Current Developments Affecting the Use of Family Limited Partnerships in Estate Planning:
Planning and Drafting in Light of Recent IRS Victories and Defeats
by Nancy G. Henderson

Introduction

The IRS is generally antagonistic toward the use of family limited partnerships. Family limited partnerships are nevertheless valid and useful planning devices for accomplishing a wide variety of tax and non-tax estate planning objectives, including, for example:

 

(1) to include children and more remote descendants in the economic benefits of family assets while maintaining management and control of those assets;

(2)  to provide a single point of contact (the manager or general partner) for third parties with regard to transactions affecting the family’s assets, thereby facilitating business dealings;

(3) to protect the partnership property from the claims of the partners’ creditors and, conversely, to protect the partners’ assets outside of the partnership from the claims of the partnership’s creditors;

(4) to provide a means for co-ownership of partnership assets without creating fractional interests or complicating the legal title to such assets;

(5) to increase the wealth of the family member partners as a group by investing and reinvesting any proceeds from the sale or refinancing of the partnership assets;

(6) to provide flexibility in business, income tax and estate planning not available through trusts, corporations or other business entities;

(7) to restrict the ability of persons who are not family members or trusts or other entities created for their benefit from obtaining an interest in the partnership assets;

(8) to provide an orderly means for resolving disputes that may arise among family members concerning the partnership assets, thereby promoting harmony among the partners and avoiding the expense of litigation;

(9) to promote knowledge of, and communication about, the management of partnership assets between senior and junior family members, thereby facilitating a smoother transition of family wealth when the senior generation passes away;

(10) with regard to publicly traded stock (or closely held stock that is expected to become publicly traded), to protect the founder and the founder’s family from securities violations by family members, such as insider trading; and

(11) to preserve confidentiality concerning the family’s assets.

To insure that your clients receive the intended benefits of a family limited partnership or limited liability company, it is important to be familiar with (a) the various theories upon which the IRS has traditionally attacked family limited partnerships; (b) which of these theories have generally been rejected by the courts; (c) which of these theories have been most successful for the IRS and under what factual circumstances; (d) methods to structure your clients’ partnerships and important factors in their administration to minimize vulnerability to IRS attack.

The following outline provides a brief overview of the most common avenues for IRS attack on family limited partnerships, whether and under what circumstances these arguments have been successful for the IRS, and what defensive strategies you as a practitioner can use to protect your client’s family partnership from successful attack. Unless otherwise indicated, all section references below are references to the Internal Revenue Code of 1986.

 

I. The IRS’s Losing Arguments

There are several common avenues of attack against family limited partnerships by the IRS which have consistently been rejected by the courts. Nevertheless, these theories are often raised in gift and estate tax audits of family limited partnerships. It is therefore important to be familiar with these theories and to be able to refer to cases where these theories were rejected.

 

A. Substance Over Form

 

1. Basic Premise of IRS Attack: The partnership should be disregarded because it has been used as an improper device to transfer assets for less than full and adequate consideration in money or money’s worth. The IRS supports its position based upon Est. of Murphy v. Comm’r. , 60 T. C. M. 645 (1990), where stock in a corporation was transferred just 18 days before Mrs. Murphy’s death in order to create a minority interest in her estate. The Court disregarded the transfer, finding that the “sole motive” for the transfer was tax avoidance and that nothing of substance changed between the date of the transfer and the date of Mrs. Murphy’s death.

2. Courts’ Typical Response to this Argument: “Taxpayers are generally free to structure a business transaction as they please, even if motivated by tax avoidance considerations. ” Kerr v. Comm’r. , 113 T. C. 449, 464 (1999). If the partnership is validly formed and administered(see discussion on 2036(a)(1) below) under stated law, and if there is no reason to believe that a hypothetical willing buyer would disregard the partnership, then the partnership form should be respected. See, for example, Est. of Strangi v. Comm’r. , 115 T. C. 478 (2000), aff’d in part and remanded in part, 293 F. 3d 279 (5th Cir. 2002), on remand, TC Memo 2003-149; aff’d 417 F. 3d 468 (5th Cir. 2005); Est. of Knight v. Comm’r. , 115 T. C. 506 (2000);  Est. of Church v. U. S. , 2000-1 USTC Parag. 60,369 (W. D. Texas 2000), aff’d without published opinion at 268 F. 3d. 1063 (5th Cir. 2001).    But, see, Est. of Bongard v. Comm’r. , 124 T. C. 8 (2005), discussed below, in which the Tax Court disregarded a validly formed limited partnership because, among other reasons, the Court determined the partnership lacked “a legitimate non-tax purpose” for its creation.

3. How to Avoid a Substance-Over-Form Attack: Be sure that the partnership is validly created under state law and that all of the necessary state law formalities in both the creation and ongoing administration of the partnership are respected, including proper Secretary of State, Department of Corporations and Franchise Tax Board filings.   Establish a legitimate non-tax purpose for the creation of the partnership and then operate the partnership consistently with that stated purpose.  

 B. Gift on Formation

 

 1. Basic Premise of IRS Attack: The conversion of the founder’s own assets into partnership interests of lesser value due to minority and lack of marketability discounts constitutes a gift to the other partners of the amount of the discount. The basis for this argument is Comm’r. v. Wemyss, 324 U. S. 303 (1945), in which the Court held that the gift tax system aims to reach transfers that are not for full and adequate consideration and which result in the withdrawal of assets from the transferor’s estate.

2. Courts’ Typical Response to this Argument: The discounts for lack of control and marketability that apply to determine the value of an interest in a validly formed partnership are not gifts.   See, for example, Strangi, supra, and Knight, supra.   The gift on formation argument is particularly difficult for the IRS where the only partners at the time of a contribution are the contributors themselves, see Est. of Jones v. Comm’r. , 116 T. C. 121 (2001).   In that case, Mr. Jones created two partnerships with his children.   Although the children made contributions to the partnerships, Mr. Jones contributed the bulk of the partnerships’ properties, receiving $17,615,857 in credits to his partnership capital accounts for the full fair market value of the properties he contributed.   Per Mr. Jones’ estate tax return, however, for his contributions, Mr. Jones acquired limited partnership interests with a fair market value of only $6,675,156.   The Court found that, because Mr. Jones received full credit to his capital accounts for his contributions, and because the value of the partnership interests of his children were not enhanced by his contributions, the contributions were not taxable gifts.   (On the other hand, see Senda v. Comm’r. , T. C. Memo 2004-160, aff’d. 433 F. 3d 1044 (8th Cir. 2006), a “bad facts” case in which transfers of shares in MCI Worldcom were treated as gifts of the transferred shares to the transferor’s children, largely because it did not appear that the family observed any of the proper formalities in the creation and administration of the partnership and the Court was unconvinced that the stock transfers occurred before partnership interests were transferred to the children).  

3. How to Avoid a Gift on Formation Attack: Make certain that the partnership is validly created under state law and transfer all assets to the partnership before any partnership interests are transferred. If the partnership property is not income producing but has ongoing maintenance expenses (for example, raw land), contribute sufficient additional resources at the inception of the partnership to create a reserve for those expenses, or provide that partners must contribute proportionately to the capital of the partnership. Be sure that partners obtain credits to their capital accounts that are equal to the fair market values of their respective contributions. Observe all partnership formalities, including filing partnership tax returns. Exercise extreme caution when partners make non-pro rata contributions to the partnership to insure that no partner’s interest enjoys increased value from another partner’s contribution.

C. Violation of Chapter 14 (Sections 2703, 2704(a) and 2704(b))

 

 1. Section 2703

 

 (a) What Section 2703 Says: Section 2703 provides that the value of property for transfer tax purposes is to be determined without regard for (a) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement or right) or (b) any restriction on the right to sell or use such property. Exceptions are provided for options, agreements, rights or restrictions that are bona fide business arrangements, that are not devices for transferring property to family members for less than full consideration, and transactions the terms of which are similar to arms’-length arrangements.

(b) Basic Premise of IRS Attack: The partnership agreement constitutes an agreement to acquire or use the underlying partnership property for less than fair market value, or a restriction on the right to sell or use property, that should be disregarded under Section 2703.

(c) Courts’ Typical Response to this Argument: Section 2703 was enacted to prevent the abuse of buy-sell agreements to allow family members to transfer entity interests among themselves for less than full and adequate consideration. There is no indication that Congress intended a broader application of this Section. Transfers of partnership interests are therefore not transfers of the underlying partnership property and, therefore, Section 2703 cannot be applied to invalidate the partnership.   See, for example, Strangi, supra, and Church, supra.

(d) IMPORTANTLY, Section 2703 CAN Affect the Value of a Partnership Interest! While the IRS is WRONG in its attempts to totally disregard the existence of a legitimate family partnership by applying Section 2703, it is certainly possible for the provisions of a partnership agreement to create rights and restrictions that can be disregarded under Section 2703 for purposes of valuing transferred partnership interests. See, for example, Est. of Blount v. Comm’r. , T. C. Memo 2004-116, in which an agreement between a controlling shareholder and the corporation establishing the purchase price for the redemption of the shareholder’s stock at death was disregarded under Section 2703 because the estate was unable to demonstrate that the terms of the agreement were comparable to similar arrangements entered into by persons in arms’-length transactions.

(e) How to Avoid a 2703 Attack:  Be sure that the partnership is validly created under state law and that all of the necessary state law formalities in both the creation and ongoing administration of the partnership are respected, including proper and timely filings with the Secretary of State, Department of Corporations and Franchise Tax Board.   Don’t rely upon provisions in family partnership agreements that establish the purchase price for a family member’s interest unless it is for the fair market value of that interest applying federal transfer tax valuation principles.   It is a nearly insurmountable factual burden to show that an arrangement for a junior family member to buy a senior family member’s partnership interest for less than it’s objective fair market value is anything other than a device for transferring property for less than full consideration and, further, that the terms of the arrangement are similar to arms’-length arrangements. Be careful as well of the effect of Section 2703 if the partnership interest to be purchased is otherwise passing under the marital or charitable deduction. The purchase price established under the partnership agreement will control the amount of the marital or charitable deduction even if Section 2703 causes the full fair market value of the partnership interest to be taxable in the deceased partner’s estate.

2.   Section 2704(a)

 

(a) What 2704(a) Says: If there is a lapse of any voting or liquidation right in a corporation or partnership, and if the individual holding that right immediately before the lapse and members of his or her family control the entity, the lapse will be treated as a transfer for transfer tax purposes, the value of which is the difference between the value of the deemed transferor’s interest in the entity before and after the deemed transfer.

 (b) Basic Premise of IRS Attack: The transfer of limited or general partnership interests in a family controlled entity creates a taxable lapse of voting or liquidation rights under Section 2704(a).

(c) Courts’ Typical Response to this Argument: So long as the restrictions on liquidation under the partnership agreement are no more restrictive than they are under state partnership law, 2704(a) does not apply. See, for example, Knight, supra.

(d)  How to Avoid a 2704(a) Attack:  Avoid creating partnerships in which the senior family members are the sole general partners.   Avoid creating restrictions on the liquidation of the partnership that are more restrictive than applicable state law.

 3. 2704(b)

 

 (a)What 2704(b) Says: If there is a transfer of an interest in a family controlled corporation to a member of the transferor’s family, any “applicable restriction” will be disregarded for transfer tax valuation purposes. An “applicable restriction” is a restriction on the liquidation of the entity that either lapses upon transfer, or a restriction that can be removed in whole or part by the transferor or any member of the transferor’s family, alone or collectively.

 (b)Basic Premise of IRS Attack: The partnership agreement constitutes an applicable restriction which the transferor and the transferor’s family can remove in violation of Section 2704(b).

(c) Courts’ Typical Response to this Argument: Both the Tax Court and the Court of Appeals for the Fifth Circuit have concluded that restrictions on liquidation contained in a partnership agreement were not “applicable restrictions” under 2704(b). For example, see Kerr v. Comm’r. , 292 F. 3d 490 (5th Cir. 2002), aff’g 113 T. C. 449 (1999); Harper v. Comm’r. , T. C. Memo 2002-121; Est. of Jones v. Comm’r. , 116 T. C. 121 (2001); Knight, supra. Before declaring victory with regard to 2704(b), however, it is worth noting that the Court of Appeal for the Fifth Circuit in Kerr seems to have given some significance to the fact that there was at least one non-family member partner (a charity), noting that a “defining feature” of 2704(b) is the ability of the family to remove a restriction on liquidation.

Comment: The Conference Committee Report related to the enactment of Section 2704 provides that, “These rules do not affect minority or other discounts available under present law. ”Nevertheless, commentators from a panel at the 2007 Heckerling Institute on Estate Planning (University of Miami) opined that “the Treasury has all the tools it needs” under Section 2704(b) to deal with valuation discounts. As a result, we might see an attempt in the future to deal with valuation discounts via regulatory action under Section 2704(b).

(d)Drafting to Avoid a 2704(b) Attack: It has been suggested that, until, if ever, the Treasury issues regulations under Section 2704(b), family limited partnership agreements should be drafted to have more than one general partner, or, if there is only one general partner, to not provide that partner the power to liquidate the partnership or his or her interest in the partnership. It has also been suggested that the partnership not continue in perpetuity, but have a fixed termination date or a statement that the partnership will terminate upon the conclusion of its specific purposes.

 

II. The IRS’s Most Successful Arguments

 

A. Attacking Gift of an Interest in an Improperly Funded Partnership as a Gift of the Underlying Assets.  This is an easy attack for the IRS under appropriate facts.   Because these facts are within the taxpayer’s control, however, it is just as easy to avoid this challenge as it is for the IRS to make it.

 

1. Basic Premise of IRS Attack: Either because of the form chosen for the transaction or because a partnership is not properly formed, a purported gift of partnership interests is in fact a gift of an interest in the underlying assets that subsequently became subject to a partnership agreement.      

2. Courts’ General Response: As noted earlier in this outline, where the taxpayer has followed all of the necessary state law formalities in the formation and administration of a partnership, the partnership will be respected.   See, for example, Strangi, supra, Knight, supra and Church, supra.   On the flip side, where taxpayers do not follow the proper formalities, the Court will follow the form of the transaction chosen by the taxpayer. See, for example,  LeFrak v. Comm’r. , T. C. Memo. 1993-526; Shepherd v. Comm’r. , 283 F. 3d 1258 (11th Cir. 2002), aff’g 115 T. C. 376 (2000).

In Shepherd, the timing of the entire partnership transaction was off.   On August 1, 1994, Mr. Shepherd transferred real property to a partnership subject to a partnership agreement.   The agreement purported that Mr. Shepherd owned a 50% partnership interest and each of his sons owned a 25% partnership interest.   However, the sons did not actually sign the partnership agreement until the next day (August 2).   On September 9, Mr. Shepherd and his wife transferred almost $1,000,000 in stock in a bank to the partnership.   The Shepherds filed gift tax returns reporting gifts of bank stock and land to the sons.   They later attempted to recharacterize the transfers as gifts of partnership interests.   The Tax Court and the Court of Appeals focused on the assets transferred (land and bank stock), rather than the nature of the assets received, and also upon the taxpayer’s own characterization of the transfer, stating that the taxpayer cannot argue against the form of the transaction that the taxpayer himself chose.

 3. Minimizing the Likelihood of a Gift of Underlying Assets: The Tax Court has been very flexible in finding for the taxpayer on issues of entity formation and respect of state law partnerships. However, if state law formalities are not followed, and if the sequential steps necessary to make a valid partnership interest transfer are not carried out, a gift of the underlying assets may result. In this regard, the following steps should be followed in the creation and formation of each family partnership:

 

(a) First, the taxpayer should form a valid limited partnership with a spouse, with a wholly owned LLC or corporate general partner, or with another individual general partner who contributes full and adequate consideration to the partnership for his or her interest. There should be in place a fully executed partnership agreement, and all of the formative state law paperwork should be completed, signed and filed. A taxpayer identification number should be obtained for the partnership.

(b) Second, the taxpayer should transfer assets to the partnership. (If another person is contributing assets for a partnership interest, these transfers should occur simultaneously. )There should be no gift if the entity is wholly owned by the taxpayer and his or her spouse or any other partners have also contributed proportionately for their interests. Allassets transferred to the partnership should be formally and legally titled in the name of the partnership. The transferors should receive credits to their capital accounts for the full fair market value of the assets they have each contributed to the partnership.

(c) Only after all of the foregoing steps have been completed should there be any gifts or sales of partnership interests.

 B. Estate Tax Inclusion Under Section 2036(a)(1). This argument first found published success for the IRS in Schauerhammer Est. v. Comm’r. , 73 T. C. M. 2855 (1997), and has been by far the most successful avenue of IRS attack on family limited partnerships.

 

1. What 2036(a)(1) Says: Section 2036(a)(1) should be familiar to anyone practicing in the field of estate tax planning. Section 2036(a)(1) provides that a decedent’s 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 the 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, any possession or enjoyment of, or the right to the income from, the property. ”Treasury Regulation 20. 2036-1(a) provides that the retention of the rights prohibited under Section 2036(a)(1) may be informal, as through an implied understanding.

2. Basic Premise of IRS Attack: All of the partnership’s assets should be included in the decedent/transferor’s estate at death because, under the terms of the partnership agreement or pursuant to a separate “implied agreement” with the other partners, the decedent/transferor retained the possession or enjoyment of, or the right to the income from, the partnership property in violation of Section 2036(a)(1).

3. The Courts’ Typical Response:  Under appropriate facts, the courts have been willing to include in a decedent’s estate the date of death value of the assets of a family limited partnership where the Court found the decedent retained, under the terms of the partnership agreement or, more commonly, by implied agreement, the right to possess or enjoy the partnership property and the income therefrom. Taxpayers have attempted to argue that Section 2036(a) is inapplicable because the partnership property itself was not transferred in connection with gifts of family partnership interests, and further, even if the funding of the partnership is a “transfer” for purposes of 2036(a), the transferor received full and adequate consideration in money or money’s worth in the form of limited and general partnership interests as well as credits to the transferor’s capital account. The courts have consistently rejected this argument, instead characterizing the funding of the partnership under facts giving rise to 2036(a)(1) inclusion as a mere “recycling” of the transferor’s assets.

 

(a) Focus Has Been “Bad Facts” Cases.   Fortunately, like a lion hunting in a pack of zebras, when it comes to applying Section 2036(a)(1), the IRS has been most successful attacking “the sick and the lame. ” It is relatively easy in most cases to protect clients from a successful 2036(a)(1) attack by understanding the “bad facts” presented in the IRS’s successful 2036(a)(1) cases.

 

(i) Est. of Reichert v. Comm'r. , 114 T. C. 144 (2000).   Mr. Reichert, who was in his nineties and suffering from terminal cancer, created two family limited partnerships two years prior to his death using “Fortress Plan” ® documents licensed by Fortress Financial Group, Inc.   (Note:  The Fortress Plan appears in three of the IRS’s early successful 2036(a)(1) cases. )  Mr. Reichert transferred over $4,000,000 in assets to the partnerships, retaining only $100,000 in other assets outside of the partnership, including his car and tangible personal property.   Four months after creating the partnerships, Mr. Reichert gifted two 30% interests to family members.   The Court found troubling that Mr. Reichert could not have sustained himself financially with his non-partnership assets for more than two years, the partnership distributed money to Mr. Reichert whenever he needed it, and Christmas gifts were made on Mr. Reichert’s behalf using family partnership assets.   The Court found little difference in Mr. Reichert’s use and control of the partnership property before and after the partnership was created.   As a result, the Court had no difficulty finding that there was an implied understanding among the partners that Mr. Reichert would retain the enjoyment and economic benefit of the property he had transferred to the partnership.   It was of no importance to the Court whether this implied understanding was legally enforceable by Mr. Reichert.                 

(ii) Est. of Harper v. Comm’r. , supra.   At the age of 85 and while suffering from cancer, Mr. Harper transferred all of his assets other than his tangible personal property, his regular checking account, his car, and his condominium, to a family limited partnership.   Mr. Harper’s two children were the sole general partners, and Mr. Harper held a 99% limited partnership interest.   Although the partnership was created in January of 1994, the partnership agreement was not executed, and the state paperwork was not filed, until June of that year.   Assets were not in fact transferred to the partnership until July 26.   A partnership bank account was not opened until September, and the partnership did not start depositing income into that account until October. Nevertheless, Mr. Harper made gifts of limited partnership interests to his children (about 60% collectively) on July 1.   Mr. Harper’s personal expenses were paid from the partnership. After Mr. Harper’s death in February of 1995, his children hired an accountant to create the partnership books and records. The Court found particularly troubling Mr. Reichert’s age and ill health at the time the partnership was created, as well as the fact that virtually all of his assets had been transferred to the partnership. As in the Reichert case, discussed above, the Court concluded that Mr. Harper’s position with regard to his assets did not change after he transferred them to the partnership.   Finding that Mr. Harper and his family had an implied understanding that Mr. Harper would retain the use and enjoyment of, and the income from, the property transferred to the partnership, the Court applied 2036(a)(1) to include all of the partnership’s assets in Mr. Harper’s estate.

(iii) Est. of Thompson v. Comm’r. , 84 T. C. M 374 (2002), aff’d  382 F. 3d 3671 (3rd Cir. 2004).   Theodore Thompson was in his 90s when he created two family limited partnerships using the Fortress Plan ®, discussed above in connection with the Reichert case.   Mr. Thompson transferred $4,000,000 in assets to the partnership, retaining only $100,000 in assets outside of it.   Upon Mr. Thompson’s death, the Court found there was an implied agreement between Mr. Thompson and his children that he would retain the use and possession of, and the income from, the assets transferred to the partnership.   The Court further stated that the partnership had been formed primarily as an alternative to a living trust as a testamentary vehicle. The facts which the Court used to support its conclusion included (1) Mr. Thompson had retained only enough assets outside of the partnership to support himself for two years; (2) the partnership distributed money to Mr. Thompson whenever he needed it and on a disproportionate basis; (3) there was no activity at the partnership level during the existence of the partnership; (4) the evidence indicated that Mr. Thompson’s son and daughter both expressed interest in how the partnership would be used to continue to fund gifts consistent with Mr. Thompson’s passed patterns of giving; and (5) loans were made to family members from the partnership in the same manner that Mr. Thompson had personally made loans to them prior to the creation of the partnership.  

The Third Circuit affirmed the Tax Court opinion, concluding that, based upon how the partnership’s affairs had been managed, there was clearly an implied agreement that the Mr. Thompson had retained the right to the partnership property and its income.   Perhaps more importantly, the Court focused on the fact that the partnership was funded predominantly with marketable securities, which the Court stated was “significant to its assessment” that there was no likely benefit derived from the partnership other than estate tax savings.

 (iv) Est. of Strangi v. Comm’r. , 115 T. C. 478 (2000), aff’d in part and remanded in part, 293 F. 3d 279 (5th Cir. 2002), on remand, TC Memo 2003-149; aff’d 417 F. 3d 468 (5th Cir. 2005) (This case is actually referred to in the original Court of Appeals case as Gulig v. Comm’r. )The Strangi case was at one point the “hot case” in family limited partnership planning, not because of its holding on Section 2036(a)(1), which is rather predictable under the facts, but because of its possible implications under Section 2036(a)(2), discussed later in this outline. However, the heat fizzled a bit in the final 2005 Fifth Circuit ruling, as Strangi has now become just one of the dozens of the many poorly conceived family partnerships that fell easily to IRS challenge, albeit this one with a much more vigorous fight by the taxpayers than others of its ilk.

In Strangi, a family partnership was created by Mr. Strangi’s son in law (Mr. Gulig) acting under a durable general power of attorney and using the Fortress Plan ®, discussed in the Thompson and Reichert cases above. At the time that the partnership was created, Mr. Strangi had just had surgery for prostate cancer surgery and he was suffering from a degenerative nerve disease. Mr. Gulig, acting for Mr. Strangi, transferred to the partnership 98% of Mr. Strangi’s wealth, including Mr. Strangi’s residence. Mr. Strangi retained a 99% limited partnership interest and he held a 47% interest in the corporate general partner. (His children held the other 53%). Mr. Strangi’s expenses were paid directly from the partnership, and although he was required to pay rent for the use of his residence, he in fact never did. After Mr. Strangi’s death, administrative expenses, estate taxes and even bequests were paid from the partnership. In the first Tax Court opinion in 2000, the Court rejected the government’s arguments that the partnership should be disregarded under Chapter 14 or due to a lack of business purpose, and determined that that government had not raised a timely 2036(a) argument. The Fifth Circuit agreed with the Tax Court’s findings generally, but remanded the case for the Court to consider the 2036 argument. Having opened that door, in a 2003 opinion, the Tax Court had no problem finding that Mr. Strangi’s limited partnership looked more like an estate plan than a partnership, that there was an implied agreement that Mr. Strangi would have the possession and enjoyment of, and the income from, the partnership, and that virtually nothing changed for Mr. Strangi with regard to his assets but for the manner in which title to those assets was held. As a result, the partnership property was includible in Mr. Strangi’s estate under Section 2036(a)(1). Upon the final appeal, the Fifth Circuit, not surprisingly, affirmed the Tax Court’s holding without much fanfare.

(v) Est. of Abraham v. Comm’r. ,87 T. C. M. 975 (2004), aff’d 408 F. 3d 26 (1st Cir. 2005). Three partnerships in this case were created six months after a guardian was appointed for Mrs. Abraham, who was then incompetent. The partnerships were created upon approval by the Probate Court and were funded with most of Mrs. Abraham’s assets other than those determined needed for her support and to make annual exclusion gifts. Mrs. Abraham’s children contributed nominal sums for their initial partnership interests and then purchased partnership interests from Mrs. Abraham. The Probate Court allocated to each partnership a proportionate share of the responsibility for Mrs. Abraham’s support. The children also admitted that there was an agreement that their mother would be provided for from the partnership. It was also found that Mrs. Abraham’s personal funds were commingled with the partnerships’ funds. The Tax Court had no difficulty applying Section 2036(a)(1) to cause inclusion of the partnership assets in Mrs. Abraham’s estate.

(vi) Est. of Hillgren v. Comm’r. , 87 T. C. M. 1008 (2004). Mrs. Hillgren and her brother entered into a Business Loan Agreement that encumbered real estate to secure obligations of Mrs. Hillgren to her brother. Pursuant to the Business Loan Agreement, the brother retained the right for nearly three decades to determine when to sell the subject properties. A few years later, Mrs. Hillgren and her brother entered into a limited partnership agreement pursuant to which the decedent contributed seven properties, four of which were subject to the Business Loan Agreement. However, none of the properties were ever titled into the partnership, the existence of the partnership was not disclosed to third parties, the leases on the properties were not assigned to the partnership, the partnership did not have dedicated bank accounts, the partnership held Mrs. Hillgren’s residence and paid the mortgage on the residence, and Mrs. Hillgren was dependent upon the cash flow from the partnerships for her living expenses. Further, prior to Mrs. Hillgren’s death, she executed deeds to the properties that were supposed to be in the partnership, instead placing those properties in her revocable trust. (The deeds, however, were unrecorded. )The Tax Court had no difficulty disregarding the partnership under Section 2036(a)(1). (Fortunately for the estate, however, the Tax Court allowed a 50% discount with regard to the properties encumbered by the Business Loan Agreement. )

 (vii) Est. of Bigelow v. Comm’r. , 89 T. C. M. 954 (2005). Mrs. Bigelow suffered a stroke at the age of 83. Her son was acting as the Trustee of her revocable trust and as agent under a power of attorney. Two years later, when Mrs. Bigelow was in a nursing home, the son created a limited partnership and transferred to the partnership from Mrs. Bigelow’s trust an investment property, encumbered by debt. The liabilities were largely retained as liabilities of the trust and were not assumed by the partnership. Mrs. Bigelow’s assets outside of the partnership were insufficient to meet her living expenses.

Each of Mrs. Bigelow’s children made nominal contributions to the partnership as well. Gifts of partnership interests were made by Mrs. Bigelow to her children and grandchildren. The partnership made the payments on the debt that encumbered its property and also paid Mrs. Bigelow’s living expenses. The Tax Court found that there was an implied agreement that Mrs. Bigelow would retain the income from the property transferred to the partnership, that the family failed to maintain partnership capital accounts and improperly maintained partnership balance sheets, and that, generally, the property was not transferred to the partnership in good faith and for legitimate non-tax purposes. The argument that the partnership was formed for creditor protection purposes was discredited because Mrs. Bigelow was, individually, the general partner of the partnership. Further, continuity of management after Mrs. Bigelow’s death was not a legitimate purpose because, as sole general partner, the partnership would terminate at her death (and it did in fact terminate within a year following her death).

 (viii) Estates of Korby v. Comm’r. , T. C. M. 2005-12 and 2005-103. Edna and Austin Korby were ill and transferred nearly all of their assets to a partnership, which they largely gifted away to their sons. The partnerships paid for their nursing home, medical and living expenses. No distributions were made to anyone other than the Korbys until their deaths. The Tax Court applied Section 2036(a)(1) to include the partnership assets in the Korbys' estates at their deaths.

(ix)Est. of Rosen v. Comm’r. , 91 T. C. M. 1220 (2006). Mrs. Rosen was incompetent when her son-in-law, an attorney, attended a seminar on family limited partnerships. Persuaded that family partnerships could save estate tax, just under $2. 5M of cash and marketable securities were transferred on Mrs. Rosen’s behalf to a newly formed family limited partnership. Each of Mrs. Rosen’s children also contributed $12,000 to the partnership. Although Mrs. Rosen started out with a 99% interest in the partnership, by the time of her death four years later, she had gifted all but 35% of her interest in the partnership. Unmoved by the estate’s arguments that the partnership was formed for asset protection, to facilitate a gifting program, and other non-tax purposes, the Court instead found that the partnership was created for estate tax avoidance purposes and, therefore, the full and adequate consideration exception to Section 2036(a) did not apply. The Court then found that there was an understanding that Mrs. Rosen would receive distributions from the partnership whenever needed, resulting in the inclusion of the partnership’s assets in her estate under Section 2036(a)(1). Among the factors taken into consideration by the Court were that partnership funds were used to pay Mrs. Rosen’s living expenses, to make gifts, to pay expenses of administering her estate, to make bequests, and to pay estate taxes.

(x)  Est. of Erickson v. Comm’r. , T. C. Memo 2007-107.   Mrs. Erickson was in her 80s and in poor health when one of her daughters, acting under a power of attorney for Mrs. Erickson, created a partnership and transferred to that partnership almost all of Mrs. Erickson’s liquid assets (about $2,000,000).   Just days prior to Mrs. Erickson’s death, the daughter also transferred certain condominium properties to the partnership and made numerous gifts of partnership interests, decreasing Mrs. Erickson’s interest in the partnership from 86% to 24%.   After Mrs. Erickson’s death, the partnership used partnership cash to purchase Mrs. Erickson’s home, and also redeemed a portion of Mrs. Erickson’ interest in the partnership, in order to provide the estate liquidity to pay estate taxes.   The Tax Court found the partnership to be a “mere asset container” that did not change the form of Mrs. Erickson’s investments or how they were managed.   As in Rosen, the Court dispelled with the notion that the partnership was created for asset protection, to facilitate gifting or for any other substantial non-tax purpose.   Among the factors that the Court considered were that the daughter stood on both sides of the transaction, the assets were mainly passive assets and they were managed exactly the same before and after the partnership was created, there was a delay in funding the partnership, and the estate was financially dependent upon the partnership, as noted by the fact that $227,000 of partnership assets had to be used to pay estate taxes after Mrs. Erickson’s death.   The Court then included the partnership assets in Mrs. Erickson’s estate on the basis of Section 2036(a)(1).   The Court found many facts compelled this conclusion, including that the family did not seem particularly rushed to fully fund the partnership until Mrs. Erickson’s death was imminent, Mrs. Erickson had no liquidity outside of the partnership (importantly, the Court disregarded about $1,000,000 of assets in a credit shelter trust established by the late Mr. Erickson), there was a commingling of funds, there were no distributions during Mrs. Erickson’s lifetime, and partnership cash was necessarily used to pay estate taxes at Mrs. Erickson’s death.

(b) Taxpayers Have Prevailed in Some Cases.   The news is not all bad with regard to Section 2036(a)(1) and the IRS is not always the winner in these cases.

 

(i)Est. of Church v. U. S. , 85 AFTR 2d 2000-804, 2000-1 USTC Parag. 60,369 (W. D. Tex. 2000), aff’d without published opinion 268 F. 3d 1063 (5th Cir. 2001). Mrs. Church and certain family members entered into an agreement to create a limited partnership to hold a 23,000-acre family ranch. Mrs. Church also transferred $1,000,000 of securities to the partnership. The stated purposes of the partnership were to consolidate fractional interests in the ranch to provide for centralized management and to protect Mrs. Church’s interest from tort creditors. While Mrs. Church had been diagnosed with breast cancer before the partnership was created, two days after signing the agreement, she collapsed and died from a heart attack. The District Court was persuaded that Mrs. Church’s death was unexpected, that the partnership was formed for a bona fide business purpose and that there was no agreement, express or implied, that Mrs. Church could continue to use, enjoy or possess the partnership property. Further, the Court applied a discount in excess of 50% to Mrs. Church’s pro rata interest in the partnership, notwithstanding the fact that all of the partnership formalities had not yet been finalized as of Mrs. Church’s death on the basis that she had committed her assets to the partnership by signing a binding agreement to form the partnership. The Fifth Circuit affirmed, noting the application of Texas law to establish the restrictions upon Mrs. Church’s property that justified the valuation discounts applied.

(ii)Est. of Stone v. Comm’r. , 86 T. C. M. 551 (2003). Mr. and Mrs. Stone created five partnerships with their children. Each partnership was funded with assets from Mr. and Mrs. Stone and with assets from the children, which were gifted to them by Mr. and Mrs. Stone. Each of the Stones’ four children was a co-general partner of one of the limited partnerships. The purported purpose of each partnership was to manage Mr. and Mrs. Stone’s assets and to resolve disputes among the children. Both Mr. and Mrs. Stone died within months of forming the partnerships and the IRS sought to include the partnership property in their estates under Section 2036(a)(1). The Tax Court’s focus in addressing the IRS’s argument was whether the partnerships were bona fide business arrangements and, in particular, whether Mr. and Mrs. Stone had received adequate and full consideration for the transfer of their property to the partnerships. The Tax Court had little difficulty finding for the taxpayers in Stone, noting, among other facts, that the partnerships were the result of arms’-length negotiations in which several members of the Stone family, including the decedents, were represented by independent counsel and that the motivations were derived from real and demonstrable business and investment concerns, as well as the desire to resolve litigation among the children.

(iii) Kimbell v. U. S. , 371 F. 3d 257 (5th Cir. 2004), rev’g 244 F. Supp. 700 (N. D. Tex. 2003). Two months before her death at age 96, Mrs. Kimbell created a family limited partnership with an LLC she owned equally with her son as the one percent general partner.   When Mrs. Kimbell died, she still held her 50% interest in the LLC and a 99% limited partnership interest, to which her son, as executor, applied a 49% discount for lack of marketability and control.   Unlike the Reichert, Harper and Thompson cases, discussed above, there was no discussion in the District Court’s opinion concerning what portion of Mrs. Kimbell’s entire estate was held in the family partnership at her death.   Rather, the District Court applied a somewhat different approach to cause inclusion of the partnership assets in Mrs. Kimbell’s estate under Section 2036(a)(1). Noting that, under the partnership agreement, the general partner had the sole discretion to determine the timing and amount of distributions, that the general partner was absolved under the partnership agreement of state law fiduciary duties, and that Mrs. Kimbell had the power as a 99% limited partner to remove and replace the general partner, the Court attributed to Mrs. Kimbell the power to distribute the income of the partnership to herself.   (Because the partnership agreement absolved the general partner of its normal state law fiduciary duties, the holding of U. S. v. Byrum, 408 U. S. 125 (1972), did not apply. )  The Court also found that the other partner’s interest in the partnership was insignificant.   Finally, the Court disregarded the argument offered by Mrs. Kimbell’s son that the family partnership was a necessary management tool for Mrs. Kimbell’s assets because the same person (her son) managed her assets through a living trust prior to the creation of the partnership.

However, the Fifth Circuit Court of Appeals reversed the District Court, finding on the basis of several “objective facts” that the creation of the partnership constituted a bona fide sale for adequate and full consideration, taking the partnership outside of the scope of Section 2036. Important facts in this regard were that Mrs. Kimbell retained sufficient assets outside of the partnership for her own support and did not commingle partnership and personal assets; all partnership formalities were observed, including the transfer of assets to the partnership; the assets in the partnership (interests in oil and gas properties) required active management; and there were credible non-tax reasons for creating the partnership. The Court found the absence of negotiations among family members in the creation of the partnership was not a significant fact, because all of the partners received full credit to their capital accounts for what they contributed to the partnership.

4. Minimizing the Likelihood of a Successful 2036(a)(1) Attack. Based upon the lessons in the foregoing cases, the following are some tips for creating a family limited partnership that should reduce the odds of a successful government attack under Section 2036(a)(1).

 

(a) Give It ALL Away More Than Three Years Before Death. Section 2036 is an estate tax inclusion provision. To apply, it requires that the decedent hold an interest in transferred property at his or her death or within three years of death. (The three-year inclusion rule is found in Section 2035). Therefore, one strategy to avoid 2036 is to simply create a partnership and make gifts of, or sell, the entire partnership at least three years prior to death.

 (b) Retention of Assets Outside of the Partnership. The smell test is alive and well. Courts find it very suspicious that a rational person would transfer all of his or her assets to a partnership over which he or she purports to have little control.   Further, transferring substantially all of the founder’s assets to the partnership virtually insures that the founder will need to invade the partnership’s assets for his or her living expenses.   The founding partner should maintain sufficient assets outside of the partnership to fund his or her normal living expenses.   The Erickson case would also suggest it is wise, where possible, to have assets outside of the partnership that can be liquidated in a third party transaction to raise funds for estate taxes, estate administration expenses and miscellaneous cash bequests.

(c) Consider the Business Purpose of the Partnership.   Although the courts have typically rejected the need for a business purpose in order to create a valid partnership (but see the discussion of Bongard, below), it is nevertheless wise to consider carefully and to document the non-transfer tax purposes of the partnership, and then to administer the partnership in a manner that fulfills those purposes.   For example, in Church, supra, an elderly woman suffering from recurring breast cancer created a family partnership to hold ranch land two days before her death, which the Court determined was unexpected and unrelated to her cancer.   The formalities of the partnership had not even been completed prior to Mrs. Church’s death. The Court nevertheless upheld the partnership because, among other reasons, improved management of the ranch was a substantial and important non-tax business purpose.

(d) Avoid Personal Use Assets.    Family partnerships can be funded with real estate, investment assets, cash, business interests, and even tangibles.   However, it is important to avoid, or to at least carefully consider the consequences of, the transfer of personal use assets to a partnership, such as the founder’s residence, automobiles or personal and household effects.   If the best asset to fund a family partnership is an asset that will be used personally by the founding partner, then the founding partner should pay fair market rent for its use. (Of course, in addition to the estate tax considerations, careful consideration must be given to the income and property tax consequences of transferring personal use assets, such as a residence, to a partnership. )

(e) Modify Asset Management.   The Court in Erickson noted that the partnership was nothing more than a “mere asset container,” an observation reminiscent of the “recycling of value” characterization proffered by the Court in the Harper, supra, Thompson, supra, and other 2036(a)(1) cases.   To address this issue, it is important that the partnership structure result in some significant change in the manner in which assets are managed: for example, a shift in the management responsibilities from one generation to another, or perhaps the participation of the partners in the selection of investment advisors, the adoption of an investment policy by an investment committee, and the monitoring of the partnership’s investments by the committee.    

(f) Have Multiple Partners Participate in Formation.    In virtually all of the cases where partnerships failed under 2036(a)(1), there were no negotiations at all between parents and children concerning the structure of the partnership and, in fact, most of these partnerships were driven by one family member, often acting under a power of attorney for a senior family member.   Greater participation by family members in the structure of the transaction, and representation of those family members by separate counsel, along with a credible non-tax business purpose for its creation, could stop the 2036(a)(1) argument in its tracks by satisfying the test for a “bona fide sale for adequate and full consideration.

(g) Proper Administration.   The best constructed partnership can run afoul of 2036(a)(1) if the partnership entity is not respected after its formation.   It is important that, from the inception of the partnership, the books and records are properly maintained and are not recreated after the fact. The partnership must have its own bank accounts to which partnership income is deposited and from which partnership expenses are paid. Business or investment activity should be conducted at the partnership level and meetings among the partners, while generally not required under state law, should be held from time to time.   Distributions, if any, should be made when the partnership has income to distribute, not when the founder needs money, and such distributions should be made to the partners proportionately.

(h) Don’t Dissolve the Partnership Soon After Death.   After the founder’s death, do not dissolve the partnership, at least until well after the estate audit, if any, has been closed.   Given that the partnership should remain in existence for some substantial period of time after death, avoid to the maximum extent possible setting up a structure that would require the invasion of the partnership’s resources to pay estate taxes, estate administration expenses, or bequests.

(i) Don’t Absolve the General Partner of State Law Fiduciary Duties.   Particularly if the founder retains general partnership interests, it is important that the partnership agreement not waive the general partner’s duties of care and loyalty to the partnership and the partners.

(j)  Don’t Gift Assignee Interests.  Trying to argue that transferred interests in a partnership are actually assignee interests rather than limited partnership interests in order to secure a better valuation discount can backfire.   This argument produces resistance by the courts and IRS, provides limited valuation benefits, and sets the client up for a 2036 problem because the other partners’ fiduciary duties to an assignee may be limited.

(k) Be Cautious of Transfers in Contemplation of Death or Through the Use of Durable Powers of Attorney.  Although it is possible to form a family limited partnership while suffering from a potentially terminal condition, or to have a partnership formed for an incompetent person using a durable power of attorney, such “death bed” transfers will be scrutinized by the IRS.   It is therefore very important under these facts to (a) take all possible steps to insure the validity of the partnership; (b) if the partnership is created under a durable power of attorney, insure that the agent has all of the necessary authority, including the authority to create and fund partnerships and to make gifts; and (c) carefully consider and advise the client of the downside of the transaction should the partnership ultimately be disregarded.

(l)  Be Cautious of Packaged Partnerships.   Three of the cases discussed above involved the use of a “packaged” partnership structure, specifically, the Fortress Plan ®.   The IRS is very aware of companies such as Fortress as well as practitioners who actively promote family partnerships as transfer tax planning vehicles and who use them aggressively.   The Service educates itself on the vulnerabilities of these programs and it is anxious to take advantage of this knowledge. This is not meant to malign the quality or viability of Fortress products or any other product.   However, all else being equal, if the goal of the client is to minimize the likelihood that his or her transaction will show up on the IRS’s radar screen, it is probably best to avoid canned products as well as the services of advisors that are known by the IRS to be “aggressive” in their approach to marketing, drafting, funding, and administering family limited partnerships.

 What About Estate Tax Inclusion Under Section 2036(a)(2)?This argument was first suggested in Kimbell v. Comm’r. , supra, and became a major concern due to commentary by the Tax Court on remand in Strangi v. Comm’r. , supra. If this argument should ever prevail, family limited partnerships will be much more difficult to create and, in many circumstances, would not longer be an attractive vehicle. Further, a successful 2036(a)(2) attack could be made against partnerships created many years, or even decades, prior to the founder’s death. Fortunately, however, the law has so far failed to develop in this area.

 

1. What 2036(a)(2) Says:Section 2036(a)(2) provides that a decedent’s 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 the 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, 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. ”

2. Basic Premise of IRS Attack:All of the partnership’s assets should be included in the decedent/transferor’s estate at death because, under the terms of the partnership agreement or applicable state law, the decedent transferor, acting alone or with the other partners, could direct the distribution of partnership assets or income, including the power to dissolve the partnership, in violation of Section 2036(a)(2).

3. The Courts’ Response:  This theory of estate tax inclusion for family partnership assets has not been thoroughly discussed in any court case.   It was mentioned as a possible avenue of estate tax inclusion by the District Court in Kimbell v. U. S. , 371 F. 3d 257 (5th Cir. 2004), rev’g 244 F. Supp. 700 (N. D. Tex. 2003), but the Court found it unnecessary to expand upon its application of the concept as it had already found full estate tax inclusion under Section 2036(a)(1).   The Tax Court in the Strangi remand (often referred to as “Strangi III) discussed this concept in somewhat more detail, concluding that the partnership assets should be includible under both Section 2036(a)(1) and (a)(2).   The Court found that the holding in Byrum, supra, was not applicable because the fiduciary duty that Mr. Strangi had owed to his family members did not adequately constrain his right to vote on liquidation and distributions and should therefore be disregarded.   This concept is troubling because the focus shifts from the retention of an economic benefit to the ability of the client to control the partnership.   Read broadly, any right of the transferor to participate in decisions concerning partnership distributions or the liquidation of the partnership, even if such decisions must be made jointly with an adverse party, and whether those rights are exercised as a general or limited partner, could result in estate tax inclusion under Section 2036(a)(2).   Fortunately, Kimbell was reversed and the final Strangi appeal was decided against the taxpayers on the basis of Section 2036(a)(1) and without further analysis of the potential application of Section 2036(a)(2) to the facts in that case.   Therefore, other than dicta from the Tax Court in its second Strangi decision, there is no current authority for the inclusion of partnership assets in a deceased partner’s estate under Section 2036(a)(2).   Further, the Byrum case is arguably strong support for the premise that Section 2036(a)(2) should not apply in the context of a properly formed and administered family partnership so long as the partnership agreement does not absolve the general partners of their fiduciary duties to the other partners and the partnership.

4. Minimizing the Likelihood of a Successful 2036(a)(2) Attack. It is unclear how reactive practitioners and their clients need to be with regard to the Court’s discussion of 2026(a)(2) in Strangi III. Importantly, if the Court’s analysis of 2036(a)(2) is ultimately upheld or repeated, it will cause estate tax inclusion not only for newly formed partnerships that do not employ defensive planning, but “old and cold” partnerships formed long ago, if the founder still possesses a voting interest in the partnership.

Nevertheless, the following are some defensive structures that have been suggested to thwart a successful 2036(a)(2) attack:

 

(a)Give It ALL Away More Than Three Years Before Death. This is the same strategy mentioned in connection with Section 2036(a)(1) above.

(b) Create Voting and Non-Voting Partnership Interests.   When creating the partnership, create voting and non-voting limited partnership interests.   Give away the voting interests and retain the non-voting interests. Retain no general partnership interests or any interest in an entity that is serving as general partner.   Some have also suggested that if another partner holds a durable power of attorney for the transferor, that partner also should not hold voting interests, even in his or her individual capacity, as state law fiduciary duty may compel the agent to act in his or her principal’s best interests.

  (c) Have an Independent Trustee Hold the Founder’s Interests in an Incomplete Gift Trust.   Create an irrevocable trust with an independent trustee to hold the founder’s limited and general partnership interests.   To avoid gift tax, this trust must have the provisions necessary for transfers to be deemed incomplete gifts.   Transfer all of the founder’s voting interests to the trust.

(d)  Preserve Fiduciary Duties.   Be certain that the terms of the partnership agreement do not relieve the general partners of their fiduciary duties to the other partners and the partnership.

C. Estate Tax Inclusion Under Section 2036(a) – Even Under GOOD Facts Where There is a Lack of a Non-Tax Purpose.

 

 1. Premise of IRS Attack: The partnership should be disregarded because it lacks a valid business purpose. Like the substance-over-form argument, the IRS supports its position based upon Est. of Murphy v. Comm’r. , supra.

2. Courts’ Typical Response to this Argument: “Taxpayers are generally free to structure a business transaction as they please, even if motivated by tax avoidance considerations. ” Kerr v. Comm’r. , 113 T. C. 449, 464 (1999). If the partnership is validly formed and administered(see discussion on 2036(a)(1) above) under stated law, and if there is no reason to believe that a hypothetical willing buyer would disregard the partnership, then the partnership form should be respected. See, for example, Strangi, supra; Church, supra.

3. The Emerging Bongard Test: The IRS’s argument for a non-tax business purpose as a requirement to create a valid family partnership was analyzed by the Tax Court in Bongard v. Comm’r. , 124 T. C. 95 (2005) in the context of whether the creation and funding of the partnership in that case was a “bona fide sale for adequate and full consideration. ” This case has quickly emerged as a governing case for the premise that a family partnership must have a legitimate non-tax purpose to survive a 2036(a) challenge on the basis of the “adequate and full consideration” exception. (See, for example, Est. of Bigelow, 89 T. C. M. 954 (2005); Est. of Korby, 89 T. C. M. 1143 (2005); Est. of Schutt v. Comm’r. , T. C. Memo 2005-126; Est. of Rosen, 91 T. C. M. 1220 (2006)).

 

(i) Bongard Facts. Mr. Bongard was the founder and sole shareholder of a Minnesota plastics manufacturing company, Empak, until he transferred 15% of his shares to a trust for his children (“Trust”). Ten years later, Trust and Mr. Bongard formed an LLC to reconsolidate their Empak shares in anticipation of a liquidation event. The LLC interests consisted of both voting and non-voting interests. Bongard made gifts of his voting interests that reduced his voting interest in the LLC below 50%. He and Trust also transferred their non-voting interests to a limited partnership (LP), and subsequently Mr. Bongard made a gift of about 7% of his LP interests to his wife pursuant to a post-nuptial agreement. Mr. Bongard then died suddenly from a heart attack at the age of 58. His estate claimed minority and lack of marketability discounts for Mr. Bongard’s interests in the LLC and the LP. The IRS assessed a $100M estate tax deficiency on the basis that the assets of the LLC and the LP should be included in Mr. Bongard’s estate under Section 2036(a) of the Code (a Section 2038 argument was raised but subsequently dropped), and the case proceeded to Tax Court, where it was heard by the entire Tax Court.

The Tax Court in Bongard focused on whether the formation of the LLC or the LP qualified for the “bona fide transfer” exception to Section 2036(a). The majority held that the bona fide transfer exception is satisfied if there is a “legitimate and significant non-tax reason” for the creation of the entity and the interests received by the partners are in proportion to the value of what they contributed. With regard to the non-tax reason for creating the entity, the majority stated that the purpose must be an actual motivation and not a theoretical justification for the entity, but it did recognize that such purpose may very well be interwoven with the partners’ testamentary objectives. In this regard, the Tax Court found that the formation of the LLC had a legitimate non-tax purpose, which was to pursue a liquidity event. No such purpose, however, was found for the LP. This allowed the Tax Court to examine whether Section 2036(a) should apply to include the LP’s assets in Mr. Bongard’s estate, which the Court found that it did based upon Mr. Bongard’s control over the LLC units transferred to the LP.

(ii)Est. of Shutt v. Comm’r. , 89 T. C. M. 1353 (2005). This case involved the creation of two Delaware business trusts, which, for all intents and purposes, were much like limited partnerships, with the Trustee serving the role of general partner. Mr. Shutt in this case was Trustee. The trusts were created by Mr. Shutt and the Wilmington Trust Co. , which was trustee of trusts for the decedent’s children. The Delaware business trusts were funded with stock in Exxon and Dupont for the primary purpose of preserving the decedent’s “buy and hold” investment philosophy. Mr. Shutt died one year later. Applying the Bongard standard, the Tax Court found that the creation of the Delaware business trusts was a bona fide sale for adequate and full consideration because the transfer was made for a “legitimate and significant non-tax reason,” that is, the perpetuation of the decedent’s investment philosophy, and that the Delaware business trusts enabled Mr. Shutt to impose his philosophy upon assets contributed by Wilmington Trust.

4. How to Avoid a “Bongard” Attack:  While it is possible to critique the Tax Court’s analysis of the facts in Bongard, this case has nevertheless brought to the forefront the advisability, if not the requirement, that each FLP or FLLC should have a legitimate non-tax purpose of its existence. Attorneys advising clients in the creation of the FLP or FLLC should insure that all documentation and correspondence concerning the partnership reflect these purposes, and, further, that the partnership actually operates consistently with that stated purpose.

D. Limited Partnership Interests are Future Interests that Do Not Qualify for the Gift Tax Annual Exclusion Under Section 2503(b).

 

 1. What Section 2503(b) Says: Section 2503(b) provides, in pertinent part, “In the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of such gifts to such person shall not, for purposes of subsection (a), be included in the total amount of gifts made during such year. ” Treasury Regulation 25. 2503-3 defines future interests as interests in property “which are limited to commence in use, possession or enjoyment at some future date or time. ”

 2. Basic Premise of IRS Attack: Limited partners do not have the current use and enjoyment of the partnership property and therefore gifts of limited partnership interests are gifts of future interests.

3. Court’s Response to this Argument: This issue has been formally addressed in only one case:Hackl v. Comm’r. , 118 T. C. No 14, aff’d, 335 F. 3d 664 (7th Cir. 2003). In that case, gift transfers were made of interests in an Indiana limited liability company subject to a restrictive operating agreement. The members could not unilaterally sell or force the redemption of their membership interests, they could not compel a dissolution, and it was expected that no income would be distributed to them for the reasonably foreseeable future. Further, when income was available, the donor, Mr. Hackl, as manager of the LLC, could determine whether to distribute it. The Court determined that the taxpayer had the burden to prove that, from all of the facts and circumstances, the donees could derive substantial current economic benefits and that these benefits were presently reachable by the donees.   The Court further stated that the right to income creates a present interest only if that income will be produced, some portion of that income will flow steadily to the donee, and that portion can be ascertained.   Because the taxpayer could not sustain this burden of proof, the annual exclusion was disallowed.   Although this case has been criticized, it has been upheld on appeal.

 4. Minimizing the Likelihood of a Future Interest. Practitioners who are drafting family limited partnership agreements should consider utilizing one or more of the following techniques to reduce the likelihood that a limited partnership interest would be treated as a future interest:

 

(a) Transferability with Right of First Refusal.  Provide the partners the right to transfer partnership interests subject to a right of first refusal by the other partners.   Note, however, that this right existed in Hackl but was insufficient, by itself, to create a present interest gift.

(b) 60-Day Transfer Window. Provide the partners a 60-day window of free transferability upon receipt of a gifted interest.

(c) 60-Day Put Right.  Provide the partners 60 days from receipt of a gifted interest to require the partnership to buy them out (a “put right”) for fair market value, determined with all of the relevant discounts.  

(d) Annual Distributions. Require some minimum amount of income to be distributed annually. For example, require the general partners to distribute at least 1% or 2% of the value of the partnerships assets each year.

(e) No Implied Understandings. Annual exclusions are being challenged in the context of trusts on the basis that there is an implied understanding that Crummey powers will not be exercised.   In those cases, the IRS is seeking to show that the holders of the withdrawal powers understood that they were not to exercise those powers.   See Est. of Trotter v. Comm’r. , T. C. Memo 2001-250.   This needs to be taken into consideration when designing and implementing family partnerships structured to cause gifts of partnership interest to be treated as gifts of present interests.

Comment Regarding Gifts to Partnerships and LLCs. A gift of cash or property to a partnership or LLC is a gift to the individual partners or members in the same proportions that the gifted cash or property is allocated to the partners’ or members’ respective capital accounts. (See Shepherd v. Comm’r. , supra. See, also, TAM 200212006, where the transfer of municipal bonds to a family limited partnership constituted an indirect gift to the other partners, who were the transferor’s children. ) Such gifts will be gifts of present interests in the contributed cash or property so long as the donee partners have the unrestricted right to withdraw their capital. Wooley v. U. S. , 736 F. Supp. 1506 (SD Ind. 1990). Similarly, a gift of forgiveness of a partnership debt should be treated as a gift to the partners of the debtor partnership. However, based upon the leading case on the tax consequences of gifts of corporate debt relief, (Est. of Stinson v. U. S. , 82 AFTR 2d Para. 98-5469 (ND Ind. 1988), aff’d. 214 F. 3d 846 (7th Cir. 2000)), it is not so clear that the gift tax annual exclusion can apply to such debt relief. In a relatively short opinion affirming the decision of the District Court, the Court of Appeals in Stinson held that because (a) donative relief of a corporate debt is an indirect gift to the corporation’s shareholders, and (b) no one shareholder in that case could secure the benefit of corporate debt relief by liquidating the corporation or declaring a dividend, the deemed donees did not have the present use and enjoyment of the gift and, therefore, the gift was a gift of a future interest.

Two important points deserve special note in connection with the Stinson case. First, at the District Court level, the taxpayer had argued that the shareholders received a present interest when the debt was relieved because they could sell their stock in the corporation for greater value, providing immediate use and enjoyment of the gift. Neither the District Court nor the Seventh Circuit found this argument persuasive, noting that virtually any property right has value, and the mere fact that a future interest received as a gift could be sold to a third party does not transform that future interest into a present interest. Of additional importance, the Seventh Circuit sustained the District Court’s holding that, although the gift of debt forgiveness to the corporation was deemed to have been made to each of the shareholders, the gift was of the full amount of the forgiven debt ($147,000 in that case) and not the increase in the value of each of the shareholder’s shares in the corporation, which would be affected by the lack of marketability and minority status of those shares. This would suggest that a more transfer tax efficient means of partnership debt forgiveness would be to gift cash to each partner using the gift tax annual exclusion and to have each partner contribute that cash to the partnership, which the partnership can apply to pay down partnership debt.

Circular 230 Notice: In accordance with IRS Treasury Regulations, we are required to notify you that any tax advice given herein (including attachments) is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding any penalties that may be imposed by any governmental taxing authority or agency or (2) promoting, marketing or recommending to another person any tax related matter.