Probate and Trust Article
Erickson Extends §2036 to Using Partnership Funds to Pay Decedent’s Estate Taxes
Summary prepared by: Steve R. Akers, Bessemer Trust
Copyright © 2007 by Bessemer Trust Company, N.A. All rights reserved.
Estate of Erickson v. Commissioner , T.C. Memo 2007-107 is another §2036 victory for the IRS in a “terrible facts” case. The case is particularly interesting in that the retained enjoyment of the partnership was the use of partnership funds to pay estate taxes (albeit through the purchase of an estate asset and a redemption of part of the estate’s interest). However, the case was surrounded with other facts that made readily apparent that the only purpose of the partnership was to try to secure an estate tax discount.
1. The decedent was an Alzheimer's patient in poor health in her 80s when the partnership was created.
2. There was a delay in funding, including scurrying to fund interests in several condos on the decedent's deathbed.
3. The decedent had two daughters, one of whom managed the decedent's affairs under a power of attorney and acted under the power of attorney to create and fund the partnership and (on the decedent’s deathbed) to make gifts of partnership interests.
4. The other daughter (who was also a partner) testified that she did not understand anything about the particulars of the partnership except that it saved taxes.
5. 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; the decedent initially acquired an 86% limited partnership interest.
6. There was also a $1.0 million credit shelter trust for the decedent that had been created at her husband's prior death.
7. 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%.
8. 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.
9. Post-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 partnership for $123,500 and the partnership redeemed some of her partnership interests for $104,000. This is the money from the partnership that the estate used to pay part of the estate and gift taxes.
Bona Fide Sale for Full Consideration Exception to §2036
(The court analyzed the section 2036(a)(1) application before addressing whether the bona fide sale exception applied. Instead, I will first summarize the bona fide sale exception discussion.)
The court first gave the obligatory regurgitation of general factors bearing on whether a legitimate and significant nontax reason existed for the partnership. The court listed the following factors: (1) “Standing on both sides of the transaction” (one daughter did everything regarding creation and funding of the partnership); (2) Financial dependence on distributions from the partnership; (3) Commingling of partnership and personal funds; (4) Failure to transfer assets to the partnership; and (5) Just serving as a vehicle to change the form of the investments, a "mere asset container." [That last factor is a throwback to the Tax Court’s “recycling of value” theory of the full consideration requirement before Bongard, but now called the “mere asset container” theory and now applying to the bona fide requirement rather than to the full consideration requirement.]
The court next rejected the estate’s purported non-tax reasons for the partnership. (1) Centralized management – the management of the investment portfolio and condominiums did not change after the assets were contributed to the partnership. (2) Creditor protection – the court’s one sentence response reflects that the court does not at all understand (or refuses to understand) the potential asset protection advantages of a limited partnership: “A creditor who sought funds from the partnership, however, would have a significant asset base from which to recover from the partnership, over $2 million.” [That’s beside the point. The point is that a limited partner’s creditors generally cannot reach inside the partnership and get access to partnership assets.] However, the facts of the case do not reflect any particular creditor concerns. (3) Facilitating gift giving – which the court says is not a significant nontax purpose.
The court emphasized that all facts and circumstances must be reviewed to determine whether the transaction is bona fide. The Court pointed to the following factors, among others, to conclude that the bona fide test is not satisfied:
- Partnership consisted mainly of passive assets (including marketable securities and rental properties)
- Same managers as before the partnership was created.
- Making loans to family members of the partnership on favorable terms.
- Partnership was planned unilaterally by one daughter.
- Same law firm represented all partners in the creation and funding of the partnership.
- Delay in funding – the key seemed to be scurrying around on the decedent’s death bed to complete the funding (suggesting testamentary motivations).
- Financial dependence – $227,000 of partnership assets were used to pay estate taxes; the disposition of cash from the partnership was characterized partly as a purchase of the decedent’s residence and partly as a redemption, but the form is not controlling.
Section 2036(a)(1) Application
The court mentioned many of the same factors as in the bona fide test analysis. It gave the following list of general factors that courts have previously considered in determining whether a decedent impliedly retained the right to possession and enjoyment of transferred assets: “co-mingling of funds, a history of disproportionate distributions, testamentary characteristics of the arrangement, the extent to which the decedent transferred nearly all of his or her assets, the unilateral formation of the partnership, the type of assets transferred, and the personal situation of the decedent."
The court noted the delay in funding the partnership (suggesting a failure to respect formalities of the partnership) and then the scurry to complete the funding of the decedent’s and other family members’ contributions on the decedent’s deathbed: There was “no hurry to alter their relationship to their assets until decedent’s death was imminent.”
The court emphasized particularly 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 as 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."
The partnership had little practical effect during the decedent's life and was mainly an alternative method to provide for the decedent’s heirs.
The court concluded that no one factor is determinative, but the court must consider all facts and circumstances. The court's summary seems to emphasize its “smell test” problem with the partnership: "The transaction represents decedent’s daughters’ last-minute efforts to reduce their mother's estate’s tax liability while retaining for decedent the ability to use the assets if she needed them.”
Key Planning Points from Erickson
1. The partnership involves a transfer of all liquid assets from an Alzheimer's patient in her 80s and in poor health by her daughter acting under a power of attorney, with some transfers and gifts being made on her deathbed. Expect the IRS to try to grab the low hanging fruit.
2. This is the first case to focus on the post-mortem use of partnership assets to pay estate tax liabilities. (The Fifth Circuit Strangi case addressed post-mortem 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, and indeed there was $1 million in a credit shelter trust for her support. This suggests keeping assets outside the partnership to pay for living expenses and anticipated post-death expenses, including estate taxes (or at least a substantial part of them). Query whether future cases will similarly focus on the use of partnership assets to pay estate taxes, even when the payment occurs in a sale and redemption transaction.
3. This raises an interesting question—what if the estate had retained enough assets to pay the gift and estate taxes? Would the transfer of substantial assets to the partnership, even on the decedent’s deathbed, have avoided the application of §2036 when there was no other evidence of an implied agreement for retained enjoyment of the assets (i.e., because the $1.0 million in the bypass trust was enough to provide all of her living expenses for her life)? The estate could not have satisfied the bona fide sale exception (for the same reasons described above), but arguably there is no retained enjoyment of the partnership assets (express or implied) that would trigger the application of §2036(a)(1).
4. The IRS in prior cases has tried to argue that the partnership’s payment of estate taxes could constitute §2036(a)(1) retained enjoyment. For example, the Estate of Bassler case (U.S. Tax Court, Docket 003532-02 (filed February 14, 2002)) was tried before Judge Thornton. The decedent contributed about $35 million to the FLP and kept about $6 million for living expenses. The IRS argued that she needed to retain assets to live on AND to pay estate taxes in order to avoid §2036(a)(1). The IRS wanted to introduce into evidence a cash flow summary including estate taxes (which the court did not allow to be introduced into evidence). (The case was settled after trial.) While the IRS has tried to make this argument previously, Erickson is the first case that explicitly focused on the payment of estate and gift taxes as the §2036(a)(1) trigger.
5. The question often arises as to how best to pay estate taxes if the estate does not have sufficient liquidity without using partnership assets. In this case, structuring the transaction as a purchase of an estate asset and as the redemption of the estate’s interest in the partnership did not avoid the §2036(a)(1) taint. Using a loan, purchase, or redemption would still seem far preferable to merely having the partnership make a large distribution to the decedent’s estate to get cash to the estate for paying estate taxes. If possible, it would be preferable for the estate to borrow the needed funds from a third party or from the beneficiaries. Another alternative would be to have third parties (perhaps family members or related entities) purchase limited partnership interests in the FLP from the estate to generate estate liquidity.
6. Management activities for some assets contributed to the partnership should change if centralized management is a nontax purpose of the partnership.
7. This is yet another case mentioning a lack of negotiations, the fact that one partner planned the entire transaction, and that the same law firm represented all parties.
8. This is also another case mentioning disproportionate distributions, but the court particularly focused on the fact that distributions were made only to the decedent (really the decedent's estate).
9. Finally, this is yet another case (reminiscent of Rosen) in which the court failed (or refused) to understand the potential asset protection advantages of owning limited partnership interests rather than owning assets directly.