It’s possible KYEstates readers are focused on the Paul-Grayson Senate race, or the Louisville mayoral race (see latest polls here, and here, respectively). If you want a break from politics, however, we can take you back to the normal state of things (i.e., all transfer taxes, all the time) with a report on a truly resounding taxpayer FLP win: Estate of Murphy v. U.S., 2009 WL 3366099 (W.D. Ark. Oct. 2, 2009).
Murphy shows that for those able to pay the tax, going to District Court rather than Tax Court can sometimes be a really excellent choice. Tax Court judges (like KYEstates Glom On Contest Laureate The Hon. Mark Holmes) are itinerant, like the “circuit-riding” judges of old. In contrast, Federal District Court judges are the opposite of itinerant. (And, if you’re a family with multi-generational ties in one area, probably with the philanthropic record and business footprint to match, perhaps that all plays into the litigation strategy.)
In Murphy, the District Court found against the IRS on section 2036, valuation, and Graegin/section 2053 questions arising from the use of a family limited partnership to implement the decedent’s buy-and-hold investment philosophy and keep historic family assets in the decedent’s family.
The issues before the Court included inclusion of assets that [the decedent] transferred to the Charles H. Murphy Family Investments Limited Partnership (“MFLP”) and the Murphy Family Management, LLC (the “LLC”) in the decedent’s gross estate under section 2036(a), the valuation of MFLP and LLC interests on the valuation date, and the deductibility under section 2053 of interest paid on loans to the estate to pay federal estate tax.
Beginning in 1941, the decedent had worked in his family’s business, which was active in banking, timber, oil and gas. The decedent served in World War II and after he returned from service, he and his wife had four children (Mike, Martha, Chip, and Madison) between 1948 and 1957. The decedent had three sisters, and he and they pooled their interests in the family business into a family partnership, C.H. Murphy & Company. The decedent served as managing general partner. The family’s timber and farming activities increased. In 1950, the partnership incorporated as Murphy Corporation, and it went public in 1956. In 1964, the corporation reincorporated in Delaware as Murphy Oil Corporation. The decedent was president, CEO, and later board chairman of Murphy Oil from 1950 through 1994. Madison succeeded to his father’s active role on Murphy Oil’s board.
By 1997, Murphy Oil’s capitalization exceeded $2 billion. The Murphy family controlled approximately 25% of the company’s stock, and the decedent’s branch of the family controlled approximately 9.6% of the stock. The family had similar percentage holdings in Deltic Timber Corporation, a former wholly-owned subsidiary of Murphy Oil that was spun off into a separate public company in 1996. Madison was also active on Deltic’s board.
In addition, the family held substantial holdings in First United Bancshares (later, after a merger, Banccorp South). The decedent (and later Madison) served on the boards of these banks.
The decedent believed Mike and Chip did not have the level of financial prudence and business skill that he wished they had. Each son had a series of spendthrift problems, sales of stock in the family’s historic companies to raise cash, and/or divorces in which shares left the family in favor of the ex-spouse. In contrast, the decedent believed Martha and Madison did share his business/investment philosophy.
The Court noted that:
In light of this realization, Mr. Murphy did not want to leave his family’s assets to his children outright. He began looking for a way to turn over the management of these assets to his children that was in keeping with his business philosophy. Thus, starting in 1994, Mr. Murphy began working closely with his youngest son, Madison, to reorganize his personal and private business assets in a way to accomplish these goals.
The decedent’s attorney “recommended to Mr. Murphy the use of a family limited partnership to accomplish his goal of pooling the family’s Legacy Assets together under centralized management and to protect those assets from being dissipated. The idea of using a partnership was familiar to Mr. Murphy as his family had successfully used partnerships for decades. Mr. Murphy decided that a partnership, with a limited liability company as its general partner, was the best vehicle to manage his family’s Legacy Assets.”
In family discussions (in which at least one child was separately represented by their own counsel), “Mr. Murphy, Madison and Martha decided that Mr. Murphy would hold a non-controlling interest (49%) in the partnership’s general partner, with Madison and Martha each holding a 25.5% member interest.”
In December, 1997, the decedent formed MFLP, with the LLC as general partner. The partnership agreement provided for discretionary pro-rata distributions in accordance with the partners’ sharing ratios, and customary restrictions protecting against transfers outside the family. Martha and Madison contributed assets to MFLP, while Mike and Chip did not.
Mr. Murphy contributed assets to the partnership in two phases. $88 million of Legacy Assets (Murphy Oil, Deltic, and First United stock) was contributed to MFLP in February, 1998, and somewhat over $1 million of Legacy Assets was contributed to the LLC. This “amounted to approximately 41% of the value of Mr. Murphy’s total assets at the time.” In May, 1998, Madison and Martha made their contributions to the LLC – Legacy Assets worth about $500,000 each.
The court summarized the post-capitalization ownership as follows:
Mr. Murphy’s resulting member interest in the LLC was 49% and Madison and Martha’s was 25.5% each. Thus, Madison and Martha collectively held a majority of the member interest in the LLC….After all contributions were made, the LLC held a 2.25% general partnership interest in the MFLP. Mr. Murphy held, individually or as trustee of various trusts, a 96.75% limited partnership interest in the MFLP. Each interest owner in the MFLP and the LLC received an interest in the entity proportionate to the value of the assets contributed…The value of the assets contributed by each owner was credited to his, her, or its capital account.
Mr. Murphy was relatively conservative in his funding of MFLP:
At the time the MFLP was funded, Mr. Murphy retained approximately $130 million in non-Legacy Assets outside the partnership. The majority of these assets were shares of First Commercial Corporation (“First Commercial”) stock. These retained assets represented over 50% of Mr. Murphy’s wealth and provided Mr. Murphy with sufficient funds to pay his living expenses for the remainder of his life and to pay his estate taxes upon his death.
The Court described the post-funding management of MFLP:
After the MFLP was formed and funded, Mr. Murphy removed himself more and more from the management of the family’s assets. Accordingly, Madison and Martha began to take over the day to day management of the partnership and its various employees. In keeping with their business/investment philosophy, no shares of Murphy Oil, Deltic or BancorpSouth stock were sold by the MFLP. In order to manage these assets effectively, Madison continued to serve on the Board of Directors of Murphy Oil, Deltic and BancorpSouth. These “seats at the management table” of the family’s Legacy Assets allowed the MFLP (through Madison) a voice in the growth and continued success of these companies, thereby, ensuring the growth and continued success of the partnership.
After the partnership was funded, Mr. Murphy gifted MFLP interests:
In furtherance of one of his purposes for creating the MFLP, Mr. Murphy began making annual gifts of interests in the MFLP to his children, their spouses and his eight grandchildren in 1998. These gifts continued until Mr. Murphy’s death in 2002. Mr. Murphy filed gift tax returns with the IRS each year reporting these gifts of partnership interests.
In 2000, Deltic sold some of its farmland, land with historic ties to the Murphy family. MFLP decided to purchase some of the acreage that Deltic was selling:
The land was purchased by Epps Plantation LLC (“Epps”), a limited liability company wholly-owned by the MFLP, using the proceeds from a $16 million loan from Mr. Murphy’s FRIT. Thereafter, Hard Bargain Farms Partnership (“Hard Bargain”), an entity comprised of Mr. Murphy’s children, grandchildren and spouses who are parents of grandchildren, was formed to operate Epps…After purchasing Epps, the MFLP made significant capital improvements to the plantation. It purchased an additional 700 acres of land and sold a small tract of land. The MFLP also purchased and manages the seven-story Union Building in El Dorado.
(Not unreasonably, given this comparatively splendid fact pattern), the Court found that MFLP had been run as a bona fide business entity:
Since its creation, the MFLP has engaged in business operations, purchased and sold assets, hired and managed employees, prepared (monthly) and disseminated (quarterly) financial statements to its partners, filed federal and state tax returns, and maintained its own bank account. The partners have met from six to eight times a year to discuss partnership business. They have also respected the partnership as an entity separate and apart from themselves. Accordingly, Mr. Murphy did not commingle any of his personal assets with the assets of … MFLP.
Further, MFLP made only two distributions during Mr. Murphy’s life – one for 1998 income taxes, and another comparatively small one so that one of MFLP’s holdings could convert to an S-corporation.
Although Mr. Murphy was (at age 77) in good health in 1997 when the partnership was formed, he later developed heart trouble and died in 2002. Madison and Martha were appointed co-executors.
Because its bank stock holdings had declined substantially, to raise funds to pay estate taxes, the Estate borrowed approximately $11 million from MFLP [apparently structured as a Graegin loan]. Mr. Murphy’s 706 reported a 95% limited partnership interest in MFLP. Notable works of art by Emil Nolde, Childe Hassam, and Richard Clague were also reported on the 706, at a relatively low total value of $292,000.
The IRS issued a Notice of Deficiency claiming that the MFLP interests and the artwork had been undervalued, and that administrative expenses had been overstated. To pay additional tax claimed by the IRS of over $34 million the Estate borrowed funds from four trusts created for the benefit of Mr. Murphy’s children. The Estate paid the tax and filed a claim for refund. The IRS denied the claim for refund (for over $41 million). and the Estate filed suit seeking the refund, plus interest.
At trial, Mr. Murphy’s family and advisors:
…testified that Mr. Murphy’s purpose for forming the MFLP was to pool the family’s Legacy Assets into one entity that would be centrally managed in a manner that was consistent with his business/investment philosophy, to pass the management responsibility of the Legacy Assets over to the next generation, to enable him to make lifetime gifts of interests in the MFLP while ensuring that the voting of the underlying assets stayed in one place, to educate his descendants about wealth acquisition, management and preservation, and to protect the Legacy Assets from creditors, failed marriages and from being dissipated by future generations. They also testified that since its formation, the MFLP has been managed in accordance with Mr. Murphy’s business/investment philosophy, the partnership, through Madison, has taken an active role in the management of its Legacy Assets, it has purchased and operated Epps Plantation, it has purchased and operated the Union Building in El Dorado, and it has explored other business opportunities. The Court found this testimony credible. Accordingly, the Court finds that Mr. Murphy created the MFLP in good faith and for legitimate and significant non-tax purposes.
The court then turned to the valuation questions relating to Mr. Murphy’s MFLP and LLC interests. The Estate’s expert found that the decedent’s 95% MFLP interest was worth approximately $74 million, while the government’s expert found that it was worth approximately $106 million.
With respect to Epps Plantation, the Estate’s expert found a value of approximately $18 million, and the IRS’s expert found a value of approximately $21 million.
With respect to the fair market value of the decedent’s LLC interest, the Estate’s expert found a value of approximately $700,000, and the government’s expert found a value of approximately $1.1 million.
In the course of a detailed analysis of the assumptions and approaches in each appraisal, the Court agreed with the Estate’s experts on the valuation questions.
The Court also reviewed questions on art valuation, undertaking a detailed analysis of each work. it found a total value for the art of $367,000.
The Court also found that interest on the loans to raise funds to pay estate taxes was actually and necessarily incurred in the course of administering the Estate, with the result that the Estate was allowed to deduct the loan interest as a administrative expense under section 2053.
After making findings of fact, the court then reached conclusions of law. It found that MFLP was created for a legitimate, significant non-tax purpose:
In this case, the MFLP was created for various purposes, among them to pool the family’s Legacy Assets into one entity to be centrally managed in a manner that was consistent with Mr. Murphy’s long-term business/investment philosophy. In order to accomplish this goal, Madison has taken an active role in the management of these Legacy Assets, serving on the Board of Directors of each company. The partnership has also purchased and is managing property (Epps Plantation and the Union Building) that is consistent with Mr. Murphy’s philosophy of acquiring and maintaining the family’s historical assets. This is a legitimate and significant non-tax purpose for creating the MFLP… Mr. Murphy also retained approximately $130 million outside the partnership. Thus, he was not dependant on distributions from the partnership in order to maintain his lifestyle….He also did not treat the partnership’s assets as his own and did not commingle his assets with those of the partnership… During the formation of the MFLP, Mr. Murphy’s two children, Madison and Martha, took an active role, with Martha being represented by her own attorney. Thus, Mr. Murphy was not effectively standing on both sides of the transaction….
Even though the Court found that Mr. Murphy was aware of MFLP’s tax advantages, citing Kimbell, it found that tax advantages do not “prevent a sale from being ‘bona fide’ if the transaction is otherwise real, actual and genuine.” Accordingly, the Court found that “Mr. Murphy’s transfer of assets to the MFLP was a bona fide sale.”
The Court found that the bona fide sale was for full and adequate consideration under the Kimbell criteria, because “Mr. Murphy received partnership interests proportionate to the value of the assets he contributed. The value of the assets contributed by each partner was credited to his, her or its respective capital account. And, on dissolution of the partnership, each partner is entitled to distributions in an amount equal to his, her or its capital account.”
Overall, the Court concluded that “Mr. Murphy’s transfer of assets to the MFLP and the LLC was a bona fide sale for adequate and full consideration in money or money’s worth. Thus, the transfer falls within the bona fide sale exception section 2036. Accordingly, the fair market value of these assets is not includable in Mr. Murphy’s gross estate under section 2036.”
With respect to valuation questions, after applying valuation discounts, the Court found that on the valuation date, the fair market value of Mr. Murphy’s limited partner interest in the MFLP was $74,500,000 and the fair market value of Mr. Murphy’s member interest in the LLC was $710,000.
On the section 2053 questions regarding deduction of the interest on the loans to pay estate taxes, the IRS argued “that the interest expense was not necessarily incurred because it was the result of an unnecessary estate-tax-avoidance transfer made by Mr. Murphy during his lifetime that drained his future estate of liquid assets..”
The Court did not agree:
Mr. Murphy created the MFLP in good faith and for legitimate and significant non-tax purposes. At the time of the transfer, Mr. Murphy retained approximately $130 million in assets outside the partnership. These assets represented over 50% of Mr. Murphy’s wealth and were sufficient to pay his living expenses for the remainder of his life and to pay his estate taxes upon his death. The deficit that resulted in the Estate having to borrow money to pay the estate taxes was caused by the value of the assets outside the partnership declining in value and the value of the partnership’s assets increasing in value, not by Mr. Murphy depleting his wealth to avoid taxes.
Further, in this case, the Court found “no evidence that Madison and Martha, as the executors of the Estate and as the controlling owners of the MFLP’s general partner, were not acting in the best interest of the Estate and the MFLP when they chose to borrow the funds necessary to pay the Estate’s taxes, rather than to liquidate assets.” Accordingly, the Court declined to “second guess their judgment”, and found “that the interest expense incurred on the MFLP and the 1956 loans was a reasonable and necessary administrative expense of the Estate. The interest on both loans is properly deductible by the Estate under section 2053.”
Overall, the Court found that the Estate was entitled to a refund of federal estate taxes and interest in an amount determined by calculations consistent with its findings.