Estate of Hurford v. Commissioner (2008), decided by the Tax Court in late December, 2008, is a case that makes estate planning attorneys cringe. In an 85 page opinion, there is virtually not a page where the court does not level criticism at the attorney who set up the estate planning at issue.
Mrs. Hurford’s husband had passed away in 1999 and she was diagnosed with cancer that had spread to her liver in early 2000. She fired the estate planning attorney she and her husband had previously used, and hired the new (and later sharply criticized) estate planning attorney, who proceeded to plan away. The new estate planning attorney had Mrs. Hurford set up three family limited partnerships to which she transferred her assets. He then had her sell most of her partnership interests to two of her three children for a private annuity. The third child was left out of the private annuity sale due to personal problems, yet it was clear from the record that Mrs. Hurford ultimately wanted him to receive one-third of the value of her estate.
The attorney no doubt seized upon the private annuity sale because of Mrs. Hurford’s poor health. In a private annuity sale, the seller transfers property to a buyer (usually a family member) for a specified stream of payments that typically ends with the seller’s death. The payment stream is valued using current discount rates and a standard mortality table. Even if the seller is very ill, as long as he or she has a 50% chance of surviving for one year, the standard mortality table can be used. In this case, even though it was clear the Mrs. Hurford’s condition was terminal, it was determined that she had at least a 50% chance to survive for one year. In fact, she died in February of 2001 which was less than one year after the annuity sale was completed.
The potential benefit of the annuity can be significant in these situations. Assume the seller has a normal life expectancy under the mortality tables of 15 years but, due to the seller’s actual health condition, is likely only to survive for 3. The tables compute a payment stream to last for 15 years. If the seller dies after 3 years, the succeeding 12 years of payments are not made and no value attributable to those payments is included in the taxable estate of the deceased seller. The buyer gets a windfall not subject to estate tax, which is fine because the buyer is typically a family member.
Private annuities have been successfully used by taxpayers for a very long time. Here the annuity failed for two main reasons. The court found that while the sale was to two of the three children, there was nevertheless an implied agreement that the two children would share equally with the third sibling. Thus, the court concluded the annuity was not a bona fide transfer but rather a will substitute. Second, the children made the annuity payments by having the partnerships write checks and make asset transfers back to Mrs. Hurford, rather than paying her from their own funds or earnings from the partnerships. This allowed the court to conclude that Mrs. Hurford had retained a prohibited interest in the transferred assets under IRC Section 2036.
The family partnerships failed as well, due to sloppy formation and funding mechanics by the attorney. The management business purpose also failed as it did in the case we discussed in the previous section. The family generally failed to follow partnership formalities and Mrs. Hurford dipped into partnership assets to pay her expenses before she began receiving her annuity payments.
There was one bright spot for the Hurford family. The court declined to impose the negligence penalty, concluding they had reasonably relied on professional advice, poor though it may have been.
The teachable point here is that where you use a private annuity sale, the buyer should not make the payments by transferring back to the seller the very assets that were purchased. Ideally the assets purchased should produce sufficient income to enable the buyer to make the annuity payment, or if not, the buyer should be able to make up the difference out of his own assets.