Tax litigation surrounding family limited partnerships is unending and we are delighted to report on two recent taxpayer victories. In Estate of Samuel P. Black, decided by the Tax Court in December 2009, the decedent set up a family limited partnership called Black, LP. He transferred stock of Erie Indemnity Co., which was his employer. He was a strong believer in Erie stock and purchased it at every opportunity. By the 1960’s, he was the second largest shareholder. His investment philosophy was described by the court as “buy and hold,” particularly with respect to his Erie stock.
Mr. Black had made gifts of Erie stock to his son and to trusts that had been created for his grandchildren. He became concerned that his son might default on a bank loan and that his son’s marriage was heading toward divorce. These factors could cause his son to have to sell some of his Erie stock. He was also concerned that the stock in the trusts for his grandchildren would be distributed to them beginning when they reached age twenty-five and they might also sell some of their Erie stock. Mr. Black was advised that if he set up a family limited partnership which included his son and his grandchildren’s trusts, he could minimize the possibility that Erie stock would be sold.
The partnership was formed in 1993 and Mr. Black was the managing general partner until 1998, at which time his son became the managing partner. Mr. Black made several gifts of interests in the partnership to his son, his grandchildren, the grandchildren’s trusts, and a charity. When Mr. Black died in 2001, the partnership still held all of the Erie stock that had been transferred to it upon its formation.
Mr. Black’s wife died only five months after he passed away. In order to pay the estate taxes that resulted from her death, Erie engaged in a secondary public offering of its stock and Black, LP sold three million shares for $98 million. The partnership then loaned $71 million to Mrs. Black’s estate to pay estate taxes. The Internal Revenue Service (“IRS”) asserted that the Erie stock Mr. Black had transferred to Black, LP should be included in his estate under IRC Section 2036, which would include the stock in Mr. Black’s estate if he either retained the possession, enjoyment or right to income from the stock or the right to designate the persons who shall possess or enjoy the stock or income from the stock. However, the retention of these rights would not cause inclusion if the transfer by Mr. Black was a “bona fide sale for an adequate and full consideration.”
It is not clear at all that Mr. Black retained any of the proscribed rights; however the court addressed the bona fide sale exception first. In prior cases, the Tax Court has held that to meet the bona fide sale exception, the decedent must have had a legitimate and significant non-tax reason for creating the family limited partnership. The court then held that using the partnership to address Mr. Black’s concerns about the Erie stock being sold was such a legitimate non-tax reason.
The case eases some of the concern we had following the Jorgensen case we reported on last year. In Jorgensen, the court implied that “buy and hold” investing was not necessarily a legitimate non-tax reason that would support the creation of a family limited partnership. We were concerned that only actively managed and traded portfolios might qualify. In Black, the lack of active management was not fatal in light of another non-tax purpose the court accepted as being significant. Since the court found that Mr. Black’s transfer of the Erie stock to Black, LP satisfied the bona fide sale exception, it did not have to address whether Mr. Black had retained any proscribed rights with respect to the stock.
The second taxpayer victory came in Estate of Charlene B. Shurtz, decided by the Tax Court in February 2010. Mrs. Shurtz came from a family that owned significant interests in timberlands. By 1993, at least fourteen extended family members, including Mrs. Shurtz, had interests in the family’s original timber holdings. They were advised by an attorney that having so many owners made management difficult and would make any sale a cumbersome process. This led to the formation of C.A. Barge Timberlands, L.P. in June of 1993. All family members holding timber interests joined the partnership and contributed their respective interests. The partnership had a corporate general partner of which Mrs. Shurtz was a one-third owner.
In 1996, Mrs. Shurtz and her husband formed Doulos L.P. for the ostensible purpose of protecting her family’s assets from possible creditor claims. Mrs. Shurtz apparently believed the Mississippi, where the timber was located, was an especially litigious state. Mrs. Shurtz contributed her interest in C.A. Barge Timberlands, L.P. along with some separate timberland that she owned. She initially held a 1% interest as a general partner of Doulos L.P. and a 98% interest as a limited partner. Her husband held a 1% interest as a general partner. Between 1996 and 2000, Mrs. Shurtz made numerous gifts of small interests in Doulos L.P. to her children and to trusts for her grandchildren. She passed away in 2002, holding her 1% general partnership interest and an 87.6% interest as a limited partner.
Doulos L.P. operated in a manner that was not optimal. Some of its expenses were paid by Mrs. Shurtz and her husband and the distributions the partnership made were not always proportional to the interests of all of the partners, although over time make up distributions were used to achieve proportionality.
Mrs. Shurtz’s estate plan was set up so that between her exemption amount and the marital deduction on what she left to her husband, no tax should have been due. So what was there for the IRS to argue about? In its apparently never-ending attack on family limited partnerships, the IRS took the position that the assets Mrs. Shurtz transferred to Doulos L.P. should be included in her estate under IRC Section 2036. However, for purposes of computing the allowable marital deduction, the lesser value of the interest in Doulos L.P. had to be used. This sounds a little like “heads I win, tails you lose.”
Once again, the court found that Mrs. Shurtz’s transfers fell within the bona fide sale exception to Section 2036, accepting the estate’s contention that Doulos L.P. was formed to protect family assets from litigation claims and to facilitate management of those assets. The court accepted as legitimate Mrs. Shurtz’s expressed concern about litigation exposure. Once again, the court was not required to consider whether Mrs. Shurtz had retained any of the proscribed rights. The marital deduction also became a non-issue because it was the value of the partnership interest that was included in her estate. Thus, there was no discrepancy between the value of the estate asset and the value of the asset that gave rise to the marital deduction.