Because of the close IRS scrutiny, however it is important that the plan is carefully thought out, properly documented (the t’s crossed, the i’s dotted), and, after formation, appropriately run as a bona fide business arrangement.
As estate planning lawyers, we pay attention to the case law involving family partnership in order to anticipate, and avoid, IRS challenges. A recent federal Court of Appeals case, involving a Texas estate, demonstrates that almost everything can go wrong in the planning yet the IRS can lose its challenge. Perhaps the way to look at this case is to figure it will only work in Texas and should not be tried anywhere else – certainly not in Maryland. It shows, however, that you should play the hand you are dealt and not fold regardless of how bleak the facts.
The case had extraordinary facts. Maude Williams thought about forming a family limited partnership in order to secure tax savings through valuation discounting. Maude thought about this for several years never taking action. Then, when hospitalized, her financial advisors met with her in the hospital and she signed various partnership documents including a “schedule of assets” contributed to the partnership. This schedule of assets, however, was left blank. Apparently, Maude had planned on contributing a sizeable amount of community property from her deceased husband’s trust and an equally sizeable amount of property from her own account. She also wanted to form a LLC to be the one percent general partner. The partnership was filed with the appropriate Texas administrative body on May 11. Maude died on May 15 before the “paperwork” memorializing the capital contributions was completed. Thus, the partnership was actually funded after her death.
After a four day bench trial in a tax refund case, the Texas U.S. District Court found that she complied with enough Texas law for the partnership to qualify as a partnership formed during her lifetime and (and this is a big “and”) it was funded before her death by her clear intention to transfer the assets to the partnership. Accordingly, at her death under Texas law it was a fully operating and funded partnership. [This, in fact, parallels the concept in our Uniform Partnership Act that provides that title need not be formally held by a partnership in order for it to be partnership property. Indeed, there are many Maryland cases involving whether a partnership was formed where the property was not titled in the name of the partnership.]
Further, when the partnership transferred cash to the estate to pay the federal estate tax, that transfer of cash was retroactively restructured as a loan from the family partnership and the loan qualified as a “Graegin note.” Under the Graegin note rules the interest payments are deductible thus triggering a tax refund because of this deduction. All in all, this is a stunning taxpayer win.
We have formed numerous family partnerships, including some that we shepherded through IRS audits, and we have achieved significant valuation discounts. It is our experience that auditors carefully look to see whether you have “dotted all of the i’s” and “crossed all the t’s” in forming, funding, and running the family partnership. We have also structured and shepherded some Graegin notes through IRS audits. [This, by the way, is a super technique in appropriate cases.] Although the original Graegin case involved a family partnership lending money to the estate, our Graegin notes have been with third-party lenders thus having all of the bona fides of third-party loan transactions. Even in these cases, IRS auditors examine the transactions carefully. This Texas case ought to come in handy when discussing technical compliance issues with auditors. Keller v. U.S., 2012 WL 4867129 (5th Cir. Sept. 25, 2012).