The IRS argued that the transfer of property to the LLC was not a bonafide transfer for adequate consideration. The Court did not buy that. And this is the part that you should really look at.
Other factors, however, support the estate’s argument that a bona fide sale occurred. First, decedent and Mr. Purdue were not financially dependent on distributions from the PFLLC. Decedent retained substantial assets outside of the PFLLC to pay her living expenses. Second, aside from a minimal dollar amount across three deposits to the PFLLC account, there was no commingling of decedent’s funds with the PFLLC’s funds. Further, the formalities of the PFLLC were respected. The PFLLC maintained its own bank accounts and held meetings at least annually with written agendas, minutes, and summaries. Third, Mr. Purdue and decedent transferred the property to the PFLLC. Lastly, the evidence shows that decedent and Mr. Purdue were in good health at the time the transfer was made to the PFLLC. (Emphasis added.)
There were other signs of good execution mentioned.
Since 2001 the Purdue children have held annual meetings in their capacities as trustees and beneficiaries of the PFT and the Purdue Testamentary Trusts, personal representatives and beneficiaries of the parents’ estates, attorneys in fact for the parents, and individual members of the PFLLC. They discussed the Purdue family’s accounts and assets, ratified prior PFLLC distributions, approved annual cash distributions, heard presentations from the Rainier Group investment manager, and received estate tax planning updates and advice from Mr. Montgomery.
The IRS also attacked the Crummey gifts arguing that interests in PFLLC were not “gifts of a present interest”. The Court did not buy the IRS argument mainly because the LLC was producing income.
First, the PFLLC held an interest in the Hocking Building, subject to a 55-year lease, expected to generate rent income, as well as dividend paying marketable securities. Second, the PFT made annual distributions from 2000 through 2008, totaling $1,997,304. Further, the PFLLC operating agreement and applicable State law impose a fiduciary duty on the PFLLC to make proportionate cash distributions sufficient for the QTIP Trust and the Bypass Trust to pay their income tax liabilities.
Stop Stalling
I find this decision particularly apt for opening 2016 although it would have been better for closing 2015, which it would have had I been a little more diligent. My second blog post ever over six years ago was a discussion of family limited partnerships, that hammered home the point that that good execution is critical with them starting with the post’s title – Devil Is In The Details.
The reason this is timely is that people considering family limited partnerships should probably act sooner rather than later. The IRS may be attacking the method with regulations soon as this post by Pasquale Rafanelli explains.
According to a senior IRS official, Leslie Finlow: “Guidance on restrictions on estate valuation discounts for certain corporations and partnerships is expected very soon and won’t be based on previous administration proposals. Tax code Section 2704(b) gives the Treasury Department the power to issue new regulations disregarding additional restrictions on liquidations of interests if the restrictions reduce the value of the transferred interest but not the value of the interest to the transferee.”
Finlow further indicated: “that the Internal Revenue Service isn’t looking to a 2013 Obama administration proposal that called for further restrictions on valuations of family business interests.” Instead, she said the guidance will focus on “the statute as it looks now.”
The sooner you start with the FLP, the more opportunity there is for gifting. Also with a mega-gift you will be sure of being able to use the current $5,450,000 exemption. Bernie Sanders would like to cut that back to $3.5 million. Lots of people discount Bernie’s chances, but he is going strong in New Hampshire and Iowa and polls well against Donald Trump.
Other Coverage
There is the argument that the Purdue decision does not teach us anything new. That is why Lew Taishoff told me that he was not covering it and then went on to post an explanation of why he wasn’t covering it and send people to my blog three days early. Ed Zollars managed to squeak in during 2015 – also focusing on execution.
CPAs involved with taxpayers like the Purdues should note that the Court spent little time on the documents in this case, but rather concentrated on the detailed facts, including what the taxpayers did and, for purposes of the present interest test, the nature of the assets in the entity.
While poorly drafted documents certainly can eliminate estate and gift tax benefits, the reverse is not true. Even the highest quality estate planning documents drafted by the most skilled attorney will not save the tax benefits if the facts don’t support the benefits. Key facts include how the family actually treats the entity in question and, for purposes of present interest gift exclusions, whether there is an actual realistic expectation of a current cash flow from the entity.
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