In Estate of Powell,1 issued by the U.S. Tax Court on May 18, 2017, the court determined that cash and marketable securities transferred into a family limited partnership (FLP) under a power of attorney (POA) approximately one week before the taxpayer’s death were includible in the taxpayer’s gross estate under Internal Revenue Code Section 2036(a)(2). While the “bad facts” surrounding the transaction makes the result unsurprising, Powell is a notable decision both because it resurrects some of the less-regarded facets of the Tax Court’s decision in Estate of Strangi.2 Additionally, the court’s opinion was divided. The majority articulated a new analytical framework to achieve the long held end result of preventing double taxation on an FLP interest and its underlying assets when there’s inclusion under IRC Section 2036(a).
Death Bed Tax Planning
In Powell, approximately $10 million of cash and marketable securities were transferred from the taxpayer’s revocable trust to a FLP formed by the taxpayer’s son, as general partner, in exchange for a 99 percent limited partnership interest. Her sons were the only other owners in the FLP structure and their contributions were unsecured promissory notes. The same day, the taxpayer’s son, acting under a POA, attempted to transfer the taxpayer’s 99 percent limited partnership interest to a charitable lead annuity trust (CLAT), which directed an annuity interest to the taxpayer’s private foundation, with the remainder to be divided among trusts for the benefit of the taxpayer’s two sons. Notably, the taxpayer’s POA only granted her attorney-in-fact the authority to make gifts to the taxpayer’s descendants and limited such gifts to the federal gift tax annual exclusion. The gift to the CLAT was reported on a timely filed federal gift tax return, and the value of the 99 percent limited partnership interest was substantiated by a professional appraisal, which applied a 25 percent discount for lack of control and lack of marketability. The taxpayer died seven days after the transaction; medical records indicated she was incapacitated at the time of the transaction. This was very much a “death bed tax planning” scenario that many of the string provisions of the IRC are designed to prevent.
The Kitchen Sink
In its notices of deficiency, the Internal Revenue Service threw the proverbial kitchen sink filled with string provisions at the taxpayer’s estate, claiming deficiencies in both estate and gift tax and coincidentally forgetting to credit the taxpayer’s estate for the amount of the additional gift tax it had assessed. On the gift tax front, the IRS argued that the actuarial value attributed to the charitable lead interest was inappropriate in light of the taxpayer’s medical condition at the time of the transfer. On the estate tax front, the IRS argued that Section 2036(a)(1) and (2) acted to pull the assets of the FLP back into the taxpayer’s gross estate both because of the existence of an implied agreement entitling the taxpayer to possession and enjoyment of the assets during her lifetime, and because of the decedent’s ability, acting with her sons, to dissolve the FLP and thereby designate the persons who would possess and enjoy the transferred property.
Power to Terminate is Retained Right
In an interesting tactical decision, the taxpayer’s estate acquiesced to the IRS’ technical arguments. More specifically, the taxpayer’s estate stipulated to the IRS’ position that the decedent’s power, exercisable in conjunction with her sons to terminate the FLP, constituted a retained right subject to Section 2036(a)(2). This is notable because this position is consistent with an aspect of the Tax Court’s holding in Strangi that’s been criticized by practitioners over the years as being an overly broad interpretation of the statute — that Section 2036(a)(2) can be triggered merely by virtue of a taxpayer’s ability to vote to liquidate a partnership.
In the years since the decisions in Strangi and, more recently, Turner,3 practitioners advising clients with respect to the formation and operation of FLPs have been largely concerned with whether their clients held an interest in the general partner of the FLP. For the most part, what’s sometimes been referred to as the “second application” of the Strangi decision with respect to Section 2036(a)(2) — that even ownership of a limited partnership interest could cause inclusion under Section 2036(a)(2) — hasn’t been regarded as a winning position for the IRS in light of the impracticality of implementing such a restriction in family enterprises, and the general feeling that such a restriction is detached from the realities of both commercial and family entities. It’s certainly the case that optics and bad facts may have had a role to play in Powell, and the old adage that bad facts make bad law certainly rings true. Powell involves a situation in which the transaction was entered into less than a week before the taxpayer’s death, was accomplished under POA, involved the transfer of only cash and marketable securities at discount and didn’t seem to be bolstered by any business rationale whatsoever. The Tax Court acknowledged this by reference to another holding in Strangi, that the deference the court had previously shown to state law fiduciary duties in Byrum4 wouldn’t be respected in family transactions and would instead be ignored as being “illusory.” This is a reminder to practitioners that if a POA is being executed to ensure that tax efficient estate planning occurs after a taxpayer loses capacity, the powers granted should be sufficiently broad to allow for gifting and disinterested parties to be named as "agent" to avoid an argument that an agent was acting in his own interest.
Gross Estate Inclusion
Having concluded its analysis under Section 2036, the Tax Court chose to delve into the mechanical calculation of gross estate inclusion under Section 2036, an issue that wasn’t briefed by either the taxpayer’s estate or the IRS. Traditionally, when confronted with gross estate inclusion of FLPs under Section 2036, the Tax Court has simply disregarded the existence of an FLP and has instead held that the assets themselves, rather than an interest in the FLP, are to be included in the taxpayer’s gross estate. By ignoring the FLP and taxing the underlying assets, there’s no double taxation issue. The majority opinion in Powell, however, found that while taxing the underlying assets but avoiding double taxation is the correct result, the reason for the end result has gone “unarticulated” and the majority chose to “fill that lacuna and explain why a double inclusion in a decedent’s estate is not only illogical, [but also] not allowed” under IRC Section 2043(a). The majority held that the taxpayer’s gross estate should include: first, the value of the taxpayer’s partnership interest in the FLP under IRC Section 2033, which includes the valuation discounts taken; and second, the value of the assets transferred to the FLP less the value of the partnership interest the taxpayer received in return. Given that the end result of both the Tax Court’s traditional analysis and its newly-created fiction is identical, it’s unclear why the majority chose to not take what the concurrence referred to as the “straightforward path to the correct result.'" Nevertheless, it will be interesting to see if the Tax Court reinforces this novel approach in future opinions.
Practitioners advising clients with respect to new or existing FLPs should take note of the Powell decision and undertake a holistic analysis of the control structure involved in both a client’s FLP and overall estate plan. When pre-mortem transactions are necessary, steps should be taken to establish a legitimate significant business purpose so as to qualify for the bona fide sale exception to the application of Section 2036(a) and conservative valuation positions should be advanced to improve the optics of such transactions.
- Estate of Powell v. Commissioner, 148 T.C. 18 (2017).
- Estate of Strangi v. Comm’r, T.C. Memo 2003-145, aff'd 417 F.3d 468 (5th Cir. 2005).
- Estate of Turner v. Comm’r, T.C. Memo 2011-209.
- United States v. Byrum, 408 U.S. 125 (1972).