Favorable FLP Case - Estate of Valeria M. Miller v. CIR. T.C. Memo. 2008-128 (May 27, 2009)

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Facts: Mrs. Miller’s deceased husband and her eldest son spent years researching and investing in securities. As a result, by the time Mr. Miller passed away in 2002, his gross estate was $7.7 million and it was virtually all marketable securities. Following Mr. Miller’s death, Mrs. Miller’s estate planning attorney established a family limited partnership (FLP) to hold the securities.

The FLP Certificate of Limited Partnership was filed in November 2001, the partnership agreement was signed in February 2002, and the FLP was funded with Mrs. Miller’s transfer of securities in April 2002. The IRS and the Tax Court did not raise any issues surrounding the timing of the formation and/or funding of the FLP. A total of 1,000 FLP units were issued to the partners, with 920 units (92%) retained by Mrs. Miller and 20 units (2%) going to each of her four adult children. After the April 2002 securities transfer, the FLP’s assets totaled nearly $4 million, constituting 77% of Mrs. Miller’s total assets. Mrs. Miller’s eldest son, Virgil, served as the manager of the FLP’s assets and he received a fee from the FLP for that management. In 2003, after falling and breaking her hip, Mrs. Miller contributed her remaining securities to the FLP, although she did not receive any additional FLP units for the contribution.

After her death in late 2003, the estate filed an Estate Tax Return reporting the value of her gross estate at $2.6 million, nearly all of which was the net discounted value of Mrs. Miller’s 920 FLP units. The estate tax of $994,299 was paid from a pro rata distribution in 2004 to FLP partners. The IRS’s notice of deficiency included in Mrs. Miller’s estate the date of death value of the 2002 and 2003 securities transferred to the FLP.

Ruling: The Tax Court was asked to determine whether the 35% valuation discount was to be allowed for the 2002 and 2003 securities transfers to the FLP, which would respect the estate’s ownership of FLP units rather than bringing the assets back into Mrs. Miller’s taxable estate.

Since the 2002 and the 2003 transfers were both inter vivos transfers made by Mrs. Miller, the Court first had to consider whether both sets of transfers were a bona fide sale or adequate and full consideration, giving the estate access to the §2036(a) “bona fide sale exception.” If the bona fide sale exception is not available then the other issue is whether the decedent retained an interest or right relating to the transferred securities either under §2036(a)(1) or (a)(2).

The estate argued that Mrs. Miller’s transfers to the FLP were bona fide sales because there were legitimate and substantial nontax reasons for creating the FLP, specifically providing for her eldest son to manage the securities portfolio. The estate also contended that the assets were actually transferred to the FLP, rather than being commingled with Mrs. Miller’s other assets, and that all partnership formalities were observed. The Service argued that the FLP was not a functioning business entity. The Service also questioned the following of partnership formalities due to the delay between filing the partnership certificate and actually funding the FLP. The Service based its arguments on the passive nature of the assets, Mrs. Miller’s age, her position on “both sides” of the transaction, and her failure to retain sufficient assets outside of the FLP.

As to the initial 2002 transfer of securities to the FLP, the Tax Court found credible evidence that the motivation behind the FLP’s formation was to allow continued management of the family assets in accordance with Mr. Miller’s investment strategies. The Tax Court also found that the FLP was not a passive holder of securities that Mrs. Miller’s age was not as important as her good health at the time of the 2002 transfers, and that Mrs. Miller retained sufficient assets outside of the FLP. The Court found that the §2036(a) bona fide sale exception was available for the 2002 transfers and allowed the 35% discount to stand.

The Tax Court then reversed itself with respect to the 2003 transfers, finding that the changes in the decedent’s health at the time of the transfers and her contribution of virtually all of her assets, made her motivations tax avoidance. Therefore the Court found that the §2036(a) bona fide sale exception was not available for the 2003 Transfers and taxed the securities transferred in 2003 at their date of death value without the application of the 35% discount.

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