Saving a Busted Family Partnership Through a Marital Deduction? Not So Fast...
Tax, trusts and estates updates from around the country
Executive Summary: With the uptick in estate tax audit activity for family partnerships, whereby the partnership is pierced for purposes of Code Sections 2035 through 2038, a question can arise as to whether gross estate inclusion can be partially or fully offset by a marital deduction if a spouse has a partnership interest. But, the divergent character of the partnership assets included in the gross estate, and the partnership interest given to a spouse, may not satisfy the requirements for the estate tax marital deduction. Care must be taken when drafting a partnership agreement or LLC operating agreement to account for this possibility.
Family limited partnerships have been under attack by the IRS for many years, usually in cases where a discount is claimed for lack of marketability or lack of control. However, there can also be issues as to how gifts are “booked” within the partnership itself. When a contribution is credited solely to the capital account of the donor, then the contribution is not treated as a gift to the other partners. On the other hand, contributions by a partner which are allocated proportionately to other capital accounts are treated as indirect gifts to the other partners. The former may require an adjustment of the percent ownership interest, or partnership units, allocated to each partner.
Recent cases, such as Powell v. Commissioner, have introduced a new wrinkle. Not only might a partnership contribution be treated as a completed gift to other partners, but the contribution itself may be included in the gross estate under Code Sections 2035-2038. (Interestingly, I have not seen Section 2037 addressed for partnerships, but this could come into play for partnerships which have a limited term). Even where the transfer was not a completed gift to other partners, the inclusion of the contributed assets in the gross estate means a loss of the claimed “discount” on the estate or gift tax value of the partnership interests (addressed as the “donut hole” under Code Section 2043 in Powell).
What if, however, a Powell-type argument is made in the case of a family partnership where a surviving spouse is a partner? Could partnership contributions that were previously credited to the surviving spouse’s capital account be eligible for the estate tax marital deduction if the contributed assets are later included in the deceased spouse’s gross estate? This was at issue in TAM 200432015.
TAM 200432015
This Technical Advice Memorandum addressed a contribution of life insurance by an insured to a family LLC. Typically, when dealing with life insurance in a trust or entity, the core concern is the retention of incidents of ownership at the time of death under Code Section 2042. But, in this case, the transfer invoked Code Section 2035 because it was a transfer made within three years of the death of the insured.
Initially, the policy’s cash surrender value was credited solely to the insured’s capital account as an LLC member. At the time, the insured and the insured’s spouse were 50/50 members. Later, one-half of the cash surrender value of the policy was shifted from the capital account of the insured to the capital account of the spouse.
The insured died, and the estate and the IRS found themselves at odds over the amount of life insurance proceeds to be included in the gross estate. There were two sets of analysis for respective halves of the policy - the portion attributable to the insured’s membership interest at the time of contribution, and the portion attributable to the spouse’s membership interest at the time of the insured’s death. Subsequent gifts of LLC interests had been made by the insured and the insured’s spouse to their children, but the gift tax value of these interests was not at issue.
I will address each half of the life insurance in turn.
One-half attributable to insured
Overall, the IRS Office of Chief Counsel (OCC) argued that the transfer of the policy occurred within three years of the insured’s death, and would thus be disregarded under Code Sections 2035 and 2042. But, for the one-half of the policy attributable to the insured’s LLC interest at the time of contribution, the estate argued that the bona fide sale exception of Code Section 2035(d) should apply. Although at the time the Bongard opinion had not yet been issued by the Tax Court (it came out in 2005), the Office of Chief Counsel applied a similar two-factor test to the test set forth in Bongard - a valid non-tax business purpose, and a bona fide sale for full and adequate consideration.
In this case, the OCC took the position that a sale requires a bargain, and that there can be no bargain when the decedent sits on both sides of the transaction when creating a family LLC or partnership. This is a similar issue to the one encountered in the recent case of Estate of Moore v. Commissioner (which was recently affirmed by the 9th Circuit) - the other partners did not negotiate the terms of the partnership agreement. Instead, they were forced to take it or leave it when they received gifts of partnership interests.
While the OCC did not need to consider the estate’s arguments of adequate consideration, it took the position that the transaction did not appear to be motivated by business concerns. In this regard, the OCC drew an interesting distinction - a contribution to a valid functioning business enterprise creates a presumption of adequate consideration for the equity interest received in return, while a transfer to a newly-created entity is merely a change in form of ownership.
Thus, for the one-half of the policy credited to the insured’s capital account at the time of transfer, the bona fide sale exception to the three-year rule was not met, and as a result the life insurance proceeds were included in the decedent’s gross estate.
One-half attributable to spouse
Since one-half of the cash surrender value had been booked to the spouse’s capital account, this one-half was treated as a gift under Code Section 2511 and Treas. Reg. 25.2511-1(h). Thus, there could be no bona fide sale exception for this half to begin with - there was a gift of incidents of ownership within three years of death, creating inclusion of the other one-half of the policy proceeds in the gross estate.
Nonetheless, the estate argued that the estate should be entitled to an estate tax marital deduction for this one-half share of the life insurance proceeds. After all, these proceeds were treated as a gift to the spouse.
However, the OCC took the position that this transfer did not qualify for the marital deduction. Why? Because it was not in a qualifying form under Code Section 2056.
Typically, for life insurance (or any asset for that matter) to receive a marital deduction, there must be an outright transfer, or a transfer in a qualifying form. For life insurance, this means that proceeds must pass to the spouse as designated beneficiary, or to a marital trust. However, the spouse was not the designated beneficiary - the owner and beneficiary of the policy was the LLC.
If this seems like splitting hairs, it was, but there is an important distinction here on the character of the testamentary transfer. There had been a lifetime transfer of an LLC interest to the spouse, which would qualify for a gift tax marital deduction. But, when it comes to the testamentary transfer, what was at issue was the estate tax value of an underlying LLC asset - life insurance - which did not pass directly to the spouse. The proceeds were subject to governance and distribution under the LLC operating agreement. (As an aside, since it was this underlying asset being valued, and not the LLC interests, there was not opportunity for discounting.)
So, since the proceeds themselves did not pass to the surviving spouse, there was no marital deduction available. For the proceeds attributable to the spouse’s LLC interest to qualify, the spouse would have needed an immediate power to withdraw one-half of the life insurance, or the spouse’s LLC interest would need to have been structured as a marital trust equivalent (life estate coupled with either a testamentary general power of appointment, or a QTIP election).
(As another aside, this is why a well-drafted ILIT contains a contingent marital trust to receive any life insurance proceeds included in the insured’s gross estate).
Takeaways
While this TAM focused solely on life insurance, it has valuable takeaways in the current planning environment for family partnerships. As noted above, the angle of attack for the IRS is typically any retained interest or control under Code Sections 2036 and 2038. The three-year rule under Code Section 2035 can be invoked where there is a gift of life insurance within three years of death, or where a retained interest or control is released within three years of death.
But, in all of these cases, the estate’s primary defense is showing a bona fide sale, because there was an exchange of contributed assets for a new equity interest or an accretion to an existing equity interest. Where this fails, you must consider the character of what is included in the gross estate. Instead of pulling previously-gifted partnership interests back into the gross estate, the IRS looks instead to the underlying partnership assets that were credited to the capital accounts of those previously-gifted interests. It also looks to the contributed assets credited to the capital account of the deceased partner who was the contributor, while netting out the estate tax value of the deceased partner’s interest received in return under Code Section 2043 (to avoid double taxation).
(Presumably, the inclusion of the contributed assets in the gross estate also has the effect of netting out any previously-gifted partnership interests from the adjusted taxable gifts included in the estate tax calculation).
The problem then becomes claiming an offsetting estate tax deduction. In this TAM, the focus was on the marital deduction, which failed because the asset actually included in the gross estate was not what actually passed to the surviving spouse. Ironically, this means form dominates over substance.
There can also be an effect on the availability of the estate tax charitable deduction. Coming down the pike, I have another contributor lined up who will address this issue in the Moore case cited above.
Now, in terms of solutions, I cited the “easiest” solution above - giving the surviving spouse the right to immediately withdraw their share of any partnership assets included in the deceased spouse’s gross estate. This may not, however, be practical, especially for a “valid functional business enterprise” as noted above, as it can cause a loss of business assets to the spouse or to a creditor of the spouse. One must also consider the effect of such a right on the value of the surviving spouse’s interest at the time of gift, or at the time of the spouse’s death - in either case, you lose a discount. Further, the spouse’s release of this withdrawal right could create a gift tax release of a general power of appointment.
Given this reality, we could also consider whether the “contingent QTIP” approach often used to address 2035-2038 issues for gifts to irrevocable trusts could work. There are numerous issues here, but this would likely require the spouse’s partnership or LLC interest to be structured as a QTIP-equivalent. Under such an approach, the spouse would have to receive all income, at least annually, attributable to the spouse’s interest. This runs into an issue of semantics, because the definition of “income” under the UPIA for trusts, versus accounting standards for partnerships and LLCs, differs.
So, I have no good solution. But, as readers, you (individually and as a collective) are much smarter than I am. I would like to hear your thoughts on handling this issue. Where a bona fide sale defense fails, what can you do to make a marital deduction defense stick in the context of a family partnership or LLC?