Property Transferred to Family Limited Partnership Was Included in Decedent's Gross Estate

(Parker Tax Publishing June 2017)

The Tax Court held that a decedent's gross estate included the excess of the fair market value of cash and securities contributed to a family limited partnership over the value of the partnership interest received. Because a purported gift of the decedent's partnership interest was held void or revocable under state law, the value of the partnership interest was also included in the gross estate; however, gift tax did not apply. Estate of Powell.v. Comm'r, 148 T.C. No. 18 (2017).

Background

Nancy Powell died on August 15, 2008. Her son, Jeffrey, was the executor of her estate. On August 8, 2008, cash and securities worth approximately $10 million were transferred from a revocable trust owned by Mrs. Powell to a limited partnership, NHP, in exchange for a 99 percent limited partnership interest. NHP had been formed two days earlier by Mr. Powell, who was the general partner of NHP. The limited partnership agreement gave Mr. Powell sole discretion to determine the amount and timing of distributions and allowed for the partnership's dissolution with the written consent of all partners.

On August 8, 2008, Mr. Powell, purportedly acting on his mother's behalf under a power of attorney (POA), assigned Mrs. Powell's interest in NHP to a charitable lead annuity trust (CLAT). The POA authorized Mr. Powell to take specified actions on his mother's behalf in the event of her incapacitation. On August 7, 2008, two doctors expressed their opinion that Mrs. Powell was incapacitated and could not act on her own behalf. The terms of the CLAT gave an annuity to the Nancy H. Powell Foundation, a nonprofit corporation, of a specified amount for the remainder of Mrs. Powell's life. On her death, the remaining assets in the CLAT were to be divided equally between two trusts for the benefit of Mr. Powell and his brother. The POA granted Mr. Powell the ability to deal in all property owned by Mrs. Powell. It also authorized him to make gifts on Mrs. Powell's behalf up to the annual federal gift tax exclusion amount. A ratification provision stated that Mrs. Powell ratified and confirmed all actions by Mr. Powell under the POA.

Mrs. Powell's 2008 gift tax return reported a taxable gift of approximately $1,600,000 as a result of the purported transfer to the CLAT of her 99 percent limited partner interest in NHP. The value of the gift - specifically, the remainder interest in the CLAT given to Mrs. Powell's sons - was computed based on an appraised value of the interest in NHP of approximately $7.5 million. That value reflected a 25 percent discount for lack of control and lack of marketability to the approximate value of $10 million for the interest in NHP.

The IRS issued notices of deficiency for both estate and gift tax. In the gift tax notice, the IRS determined that Mrs. Powell's interest in NHP was worth approximately $8.5 million on August 8, 2008, and that her sons' remainder interests in the CLAT were worth approximately $8.3 million. The IRS valued the remainder interests based on the fact that Mrs. Powell was terminally ill when the gift was made. The estate tax notice increased the value of Mrs. Powell's estate by approximately $12.9 million; approximately $10 million of that was for the value of the cash and securities transferred to NHP. The remaining increase of approximately $2.9 million resulted from a gift tax deficiency for the purported transfer of Mrs. Powell's interest in NHP to the CLAT.

Under Code Sec. 2036(a), the value of a decedent's gross estate includes the value of transferred property if the decedent retained, either for life or for a time not ascertainable without reference to the decedent's death or for any period which does not in fact end before the decedent's death, the possession, enjoyment or right to the income from the property or the right to designate the beneficiaries of the property. An exception for bona fide sales applies, in which case the property is not included in the estate if the decedent transferred the property for full and adequate consideration. When property is included in an estate under Code Sec. 2036 and it was transferred for less than full consideration, its value under Code Sec. 2043 is the excess of its fair market value at the time of death over the value of the consideration at the time of the transfer. Under Code Sec. 2038, the value of a gift made by a decedent is included in the gross estate if the gift is subject to the decedent's power to amend or revoke it.

IRS's Position

The IRS argued that the cash and securities Mrs. Powell transferred to NHP should be included in her gross estate under Code Sec. 2036 for two reasons. First, the IRS asserted that the transfer was subject to an implied agreement under which Mrs. Powell retained the possession or enjoyment of the transferred property. Second, according to the IRS, Mrs. Powell, acting with her sons, had the power to dissolve NHP and then decide who would take possession of the property. The IRS argued that the bona fide sale exception did not apply because there was no significant nontax purpose for the creation of NHP and, due to the estate's claimed valuation discount of the partnership interest, the transfer was not made for full and adequate consideration.

Regarding the purported gift of Mrs. Powell's interest in NHP to the CLAT, the IRS argued that the gift was revocable because it was invalid under California law. That is, Mr. Powell's authority under the POA allowed him to make gifts only up to the federal gift tax exclusion amount, and the gift of the partnership interest to the CLAT exceeded that authority. Because the gift was invalid, the IRS argued that value of the partnership interest therefore had to be included in Mrs. Powell's estate under Code Sec. 2038(a).

Estate's Position

The estate did not deny that Mrs. Powell's ability to dissolve NHP with the consent of her sons constituted a right, in conjunction with others, to designate the persons who could possess or enjoy the property she transferred to the partnership or the income therefrom within the meaning of Code Sec. 2036(a)(2). However, the estate argued that Code Sec. 2036 did not apply to the transfer of cash and securities to NHP because Mrs. Powell did not retain the right to designate beneficiaries of the assets for the remainder of her life, and that the brief period for which she held the right was not ascertainable without reference to her death. Regarding the gift of Mrs. Powell's interest in NHP to the CLAT, the estate argued that Mr. Powell's authority to make the gift derived not from any specific provision in the POA but from a general grant of authority to deal in Mrs. Powell's property. According to the estate, the gift was consistent with Mrs. Powell's history of charitable giving and with the provisions of her estate planning documents.

The estate also asserted that, even if the POA did not provide the authority to make gifts in excess of the gift tax exclusion amount, the gift was nonetheless valid under the POA's ratification provision.

Tax Court's Decision

The Tax Court held that the excess of the fair market value of the cash and securities over the value of the partnership interest Mrs. Powell received in exchange for the cash and securities was includible in the gross estate. First, the court found that the purported gift of Mrs. Powell's interest in NHP to the CLAT was either void or revocable because Mr. Powell did not have the authority under the POA to make a gift in excess of the gift tax exclusion amount. The transfer of the partnership interest to the CLAT was therefore disregarded. Second, the court found that Code Sec. 2036(a)(2) applied because Mrs. Powell's ability to dissolve NHP with the cooperation of her sons constituted a right in conjunction with others to designate the beneficiaries of the cash and securities transferred to NHP or the income from them.

The Tax Court distinguished the Supreme Court's decision in U.S. v. Byrum, 408 U.S. 125 (1972), which held that a decedent's right to vote shares he placed in a trust for his children did not cause them to be included in his estate under Code Sec. 2036(a)(2) because, as the controlling shareholder, his fiduciary duties to minority shareholders limited his influence over the company's dividends. The Tax Court, following its previous decision in Estate of Strangi, T.C. Memo. 2003-145, aff'd, 417 F.3d 468 (5th Cir. 2005), found that the fiduciary duties applicable to a family limited partnership are not equivalent to those implicated in Byrum. The Tax Court noted that in addition to his duties as general partner, Mr. Powell owed duties to Mrs. Powell that he assumed either before he created the partnership or at about the same time. The Tax Court saw no reason to believe that Mr. Powell would have exercised his power as the general partner in ways that would have prejudiced Mrs. Powell's interests. Further, because Mrs. Powell owned 99 percent of NHP, any fiduciary duties Mr. Powell owed would be almost exclusively to Mrs. Powell. Finally, the court saw no evidence that NHP conducted any meaningful business operations; it was simply an investment vehicle for Mrs. Powell and her sons. Any fiduciary duties that might limit Mr. Powell's power over NHP's distributions were, in the Tax Court's view, illusory.

Having held that Code Sec. 2036(a) required the inclusion of the cash and securities in Mrs. Powell's estate, the Tax Court then determined that the amount of the inclusion had to be reduced by the value of the partnership interest received by Mrs. Powell. Under Code Sec. 2043(a), the value of the property included in the estate is the excess of the value of the transferred assets on the date of death over the value of the consideration received in exchange, as of the date of the transfer. The court said that the inclusion must take into account any discounts applied in valuing the partnership interest and any increase or decrease in the value of the transferred assets between the date of transfer and the date of death.

On the issue of the purported gift of Mrs. Powell's interest in NHP to the CLAT, the Tax Court held that under California law, general grants of authority to convey property do not provide the power to make gifts, and that an express grant of authority is required. Further, the estate's ratification argument was rejected. The court found that the ratification provision in the POA only ratified acts done by virtue of the POA, and not acts done outside the authority granted by the POA. Interpreting the ratification provision to authorize a gift in excess of the gift tax exclusion amount would conflict with the California rule that the power to make gifts must be expressly granted. Because the Tax Court found that the gift was either void or revocable, the gross estate included the value of the partnership interest, including any applicable discount for lack of marketability. However, the estate was not liable for any gift tax deficiency on the purported gift

Observation: In a concurring opinion, seven judges disagreed with the court's application of Code Sec. 2043(a), which in their view was an untried new theory that could invite overly aggressive tax planning. Rather, the concurring judges would have disregarded the purported transfer of the cash and securities to the partnership under Code Sec. 2036(a)(2) and held that their full value was included in the gross estate. Under this approach, Mrs. Powell's partnership interest would have been treated as an alter ego with no value other than the cash and securities, so there would be no double inclusion problem as a result of including both the cash and securities and the partnership interest in the gross estate.

For a discussion of the inclusion in a gross estate of transfers with a retained life interest, see Parker Tax ¶225,510. For a discussion of inclusions of revocable transfers, see Parker Tax ¶225,910.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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