The Tax Court held that although a family limited partnership (FLP) conducted no active trade or business, it nonetheless fulfilled a legitimate and significant nontax purpose. Thus, a discounted value of an interest in the FLP, rather than that of stock with which it was funded, was includible in a decedent’s estate. The Tax Court held that other important factors in the FLP’s legitimacy were that interests in it constituted adequate and full consideration for the transfer of stock to it and that the interests were apportioned proportionately to its participants’ contributions.
The court thus rejected an IRS deficiency determination with respect to the estate of Samuel P. Black Jr. of more than $129 million. Also as a result, the Tax Court rejected a deficiency determination of more than $82 million with respect to the estate of Black’s widow, who died five months after him.
Samuel P. Black Jr. was a founding employee in 1927 of Erie Indemnity Co. Over the next 70 years, he, more than any other person, made the company successful and accumulated much of its stock. Following the recommendation of his estate planner, he made gifts of stock to his son and trusts for each of his two grandchildren. In 1993 he was concerned that his son would either sell the stock or lose it in a divorce. He was also concerned that his grandchildren, who would soon receive distributions from the trusts, would sell the stock, because they were not employed or seeking employment. He wanted to prevent the disposition of the stock because he felt that it would appreciate significantly and that the ownership of all the stock would provide enough voting interest to affect the future direction of the company. Consequently, he created the FLP, transferring into it for his interest the Erie Indemnity stock.
His son and the trusts transferred in their stock for their ownership interests in the FLP. At Black’s death in 2001, the discounted value of his interest in the FLP was included in his estate. The IRS contended the estate’s value should be based on the full value of the stock, arguing that the partnership was created for tax avoidance purposes. The Tax Court noted that an appeal from its decision would go to the Third Circuit Court of Appeals. Therefore, it relied on this court’s approach to the issue.
Pursuant to IRC § 2036, such a transfer to an FLP must be a bona fide sale for full and adequate consideration. A bona fide sale need not be at arm’s-length, but it must provide the transferor some potential nontax benefit. Consequently, the FLP must demonstrate legitimate and significant nontax reasons for its creation. These reasons must be real and not theoretical.
Normally, a taxpayer’s desire to force a buy-and-hold investment strategy on related owners of the stock is not a valid nontax reason for forming a partnership. In unusual circumstances, however, it can rise to the level of a valid purpose. For example, in Estate of Schutt (TC Memo 2005-126), the desire for a buy-and-hold strategy for DuPont stock was a valid purpose because the transferor was a member of the DuPont family. In the present case, the court accepted the decedent’s long-term relationship with Erie Indemnity, his honest belief that its stock would significantly increase in value, and the need to protect its voting power as justifying his buy-and-hold strategy. The taxpayer was able to prove that the disposition of the stock was not just a hypothetical possibility but a reason for concern. The son had already pledged some of the stock to aid his father-in-law. The grandchildren’s need to convert the stock to cash was also demonstrated. Therefore, the court ruled that significant nontax reasons existed for the creation of the partnership.
Next, the court turned to whether full and adequate consideration was paid. The taxpayer argued that adequate consideration was proven, because the Service acknowledged that the interests in the partnership the transferors received were proportionate to the fair market value of their stock transferred to it. The Service argued that value swaps were insufficient and the taxpayer must show that the partnership was engaged in a business. Merely holding investments was not such a business, the IRS argued. However, having held the FLP to have had a valid nontax purpose, the Tax Court held that purpose sufficient to allow a finding of adequate consideration based on the proportionate value of the interest in the FLP to that of the stock transferred for that interest.
Estate of Samuel P. Black Jr. v. Commissioner , 133 TC no. 15
By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.