Estate planning strategies such as family limited partnerships and gifts to charitable trusts are part of an estate planning professional's toolbox to achieve client goals such as minimizing taxes, effectuating philanthropic plans, teaching younger generations about a family business and passing on wealth. In the best-case scenario, attorneys and their clients have time to review how the plan will work, allow younger generations to evaluate their role in the plan, evaluate the goals it will achieve, and recognize any risks associated with the plan. Whether a client's estate is of a significant amount or of a more modest size, recent experience with COVID-19 highlights the need for individuals to take care of their planning while they have time to consider all issues involved versus rushing to implement a plan when there is a serious illness or fear of one driving their actions. These concerns are magnified, of course, when one must consider federal estate and gift tax issues. A recent memorandum opinion by the U.S. Tax Court provides an example of a last-minute, complex plan that may have been doomed from the start or headed off the rails in its implementation. See Estate of Howard V. Moore v. Commissioner of Internal Revenue, Docket Nos. 21209-09, 22082-09 (U.S. Tax Ct. April 7, 2020).

Background

Howard Moore, the decedent, owned a large amount of property and operated a successful farm. Moore was admitted to the hospital with a critical illness in December 2004 and was discharged to hospice care that same month with advice that he only had a short time to live. Within a matter of days, Moore contacted an attorney who was able to design an estate plan consisting of a family limited partnership (FLP), a living trust, a charitable lead annuity trust, a trust for his adult children, a management trust that acted as the general partner of the FLP and an "Irrevocable Trust No. 1"designed to act as a conduit for the transfer of funds from the FLP to a charitable foundation. The decedent survived for a few months after creating these entities, but succumbed to his illness in March 2005. At the time he died, assuming no taxable gifts during a person's lifetime, the amount excluded from federal estate tax for an individual amounted to $1,5 million. With somewhere between $8 to $20 million in his estate and a top estate tax rate of 47% at the time, the goal of saving estate taxes must have seemed important enough to pay his attorney $320,000 for designing the plan.

The primary thrust of the planning included a transfer of the farm to a living trust and a subsequent transfer of 80% of the farm property to the FLP. A management trust established by the decedent acted as general partner of the FLP, with the decedent's living trust owning 95% of the limited partnership interests and each of the decedent's children each owning a 1% limited partnership interest. The decedent's estate and his family later asserted that the purpose of the FLP was to offer protection against liabilities from the use of pesticides, health risks to workers, creditors and potential bad marriages of the decedent's offspring. Another reason for forming the FLP was to bring the "dysfunctional" family together since they would be required to jointly manage the FLP and its property. The FLP contained transfer restrictions and the limited partners had no right to participate in business management or operation decisions regarding the FLP.

The trust known as Irrevocable Trust No. 1 was nominally funded at the time of decedent's death and thereafter received funds from the FLP. In turn, those funds were transferred to the charitable trust in pursuit of a charitable deduction by the estate. Shortly before the decedent's death, Moore had also used FLP funds to make significant transfers to his children that were designated as loans, as well as making outright gifts to his children and a grandson.

Tax Court Analysis

The decedent's estate filed an estate tax return and a gift tax return after his death. Following review of the returns, the Internal Revenue Service (IRS) issued a notice of deficiency of almost $6.4 million. The tax court, which issued its opinion on April 7, agreed in large part with the IRS findings that the decedent's plan to save estate taxes was ineffective. The court viewed the estate's arguments as one of form over substance, in which the only recognizable goal of the transactions entered into before the decedent's death was to save estate taxes. While the opinion does not specify what caused the IRS to audit the return, it is apparent that the intense planning and creation of various entities within a short time before the decedent's death raised questions.

Federal estate taxes are imposed on the taxable estate of a decedent, which includes the value of property in which the decedent owned an interest at the time of death, less appropriate deductions. While assets transferred from the decedent to others prior to death may escape inclusion in the taxable estate, various statutory provisions pull some transfers back into the taxable estate. We will focus on the transfer to the FLP and also address the loans to decedent's children and the IRS rejection of a deduction for a transfer of over $4 million to the charitable trust.

The decedent and his attorney were faced with several hurdles after learning of decedent's terminal illness in December 2004. The most significant asset in the estate, the farm, was already the subject of negotiations for sale to a neighbor. While these negotiations were ongoing, the decedent transferred the farm to his living trust and then transferred 80% of the farm from the living trust to the FLP. Notably, a contract to sell the farm was executed within days of transferring it to the living trust. In making such transfers, decedent and his attorney had to consider Section 2036 of the Internal Revenue Code. Section 2036 pulls back any transfers made by the decedent into the taxable estate, except those that are bona fide sales for adequate consideration. It also pulls back any transfers that are made where the decedent retains the right to possession or enjoyment of the property. Under Moore's plan, the decedent transferred the farm to his living trust in December 2004, transferred 80% of it to the FLP in December 2004 and entered into a contract to sell the farm for over $16 million within days of these transfers. This sale of the farm from the FLP to a third party closed in February 2005. At the same time, the living trust distributed $500,000 to Irrevocable Trust No. 1, which was reported as a gift to the decedent's children. A short time later, the living trust then transferred all of its interest in the FLP to the Irrevocable Trust No. 1 in exchange for $500,000 in cash and a $4.8 million promissory note. There was no record of how this value was set and the trust never made principal or interest payments to the FLP.

This estate purported that this series of transfers and sales resulted in inclusion of only a small portion of the FLP's value in the decedent's taxable estate. Essentially, the estate took the position that only the 1% general partnership interest and the $4.8 million note were included in the decedent's taxable estate and that all other value from the sale of the farm was removed from the taxable estate through these transactions. The court disagreed with this position. First, it concluded that there was no bona fide sale to the FLP for full and adequate consideration since there were no "nontax" reason for transferring the farm to the FLP. The decedent made the transfer knowing that it would be sold and would not require active management. While the estate also argued that the transfer occurred to protect the assets from creditors, the tax court found that there was no credible evidence of possible claims or threats of litigation. The tax court also gave weight to the decedent's ill health and creation of the complex estate plans within days after discharge from the hospital. Further, the court pointed out that the decedent made the decision to name his children limited partners in the FLP with no input from them or examination of the restrictions imposed on them by the FLP. The court concluded that all decisions about the FLP after its formation, despite appointing two of Moore's children as trustees of the management trust/GP, were made unilaterally by the decedent.

As an alternative holding, the tax court concluded that the transfers were includable under Section 2036 because the decedent retained possession or enjoyment of the portion of the farm transferred to the FLP. The IRS takes the position that transferring all or almost all of a decedent's assets during his lifetime is evidence of a retention of an interest in the transferred assets because a transferor would have no assets left to support him.  While the decedent's attorney likely considered this argument by planning for decedent to retain a 20% interest in the farm through his living trust, the court found that the level of control decedent exercised over the transferred assets was problematic. For example, the decedent used FLP assets to pay personal expenses, continued to live on the farm, used FLP assets to make gifts/loans to his children and paid a large part of his attorney's fees out of the FLP. In the court's view, these factors added up to an understanding that decedent would continue to have access to the FLP funds as needed. Therefore, under either the non-bona fide sale or retention of possession or enjoyment arguments, a portion of the assets of the FLP should have been included in the decedent's taxable estate under Section 2036.

While the FLP analysis was the main thrust of the opinion, the Tax Court also rejected the characterization of the $500,000 transfers to each of the decedent's children as loans, finding that they were gifts from the decedent using FLP assets. The court also rejected a charitable deduction claimed by the estate because it concluded that gifts to be made to the charitable trust after decedent's death were not ascertainable at the decedent's death, but instead based on a formula clause that would only occur if the IRS successfully determined that additional amounts should be included in the taxable estate. As a final matter, the tax court also disallowed a deduction for $475,000 in attorney fees for administration of the estate because the estate failed to produce evidence of the work the attorney had done to administer the estate and justify the fee.

The decedent and his attorney were faced with a difficult situation. The decedent knew he had less than six months to live, had not accomplished any prior estate planning and was in the middle of negotiations to sell the most valuable asset in his estate. If Moore had engaged in planning five or ten years before his death, his attorney could have drafted a plan in which the substance and execution were sound and saved the estate millions of dollars in taxes. By waiting until such a late stage, they were left with a plan that attempted to recognize established transfer requirements without a favorable opportunity of satisfying them. It is unknown whether the matter will be appealed.

Joseph N. Frabizzio is of counsel at Robson & Robson where he focuses his practice on tax planning and controversy. Frabizzio holds an LL.M. in taxation and helps clients minimize their federal and state tax obligations associated with business transactions. He also assists clients with complex trusts and estates issues and succession planning. Frabizzio can be reached at 610-825-3009 or [email protected].