Couple Insists They Transferred Assignee Interests Not Limited Partnership Interests

In 1993 Baine and Mildred Kerr and their children formed two family limited partnerships, KFLP and KILP, under Texas law. The Kerrs contributed all the capital and were the sole general partners, but they immediately assigned a portion of each to their children. The partnership agreements restricted dispositions of partnership interest to any persons other than "permitted assignees" (descendants of the Kerrs or certain entities owned by such assignees). The agreements also stated that the partnerships would dissolve and liquidate at the end of 2043, by agreement of all partners, or on the occurrence of certain acts of dissolution, whichever occurred earlier.

In June 1994 the Kerrs transferred limited partnership interests in both KFLP and KILP to the University of Texas. On December 28, Baine and Mildred each created a GRAT and transferred a 44.5 percent limited partnership interest in KFLP. The GRATs were permitted assignees. On December 31 of 1994 and 1995, the Kerrs transferred additional class B limited partnership interests to each child.

The Kerrs filed gift tax returns for 1994, reporting tax liabilities attributable to their transfers to the GRAT trustees and to their children. They valued the KFLP limited partnership interests transferred to the GRATs by applying discounts for lack of liquidity and minority interest; for the value of the KILP limited partnership interests transferred to their children, they applied a discount for lack of liquidity.

The IRS determined deficiencies against both Blaine and Mildred for both 1994 and 1995, asserting that the couple had understated the values of the transferred partnership interests. The IRS determined that the liquidation restrictions in the partnership agreements were "applicable restrictions" within the meaning of section 2704(b) and, thus, that the liquidation restrictions should have been disregarded in the valuations, i.e., that no liquidity discount was allowable.

The Tax Court rejected the Kerrs' contention that they merely transferred assignee interests to the GRATs and held that the couple transferred limited partnership interests. But the court then determined that section 2704(b) did not apply because the partnership agreements' liquidation restrictions were not "applicable restrictions" under section 2704(b)(3)(B) and reg. section 25.2704- 2(b). The court concluded that the dissolution and liquidation provision contained in the partnership agreements was no more restrictive than the limitations that would apply generally to the partnership under Texas law, thus under reg. section 25.2704-2(b), the partnerships' dissolution and liquidation provisions were not "applicable restrictions." (For a summary of this opinion, see Tax Notes, Jan. 3, 2000, p. 72; for the full text, see Doc 2000-296 (41 original pages) or 1999 TNT 247-58 .)

The Kerrs argue that the Tax Court erred when it determined that they transferred Class B limited partnership interests rather than assignee interests. They insist that they had no authority under the Kerr family limited partnership agreement to unilaterallly convey limited partner status to the trustees of the GRATs. The couple further emphasizes that whether or not their children might have consented to the transfer of the interests in the partnership to the GRATs is irrelevant. The Kerrs also maintain that the documents executed by them in connection with the transfers of interests to the GRATs and the appraisal reports do not indicate that limited partner status was conveyed. Finally, the couple contends that their children were properly admitted to KFLP as general partners and that section 2704(b) does not apply to assignee interests.

I. INTRODUCTION.

[2] The Tax Court and the Commissioner fail to recognize that federal transfer taxes (i.e., the gift tax and the estate tax) are not direct taxes on property (which would be unconstitutional), but excise taxes based upon the fair market value of the property that is actually transferred. See U.S. Const. Art. I, section 9 (for direct taxes on property); United States v. Land, 303 F.2d 170, 171-73 (5th Cir). Thus, in determining the value of the transferred interest for gift tax purposes, it is fundamental that only the rights actually transferred are relevant as a matter of law. Estate of Bright v. United States, 658 F.2d 999, 1001 (5th Cir. 1981) (en banc); see also Land, 303 F.2d at 171-73. The Tax Court violated this basic maxim in determining that Mr. and Mrs. Kerr transferred limited partnership interests in KFLP.

[3] In determining that partnership interests were transferred, the Tax Court stressed the intrafamily nature of the transaction, tax-saving motivation, and the differences in rights possessed by an assignee and a Class B limited partner. The Commissioner seeks to justify the Tax Court's holding by asserting that "in short", because taxpayers occupied every role with respect to the transfers, it is apparent that there was no substantive difference between transferring an assignee interest and a limited partnership interest." Response at 38. The Commissioner further argues that "even if taxpayers transferred assignee interests, instead of limited partnership interests, to themselves, they nevertheless had the right to vote the underlying limited partnership interests (albeit in an individual capacity as opposed to their trustee capacity). Furthermore, taxpayers and their children, as general partners of KFLP, could convert the alleged assignee interests to limited partnership interests at any time." Id. The Tax Court's holding and the Commissioner's attempt to justify the Tax Court's back-door family attribution run squarely afoul of this Court's decisions in Bright, 658 F.2d at 1002, Estate of McLendon v. Comm'r, 77 F.3d 477, 96-1 USTC paragraph 60,200 (5th Cir. 1995), and Estate of Bonner v. United States, 84 F.3d 196, 198 (5th Cir. 1996). In each of these cases, this Court has held that the identity of the recipient is irrelevant in determining the value of transferred property. Instead, the Court should focus on the interests that Mr. and Mrs. Kerr actually transferred to the GRATs under state law. Pursuant to the terms of the Partnership Agreement and applicable law, Mr. and Mrs. Kerr transferred assignee interests in KFLP. Exh. 12-J section 8.19, 8.21; Tex. Rev. Civ. Stat. Ann. art 6132a-1 sections 7.02, 7.04.

[4] In Wheeler v. United States, 116 f.3d 749 (5th Cir. 1997), this Court opined that the "present transfer tax scheme eschews subjective intent determinations in favor of the objective requirements set forth in the statutes." Wheeler, 116 F.3d at 765. The Commissioner claims that Wheeler is inapplicable because "intrafamily transfers are to be treated differently," in direct conflict with the Court's holdings in Estate of Bright and McLendon. Response at 41. Citing Wheeler, the Commissioner argues that because it seeks to apply Chapter 14 to the transfer of the interests in KFLP, the Tax Court had carte blanche to embark on a subjective inquiry to determine the nature of the interests transferred. Response at 41. ² This Court did not state in Wheeler that any Chapter 14 argument eviscerates the requirement that the nature of the property transferred be determined under state law or automatically permits an inquiry into the transferor's subjective intent to determine the nature of the transferred interest. To the contrary, the Court's opinion in Wheeler can only be fairly read to mean that subjective intent inquiries are permitted ONLY where Congress passes statutes specifically authorizing such subjective intent determinations. ³

[5] But I.R.C. section 2704(b) does not authorize a subjective intent determination, nor does it permit the Commissioner or the Tax Court to ignore the nature of the property being transferred pursuant to the terms of the KFLP Partnership Agreement and Texas law before determining whether an applicable restriction exists; rather, I.R.C. section 2704(b) simply provides that if any "applicable restriction[s]" exist with respect to the transferred interest, those applicable restrictions can be ignored in determining the fair market value of the transferred interest. I.R.C. section 2704(b). Before the Court can determine whether I.R.C. section 2704(b) applies in determining the value of the interest transferred, the Court must determine the nature of the transferred interest under the Partnership Agreement and state law!

[6] The Commissioner also erroneously argues that Estate of McLendon v. Commissioner is inapplicable because of the alleged tax motivation in the Kerr transaction. In McLendon, this Court stated that

Significantly, the Tax Court did not discuss Texas partnership

[7] As this Court held in McLendon, "[w]here the Internal Revenue Code has not superseded state law, the tax consequences of a transaction must depend on the nature of the deal under state law. Accordingly, we look to Texas law as well as the various agreements to evaluate the transactions. . . ." Id. As demonstrated above, I.R.C. section 2704(b) does not supercede Texas law with respect to determining the nature of the property transferred. Looking at Texas law and the partnership agreement, it is clear that Mr. and Mrs. Kerr could not transfer partner status to the trustees of the GRATs without the consent of their children, which was not obtained.

2. MR. AND MRS. KERR HAD No AUTHORITY UNDER THE KERR FAMILY

[9] Texas law prohibits the transfer of partner status without the agreement of the other partners. See, e.g., Tex. Tex. Rev. Civ. Stat. Ann. art 6132a-1 sections 7.02, 7.04(a) (Vernon 1994); see also McLendon, 96-1 USTC paragraph 60,200 at 84,201. The Commissioner claims, however, that the partnership agreement departs from this well settled tenet of partnership law by allowing "Permitted Assignees" to obtain partner status automatically upon a transfer. Again, the Commissioner is wrong.

[10] Mr. and Mrs. Kerr do not contest the fact that the trustees of the GRATs were "Permitted Assignees" as defined in section 8.03 of the partnership agreement. However, the definition of "Permitted Assignees" under section 8.03 does not relate to whether or not the trustees of the GRATs were automatically admitted as limited partners. Instead, the definition determines whether or not the right of first refusal/buy-sell provisions in the partnership agreement are triggered. Stated differently, there are two barriers in the partnership agreement to a potential transferee becoming an owner with the full rights of a limited partner: (1) the transferee must be a "Permitted Assignee" or the buy-sell provisions of Article VIII must be complied with; and (2) the transferee must be admitted as a limited partner by each partner of the partnership. The fact that a transferee (including the trustees of the GRATs) may satisfy the first barrier does not mean the transferee has satisfied both barriers. If the transferee satisfies only the first barrier, his status will simply be an assignee, not a partner.

[11] An examination of the specific language of the partnership agreement illustrates this point. See Exh. 12-J. Specifically, section 8.01 of the partnership agreement provides the general rule that

No Limited Partner . . . shall make any Disposition (as defined

[12] Reading sections 8.01, 8.02, and 8.19 together, a limited partner cannot make a "Disposition" of a limited partnership interest without the written consent of the partnership and the other partners. Even if the other partners consent to a "Disposition," the transferee does not automatically become a partner since a transfer to a "Permitted Assignee" does NOT give that person the right to become a substituted limited partner under section 8.19. A transfer to a "Permitted Assignee" (such as the trustees of the GRATs) is not a "Disposition" under section 8.02. Therefore, the question is, what rights does a "Permitted Assignee" receive? That question is answered by section 8.21, which specifically provides that

Except as otherwise provided in Section 8.20 and Section 9.01,

[13] The Court may ask what specific exception under Article III the section 3.06 language "except as provided in Article VIII" refers to. There are two provisions: first, section 8.21, which allows a person who is already a partner to become a substituted partner upon the transfer of additional interests to him; second, section 8.20, which provides that "if a General Partner makes a transfer of a General Partnership Interest at or by reason of his death to a Permitted Assignee, the General Partners shall admit such transferee into the Partnership as a General Partner and while the General Partner's General Partnership Interest is subject to estate administration, the personal representatives of that deceased General Partner's estate shall have full rights of a General Partner and shall be admitted by the Partners of the Partnership as a General Partner." Both provisions would be unnecessary if, as the Commissioner claims, a "Permitted Assignee" automatically attained partner status.

[14] In sum, the plain terms of the partnership agreement provide that the trustees of the GRATs were not automatically admitted as partners. Sections 3.06, 8.19, and 8.21 of the partnership agreement clearly demonstrate that the trustees of the GRATs received assignee interests and could not be admitted as limited partners until unanimous consent of the partners was obtained. A full and fair reading of Article VIII demonstrates that it addresses the buy-sell provisions of the partnership, which do not apply to transfers to a group of potential transferees defined as "Permitted Assignees," and does not provide that a transfer to a "Permitted Assignee" confers partner status on that "Permitted Assignee" until all of the Partners consent to that "Permitted Assignee" becoming a limited partner.

3. WHETHER MR. AND MRS. KERR'S CHILDREN MIGHT HAVE

Determination of whether Mr. Prechel and Ms. Prechel will be

4. THE DOCUMENTS EXECUTED BY MR. AND MRS. KERR IN

[17] The Commissioner claims that the Kerr children's consent to the admission of the GRAT trustees as substituted Class B partners should be imputed because of the terms of the assignment document signed by Mr. and Mrs. Kerr. However, the Kerr children did not sign the transfer documents, and there is no document signed by them indicating their consent to admit the GRAT trustees as limited partners. Addressing a similar argument in McLendon, this Court stated

Imputing consent of all of the partners to Bart's

[18] Regardless, a closer look at the documents highlighted by the Commissioner demonstrates that that those documents are consistent with the theory that an assignee's, not a partner's, interest was transferred.

[19] The documents executed by Mr. and Mrs. Kerr transferring the interest are entitled "Assignment of Partnership Interest." Exh. 15-J, 16-J. The documents provide that "Assignor or Assignee desire that Assignor to assign to Assignee a portion of the Partnership Interest of Assignor in Kerr Family Limited Partnership." Id. The "Assignment and Conveyance" is expressly made subject to the encumbrance described on Schedule II hereto and hereby made a part hereof. The encumbrance reflected on Schedule II reads "the agreement and articles of Partnership of Kerr Family Limited Partnership, as regards the Class B Limited Partnership Interest in the partnership assigned hereby, and the restrictions on transferability therein contained." Obviously, one of the encumbrances of the Partnership Agreement is contained in section 8.21, which prevents an assignee from attaining partner status without the consent of all of the other partners. See also Tr. 19.

[20] The Commissioner argues that the transfer documents, by their terms, conveyed Class B limited partnership interests because the documents stated that all consents necessary to transfer the interests reflected had been obtained. The Commissioner is wrong for several reasons. First, there is no provision in the transfer document reflecting the other general partners' consent to admit the GRAT trustees as limited partners. Indeed, two of the Kerr children's unrefuted testimony is that they had not consented to the admission of the trustees as a partner. Tr. 59, 63. Second, even if the transfer documents purported to admit the trustees as full limited partners of KFLP, they could not be admitted as limited partners without the consent of all partners. Numerous courts have held that a purported assignment of a partnership interest is insufficient to convey partner status without the consent of all of the partners. See Buffkin v. Strickland, 312 S.E. 2d 579, 581 (S.C. App. 1984); Tamir v. Lamb, 427 N.Y.S.2d 487, 488 (N.Y. App. Div. 1980), aff'd 441 N.Y.S.2d 669 (N.Y. App. Div. 1981); Rapoport v. 55 Perry Co., 376 N.Y.S.2d 147, 149-50 (N.Y. App. Div. 1975). Third, the Kerrs executed similar transfer documents in transferring assignee interests in Kerr Family Limited Partnership ("KFLP") to the University of Texas. Exh. 5-J. However, a separate document formally admitting the University as a Class A limited partner was later executed, evidencing that the partners recognized that consent of each partner was required before a transferee of a limited partnership interest could be admitted as a limited partner in KFLP. Exh. 9-J.

[21] In connection with securing the promissory demand notes issued by the trustees of the GRATs, the trustees executed documents entitled "Security Agreement -- Assignment of Partnership Interest." Exh. 20-J, 21-J. Section 2 of the Security Agreement provides that

Assignor hereby transfers, sets over and collaterally assigns to

[22] The Commissioner also claims that the valuation reports attached to Mr. and Mrs. Kerr's gift tax returns demonstrate an intent that substitute limited partner status was conferred. They show just the opposite. The 1995 valuation report is entitled "Valuation of Two 44.535 Percent ASSIGNEE Interests of Class B Limited Partnership Interests in Kerr Family Limited Partnership as of December 29, 1995." (Emphasis added). Page 6 of the 1995 valuation report ⁵ states as follows:

Any Disposition of a Limited Partnership Interest will be

In sum, it is clear that the documents executed by Mr. and Mrs. Kerr transferred an assignee interest in the Partnership. To have held otherwise is reversible error.

5. THE KERR CHILDREN WERE PROPERLY ADMITTED TO KFLP AS

[24] It is true that section 4.01 of the Partnership Agreement states that Mr. and Mrs. Kerr assigned a portion of their general partnership interest to their children at the time KFLP was created. But the Partnership Agreement clearly provides that the Kerr children were original General Partners, and Mr. and Mrs. Kerr acknowledged that the Kerr children were original General Partners in the partnership agreement. For example, page 1 of the Partnership Agreement (Exh. 12-J) states:

THIS AGREEMENT OF LIMITED PARTNERSHIP (this "Agreement") of Kerr

[25] The Commissioner argues at pages 31-32 of its Response that Mr. and Mrs. Kerr's position that the Kerr children were original general partners of KFLP is contradicted by the statements of their counsel before the Tax Court. But the Commissioner takes counsel's statement to the Tax Court completely out of context, disingenuously failing to provide this Court with the entire statement, which was as follows:

At the time the partnership was created, the only general

6. I.R.C. SECTION 2704(B) DOES NOT APPLY TO ASSIGNEE

[28] Under the KFLP partnership agreement, an assignee has no right to liquidate KFLP or to withdraw his interest from KFLP. Under Texas law, an assignee has no right to liquidate the partnership or withdraw his interests from KFLP. Tex. Rev. Civ. Stat. Ann. art. 6132a-1 section 7.02. Therefore, an applicable restriction does not exist even under the Commissioner's overbroad interpretation of I.R.C. section 2704(b) because the liquidation and withdrawal rights are the same under both state law and the KFLP partnership agreement.

[29] The examples in the Conference Report and Treas. Reg. section 25.2704-2(d) cited by the Commissioner do not allow the Commissioner to claim that an applicable restriction exists where the restriction on liquidation is no more onerous that [sic] the restriction that would otherwise apply under state law. Although both examples deal with the death of a partner, both examples ASSUME that the transferee in fact received partnership interests. See H.R. Conf. Rep. 101-964 at 1138, Ex. 8 ("Mother dies and leaves HER PARTNERSHIP INTEREST TO DAUGHTER. AS THE SOLE PARTNERS, DAUGHTER AND SON acting together could remove the restriction. . ."); Treas. Reg. section 25.2704-2(d) Ex. 1 ("On D's death, D's PARTNERSHIP INTEREST PASSES to D's child, C."). (Emphasis added). The general rule that a transferee of a partnership interests does not obtain partner status (absent a contrary provision in the partnership agreement) seems to have been ignored by the Commissioner in the examples, similar to the manner it has ignored that rule in this case. The examples cited are simply poorly worded and must be construed against the Commissioner and in favor of the taxpayer. Miller v. Standard Nut Margarine Co., 284 U.S. 498, 508 (1932); Tandy Leather Co. v. United States, 347 F.2d 693, 694-95 (5th Cir. 1965). Regardless, the examples cannot give rise to the finding that an applicable restriction exists where the plain application of the statute demonstrates that no applicable restriction exists with respect to an assignee interest. See United States v. Ogilvie Hardware Co., 155 F.2d 577, 580 (5th Cir. 1946) (holding that even where an example is placed in the legislative history of a bill, that same example in the regulations cannot be used to expand the law as passed; "[n]or can putting an example into the Regulation add to or change the law as passed").

PRAYER

[30] For the reasons stated above, the decision of the Tax Court stating that Mr. and Mrs. Kerr transferred Class B Limited Partnership interests in KFLP to the GRAT trustees should be reversed, and this Court should render judgment that Mr. and Mrs. Kerr transferred assignee interests to the GRAT trustees. In addition, this Court should affirm the decision of the Tax Court that I.R.C. section 2704(b) does not apply to the transactions at issue.

Respectfully submitted,

[31] This Reply Brief of Appellees/Cross-Appellants in paper and electronic form has been filed by Federal Express, with the United States Court of Appeals for the Fifth Circuit, and has been served upon all parties through their counsel of record by Certified Mail, Return Receipt Requested, on this 4th day of September, 2001, addressed as follows:

Claire Fallon

[32] Pursuant to Fed. R. App. P. 32(a)(7)(C) and 5th Cir. R. 32.3, the undersigned certifies this brief complies with the type- volume limitations of Fed. R. App. P. 32(a)(7)(B) and 5th Cir. R. 32.2.

1. Exclusive of the exempted portions in 5th Cir. R.

² A review of the legislative history of Chapter 14 demonstrates that Congress was not attempting to override the hypothetical willing buyer-seller rule in all inter-family transactions. Rather, Chapter 14 was intended to substitute "for section 2036(c) a series of TARGETED RULES generally designed to assure a more accurate determination of the value OF PROPERTY SUBJECT TO TRANSFER TAX." 136 Cong. Rec. S 15679, at S 15680 (emphasis added).

³ For example, I.R.C. section 2703 permits a subjective intent inquiry to determine whether the safe harbor provisions of Subsection (b) of section 2703 apply. See I.R.C. section 2703(b)(2) ("Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements. . . . It is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth.")

⁴ The Commissioner's response disingenuously implies that Mr. and Mrs. Kerr made these transfers without incurring any gift tax obligation. See Response at 23. That is simply not true. The interests in KFLP were transferred to the GRATs, which had the obligation to pay to Mr. and Mrs. Kerr an annuity equal to 95% of the fair market value of the interests transferred. Exh. 13-J and 14-J at 3. The annuity obligation was exchanged for secured demand notes, which the Kerrs later forgave. When the notes were forgiven in 1998, Mr. and Mrs. Kerr made taxable gifts calculated from the face value of each of the notes, which equaled $1,592,831 combined. Exhs. 27-J, 28-J. They filed gift tax returns for calendar year 1998 reporting the gifts.

⁵ The same language is found on page 6 of the 1994 valuation report. (Exh. 40-J.)

⁶ The same language is found on page 19 of the 1994 valuation report. Exh. 40-J.