One Heck of a Refund

One Heck of a Refund

Fifth Circuit affirms an estate is entitled to over $115 million in overpayment of estate taxes

When Maude Williams died over 12 years ago, she left behind a family limited partnership (FLP).  The good news for her heirs was that at the time of her death, Maude had amassed a substantial fortune. The bad news was that her estate-planning documents were incomplete and, as a result, an estate tax bill of $147 million was due.  Maude’s heirs, however, were in luck:  The U.S. Court of Appeals for the Fifth Circuit agreed with the district court that despite a few blanks in Maude’s FLP transfer documents, Maude had sufficiently capitalized her FLP before her death and, as such, her estate was entitled to a hefty refund of the estate taxes paid (Thomas Lane Keller, et al. v. United States, Case No. 10-41311 (5th Cir. Sept. 25, 2012)).

Forming the FLP

After Maude’s husband died in 1999, she decided to establish an FLP to protect her family’s assets.  The FLP was to be comprised of two limited partner trusts (each holding 49.95 percent limited partnership interests) and a general partner limited liability company (LLC) that would hold 0.1 percent limited partnership interest.  The two limited partner trusts were to fund the FLP with bonds, and Maude was to initially own all shares of the LLC.

Maude approved all of the plans to create the FLP; her advisors registered the FLP with the appropriate secretary of state and filed the LLC’s articles of organization.  However, Maude never signed any transfer documents until she became ill and was hospitalized.  During one of her hospitalizations, she signed the FLP agreement and the LLC incorporation documents, and one of her advisors notarized her signature.  However, the capital contributions section of the FLP agreement was left blank.

When Maude passed away, her advisors thought that they didn’t fully create and fund the FLP prior to Maude’s death, and they stopped activating the FLP and LLP.  When Maude’s tax bill came due, her estate paid over $147 million in estate taxes.  About a year later, one of Maude’s advisors attended a seminar and reconsidered his initial conclusion that Maude’s FLP wasn’t sufficiently created and funded.  He then formally transferred the bonds to the FLP and determined that, at the time of the estate tax payment, the FLP didn’t have enough liquid assets to pay the tax bill.  So, Maude’s advisors restructured the tax payment as a $114 million loan from the FLP to the estate, and the estate issued a promissory note back to the FLP.  Maude’s estate then filed a claim for a refund with the Internal Revenue Service, asserting that: 1) the estate’s initial fair market value of Maude’s assets didn’t discount the value of the FLP, which resulted in an overpayment of taxes, and 2) the estate had accrued interest on the FLP’s loan, entitling the estate to a deduction.

Taxpayer Victory in District Court

Maude’s estate argued that despite Maude’s failure to complete the FLP documents, her intent to transfer bonds to the FLP was enough to transform the bonds into FLP property.  This transfer rendered the estate taxes paid a loan from the FLP and, accordingly, the loan interest was deductible.  The IRS argued that Maude never created the FLP, because she failed to commit in writing the transfer of assets.  The IRS also argued that any loan between the FLP and the estate was a sham.

The district court found in favor of the estate, determining that Maude’s intent to transfer the bonds to the FLP was enough to effectuate the transfer, despite the absence of a completed written document confirming the transfer.  The court further found that the FLP was formed for a limited, non-tax-related purpose, with full and adequate consideration.  Finally, the court found that the loan transfer from the FLP to the estate was necessary in the estate’s administration, thus entitling the estate to a deduction for loan interest.  The court granted the estate a refund of $115,375,591.

Fifth Circuit Agrees

The appellate court affirmed the district court on all counts.  Rejecting the IRS’ statute of frauds argument that an FLP isn’t enforceable unless set out in writing and signed by the limited partner, the Fifth Circuit ruled that intent determines property ownership.  Because Maude transferred the bonds to the FLP immediately by forming the FLP and executing the FLP agreement with the intent that the bonds become community property, her intent immediately conferred “equitable title…to the partnership.”  The Fifth Circuit further found that Section 1.07(a)(4)(A) of the Texas Revised Limited Partnership Act is a record-keeping provision; it’s not meant to potentially invalidate a transfer for failure of recordation.  Therefore, prior to her death, Maude transferred to the full amount of the bonds to the FLP.

The Fifth Circuit also affirmed that the estate correctly deducted the interest on the restructured loan; the restructured loan wasn’t an “indirect use” of the bonds.  The court distinguished the facts surrounding Maude’s transfer from Estate of Black, 133 T.C. 340 (2009), in which the Tax Court denied a deduction for loan interest between an FLP and an estate.  In contrast to Black, involving a situation in which the estate couldn’t satisfy its tax bill without selling the underlying stock held by the Black FLP, Maude’s estate didn’t need to resort to redeeming partnership units or distributing FLP assets to repay the loan. Maude’s estate, excluding the FLP, had over $110 million of assets comprised of land and mineral assets from which to repay the loan.  However, these assets were illiquid and as such, justified a loan to the estate to pay the tax bill.   Since the loan was justified and a necessarily incurred administrative expense, the loan interest was deductible.

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