subject: Family Limited Partnerships And Valuations And Estate Tax Consequences Recent Cases Part 1 [print this page] Over the last few years or so, there have been several cases decided involving Family Limited Partnerships and Limited Liability Companies and valuation issues or inclusion in the federal gross estate pursuant to Section 2036 (retain enjoyment or control). These cases have raised several issues worthy of study and review of which practitioners must be aware.
The Section 2036 Cases
Section 2036(a) provides:
"The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death '
(1) the possession or enjoyment of, or the right to the income from, the property, or
(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom."
The IRS 2036(a) position
(a) A transfer of property to the Family Limited Partnership is not a "bona fide sale for an adequate and full consideration of money or money's worth"; and
(b) The Decedent retained possession, enjoyment or right to income from the assets within the FLP and the right to "designate the persons" who would possess or enjoy such assets.
Historical Background
In U.S. v. Byrum, 408 US 125 (1972), the Supreme Court held that the Decedent did not retain the "right" within the meaning of Section 2036(a)(2) to designate who was to enjoy the trust income and discussed how various legal and economic constraints on the Decedent's retention of management control did not amount to a legal "right". The Court drew a distinction between designating persons who would possess or enjoy property or income and the power that is subject to outside constraints. Query whether Byrum stands for the proposition that a majority owner of an enterprise is not treated as having, for purposes of Section 2036(a), a "legally enforceable right" to determine the flow of income from the enterprise.
Estate of Morton B. Harper, TC Memo 2002- 121, 83 TCM 1641, May 15, 2002
Decedent was in ill health when he formed a California Family Limited Partnership and died about eight months later. Originally the Decedent had a 99% interest but it was reduced within a matter of weeks by gifts to 39%. Funding of the FLP was accomplished primarily with securities and the income therefrom was received in the Decedent's personal account rather than the FLP's. The Court held that only legal title changed and emphasized the failure to comply with the formalities of the Partnership Agreement including commingling the funds, a history of disproportionate distributions to the Decedent, and the fact that there were too many "testamentary" characteristics of the asset transfer to the FLP.
Estate of Theodore R. Thompson, TC Memo. 2002-246, 84 TCM 374, September 26, 2002
The Court agreed with the IRS that the assets transferred by the Decedent to two Limited Partnerships were includable in his Estate under 2036(a)(1) because of retained enjoyment of the assets. The Court's opinion emphasized the lack of any legitimate business factors involved in the formation of the Partnerships and stated that the assets were merely "recycled". Where there is only a "recycling" that does not appear to be motivated primarily by legitimate business concerns, no transfer for consideration within the meaning of 2036(a) takes place
Turner v. Commissioner No. 03-3173 (3rd Cir. 2004) affirming Estate of Thompson above.
The Court held that marketable securities transferred by a decedent to Family Limited Partnership, which the Estate discounted for lack of control and marketability were includible in Decedent's estate because an implied agreement existed between the Decedent and his family that the Decedent would retain enjoyment and economic benefit of the transferred property. The Court also concluded that the Decedent's transfers (a mere recycling of value) to the Family Limited Partnership did not constitute "bona fide sales" within the meaning of Section 2036(a) because the Decedent did not replenish his Estate with other assets of equal value and said that although a bona fide sale does not necessarily require an arms length transaction between the transferor and an unrelated third party, it still must be made in good faith. A good faith transfer to a Family Limited Partnership must provide the transferor some potential for benefit other than the potential estate tax advantages than might result from holding assets in the Partnership form. The Court noted that this sort of dissipation of value in the estate tax context should trigger heightened scrutiny into the actual substance of the transaction where the transferee Partnership does not operate a legitimate business and the record demonstrates the valuation discount provides the sole benefit for converting liquid, marketable assets into illiquid partnership interests.
David A. Kimbell v. U.S. 93AFTR 2d 2004 - 2400 (5th Cir, 2004) vac'g and rem'g 244F Supp. 2d 700
The 5th Circuit, in vacating and remanding the District Court Case, held that the assets the Decedent transferred to a trust, an LLC and to an FLP were not includible in the Estate under Section 2036(a), but rather the transfer was a bona fide sale for adequate and full consideration. The Court agreed with the IRS that a bona fide sale takes on heightened significance in an inter family transfer, but held that there was no additional requirements under Section 2036 for such transfers. The 5th Circuit noted that the "willing buyer-willing seller" test for fair market value is different from the adequate and full consideration under Section 2036(a). The Court cited the following facts supported the existence of a bona fide sale: a. The Decedent retained sufficient assets outside the Partnership for her own support and there was no commingling of Partnership and her personal assets;
b. Partnership formalities were satisfied and the assets were assigned to the Partnership;
c. Assets contributed to the Partnership included working interests in oil and gas properties which require active management; and,
d. The Estate's witnesses advanced several credible and unchallenged non tax business reasons for the formation of the Partnership that could not be accomplished via the Decedent's trust alone.
In Stangi II the FLP paid all of the 24 hour homecare costs of the Decedent immediately prior to his death as well as for his surgery expenses and the Decedent's funeral, estate administration expenses and the estate and inheritance taxes. The Court relied on the fact that the Corporate General Partner although not technically controlled by the Decedent (only a 47% ownership interest), had entered into a management agreement with his son who was the holder of the Decedent's Power of Attorney so that the disbursements of funds from the FLP were essentially the actions of the Decedent acting through his Attorney-in-Fact. The Strangi II opinion is viewed by many practitioners as a significant expansion of the reach of 2036(a)(2) because the Court pointed out that the formalities were adhered to.
Planning Suggestions to Avoid Applicability of 2036(a):
a. Valid business purpose for establishment of FLP.
b. Strict adherence to cash distribution allocations.
c. Significant other ownership interests.
d. Sound accounting principals and practices adhered to.
e. Fiduciary standard required of General Partner.
f. The sooner the better with respect to the establishment of the FLP before the death of the transferor.
g. Consider having independent General Partner or children act as General Partners.
h. Do not place power to remove or elect General Partner with the transferor.
i. Do not fund FLPs with personal assets.
j. Real estate is better than securities and cash.
As stated, these cases have raised several issues worthy of study and review of which practitioners must be aware. Look for a continuation of this article entitled: Family Limited Partnerships and Valuations and Estate Tax Consequences Recent Cases Part 2.
