Although we wish it were otherwise, taxpayers don’t always win FLP cases. In fairness, the IRS ought to win a case from time to time, given that they’re usually the party making the decision to settle or litigate. When the facts are as unfavorable to the taxpayer as they were in Estate of Malkin v. Comm’r, T.C. Memo. 2009-212 (Sept. 16, 2009), a self-respecting government really ought to be able to put a case in the win column, and that’s what happened here (even though the decedent was a timber baron, a fact that often bodes well for the taxpayer).
In Malkin, section 2036 was successfully applied against a taxpayer’s use of two family limited partnerships. The Tax Court also reviewed a series of taxable gifts to children upon the decedent’s repaying debts of the LLCs and the decedent’s various undocumented and documented loans to his children.
The decedent, a Mississippi resident, was CEO of a timber company, Delta & Pine Land Co. (D & PL). The decedent was diagnosed with pancreatic cancer in 1999 and died in November, 2000. Earlier in the 1990s, as decedent considered his estate planning, he “wanted to transfer some D & PL shares (worth more than $16 million) to his children, but he did not want them to sell those shares….In the end, decedent decided to form an FLP to hold the D & PL shares, and two trusts, one for each of his children, to hold limited partnership interests in the FLP.”
The decedent also controlled several limited liability companies (designated by roman numerals, and sometimes called the “Malkin LLCs”) with his son, Jonathan Malkin. Malkin III and Malkin IV were the capital members of a partnership decedent and his son controlled. Malkin I owned 43.33 percent of the general partner of that partnership. Malkin II and Malkin V each had a single $500,000 investment in two different private equity ventures.
To this end, the decedent’s accountants and attorneys undertook the following transaction to organize the Roger D. Malkin Family Limited Partnership (MFLP) and two trusts:
In August 1998, an unidentified source deposited $25,000 in the bank account of each MFLP trust. Each trust then issued its respective beneficiary a $25,000 demand promissory note payable to that beneficiary. A few days later, decedent made gifts of $500,000 to both trusts….
Decedent transferred 365,371 D & PL shares worth $16,782,120 to MFLP for 1,000 general partnership units and 98,494 limited partnership units. The trustees of each MFLP trust transferred $25,000 to MFLP for 253 limited partnership units. The trustees of each trust then entered into a contract with decedent for the purchase of 44,297 limited partnership units for $442,424 in cash and a 9-year, $3,981,816 self-canceling installment note (SCIN) with interest of 7.14 percent.
The trustees executed the SCINs and transferred the cash to decedent, and he assigned the limited partnership interests to the trustees. The trustees executed security agreements granting decedent a security interest in the limited partnership interests.
The trusts did not simply make SCIN payments as they came due. Instead, the payments were made through a circular flow of funds, in which the decedent loaned funds to his children, who loaned them to the trusts, which gave promissory notes to the children, and then finally paid the decedent.
In two instances, the trusts’ MFLP units were pledged to secure the decedent’s debts. In connection with the pledges, the decedent provided a personal guaranty of his assets to the trusts, and in one instance, MFLP was paid a guaranty fee of 0.75% of its assets pledged as security for the decedent’s debt.
After his pancreatic cancer diagnosis, the “decedent decided to create another FLP (Cotton Row Family Limited Partnership, or CRFLP) to hold his interests in the Malkin LLCs and another two trusts for his children to hold limited partnership interests in that second FLP.”
Because the decedent was terminally ill, the second transaction were sales for cash and ordinary promissory notes (SCINs weren’t used).
The Tax Court described the second transaction as follows:
On February 29, 2000, in exchange for all 100,000 CRFLP partnership units, decedent transferred to CRFLP a 30-percent interest in Malkin I, a 50-percent interest in Malkin II, a 99-percent interest in Malkin IV, and a 50-percent interest in Malkin V. On the same day, decedent executed an agreement purporting to assign 44,500 CRFLP limited partnership interests to each CRFLP trust.
On March 1, 2000, decedent executed documents establishing the CRFLP trusts. [The decedent’s accountant and attorney] were the original trustees of both trusts, and they served as trustees until shortly after decedent’s death. Each trust had its own bank account.
The trustees of both trusts entered into contracts with decedent for the purchase of 44,500 CRFLP limited partnership units for $400,500. The terms of the contracts [provided for a 10% cash down payment of $40,500 and a 9-year, $360,450 promissory note bearing interest at 6.8 percent].
About a week after the signing of the contracts, decedent transferred $40,525 to each CRFLP trust. Two days after those transfers, each trust transferred $40,500 to decedent as the 10-percent down payment for the CRFLP limited partnership units. The trustees also executed the promissory notes for the remainder of the purchase price. The trustees executed security agreements granting decedent a security interest in the limited partnership interests.
Subsequently, in “November 2000, decedent transferred 80,000 D & PL shares to CRFLP. Before transferring the shares, decedent had pledged them as collateral for a personal loan from Morgan Guaranty, and the shares remained as collateral after the transfer.”
The Tax Court further noted that “CRFLP trustees never paid interest on the promissory notes; decedent died before the first payment became due, and the estate never made any demand. MFLP and CRFLP constituted decedent’s entire estate plan for transferring wealth to his two children. Decedent, by his will, left nothing to them, and his estate was insolvent.”
The Tax Court also noted that even though the decedent’s 706 reported assets available to satisfy the decedent’s debts of less than $15.5 million, the total deductions claimed on Schedules J, K and O of the 706 exceeded $18 million.
The Tax Court then reviewed the arguments of the Service and the taxpayer on the section 2036(a)(1) issues. The Service argued that:
For purposes of section 2036(a), a transferor retains the enjoyment of property if there is an express or implied agreement at the time of the transfer that the transferor will retain the present economic benefits of the property, even if the retained right is not legally enforceable.” Respondent contends that both an express and an implied agreement existed between decedent and the trustees of the MFLP and CRFLP trusts that decedent would retain the present economic benefits of the property decedent transferred to MFLP and CRFLP. According to respondent, the…actual use of all…MFLP’s and CRFLP’s assets to secure and collateralize decedent’s pre- and post-death financial obligations belies the claim that no such understanding existed.
The Tax Court summarized the taxpayer’s defense on the section 2036 issues as follows:
Petitioners deny that any express or implied agreement allowed decedent to retain the present economic benefits of the property he transferred to the FLPs. As to MFLP, petitioners assert that its partners, i.e., decedent, the general partner, and …trustees for the limited partners, approved both resolutions pledging the D & PL shares. Even though the shares served as collateral for personal loans to decedent, to support each resolution decedent signed a guaranty that he would use his “personal assets” to repay his debt, plus interest.
Petitioners argue that pledging the D & PL shares was an investment decision, made at arm’s length, in the best interests of MFLP. As to CRFLP, petitioners assert that nothing in the record indicates that decedent pledged any CRFLP asset to secure his personal obligations, noting that decedent had pledged the 80,000 D & PL shares to Morgan Guaranty before he transferred them to CRFLP.
The Tax Court agreed with the Service:
We agree with petitioners as to the interests in the four Malkin LLCs decedent transferred to CRFLP. Nothing in the record suggests that any express or implied agreement gave decedent the right to retain the present economic benefits of those LLC interests. Petitioners fail to convince us, however, with respect to the D & PL stock. We agree with respondent that an implied agreement existed between decedent and the MFLP and CRFLP trustees that decedent would retain the right to use that transferred stock.
[Treas. Reg. Section 20.2036-1(b)(2)] states that a decedent retains “[t]he ‘use, possession, right to the income, or other enjoyment of the transferred property’… to the extent that the use, possession, right to the income, or other enjoyment is to be applied toward the discharge of a legal obligation of the decedent, or otherwise for his pecuniary benefit.” Decedent applied all the D & PL stock he transferred to the FLPs toward the discharge of his legal obligations.
As to the 365,371 D & PL shares MFLP held, petitioners have failed to show that the decision of decedent, [and the trustees of the trusts] to pledge those shares to secure the personal debts of decedent was a business decision made at arm’s length. ….petitioners argue that the decision to allow decedent to pledge the D & PL stock to secure his personal debt was in the best interests of MFLP. Yet petitioners do not explain what business purpose of MFLP that decision served….We find that decedent retained the right to use the 365,371 D & PL shares he transferred to MFLP.
As to the 80,000 D & PL shares CRFLP held, petitioners argue that nothing in the record indicates that decedent ever pledged any CRFLP assets to secure any personal financial obligation. Yet petitioners concede that decedent had pledged the 80,000 D & PL shares…before he transferred those shares to CRFLP. Petitioners evidently believe that timing is dispositive, but we see no relevant distinction between CRFLP’s pledging shares itself and receiving previously pledged shares….Moreover, petitioners offer no business reason for having CRFLP hold 80,000 D & PL shares pledged to secure decedent’s personal debt. We find that decedent retained the right to use the 80,000 D & PL shares he transferred to CRFLP.
The Tax Court agreed with the Service’s summary of the case:
Decedent’s relationship to his…[D & PL shares] never changed. He controlled them before and after the transfer to MFLP and CRFLP. The trusts… had no role in the affairs of the partnerships. Neither the trustees nor decedent’s children objected to his use of the stock to obtain personal loans. Decedent’s unrestricted use of…[the D & PL shares] suggests that there was an implied agreement that the … transferred [D & PL shares] would be available for decedent’s use.
Accordingly, it found that the decedent retained “the possession or enjoyment of” the D & PL shares he transferred to the FLPs within the meaning of section 2036(a)(1). Further, the Tax Court found that the decedent’s transfers of D & PL stock did not fall within the section 2036(a) exception for “bona fide” sales for “adequate and full consideration in money or money’s worth”:
Favorable estate tax treatment was the aim of the change in form. We are unable to identify a legitimate and significant nontax reason for the transfers. …We find that decedent’s transfers of D & PL stock to the FLPs achieved nothing more than testamentary objectives and tax benefits, and thus those transfers do not qualify for the bona fide sale exception in section 2036(a).
With respect to gift tax issues, the Tax Court found that:
Decedent made indirect gifts to his children when he transferred to CRFLP interests in the Malkin LLCs and subsequently transferred to his children’s trusts limited partnership interests in CRFLP. The gifts were of the interests in the Malkin LLCs, not of the limited partnership interests.
The Tax Court analogized the facts before it to those in Shepherd v. Comm’r, 115 T.C. 376 (2000), affd. 283 F.3d 1258 (11th Cir. 2002).
On February 29, 2000, decedent and the trustees of the CRFLP trusts signed the CRFLP partnership agreement….On March 1, 2000, decedent established the CRFLP trusts. Because Mississippi State law does not recognize a one-person partnership, CRFLP was valid only after the formation of the trusts…Only after CRFLP was validly formed on March 1, 2000, could decedent transfer his interests in the Malkin LLCs to it. Thus, at the time of that transfer, the CRFLP trusts were already limited partners, and they acquired interests in the Malkin LLCs by virtue of their status as limited partners.
Further, the Tax Court found “that decedent’s purported sale of limited partnership interests was a sham…” because:
The CRFLP trusts never paid any interest on the promissory notes; decedent died before the first payment became due, and the estate never made any demand…At the time decedent and the trusts executed the contracts, decedent was terminally ill. Decedent provided all the money for the 10-percent down payments; in effect, the notes constituted the only consideration the trusts gave decedent….petitioners offer no evidence, beyond the self-serving testimony of decedent’s children, that decedent expected the trusts (or his children) to pay the promissory notes. Given that decedent gave his children the money to pay the interest on the MFLP SCINs, we find their testimony as to the CRFLP promissory notes unconvincing.
On the gift tax issues, the Tax Court concluded that:
Petitioners offer no explanation for decedent’s actions other than his generosity and a donative intent. Those are motivations for a gift, however, not a sale…..Because a gift to a trust is a gift to its beneficiary…we find that in 2000 decedent made gifts to his children of his interests in the Malkin LLCs.
On various direct and indirect gift issues, the Tax Court found that:
In 2000, decedent made indirect gifts to his children when he transferred to CRFLP his interests in the Malkin LLCs. In 1998, 1999, and 2000, decedent made direct gifts to his children when he transferred cash to them. In 1998 and 2000, decedent made indirect gifts to his children when he paid debts of Malkin I and Malkin IV and transferred cash and a promissory note to Malkin IV.
With respect to deductions for administrative costs and expenses, the Tax Court concluded:
We deny the estate any deduction for…debt above the value of the collateral, (2) the claimed obligation of decedent to Malkin IV, and (3) the executors’ commission, attorney’s fees, and accounting fees. The sum of all deductions of the estate may not exceed the value of property includable in the estate for Federal estate tax purposes.
The lessons of Malkin aren’t new, but they bear repeating: family partnerships are well advised to actually follow through on the form of transactions:
- Make scheduled payments of interest and principal.
- Avoid circular flows of funds when notes are being repaid (or put differently, don’t use repayment terms that the underlying assets in the family limited partnership can’t support).
- Make sure actual funding sequences follow the form set out in transaction documents (or put differently, fund a trust purchasing partnership units before the transaction, not afterwards).
- Avoid making indirect gifts.
- Don’t “over-fund” family limited partnerships in relation to the decedent’s other assets and projected liabilities.
If the taxpayer must lose, it’s better that they lose because of bad facts, rather than a substantive change in the law, and it’s at least some consolation that Malkin is that kind of loss.