Merry Christmas and Good Cheer for the Holidays - Let's hope that the year 2009 will see an improvement in the national economy, that peace efforts throughout the world will bear fruit!
Mary Ann and I have much to be thankful for - love and good health truly are important assets to be preserved and enjoyed. We enjoyed a summer small ship cruise in Southeastern Alaska, and of greatest enjoyment, we witnessed our son Mark's marriage to his love, Chelsea - on the beach at Stinson Beach just north of the SF Golden Gate Bridge. Also, my consulting and education activities in 2008 allowed me to apply my decades of experience in estate planning - more of the same is anticipated in 2009.
My next newsletter, in January of 2009, will focus appropriately on the impact on estate planning of the current recession involving much loss of wealth for many families. In addition, the incoming Obama Administration, while having many issues to consider, most probably will get into the tax arena big time -
even the gift and estate tax area(especially with the 2001 Act coming to the point of the 1-year repeal of the Federal estate tax in 2010). Watch for the January newsletter as it will provide suggestions for client communications with clients on estate plan review and update, new practitioner resources to do a better job in estate planning, and as always, recent developments.
In January, on January 13th and 14th specifically, I again am online in a live webcast sponsored by CPE Link - see www.cpelink.com for details of the Valuation and FLP courses to be offered online those days. These are interactive webcasts so lots of give and take is possible.
In 2009, my association with Western CPE continues, which this coming year includes my being a presenter for two (2) days at each of 7 "resort conferences"(35 such conferences are offered by Western CPE each year). My two (2) new courses are as follows: "Hot Topics in Estate Planning" and "Family Business and Investment Entity Planning and Preservation". My presentations will be in such places as Jackson Hole, WY (late May), Whitefish, MT, Sunriver, OR, San Diego, CA(all in July), and then later on in the year(see the schedule at www.westernCPE.com) I will be at resort conferences in Palm Springs, CA, New Orleans, LA, and Las Vegas, NV.
The Hurford Tax Court Opinion (12/11/08) - Hurford v. Commissioner, T.C. Memo. 2008-278, decided by Tax Court Judge Holmes - - FLPs and a Private Annuity Exchange of FLP Interests for an Annuity Disregarded Entirely!
Estate planners - and their clients - should be shocked by the Hurford opinion due principally to the overreaching, sloppy, manipulative advice and actions the estate planning attorney for Thelma Hurford. As we will see in this case discussion, the planner stretched to combine the FLP plan with a private annuity even while his client was suffering from cancer, he failed miserably in execution of his plan in many ways, he obviously disregarded or failed to appreciate the lessons learned over the past dozen years on how properly to use FLP/LLC planning. But Judge Holmes patiently went through some 45 pages of finding of facts and then in his final 40 pages of opinion in the 85 page decision set out a number of issues, finding against the estate in all of them(actually against the estate's attorney, but the estate paid the price!) except on the negligence penalty asserted by the Service. Along the way in this opinion, there are not only lessons to be learned, but also specific factors to consider in how to structure, document, implement and monitor a successful FLP plan - which might well in some fashion even be combined with a private annuity in some instances.
A key to what came after in the opinion is Judge Holmes' first statement therein: "It is a truth universally acknowledged, that a recently widowed woman in possession of a good fortune must be in want of an estate planner." As we will see, this perhaps "tongue in cheek" statement foretells the story of disaster that occurred by the Hurford case. So below, I will review the family and its wealth, the estate plans of husband Gary, who died in April, 1999, and his wife, Thelma, who died in February, 2001, and what went on in the estate planning area, while Thelma was bravely battling cancer. Then we will try and make some sense, in terms of positive planning lessons, out of this latest Tax Court opinion in the most litigious area of Federal transfer taxation.
I should mention that any day now we expect some commentary from Paul Hood and from John Porter on the Hurford case to appear in LISI - www.leimbergservices.com - the outstanding source for alert newsletters on estate planning and other subjects. In addition, FMV Opinions, Inc., www.fmv.com, just released an extensive analysis of the case. Finally, Business Valuation Resources, www.bvresources.com, in its BVWire publication, bvwire.com, alerted its appraiser and other subscribers to the case and its various implications.
In earlier newsletters of mine this past year, I discussed estate tax cases Rector v. Commissioner(1/3/08) and Estate of Mirowski(5/1/08), and more recently several gift tax FLP cases - see newsletters of 9/14/08 and 10/20/08 - - all available in my newsletter archives for your review. But really, in terms of "bad lawyering", Hurford wins the prize! So in the following discussion, keep thinking how you would do the planning differently than Mr. Garza, the hapless planner hit hard by Judge Holmes in his opinion. Judge Holmes criticized Mr. Garza for his "sloppiness", pointed to his having "mangled" the predeceased husband's estate plan(handled by former counsel, quite competent and well respected), and concluded that Garza had "conjured partnership discounts out of the air"! Further, the husband having died in April of 1999, and Garza having filed the 706 estate tax return for his estate, a year later - in spite of obviously substantial value changes in estate assets - Garza merely continued using the 706 values, i.e. without any new evaluations! This case is a must reading for tax professionals, although I warn you it is also sad to see a trusting, perhaps naively so, family served so poorly by a tax professional.
First Estate Tax Case to Refer to IRC Sec. 704(e) in the past 10 years!
In the early 1950s, after judicial confusion about the income tax reality of family partnerships, Congress took over and enacted IRC Sec. 704(e), the family partnership "safe harbor". Here the tests are first is capital a material income-producing factor for the partnership. Then, second, is the "donee partner" (younger generation family member usually, by gift or sale) of a partnership interest treated as a true partner.
At page 71 of an 85 page opinion, Judge Holmes points out that "For an FLP to work, the minority interest holders must at a minimum receive their interests either by gift or by contributing their own assets or services", citing Income Tax Regs. Sec. 1.704-1(e)(1)(iii) - which sets out a bona fide transaction test, i.e. "not a mere sham for tax avoidance or evasion purposes", i.e. that the donee partner must be a real owner of the interest in the entity. So here in Hurford, Judge Holmes points to the income tax area, and then of course continues thereafter by applying IRC Sec. 2036 and 2038 to the situation, as seen below. What he then says is significant: "We have found no legal authority for Garza's position that partners can have a partnership interest with nothing more than a shuffle of paper."(referring to Garza's having set up 3 FLPs with partners including children prior to any funding of the entities, and in fact the children never contributed anything and mother never reported gifts of interests to them!)
The Hurford Family, Its Wealth and the Deaths of Gary and Thelma.
Gary and Thelma Hurford had three children, Michael(a psychiatrist), David(having ongoing problems, and working on family ranches), and Michelle(involved in parents' finances and bookkeeping). The Hurfords were domiciled in Texas, where Gary eventually became the first non-family President of Hunt Oil Co. In fact the largest single asset in the Senior Hurfords' estate(Texas community property) was Hunt Oil Co. "phantom stock" - i.e. a nonqualified deferred compensation program tied to the value of Hunt Oil shares.
Gary died in April, 1999, and at that time the community estate was in excess of $14 million in value, with farms and ranches of over $2 million, over $2 million in marketable securities, $5.5 million in the referenced Hunt Oil phantom stock, plus life insurance and other property.
A highly respected estate planner, Sandy Bisignano, planned the Hurfords' estates in 1993 using a conservative approach as Gary's choice (even though Sandy had discussed FLPs, GRATs, and irrevocable life insurance trusts). So Gary's estate plan at his death involved dividing most of his community half of the total estate of the Hurfords into a $650,000 bypass "Family Trust" and the QTIP Marital Trust, with Thelma as the successor trustee upon Gary's death. Following Gary's death, Thelma had to get into the financial picture, something new for her, and professional advice was sought - including Chase Bank of Texas for investment advice, first Mr. Bisignano as counsel - including on Thelma's own estate plan. First of all, Sandy suggested and Thelman agreed to make $675,000 in gifts to the 3 children, which was done in February of 2000 - totaling the gift-tax exemption amount at the time. The Bisignano recommendations included partnership planning, but no action then was taken. In August, 2000, Gary's retirement a/c was rolled into an IRA in his wife's name. Then the farm and ranch properties all were leased out, as Thelma did not want to be involved in them.
Unfortunately, in early 2000 Thelma was diagnosed with stage 3 cancer, and she began fighting the disease during this period of having to be involved more in the financial aspects of family wealth than ever before. There were family concerns about understanding Mr. Bisignano's recommendations, as well as the timeliness of his planning for Thelma - who knows the reality involved here? In any event, Michael searched for a new attorney, one was found and retained, Joe B. Garza, and Bisignano was terminated - obviously this was not a wise choice for the family as it turned out. Judge Holmes, in introducing his discussion of the "Garza Plan" stated that, according to Garza, a "brilliant estate-planning strategy" is one "that saves estate tax". Who could quarrel with that - if that is NOT the sole purpose of the estate plan!
So, as reviewed below, Mr. Garza began his program of setting up three (3) FLPs, and then having Thelma enter into a private annuity transaction with her transfer in exchange for an annuity of all her interests (over 96%) in the FLPs - if it had worked great result, as she died within a year of setting this all up and the concept in a private annuity is that there is no estate tax includability of the exchanged assets upon the annuitant's death. Sham transactions, Secs. 2036, 2038 and 2035 applicability, and strong criticism of the failures of Garza were the opinions of Judge Holmes in his analysis of what had been done. Mr. Garza had even had Thelma pull out the assets from the bypass and marital trusts to put into the FLPs, thus, as the Judge noted, "mangling" the husband's estate plan.
The Garza Plan - Planning Without Care and without Careful Implementation.
Much detail on the facts and the failings of Mr. Garza is included in Judge Holmes' opinion. The formalities of the FLPs were not followed, the handling of formation and funding was amazingly fouled up, the values used were out-of-date at time of formation and the private annuity exchange(Garza using lower Gary estate tax return values from the year before), moneys to pay the private annuity payments of $80,000 per month came from the partnership assets just previously contributed to the FLPs. In fact, one of the FLPs held only the Hunt Oil Co. phantom stock - note that this was a Sec. 691 asset in the estate without step-up in basis, and clearly as time went on there would be an "anticipatory assignment of income" (Sec. 61) issue for income tax purposes!
The "first obstacle" facing an aggressive planner, per Judge Holmes, is the necessity of using "fair market value" in valuing gifts or estate transfers. Then the Court considers how private annuities work, being able (absent an issue, which really appeared to be present here, of not having a reasonable life expectancy of beyond at least a year) to using mortality tables in structuring the private annuity.
The Court delved in depth into the "execution" of Garza's Plan - first, "Phase I" the three (3) FLPs - and here in all the documents, the Court noted an "unsteady drafting ability" pointing out many errors in the documents, the setup, the funding, etc. The Garza Plan went forward without completion in proper manner of the FLP funding! Then, second, "Phase II" was the private annuity transaction between Thelman and only 2 of her children, Michael and Michelle - even though the evidence showed the intention was that David was a 1/3 owner/beneficiary - Query? - was the lawyer just avoiding working out a carefully drafted trust to protect David from his problems?
In valuing the FLP property, as stated above, Garza just utterly failed to use current values, instead using the 706 values in Gary's estate. Further, he obtained valuation discount information informally from appraisers, and then "out of the air" set his own numbers - how bad is that?
Thelma died in February, 2001, not even 2 years after her husband's death, possibly believing she had preserved her estate for her children - nothing was further from the truth,sadly.
Tax Returns, Audit, Deficiencies Proposed and the Court's Determinations.
The opinion of Judge Holmes goes into detail on the many tax returns involved in the Garza Plan, including that Garza prepared and filed the 706 in Gary's Estate as well as the 706 for Thelma's estate. In Thelma's 706, Garza failed to answer the pointed questions on the 706 Form as to whether decedent owned an interest in a partnership, whether 2035, 2036, 2037, 2038 transfers were involved, and on and on - so the Court roundly criticized Garza on his return preparation. Thelma's estate tax return reported only $847,000 in assets - this could have been the proper reporting, in my view, if the facts were better, Thelma lived a number of years, the documents and their handling in fact had been handled properly - but with "Garza at the switch", that was not going to happen!
The 90-Day Letter Notices of Deficiency following audit included estate tax deficiency in Thelma's estate of $9.8 million, plus the proposed $1.9 million negligence penalty. A companion and alternative deficiency notice for gift taxes, $8.3 million, was issued - but eliminated by the Court, which went with the estate tax deficiency approach. Right out of the box, the estate conceded an estate increase in value of $3.4 million as Garza failed to report certain items, including money Thelma received when she liquidated her IRA(!).
So the Court, in introducing the Opinion section to its decision. stated the main issue to be decided is "what else should have been included - - specifically, whether Thelma's transfers to the FLPs and the subsequent private annuity transaction were valid under sections 2035, 2036 and 2038", plus several other issues. Essentially, without belaboring the facts and failings of the attorney, the Court concluded the private annuity was a sham and the partnerships should be disregarded(including all claimed "discounts") under sections 2036 and 2038 - lots of detail in the opinion to analyze on these points.
This appears to be the ultimate "house of cards" situation, i.e. the private annuity disregarded, the partnerships disregarded, and the above-referenced "mangling" of the predeceased husband's estate resulting in the maximum possible value in Thelma's estate subject to estate tax. The only issue won by the estate related to the negligence penalty, perhaps due to the obvious trusting nature of the family and its having been open with the Service throughout the process of the case.
A reading of this case provides insights into the Tax Court's perceived factors both as to the "bona fide sale" exception to Secs. 2036 and 2038 and as to the issues under Secs. 2036(a)(1) and (a)(2) designed to bring back into the estate assets transferred in essentially testamentary fashion. I recommend that tax practitioners review the factors presented by the Court in these areas, considering them in future planning.
I sincerely hope this review of Hurford is helpful to my readers - no doubt more cases will come down on FLPs, hopefully some will confirm the propriety of this approach to wealth preservation. However, the advisors and the client must be in sync with the plan and not try and, especially with someone suffering from severe illness, eliminate virtually all estate tax.
Again, regards and enjoy the Holiday Season!
Owen Fiore
