Jorgensen Application of Bona Fide Sale for Adequate Consideration Exception to IRC Section 2036

In Estate of Jorgensen v. Commissioner, T.C. Memo. 2009-66, the Tax Court included family limited partnership (FLP) assets in the decedent transferor’s gross estate pursuant to I.R.C. Section 2036. The decedent, Ms. Jorgensen, survived her husband, Colonel Jorgensen, who had been principally responsible for the couple’s financial and estate planning decisions. In the event of Colonel Jorgensen’s death, his daughter and son became co-trustees of the couple’s revocable trusts and general partners of the FLP. The couple’s assets consisted primarily of marketable securities purchased pursuant to a buy-and-hold philosophy of Colonel Jorgensen. The decedent apparently conversed with the estate planning attorney only through letters, and it was her husband and children who met with the attorney. Letters written to Ms. Jorgensen by the estate planner recommended the family limited partnership for the purpose of qualifying for a “35% discount” for federal estate tax purposes. Following Colonel Jorgensen’s death, the decedent created a second FLP so that one FLP would hold high basis assets and the other low basis assets. The opinion focuses on the issue of whether the transfers to the FLP were excepted from application of IRC Section 2036(a) under the bona fide sale for adequate and full consideration exception.
The court addresses the exception based on the two-prong analysis of the Tax Court in Estate of Bongard v. Commissioner, 124 T.C. 95 (2005). The court first considered whether “legitimate and significant nontax” reasons existed to substantiate creation of the limited partnership as “bona fide.” It addressed each of the following nontax reasons for formation of the two FLPs asserted by the estate. 
(1)       The court rejected taxpayer’s assertion that the FLPs were created to assist in providing “management succession.” The court distinguished this case from Estate of Mirowski v. Commissioner, T.C. Memo 2008-74, on the basis that the FLPs in Jorgensen did not require “active management” and instead were “passive investment vehicles” with no active securities trading. It also noted that management could have just as effectively been provided through Ms. Jorgensen’s revocable trust.
(2)       The court also rejected taxpayer’s assertion that the FLPs would educate children in how to manage a portfolio because the facts did not support such a purpose since Colonel Jorgensen made all management decisions without the involvement of his children and the children acknowledged they “faced a steep learning curve” following his death.
(3)       The estate’s argument that the FLP perpetuated an “investment philosophy” to “buy and hold” securities proved “unconvincing” since no special skills were needed to pursue this strategy. Nor did the court find the estate’s argument that the FLP would motivate the children to actively participate in management persuasive as the facts did not indicate the children participated in a “meaningful” manner.
(4)       Because testimony indicated that special investment advice could have been obtained from the financial advisor simply by linking the separate investment accounts together, the court determined that the FLP was unnecessary for this purpose and rejected the estate’s pooling of investments as a nontax reason.
(5)       The court also rejected spendthrift concerns of the estate. While it was acknowledged that Ms. Jorgensen’s son was not a responsible money manager, the fact that he was named a co-trustee and was provided a “loan” from the FLP undermined the argument that creditor protection was a significant nontax reason.
(6)       Finally, the need to treat children and grandchildren equally was irrelevant because simplification of gift giving is not an acknowledged legitimate nontax reason.
In coming to the conclusion that the sale was not bona fide, the court highlighted the letters from the estate planning attorney specifically noting discounts as the reason for creation of the FLPs, and the fact that the letter setting forth other reasons for FLP creation was drafted after the fact in contemplation of possible litigation. The court noted that Ms. Jorgensen had not respected the FLPs and had used the FLP assets to achieve her program of gift giving. Finally, it relied on the fact that, unlike in other cases, there was no arm’s length bargaining with regard to the terms of the FLP agreement since no one other than Colonel Jorgensen was consulted with regard to formation of the first FLP, and with respect to the second FLP, the decedent stood on both sides of the transaction.
Align Operation of FLP and Asserted Legitimate and Significant Nontax Reasons. The Jorgensen case, discussed above, highlights the danger of setting forth in a letter to the client that the reason for creating the family limited partnership is to obtain valuation discounts. The court intimated that legitimate and significant nontax reasons should be the motivating factor for creation of the FLP, and not an afterthought set forth in a letter after its creation. The Jorgensen opinion also reminds estate planners that operation of a family limited partnership must bolster the assertion of significant and legitimate nontax reasons for creation of the entity. For example, if the partnership has been created to encourage management participation of children, the children should in fact participate in FLP management. Also, if a beneficiary’s spendthrift tendencies are of primary concern, the beneficiary should not be named a manager. In Jorgensen the actual facts undercut the asserted nontax reasons for creation of the FLP.
In the Event the Service Successfully Includes FLP Assets in the Gross Estate, Determine Whether the Estate Should Request a Refund of Other Taxes That May Have Been Incurred by the Estate or Its Beneficiaries Because of the FLP. In Jorgensen, the FLPs sold stock following the decedent’s death in order to pay for estate taxes, and as a result reported capital gain on the stock sale, based on the transferred basis as opposed to a stepped-up basis. The gain was passed through to the FLP partners, and income tax was paid by them. The estate asked for a refund of income taxes paid by the partners on the earlier reporting of the stock sale by the FLP in light of the subsequent determination that the FLP assets must be included in the decedent’s gross estate thereby resulting in a stepped-up basis, which should have led to lower income taxes. The court applied the doctrine of equitable recoupment and allowed the estate to recover the unnecessarily paid income tax despite the bar of the statute of limitations. The equitable recoupment doctrine serves to prevent a windfall to either the taxpayer or the government. The taxpayer must prove four elements: (1) the statute of limitations has barred a claim for refund of the tax overpayment, (2) the time barred overpayment arose from the same taxable event as that giving rise to the tax, (3) the event has “been inconsistently subjected to two taxes,” and (4) there is sufficient identity of interest between the taxpayers subject to the two taxes at issue so that they “should be treated as one.” The Jorgensen court found that all four elements were met. With respect to the fourth element, the court cited Ms. Jorgensen’s implied agreement to retain the assets, and her objective to reduce taxes on passage of the estate’s property. The court analogized to the holding of Estate of Branson v. Commissioner, 113 T.C. 6 (1999), aff’d 264 F.3d 904 (9th Cir. 2001), which had allowed application of the doctrine of equitable recoupment when stock held by an estate was revalued after the residuary beneficiary had overpaid her income tax based on a lower basis.
For further discussion of family limited partnerships and estate tax considerations, see Modern Estate Planning (Second Edition) (LexisNexis)