Opinion gives a summary of many planning tests established in prior cases. David Eckstein is a managing director and co-founder of FMV Opinions, a New York-based valuation and financial-advisory services firm. Harry Kang leads the FMV Opinions' business valuation activities for its New York office.

Estate planners and literature lovers will want to read the Estate of Thelma G. Hurford v. Commissioner (T.C. Memo. 2008-278, 11 December 2008) opinion. It starts with a nice allusion to Jane Austen -- "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" -- before telling, as in a medieval morality tale, how the virtuous but naive Hurford family was led astray by estate-planning attorney Joe Garza, and avoided the worst of all fates -- penalties -- by dint of their honesty and good faith.

That's the literary side of Hurford v. Commisioner. For estate planners, the case provides a comprehensive review, based on numerous prior cases, of the factors that put an estate on the right or wrong side of Section 2036(a), and considers the connections between this section and sections 2035(a) and 2038(a)(1). Background

Gary Hurford was an oil-field engineer employed by Hunt Oil. After 25 years there, he became its president. Gary died on 8 April 1999, leaving an estate of approximately $14 million, consisting mostly of cash, marketable securities, Hunt Oil phantom stock and real estate. Gary and his estate-planning attorney Santo Bisignano had set up a bypass trust and a Qualified Terminable Interest Property (QTIP) trust to be funded by Gary's assets after his death. Gary's wife Thelma was generally not involved in the family's financial or estate planning.

Less than a year after Gary's death, Thelma was diagnosed with cancer. Thelma had already begun working with Bisignano to develop her own estate plan, but became dissatisfied and, one month after her diagnosis, switched to Garza. As Judge Holmes says of the Hurford family's selection of Garza over Bisignano, "Their infatuation with Garza was understandable. We observed Bisignano to be reserved and fastidious, and proud of the high quality of his work, but with a manner that on first appearance is perhaps not the most inviting. Garza, in contrast, is a model of the amiable and pleasing man."

Gary and Thelma had three children, Michael, David and Michelle. Thelma and Michelle kept detailed notes throughout the estate planning process. As noted in the opinion, "Michelle saved all these notes and turned them over to the Commissioner during discovery. We view Michelle's action as a strong indicator of her honesty and have used these notes extensively to reconstruct what happened after Gary died." The Judge Holmes continues: "But we use them with some caution. They show a general lack of understanding -- even some confusion -- about the tax and estate-planning concepts at issue in this case. This is entirely understandable, since neither Michelle nor her mother had an education in law or accounting."

Garza formed three family limited partnerships (FLPs; individually referred to as HI-1, HI-2 and HI-3) for Thelma, into which she transferred most of her assets and those of her husband's estate. Judge Holmes found that Garza made numerous mistakes when forming the FLPs. His documents demonstrated "unsteady drafting ability" by granting a limited partnership interest to a trust that didn't exist and including the wrong general partner in two of the three partnerships. "An unusual feature of Garza's plan was that he created the limited partnership interests before the partnerships were funded," the judge notes. "He testified that he did this to avoid gift taxes when Michael, David, and Michelle received their 1% interests. Garza reasoned that by creating the partnership interests first, each partner would start with a zero balance in his capital account and each capital account would remain at zero until that partner made a contribution. So when Thelma and Gary's estate funded the partnership, their capital accounts were to have increased by the amount each contributed. Conversely, Michael, David, and Michelle did not contribute anything to the partnerships, so they held a 1% interest in each partnership but had capital account balances of zero."

When assets were contributed to the FLPs, the contributions were reflected in the capital accounts, but the capital accounts reflected values from Gary's estate tax filing, not current values. Furthermore, the contributions were not proportional to the ownership percentages, and the ownership percentages did not change. The bypass trust's assets were distributed to Thelma, then contributed to the FLPs, thereby causing these assets to be included in Thelma's estate unnecessarily.

On 5 April 2000, about two weeks after the formation of the FLPs, Thelma sold her interests in the partnerships to her children for annuities. Although Garza contacted appraisers, he ultimately determined the values of her interests by multiplying the net asset values by her ownership percentages (ignoring the fact that her capital accounts represented a larger percentage) and then applying valuation discounts for lack of control and lack of marketability which he estimated himself. His calculations included outdated values and numbers which could not be reconciled by the court with any source. The amount of the valuation discounts was also unclear to the court from the record. (It is interesting to note that while the court commented on the prohibition against using the actuarial tables for an annuity on the life of a terminally ill individual, this possible attack on the annuity transaction is not discussed in the opinion.)

The annuity transaction transferred interests to Michael and Michelle, but not to David. The court ultimately concluded that Thelma intended for David to get one-third of Thelma's assets at death, but did not formally transfer the interest because David "struggled with difficult personal problems" and Thelma "wanted to protect both him and the assets, so she thought it best not to give him signature authority." The opinion later suggests: "A more artful attorney might have written a private annuity that made David's rights and obligations clear without giving him the ability to deplete the FLPs' assets."

Thelma died on 19 February 2001. Her estate subsequently reported taxable assets of $846,666. On 18 November 2004, the estate received two notices of deficiency: $9.8 million in taxes and $2.0 million in penalties for the 2000 estate tax return, and $8.3 million in taxes and $1.7 million in penalties for the 2000 gift tax return.

IRS' position

The court summarizes the position of the IRS like so.

"The Commissioner attacks the entire estate plan as nothing more than a transparently thin substitute for a will. He argues first that the property transferred to the FLPs is includable in Thelma's estate because Thelma kept control over the assets after the transfer, and because there was an implied agreement among the Hurfords for Thelma to do so. He also argues that Thelma's transfer of her property (and the property of the Trusts) in exchange for an interest in the FLPs was neither bona fide nor done for adequate and full consideration. The same is true for the exchange, only two weeks later, of her interest in those FLPs for the private annuity: The Commissioner argues that there is grossly insufficient evidence that the exchange of Thelma's interests in the FLPs for the private annuity was a bona fide sale for adequate and full consideration, and also argues that Thelma continued to control these assets well after the transaction was complete."

The court's analysis

In its opinion, the court works backwards, first considering the annuity transaction, then considering the formation and operation of the FLPs. Ultimately, the court decided that the annuity transaction did not remove the FLP interests from Thelma's estate, and the formation and operation of the FLPs caused the contributed assets to be brought back into Thelma's estate. In the process, the court seemed to go out of its way to provide clarity on the factors that indicate how Section 2036(a) is applied.

1.) Was the Private Annuity Effective to Remove Assets from Thelma's Estate?

a. Was the Transfer of Thelma's Interest in the FLPs for the Private Annuity Bona Fide and for Adequate and Full Consideration?

With regard to the bona fide transfer test, the court stated: "Hunting for the bona fides of a transfer is a question of motive -- did Thelma have a legitimate and significant non-tax reason, established by the record, for transferring her property?

As noted earlier, the court concluded that there was an implied agreement to carry out Thelma's wishes so that David would ultimately receive one-third of Thelma's estate, in spite of the fact that the annuity transaction only transferred FLP interests to Michael and Michelle. The xourt concluded: "That rendered the private annuity a sham - nothing more than a substitute for a will leaving Thelma's estate in equal shares to her children."

The Court also noted that after the annuity transaction, the assets in the FLPs did not change form, so that the effect of the annuity was: "Thelma's children [held] the assets in the exact same form that they were in before the private annuity and then slowly transfer[ed] bits and pieces of them back to her, planning to divide what was left over (including a share for David), after she died. Again, this makes the private annuity look much more like a testamentary substitute than a bona fide sale.

With regard to the adequate and full consideration test, the Court stated: "The key is whether what Thelma received is roughly equivalent to what she gave up.... It is on this point that the private annuity is most vulnerable."

The court argued that the annuity transaction was not a transfer for adequate and full consideration: "We have already found that Garza conjured the partnership discounts out of the air. But even if those discounts were correct, Garza undervalued each FLP interest sold in the private annuity." Garza used outdated values that undervalued the securities by over 40% and undervalued the phantom stock by over 15%.

Having decided to disregard the annuity transaction, the court stated that the transferred assets must be added to Thelma's estate "unless she retained neither possession, nor enjoyment of, nor the right to income from the transferred property, nor the right to designate the persons who would possess or enjoy that property" according to the terms of Section 2036(a), nor retained "a right to revoke or change the transfer" according to the terms of Section 2038(a)(1).

b. Did Thelma Retain a Prohibited Interest in the Property She Transferred to Her Children through the Private Annuity?

The court found that the FLPs failed the following tests under Section 2036(a)(1):

Thelma's relationship to the assets didn't change materiall.

"Now it is true that Thelma's relationship to the assets changed after the private annuity. She didn't need to regularly dip into the FLPs once she began receiving $80,000 a month under the annuity. But as previously discussed, her children paid her with the very assets she supposedly sold to them. Her monthly payments came directly from HI-1 THIMA, which was an FLP account, meaning that she retained a present economic benefit from her assets after she 'sold' them."

Thelma retained control over some assets.

After the private annuity agreement, Thelma never resigned as president of the limited liability companies (which served as the general partners of the FLPs) and remained a party to the farm leases (which were assets of one of the FLPs). She also had ongoing signature authority over assets in HI-1's bank accounts, which she exercised after the annuity agreement.

Thelma commingled funds.

"[After the annuity transaction, Thelma] also continued to make deposits into the various FLP accounts, shifted assets between accounts, and otherwise treated them as if they were her own rather than actually transferred to Michael and Michelle. At trial, Michelle testified that her mother withdrew money from HI-1 to pay her income taxes after she sold the partnership interests to her children."

The court also found that the FLPs failed under Sections 2036(a)(2) and 2038(a)(1).

"Thelma also made it clear to Michael and Michelle, even after the private annuity was signed, that they were to make sure that David got one-third of the property in the FLPs.... Under Section 2036(a)(2), we find this to be an exercise by Thelma of a "right, either alone or in conjunction with any other person, to designate the persons who shall possess or enjoy the property." We also find that it is the exercise of a power by Thelma altering or amending the transfer of the property going to pay for the private annuity of the sort described in Section 2038(a)(1)."

Thus, Thelma's FLP interests were brought back into her estate because the annuity transaction was disregarded, and she retained a prohibited interest in the FLPs.

Thus, Thelma's FLP interests were brought back into her estate because the annuity transaction was disregarded, and she retained a prohibited interest in the FLPs. 2. Were the FLPs Valid?

a. Was the Creation of the FLPs Bona Fide and for Adequate and Full Consideration?

In the final portion of the analysis, the court determined whether the formation of the FLPs met the bona fide transfer and adequate and full consideration tests, and thus whether Thelma's estate held partnership interests or the assets themselves. To determine the bona fides of the formation, the Court focused on Thelma's motivation. Of the ten reasons for forming the FLPs cited by Garza in the FLP agreements (which the court noted were numbered 1-6 and 8-11), the Hurfords relied mainly on two: asset protection and asset management.

With regard to asset protection, the court says, "We have found in other cases that similar claims about asset protection, without supporting evidence, were insufficient proof of a significant non-tax purpose. And we find that placing the assets in FLPs provided no greater protection than they had while held by the family or marital trusts, or in Thelma's own name."

With regard to asset management, the court acknowledged that while consolidated asset management can be a significant non-tax purpose, "we cannot find in this case any advantage in consolidated management that Thelma or the two trusts gained from the transfer, particularly because the partners' relationship to the assets didn't change after formation." Thus, the court was unable to find any significant non-tax reason for the formation of the FLPs.

Nevertheless, the court looked to case law for "factors that, if present, will incline us to find that the transfer of property to a FLP was not motivated by a legitimate and significant nontax reason. In other words, the lack of an apparent nontax reason is "not enough by itself" to disregard the formation of the FLPs. The court looks for confirmation that tax planning is the only material purpose of the FLP. The factors cited by the court are (citations omitted):

the taxpayer's financial dependence on distributions from the partnership; whether the taxpayer commingled her own funds with partnership funds; the taxpayer's delay or failure to transfer the property to the partnership; the taxpayer's old age or poor health when the FLP was formed; and whether the FLP functioned as a business enterprise or otherwise engaged in any meaningful economic activity.

The court discussed the failures of the FLPs with regard to each of these items, other than (inexplicably) Thelma's poor health. The court provided a particularly lengthy discussion of the last item.

"The other underlying theme in our caselaw is that a FLP needs to be a functioning business or at least have some meaningful economic activity. Look at the FLPs in this case. HI-1 just held marketable securities and cash. The Hurfords did not have even a minimal involvement in deciding which securities HI-1 should own, or even whether it should buy or sell. All investment decisions were left to Chase, and the same people at Chase made the decisions before and after the assets were moved to HI-1. HI-2 required even less of the Hurfords than HI-1. The only choice they could make concerning the Hunt Oil phantom stock was to hold it or to cash out. The HI-3 partnership did hold real estate, but again, the partnership was not actively managing any of the farms or ranches. The three leases of those properties were all in place when HI-3 was formed and the Hurfords did nothing more than collect rent. There is no evidence that the partners met to discuss family business or investment strategy, or even discuss the partnerships' profits or losses."

This suggests that actively discussing investment strategy and buying and selling assets might have resulted in a different decision on this point.

As to whether Thelma received adequate and full consideration for the assets she transferred to the FLPs, the court looked to the three-part test from Kimbell (371 F.3d at 262) (citations omitted):

whether the interests credited to each of the partners was proportionate to the fair market value of the assets each partner contributed to the partnership, whether the assets contributed by each partner to the partnership were properly credited to the respective capital accounts of the partners, and whether on termination or dissolution of the partnership the partners were entitled to distributions from the partnership in amounts equal to their respective capital accounts.

However, the court looked primarily to Bongard's (124 T.C. at 117) slightly different test, as to whether "all partners in each partnership received interests proportionate to the fair market value of the assets they each transferred, and partnership legal formalities were respected." Garza's "unusual" FLP structures run afoul of the proportionality test. "Thelma transferred almost $4 million of assets to HI-1 in April 2000. The Family and Marital Trusts contributed a little under $1.2 million combined." In spite of this, Thelma on the one hand, and the two trusts on the other hand, each continued to have equal percentage interests. Furthermore, "there was no pooling of assets," "[t]here was no contribution from any of the Hurford children," and "the crediting of the partners' capital accounts was entirely fictional."

In conclusion, the FLPs failed both the bona fide transfer and adequate and full consideration tests, so the FLP would be disregarded if Thelma retained a prohibited interest. b. Did Thelma Retain the Possession or Enjoyment of, or the Right to the Income From, the Property She Transferred to the FLPs in Violation of Section 2036(a)(1)?

Next, the court looked for evidence of an implied agreement for Thelma to retain prohibited rights by considering factors that previous cases considered indicative of an implied agreement. The decedent used FLP assets to pay her personal expenses; the decedent transferred nearly all of her assets to the FLP; and the decedent's relationship to the assets remained the same before and after the transfer.

The court states the "Garza's plan plunges this case right into these precedents," then enumerates the supporting facts (which have already been discussed herein). At this point the court introduces Section 2035(a), which causes property to be included in the gross estate if it would have been included under Sections 2036, 2037, 2038 or 2042, but for having been transferred within three years of death. The court concludes that even if the problems with the annuity had not brought the assets back into the estate, Section 2035 would have done so.

Other issues

Having unwound all of Thelma's estate planning with regard to the FLPs and brought all of the assets back into her estate without valuation discounts, the court briefly turned to certain other issues. Of particular interest is the request of the IRS for 20 percent penalties due to negligence. The court began by noting that "If Michael had prepared the estate tax return himself, there is little doubt that we could find negligence or an intentional disregard of the tax rules." Instead, the court found "that Michael's reliance on the professionals he chose, however unsuitable they turned out to be, was nevertheless under the circumstances done reasonably and in good faith. We therefore impose no penalty for negligence or disregard of the Code." Summary

With so many bad facts, it seems Judge Holmes could have rendered his opinion without going through so many steps of analysis. However, presented with a wealth of bad facts and detailed records, he seized the opportunity, not only to demonstrate his literary talents, but also to provide an integrated summary of the many tests established by prior cases to determine the application of Section 2036(a). He determined that the annuity transaction failed the bona fide transfer and adequate and full consideration tests, as well as the prohibited retained interest test, so that the transfer of Thelma's FLP interests was unwound. He also determined that the creation of the FLPs failed the same tests, so that the FLPs were unwound and the contributed assets brought back into direct ownership by Thelma's estate. The bad facts supporting these findings were numerous, including the following

There was an implied agreement to give David one-third of his mother's estate, even though no interest was formally transferred to him during Thelma's life. There was no material change in the nature or management of the assets transferred and they served merely to hold the assets used to pay the annuity. The FLP interests were undervalued for the annuity transaction. Thelma retained formal rights to assets in the FLPs. Thelma contributed assets and removed assets from the FLPs after she transferred all of her interests. The asset protection and asset management reasons for forming the FLPs were not supported by the facts. Thelma contributed nearly all of her assets into the FLPs. There were delays in funding the FLPs. There was no active management of the FLP assets. The interests held in the FLPs were not proportional to the value of the assets contributed by each partner. Thelma disposed of her interests in the FLPs less than three years before her death.

After losing each point of argument and finding all of the assets brought back into Thelma's estate, so that they ended up paying more taxes than if no further planning had been done after Gary's death, the Hurford heirs had only one consolation: their honesty and credibility did save them from a 20% negligence penalty.

Let Everyman learn from the many lessons of this case. -FWR

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This is not intended or written to be used, and cannot be used by any taxpayer or advisor to a taxpayer, for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. Nor is this writing legal advice and it should not be construed as such.