In Kelly, the Tax Court held that property of a family limited partnership should not be included in a decedent’s estate, even though the decedent owned 100% of the stock of the corporate general partner, and a management fee was paid to the corporation which could have potentially been used to pay the decedent’s living expenses.

The decedent, Beatrice Kelly, owned various real properties, including quarries, a post office and rental properties, which had been operated by her husband until his death. After her husband’s death, the decedent’s children helped her manage the properties as well as her financial investments. The decedent executed a Will, which included specific bequests of real estate, securities and personal items, and divided the residue of her estate equally among her children.

Several years later, the decedent’s health began to decline and she was ultimately diagnosed with Alzheimer’s. The decedent’s children were appointed co-guardians. The children then read the decedent’s Will and discovered that it would not actually divide her estate equally among them, primarily because of uneven appreciation in the decedent’s assets since she executed the Will. Therefore, the children entered into a settlement agreement, agreeing to honor any specific bequests to individuals other than themselves and to divide the balance of the decedent’s estate equally.

Thereafter, the children consulted an attorney, who advised them that if a child predeceased the decedent, and the child’s heirs (the decedent’s grandchildren) refused to sign disclaimers, the settlement agreement might not ensure an equal division of the decedent’s residuary estate. Thus, the attorney proposed that the decedent create family limited partnerships, one to own the quarries and three others to own the non-quarry properties. The decedent would gift limited partnership interests in the non-quarry partnerships to her children, and would retain the entire 99% limited partnership interest in the quarry partnership. The decedent also would retain about $1.1 million of liquid assets in her guardianship account. The partnerships would be managed by a corporate general partner, to be owned entirely by the decedent. The children would be the directors and officers. The partnerships would pay the corporate general partner a management fee equal to approximately 1% of the values of the partnership assets.

The children liked the proposal and applied to a Georgia court to approve the plan. In the Georgia court petition, the children stated that the plan would save close to $3 million of estate taxes. They also stated in the petition that the management fees paid to the corporate general partner would be used to pay the operating expenses of the partnerships and to provide adequate income to the decedent to cover her living expenses. The court approved the plan and the children proceeded.

The children all provided regular services to the partnerships. The son did maintenance on the properties, one of the daughters prepared financial reports and communicated with the accountant for the companies, and the other daughter did administrative work and communicated with the attorneys for the companies. The children also held regular board meetings, at which they discussed needed repairs to the properties and approved budgets.

The decedent died less than two years after she funded the partnerships and gifted interests in the partnerships to her children. At the decedent’s death, she owned 100% of the corporate general partner, the 99% limited partnership interest in the quarry partnership and a 33-35% limited partnership interest in two of the other three partnerships. The children, as executors, reported those interests on the decedent’s estate tax return. The IRS assessed a deficiency of $2.2 million, asserting that the value of the assets contributed to the partnership were includible in the decedent’s estate.

The Tax Court found that decedent’s transfers of assets to the partnerships qualified for the bona fide sale exception, because the decedent had legitimate and significant nontax reasons for creating the partnerships, and she received partnership interests in proportion to the value of the assets transferred. The primary concern of the family was to ensure the equal distribution of the decedent’s assets among the children, thereby avoiding litigation. In addition, the partnerships protected the family from legitimate liability concerns with respect to the real properties, as well as concerns regarding the effective management of the assets. The court noted that the Georgia court petition referenced estate tax savings, but found that there was no evidence that tax savings actually motivated the transaction.

The gifts of the partnership interests, on the other hand, did not qualify for the bona fide sale exception, and the IRS argued that the interests in the partnerships were includible in the decedent’s estate because there was an agreement for her to retain income from the partnerships. The IRS pointed to the language of the Georgia court petition, which stated that the management fees were to be used to pay for the decedent’s living expenses, in addition to the costs of operating the partnerships.

The court rejected the argument. First, it noted that the decedent and her children respected the partnerships as separate legal entities, observing their formalities, and sufficient assets were retained outside of the partnerships for the decedent’s personal needs. Second, the decedent’s personal expenses were never actually paid from the management fees. The language in the Georgia court petition suggesting that the fees would cover the decedent’s expenses was not a legally binding directive. Moreover, for the general partner to permit the fees to be used in that manner would have violated the fiduciary duties imposed on the general partner. Thus, the court held in favor of the estate.