Posted on March 27, 2009 by David Shulman

Estate of Jorgensen v. Commissioner: IRS wins another Family Limited Partnership Case due to the Taxpayer Doing Everything Wrong

In writing a blog, or in writing anything, the most important question is "Who is your audience?"  So far, my posts have been aimed towards what I call "the sophisticated layman."  I have been writing for the educated reader who is not an expert in matters regarding estate planning or tax, and is interested in learning more. 

But every now and then there is "breaking news" in the estate tax world, that most laymen, sophisticated or not, probably would not be interested in, but would be of interest to estate planning and tax experts. This is one of those times. 

Yesterday, the US Tax Court's issued its opinion in Estate of Jorgensen v. Commissioner, ruling that the entirety of assets transferred to a family limited partnership were included in the gross estate of a decedent under s. 2036(a)(1) of the Internal Revenue Code.

Like many other cases in which there is a complete victory for the Government, the most important lessons in this case for Estate Planning attorneys is "Don't do this." 

More after the jump

THE FACTS OF THE CASE

The Decedent, Mrs. Erma Jorgensen, died on April 25, 2002.  Her late husband was Colonel Jorgensen; her daughter was Jerry Lou and her son was Gerald.  During their lives, the Colonel was responsible for managing the family's investments.  He was actively involved in picking stocks, managing the family's money, and engaging in their estate planning.  Mrs. Jorgensen was not interested in these matters.

From the decision:

"On June 30, 1995, Colonel and Ms. Jorgensen each contributed marketable securities valued at $227,644 to JMA-I in exchange for 50-percent limited partnership interests. Gerald and Jerry Lou, along with their father, were the general partners. Colonel and Ms. Jorgensen had six grandchildren; three were Gerald's and three were Jerry Lou's. Gerald, Jerry Lou, and the six grandchildren were listed as limited partners and received their initial interests by gift. Neither Gerald, Jerry Lou, nor any of the grandchildren made a contribution to JMA-I, although each was listed in the partnership agreement as either a general or a limited partner. During his lifetime Colonel Jorgensen made all decisions with respect to JMA-I." Emphasis Added.

The Colonel died on November 12, 1996.

After his death, the Jorgensens' estate planning attorney, who Mrs. Jorgensen had little contact with during her husband's life, advised Mrs. Jorgensen to transfer her brokerage accounts to the FLP.  The attorney wrote to her in a letter: 

    Hopefully, this will allow your estate to qualify for the discount available to ownership of interests in limited partnerships and at the same time, facilitate your being able to make annual gifts to your children and grandchildren. This is important if you wish to reduce the amount of your own estate which will be subject to estate taxes.

 And then again in a letter the following day:

The reason for doing this is so that hopefully your limited partnership interest in JMA partnership will qualify for the 35% discount. Instead of your estate having a value in various securities of about $1,934,213.00 it would be about $1,257,238.00. The difference of $676,975.00 would result in a potential savings in estate taxes to the beneficiaries of your estate of $338,487.50. Obviously, no one can guarantee that the IRS will agree to a discount of 35%, however, even if IRS agreed to only a discount of 15%, the savings to your children would be $145,066.00, and there can be no discount if the securities owned by you continue to be held directly by you. (Emphasis Added. Thirty five percent? No wonder they were audited)

The FLPs (there was a second one formed)  did not operate a business, and were passive investments only.  There were no books or records, just unreconciled checking accounts.  Gerald took a $125,000 loan from the Partnership to buy a house, after learning to his shock and dismay that the money in the partnership wasn't his.  Gerald testified that "it took a while to get my head around the fact that it wasn't just like a bank account you can get money out of." Gerald did not make any payments on the loan for two years, after which he made a payment of accumulated interest only. While Jerry Lou believed that if Gerald did not repay the loan, she would take it out of his partnership interest, the partnerships required that all distributions be pro rata.

During Mrs. Jorgensen's life, there was much mingling of her personal funds and the partnerships' assets. Mrs. Jorgensen died on April, 25, 2002.  In August of that year, Jerry Lou sent her brother Gerald a letter stating, that their attorney:

     highly recommends that you pay back Jorgensen Management II Partnership the $125,000 you borrowed. You paid the interest in July for $7,625.00 so you are just about square. He says it will clean up the Partnership and things will look much better should we get (and we probably will) audited in the upcoming months. * * * Guess we have to be real straight on who borrowed what etc. so the partnership looks very legit. (Emphasis added).

The FLP paid Mrs. Jorgensen's $179,000 Federal estate tax liability and $32,000 California estate tax liability (as calculated by the estate).

 THE COURT'S ANALYSIS

This was a clear slam dunk case for the IRS.  There are so many bad facts here (and I didn't list a lot of them).  The court had no problem deciding that the entire value of the FLPs were included in Mrs. Jorgensen's estate of s. 2036(a).  The Court took the effort of going through all of the prongs to show how the estate lost on every level.

The Court found that there was a "transfer" as that term is defined in 2036(a).  The court stated that a transfer includes "any inter vivos" voluntary act of transferring property.

The transfers were NOT bona fide sales for adequate and full consideration

The Court had no problem finding that under the Bongard standard, the transfers were not bona fide sales for full and adequate consideration.  There were no non-tax reasons for forming the partnerships. The Estate tried to argue that the reasons it formed the FLPs included

  1. Management Succession
  2. Financial Education of Family Members and Promotion of Family Unity
  3. Perpetuation of the Jorgensens' Philosophy and Motivating Participation in the Partnerships
  4. Pooling of Assets
  5. Spendthrift Concerns
  6. Providing for Children and Grandchildren equally

The Court did not buy any of those arguments, as the facts didn't seem to support them.  Additionally, the Court found that Ms. Jorgensen retained the possession and enjoyment the property contributed.

The entire value of the assets transferred to the FLPs by her were included in her estate, a big win for the Commissioner.

The one silver lining for the taxpayer is that since the estate sold some of the assets after her death using a carryover and not a step up in basis, they were entitled to equitable recoupment of the taxes paid, even though the statute of limitations had expired.

Link to full text of the decision here.

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Posted on March 26, 2009 by David Shulman

IRS to Reduce Penalty for Offshore Account Holders (If They Fess Up)

For most people, taxes are relatively straightforward.  Not easy, not pleasant.  But straightforward.  If you have a bank account that earns interest during the year, then at the beginning of the following year your bank sends you a Form 1099-INT reporting the interest that you earned, and sends a copy of that same form to the IRS.

Now there are some people out there who aren't big fans of the whole "bank sends 1099 to the IRS" regime.  Or, in some circumstances they don't want the IRS to know about where the original money came from at all.  Many of these people place their money in banks located in other countries or "offshore" accounts.  Since these banks are in foreign countries, they generally do not report interest earned on their accounts to the IRS.

Before going further I want to point out that there are plenty of legitimate reasons to open an offshore account and that most people who do open offshore accounts properly report and pay their tax obligations.  But there are some that don't.  UBS has been in the news lately for the 52,000 "secret" accounts that it holds for US taxpayers.  How many of them are owned by people who haven't been properly reporting their income?  No one knows.

The IRS and UBS have been wrangling over whether or not UBS will be required to turn over the information to the US government, or whether Swiss Banking laws prohibits it from doing so.  People who have these accounts and have not reported their income or paid their taxes are subject to massive civil and criminal penalties and possibly criminal prosecution.

Today, the IRS is offering the carrot instead of the stick.  Or maybe just a very sharp carrot.  IRS Commissioner Douglas Shulman [no relation] announced that for taxpayers who "voluntarily disclose" their accounts (before the IRS catches them first), the IRS is willing to reduce some of the penalties.

From the Wall Street Journal Article:

In its definition of "voluntary disclosure," the IRS says taxpayers must come forward before the IRS has been given their name by a third party. However, in a call with reporters, IRS spokesmen said that UBS customers whose names already have been divulged to the IRS may still qualify under the "voluntary disclosure" guidance issued Thursday.
 
Taxpayers who come forward voluntarily will face a 20% penalty on their foreign account assets in the year with the highest account value, down from the current 50% penalty levied on account assets in each year the taxpayer failed to disclose the account.
 
Other penalties continue to apply for people who come forward, including either a failure to file penalty of 25% or an accuracy penalty of 20%. Taxpayers will also be responsible for back taxes and interest going back six years, the IRS said.
These rules, in effect for six months, "make sure that those who hid money offshore pay a significant price, but also allow them to avoid criminal prosecution if they come in voluntarily," Shulman said.

Of course, for the average person who doesn't have millions in an offshore account, the IRS is just as friendly as ever with regards to penalties imposed.

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Posted on March 26, 2009 by David Shulman

IRS Publishes 2009 Edition of Publication 559, Surviors, Executors and Administrators (to be used with 2008 Returns)

The 2009 Edition of Pub 559, which advises Personal Representatives and Executors how to prepare the income tax returns of decedents whose estate they are administering, has been published by the IRS.  It is to be used for the 2008 year.

The full PDF of the publication can be downloaded from the IRS's Website here.

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Posted on March 17, 2009 by David Shulman

Breaking: IRS Commissioner Sets Forth Plan for Deductions for Madoff Victims

In testimony before Congress this morning, IRS Commissioner Douglas Shulman [No Relation] testified that the Service will be issuing guidance as to how victims of Ponzi schemes can treat their losses for tax purposes.  According to the New York Times:

The plan, which applies to victims of all Ponzi schemes, is likely to provide major relief to the victims of Mr. Madoff, who pleaded guilty last week to orchestrating what prosecutors say is the largest Ponzi scheme ever — one that could reach $65 billion and cover 13,000 investors.

The plan would ease existing rules governing what are known as theft-loss deductions, which are losses claimed by investors who are cheated by their investment advisers and others in Ponzi schemes and other frauds.

Under the plan, which has been reviewed by the congressional offices, the I.R.S. will allow investors who are not suing Mr. Madoff to claim a theft-loss deduction equal to 95 percent of their investments, minus any withdrawals, reinvested gains and payouts from Securities Investor Protection Corporation, the government-chartered fund set up to help protect investors of failed brokerage firms.

Investors who are suing Mr. Madoff, and who thus may have some prospect of recovery, can claim a deduction equal to 75 percent of their investments.

The I.R.S. is also relaxing the rules on how far back the losses can be carried. Current theft loss rules typically allow loss to be carried back 2 years and forward 20 years, but under the plan, the I.R.S. will allow losses to be carried back 5 years as well as forward 20 years.

Under the plan, investors must claim the loss as having happened in 2008.

 I will post any original sources when I find them.

UPDATE: The IRS has issued a Revenue Ruling (Rev. Rul. 2009-09) and a Revenue Procedure (Rev. Proc. 2009-20) (Thanks to Joe Kristan of Roth CPA for the links). Joe did his own reading and analysis of the releases.  My quick read is as follows:

First, the Service issued both a Revenue Ruling and a Revenue Procedure.  A Revenue Ruling generally states what the Service's posistion is on a specific area of law.  A Revenue Procedure sets forth methods for Taxpayers to comply.

Rev. Rul. 2009-09 answers the following questions:

  1. Is a loss from criminal fraud or embezzlement in a transaction entered into for profit, a theft loss or a capital loss under s. 165 of the Internal Revenue Code? (The Service ruled it was a theft loss and not a capital loss)
  2. Is such a loss subject to either the personal loss limits in 165(h) of the Code or the limits on itemized deductions in 67 and 68? (The Service ruled that the deduction that can be taken pursuant to the answer to 1 above is not subject to the limits of 67 and 68.
  3. In what year is the loss deductible? (The Service ruled that a theft loss is deductible in the year in which the taxpayer discovers the loss, which is 2008 and should be deducted on 2008 returns filed in 2009.)
  4. How is the amount of the loss determined. (The Service ruled that the amount of the deduction is the initial amount invested plus any additional amounts invested, reduced by any amounts withdrawn, and reduced by claims as to which there is a reasonable basis for recovery.  Therefore, for a Madoff investor, their loss is the initial investment, plus any additional investment, plus any amount that they reported on their income tax returns as gross income over the time of the investment, reduced by any money that was distributed to them. Also, if the Taxpayer has a reasonable chance of recovery of any property, they can not deduct that amount either.)

The Revenue Ruling also discussed Net Operating Losses, the Claim of Right doctrine, and the Statute of Limitations.  It provides that a taxpayer can treat these losses as a NOL, that there is NOT a benefit under s 1341 (the Claim of Right Doctrine), and that a Taxpayer can take a decution in 2008 for amounts taken into income for past years, even if the statute of limitations has expired.

The Revenue Procedure provides a "safe harbor" for Taxpayers -- meaning that if Madoff victims follow it, their returns will not be challenged by the IRS.  It provides for a deduction of 95% of the "qualified investment" a term defined in the Rev. Proc, if the taxpayer is not going to sue Madoff, and 75% if they are going to sue Madoff (or other Ponzi promoters).

 

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