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Two Taxpayer Victories Demonstrate Winning Facts for Family Limited Partnerships

As textbook examples of how to form, fund and operate a family limited partnership (FLP) - sufficient to value various assets (including real estate, restricted holdings and publicly traded securities) at substantial discounts for federal estate tax purposes - the Murphy and Black cases make excellent reading for attorneys and financial advisors alike.

Lynton Kotzin

For more information on issues related to gift and estate taxation, contact Lynton Kotzin

 

Legitimate Business Purpose

The Murphy Oil Corp. grew from a small family-owned business into a $2 billion international conglomerate. During the 1990s, Mr. Murphy established an FLP (Murphy LP) funded with $89 million in company stock plus bank and real estate holdings. Importantly, this represented only half his net worth, and he never mingled his personal assets with those of the FLP. Overall, the father retained a 95% limited partnership interest in the FLP, with his two sons in charge of daily operations.

For five years, the FLP traded assets, managed employees, held regular meetings and prepared regular statements. It made only two distributions, with appropriate adjustments to the partners' capital accounts. After the father died suddenly in 2002, the IRS issued assessments of $34 million stemming from alleged tax deficiencies, prompting a legal challenge by the father's estate.

In Murphy v. U.S., 2009 WL 3366099 (W.D. Ark.) the Court determined that the Murphy LP was created with the purposes of:

  • pooling and investing the family assets according to the father's philosophy;

  • passing management responsibility onto the next generation;

  • enabling the father to gift interests in the FLP while the underlying assets stayed under central management;

  • educating the father's heirs about wealth acquisition, management and preservation; and

  • protecting family assets from creditors, divorce and dissipation by future generations.

Moreover, the Court found that the Murphy LP was an active, ongoing entity that respected partnership formalities. Based on these strong facts, the Court concluded the FLP was established for legitimate and significant non-tax purposes, sufficient to exclude the value of its underlying assets from the father's gross estate per IRC Sec. 2036(a)(1)(bona fide sale exception for adequate consideration).

To value Mr. Murphy's 95% FLP interest, the Court considered the parties' credentialed experts, who took the net asset values of the underlying interests before applying Rule 144 and blockage discounts as well as minority and marketability discounts. Their results diverged widely, but in each instance the Court found the taxpayer's expert to be more credible, largely because he considered specific qualitative factors, including the FLP's substantial cash balance and the relative holding period, risk, distribution policy, and transfer restrictions of its assets. After adopting all the estate's discounts, the Court found the fair market value of the 95% Murphy LP interest to be $74.5 million and ordered a complete tax refund.

Another Winning Story

Samuel Black worked his way up from peddling newspapers on the street to senior vice president and second largest shareholder of the Erie Indemnity Co., a national insurance company. To pool, protect and prolong his family's wealth, Mr. Black formed an FLP in 1993, retaining a 1% general partnership interest with LP interests dispersed among his son and his grandsons' trusts, with substantial restrictions. He funded the FLP with Erie stock worth $80 million, which increased to $318 million over the next seven years. The partnership distributed 92% of Erie dividends, with appropriate adjustments to the partners' accounts, and the Blacks never dipped into the assets for their own expenses.

Mr. Black died in 2001, and Mrs. Black followed soon after. The IRS assessed deficiencies totaling over $83 million on their estate tax returns. The parties resolved all the valuation issues prior to trial, leaving only the Sec. 2036(a) issue, i.e., whether the stock transfers were bona fide, for a legitimate non-tax purpose. The taxpayer claimed the following in support:

  • The FLP's net asset value increased dramatically through active investment according to Mr. Black's "buy and hold" philosophy.

  • The transfer restrictions successfully prevented Mr. Black's son from dissipating his assets in divorce and his grandsons from reaching their stock, even when their trusts terminated.

  • The Black family's consolidated position allowed it to maintain a seat on the Erie board.

The taxpayer also cited Estate of Schutt v. Comm'r (T.C. Memo 2005), in which the Tax Court validated an FLP for its "unique circumstances" primarily its pooling of assets according to the founder's investment philosophy, to preserve them against claims from creditors, divorcing spouses, and irresponsible heirs.

The IRS tried to discount the relevance of Schutt by claiming that Black's concerns for his Erie holdings was either "ill-founded" or insignificant. The Court was persuaded by the precedent, however, and the similar "unique" facts of this case. Moreover, the FLP respected partnership formalities, including appropriate adjustments for contributions and distributions.

Accordingly, the court held that the fair market value of Mr. Black's FLP interest, rather than the fair market value of the underlying Erie stock, was includable in his gross estate.