If there is one lesson I have learned in preparing estate plans, it is to avoid getting too "cute" in drafting them. One family’s attempt to guarantee maintenance and support of an aging widow went too far and caused the IRS to bite back.

Mr. Abraham died in 1991 leaving a wife and four children. When he died, his children challenged his Will and guardians were appointed for his wife who was no longer able to care for herself. The guardians wanted to ensure adequate funds for Mrs. Abrahams’ needs and agreed to a settlement with the children and the probate court. It required the guardians to set up four family limited partnerships (FLPs), one for each child. It also said the children would "share equally any and all costs and expenses related to the support of Ida Abraham insofar as the funds generated by Ida Abraham’s properties . . . do not provide sufficient funds for her adequate health, safety, welfare and comfort as determined by the guardians." It also said the income from these FLPs would be paid to the children, but only after all "fees, taxes, partnership administrative expenses, and reserves for the expenses and monies needed in the discretion of the guardians for Ida Abraham’s support" were deducted.

The children were gifted and bought interests in these FLPs. Two years prior to Ida’s death, the children each transferred $160,000 to Ida for certain partnership interests. The price to be paid was based on an appraisal in which the appraiser said "I make no representation that these discounts will hold up." Sometime later, the children each paid their FLPs another $170,000 for the purchase of additional FLP interests.

The general partners (GPs) of the FLPs were separate corporations, the presidents of which were Ida’s guardians. The corporate shares were held in separate trusts with Ida’s guardians acting as Trustees.

You can see what the family and guardians were doing. They built interwoven layers of FLPs, GPs, corporations and a guardianship between Ida Abraham and the assets supporting her to conceal from the IRS what was really happening. The IRS was not fooled.

When Ida Abraham died, the family excluded all of the FLP interests gifted or sold to her children. The IRS challenged this exclusion and the case wound up before the United States Tax Court. During the hearings, one daughter admitted that if there wasn’t enough money in her mother’s FLP fund, "it had to come out of" her shares or her siblings’, but the protection was there to guarantee Ida could continue to live "status quo." Also, one of the guardians testified that only after he paid all of Ida’s expenses did he pay the excess income to the daughter.

The Tax Court said it would only exclude gifted or sold assets from a decedent’s estate if she "absolutely, unequivocally, irrevocably, and without possible reservations, parts with all title, possession and enjoyment of the transferred property." It also said that "the retention of a property’s income stream after the property has been transferred is ‘very clear evidence that the decedent did indeed retain possession or enjoyment’"

The court ruled against the family on several grounds. First, it looked at the $160,000 purchases of FLP interests and said these were not based on a proper appraisal since even the appraiser was unwilling to stand behind his appraisals. The statement that he made "no representation that these discounts will hold up" sounded a death knell for these purchases.

The court then examined the second set of $170,000 purchases and found the payments were made to the FLPs, not Ida. Because the payments were not made to her, they were not adequate consideration for these purchases and their exclusion was rejected, as well.

The court had the biggest problem with Ida’s retention of the FLP income. The court said that even though she transferred her interests to her children, she continued to enjoy the right to support and maintenance from all the income generated by the FLPs. The settlement with the probate court said Ida’s support was to be paid from the FLPs’ income first and only after her needs were met would her children receive their share of the FLPs’ income. Ida’s support needs were treated as an obligation of these limited partnerships.

Judge Ruwe, writing for the Tax Court, said "the record demonstrates that the structure that decedent employed through her legal representatives and family was merely a testamentary vehicle employed to shift her assets to future generations while maintaining her continued right to benefit from the FLP interests transferred."

There are two major lessons to be learned from this case. First, you cannot remove property from your estate by sale or transfer and still retain a priority claim on all income generated by the asset during your lifetime.

Second, to qualify for valuation discounts, you must have a full and meaningful appraisal. If the appraiser waffles or tries to limit responsibility for the report, the IRS and Tax Court will reject the discounts.

Estate planning is a trap waiting for the unweary. Consult with a competent, professional advisor, be sure you understand exactly what he or she is doing on your behalf, and remember that being too cute can cost you big money in the long run.

© Jerry E. Shiles 2004

To return to the Strategic Planning Articles click here.

Please read the following disclaimer about this website.
Content ©2004 Brown & Associates, PLLC. All rights reserved.