The stream of family limited partnership litigation continues. After early taxpayer successes, the IRS has recently become smarter about the cases they pursue and this has resulted in a more recent string of IRS victories, which continues here. The recent Tax Court case of Estate of Jorgensen v. Commissioner (March, 2009), shows that bad things can happen to seemingly good people. Colonel Gerald and Erma Jorgensen seemed to be a quintessential American success story. Colonel Jorgensen was a thirty-year career Air Force officer who had served as a highly decorated bomber pilot in both World War II and the Korean War. After retiring from the Air Force, he served as an aide to a United States Congressman. The Jorgensen’s lived frugally and continually saved money from Colonel Jorgenson’s government salaries and pensions. Colonel Jorgensen astutely invested their savings and by the early 1990’s had accumulated over $2 million in marketable securities. Enter the estate planner.
The Jorgensen’s formed a family limited partnership in 1995 and transferred marketable securities to it. Colonel Jorgensen and his two adult children were the general partners. The Jorgensen’s had six grandchildren who became limited partners. None of the children or grandchildren made any contribution to the partnership and received their interests as gifts. Colonel Jorgensen passed away in 1996, and Mrs. Jorgensen subsequently formed a second limited partnership to which she transferred marketable securities and additional marketable securities from her husband’s estate. Mrs. Jorgensen died in 2002, and the IRS sought to include the assets Mrs. Jorgensen had transferred to the partnership in her estate under IRC Section 2036(a). To be so includible Mrs. Jorgensen must have: i) transferred assets during her life; ii) the transfer must not have been a bona fide sale for full and adequate consideration; and, iii) she must have retained the right to receive income from or the right to possess or enjoy the assets that she transferred. As the law has developed, for a sale to be bona fide the taxpayer must have had a significant non-tax reason for making the transfer.
Where taxpayers have prevailed in these cases, they have usually been able to demonstrate that the partnership facilitated the centralized management of the assets and enabled the family to introduce younger generation members to the management process. This did not work for Mrs. Jorgensen because the court found that the securities portfolios did not require active management. Colonel Jorgensen had been a “buy and hold” investor and sold positions infrequently. Following Colonel Jorgensen’s death, the general partners were the children who, unlike Colonel Jorgensen, were not sophisticated investors but relied instead on financial advisors and did not even want to hear from them very often.
The court noted other problems as well. The partnerships did not keep accounting records, loaned money to one of the children, and Mrs. Jorgensen used partnership funds to make gifts. Also, after Mrs. Jorgensen died, one of the partnerships made distributions to enable her estate to pay taxes, legal fees and other estate obligations. This enabled the court to conclude that Mrs. Jorgensen had retained the prohibited interest in the property she had transferred. The court therefore found that IRC Section 2036(a) did apply to include the assets in her estate.
Further cases will be necessary to see where the Tax Court goes with its distinction between assets that require active management and those that do not. More troublesome is the court’s apparent equating of active management to trading. It would be unfortunate if day traders and speculators can use family partnerships but the Warren Buffets of the world cannot. We suspect that while Warren Buffet may not trade often, he nevertheless spends enormous amounts of time monitoring the financial health of the companies in which he holds large positions. Why should that not count as active management? It seems nonsensical to conclude that you have to be trading to be managing. It seems more likely that a flurry of trading activity may reflect an absence of any real management. Hopefully, the right set of facts will come before the court and this clarification can be made.
It is possible that even where assets do not require active management, the taxpayer may still defeat Section 2036 by avoiding the kind of conduct that allows the court to conclude the taxpayer retained an interest in the assets. This requires that partnership formalities be rigidly followed, and all distributions must be proportional to all partners in accordance with their interests. The taxpayer also must have enough assets outside of the partnership to pay all of their expenses, including apparently expenses that result from their death.
The Jorgensen case is a reminder that success with a family partnership is not guaranteed. You cannot just sign the papers and get a discount. It must be treated as a family business entity and managed as such.