Heirloom Stock + Predator Creditors = Family Limited Partnership Win for Taxpayer

KYEstates is pleased to share welcome news of a taxpayer win in Estate of Black v. Comm’r, 133 T.C. No. 15 (Dec. 14, 2009).

Black involved (you guessed it) a family limited partnership, and prominently features all four Big Themes of estate planning: favored and disfavored Family members, really large amounts of Money, and correspondingly large estate Taxes. Over 70 years, the decedent and his family had accumulated enough shares in an insurance company to make it almost a Family Business.

As KYEstates readers would expect it to do when presented with a family partnership that threatens to cost it a lot of money, the Service made a section 2036 argument that the decedent’s taxable estate should include the underlying value of partnership assets attributable to the decedent’s pro rata share in the partnership, rather than the value of the partnership interests themselves.

Because the decedent was not the surviving spouse, the section 2036 argument presented risks for the taxpayer’s section 2056 estate tax marital deduction.  The Service claimed that the marital deduction should be measured by the value of the partnership interests actually passing to the surviving spouse, not the underlying asset value attributable to such partnership interests.  The Service also disputed large section 2053(a)(2) administrative deductions for loan interest.

In Black, John Porter, Stephanie Loomis-Price, and colleagues continued their good service to the T&E Community by fending off the Service’s section 2036 attacks.  Although they were blessed with good facts that made Black tantamount, almost, to Schutt II, let’s take a closer look at how they did it, shall we?

Mr. Black, the decedent, died at age 99 in December, 2001.  Mrs. Black died at age 95 or so, six months later.  Mr. and Mrs. Black were married for almost 70 years, and Mr. Black had similar longevity at the Erie Indemnity Company.  He started as a claims manager in 1927, and his career grew along with the Company, as it expanded to be a multi-line insurer writing policies in 11 states and the District of Columbia.  Although he retired as an officer in 1960, he served as a director until 1997.  Mr. Black didn’t miss a single board meeting in 67 years, and over time he accumulated enough Erie stock to become the Company’s second-largest shareholder.  As one would expect from the consistency of his personal life and career, Mr. Black had a buy-and-hold investment philosophy, especially with respect to Erie stock.

Mr. Black became concerned that his son, who stood to inherit large amounts of Erie stock, would be taken advantage of by his daughter-in-law (whom his son later divorced) and her parents.  Further, he perceived that his grandsons were not industrious enough and had spendthrift tendencies.  At the same time, other large Erie shareholders were at odds with each other, and the likelihood that the Black family’s Erie stock would become the swing-vote bloc in the Company’s affairs increased.  Mr. Black believed it was important for his family’s shares to act as a unified bloc in the Company’s governance struggles.

Mr. Black’s advisors recommended a family limited partnership to accomplish his goals of consolidating and protecting the family stock and minimizing estate taxes, and a limited partnership was established in 1993.  Substantially all of the family’s Erie stock (held by several trusts and by Mr. Black himself) was contributed to the partnership.  Mr. Black was the initial general partner (but later transferred his general partnership interest to his son in 1998).

The partnership agreement contained customary transfer restrictions and rights of first refusal upon transfer in favor of the partnership or the other partners.

The Tax Court explained in detail how Mr. Black was in good health and living an active lifestyle when the partnership was formed, even though he was 91.

The partnership’s major business activity between 1993 and 2001 was holding Erie stock.  (This proved to be a pretty good business decision, in that the net asset value of the partnership increased from $80 million to $318 million during that time.)  During this time, the partnership distributed amounts equal to about 92% of the Erie dividends it received.

From time to time, Mr. Black gifted partnership units to family members, family trusts, a community foundation, and other charitable trusts.  In August, 2001, he contributed most of his remaining partnership interest to his revocable trust.

The revocable trust provided for a typically-structured marital trust for Mr. Black’s wife, if she survived him.

Mr. and Mrs. Black retained assets other than partnership interests that provided income that was more than sufficient to cover their personal living expenses.

Mrs. Black died so shortly after Mr. Black that his pecuniary bequest to the marital trust for the benefit of Mrs. Black hadn’t yet been funded.  The Black’s son, their executor, deemed the marital trust to have been funded on Mrs. Black’s date of death, and made a QTIP election on Mr. Black’s estate tax return.

The Service and the taxpayer agreed that the value of the partnership interest in Mr. Black’s revocable trust was approximately $165 million.

The executor set about raising funds to pay the estate tax due on Mrs. Black’s death.  He approached many leading commercial and investment banks, seeking a loan secured by a pledge of the estate’s partnership units.  No lender was willing to lend on those terms; rather, they requested a pledge of the partnership’s underlying Erie stock, as well as a “collar” under which Erie shares would be sold if their price fell below a specified level.  Neither was Erie willing to lend funds to Mrs. Black’s estate.

Instead, the executor and Erie settled on a secondary offering of some of the partnership’s Erie stock as an alternative to raise liquid funds to pay the estate tax.  A secondary offering was conducted, and raised $98 million.

The partnership then entered into a loan commitment with Mrs. Black’s estate and revocable trust, under which it agreed to loan $71 million at 6% interest under a 5-year balloon note.  The transaction was structured as a Graegin-type loan; prepayments of interest were not allowed.  Partnership units were pledged to secure repayment of the loan.  Interest on the loan was calculated at over $20 million, and was deducted on Schedule J of Mrs. Black’s estate tax return.

The loan proceeds were used for estate taxes, state inheritance taxes, funding a large charitable bequest, and administrative expenses.

The Tax Court first addressed the section 2036 issues.

Citing Thompson, Bongard, Mirowski, Kimbell, Stone, and (particularly) Schutt, the court found that Mr. Black’s transfer of Erie stock to the partnership was a bona fide said for full and adequate consideration [section 2036(a)].  The Service relied on Jorgensen in an effort to distinguish Schutt from the Black family’s facts, as well as Thompson, Strangi, and Harper.

The Court found that Mr. Black’s 70-year history with Erie was “easily the equal” of Mr. Schutt’s ties to and belief in Exxon and DuPont in Schutt.  Further, the Court found that Mr. Black’s concerns that his son might divorce his wife, or be pressured to sell Erie shares to raise cash requested by his wife (or by his wife’s parents) “proved to be prophetic”.  The Court also found that tying up Erie stock in the partnership provided effective protection against the stock being sold to fund an award to Mr. Black’s daughter-in-law under a divorce decree.  It accordingly determined that protection from (inter-family) creditors was a legitimate, significant non-tax business purpose for the partnership.

The Service argued that Mr. Black’s concerns that Erie stock in his grandchildren’s trusts might be sold were “speculative”, but the Court disagreed, finding them “reasonable given [the grandsons’] unwillingness to seek employment and their financial inexperience.”

Having found that the sale of Erie stock to the partnership was bona fide, the Court also found that it was for adequate and full consideration in money or money’s worth.  In so finding, the Court relied on its finding of a legitimate and significant non-tax purpose for the partnership, and the fact that the partners had received partnership interests proportionate to the value of the Erie stock they contributed.  Two other positive factors were proper crediting to capital accounts, and distributions requiring negative adjustments to distributee capital accounts.

The Court cited Thompson, Bongard, and Schutt in support of the observation that a “family limited partnership that does not conduct an active trade or business may nonetheless be formed for a legitimate and significant nontax reason.”

In conclusion, the Court found that Mr. Black’s transfer of Erie stock to the partnership was made for adequate and full consideration.  Accordingly, the fair market value of the underlying Erie stock was not includable in Mr. Black’s estate under section 2036(a)(1) or section 2036(a)(2).  Instead, the fair market value of the partnership interest was includable in the estate.

On the marital deduction issue, because it had found that the partnership interest (and not the underlying Erie stock) was includable in the gross estate, the Court found that the martial deduction to Mr. Black’s estate under section 2056 must be calculated according to the value of the partnership asset that actually passed to Mrs. Black, not the proportionate value of the underlying Erie stock.

On the section 2053 issues of whether the Graegin-type interest was deductible, the Service claimed that the loan was unnecessary, because the partnership could have distributed Erie shares to the estate or revocable trust, which could then have been sold to pay estate tax.  The Service claimed that the loan had no economic effect other than to generate an estate tax deduction.  The Court agreed with the Service on this issue, finding that the loan was unnecessary, and that the loan interest was not deductible under section 2053(a)(2).  Or, in the Court’s words: “The loan structure, in effect, constituted an indirect use of Erie stock to pay the debts of Mrs. Black’s estate and accomplished nothing more than a direct use of that stock for the same purpose would have accomplished, except for the substantial estate tax savings.

A key point differentiating the Black family’s facts from those in Todd, Graegin, or McKee was that a public market existed for Erie stock (while there had no corresponding public market in the other cases).

Most clients will not present facts as favorable as those in Black (most notably, a 70-year track record with one company and its stock, along with a “perfect storm” of bona fide inter-family creditor concerns relating to disfavored in-laws and allegedly feckless grandchildren).  For that reason, the decision’s applicability to other family limited partnerships may be somewhat limited.  Nonetheless, at KYEstates, every entry in the taxpayer win column is good news, and Black is no exception.