While practitioners know that attention to detail is important in tax planning, a reminder of that fact can be helpful. In a recent decision, the U.S. Tax Court served up such a reminder by pointing out the importance of properly structuring a family limited partnership (FLP).
The Tax Court’s opinion, issued on Nov. 2, 2011 in the case of Estate of Liljestrand v. Commissioner, resulted in the estate of Dr. Phillip Liljestrand paying an additional $2.5 million in estate taxes. The Internal Revenue Service successfully argued that approximately $6 million of Dr. Liljestrand’s assets transferred to an FLP prior to his death should have been included in his estate for tax purposes.
Dr. Liljestrand was born in Iowa in 1911, attended Harvard Medical School and then settled in Hawaii to practice medicine. Shortly after retiring in 1978, he also sold a hospital building that he owned. He sold the property in an Internal Revenue Code Section 1031 exchange, receiving a variety of properties, including a mini-warehouse in Oregon, eight condominiums in California, a medical building in Arizona and small shopping centers in Florida and California. In 1984, he placed the properties into a revocable trust that was eventually managed by one of his four children, Robert, pursuant to a management agreement. In 1996, Dr. Liljestrand met with an estate-planning attorney. He wished to leave the properties in equal shares to his four children, but wanted to be sure that Robert would continue to manage the assets. The attorney suggested an FLP and, in 1997, Dr. Liljestrand formed “Paul H. Liljestrand Partners Limited Partnership” (PLP), into which all of the assets were transferred. That’s where the trouble began.
While Dr. Liljestrand’s intentions were good, the execution of the plan was weak. For example, although PLP was formed in 1997, it wasn’t until 1999 that PLP opened a bank account or filed a tax return. PLP simply continued to use the trust’s bank account and reported the income on Dr. Liljestrand’s personal tax return. In addition, gifts to the children of interests in PLP were made in 1998 and 1999, but no gift tax return was filed until 2005, a year after Dr. Liljestrand’s death.
The Tax Court focused on IRC Section 2036(a) which, as several prior cases have pointed out, is intended to prevent the taxpayer from avoiding estate tax by purportedly transferring assets during life while retaining the enjoyment and use of the property. Unfortunately for the family, Dr. Liljestrand treated PLP more as a piggy bank than a separate entity. He received disproportionate distributions, PLP paid his personal expenses and he failed to retain sufficient funds to support himself without the partnership assets. While the court had little trouble in determining that Section 2036(a) applied, an exception exists if the assets transferred to the FLP are part of a bona fide sale for adequate and full consideration. To meet this exception, the taxpayer must establish that there was a significant non-tax reason for the transfer (the “bona fide sale” requirement) and that the partners’ capital accounts were properly maintained and their interests were proportionate to the fair market value of the assets transferred to the FLP (the “adequate and full consideration” requirement).
Unfortunately for Dr. Liljestrand and his family, they were unable to establish that there was any material non-tax reason for establishing the partnership, nor could they establish that Dr. Liljestrand or the other partners received partnership interests in PLP with a value approximately equal to the property each transferred to PLP. What did the family and advisors do wrong? The court was quick to point out numerous problems with the way PLP was established and operated, including:
· The FLP agreement provided a guaranteed payment to Dr. Liljestrand, which was approximately equivalent to the anticipated income that the FLP assets would generate;
· It was unclear how the family valued the interests received. Although they had an appraisal of the underlying assets and a second appraisal valuing the partnership interests, they ultimately used a small value that wasn’t related to either appraisal;
· Dr. Liljestrand failed to retain sufficient funds outside of the FLP to pay his personal expenses, and relied upon the assets of the FLP to provide him with the necessary income;
· The FLP paid a variety of Dr. Lijestrand’s personal expenses, including gifts to family members, household expenses (for example, the housekeeper’s salary) and mortgage payments on his personal condominium;
· Dr. Liljestrand received disproportionate distributions (in fact, in some years he was the only partner to receive distributions), and the distributions were improperly tracked in the partnership's accounting records;
· As part of the formation of the FLP, the other family members knew little of the plan and had no separate representation or advice in connection with the development of the terms of the FLP agreement;
· The FLP disregarded a variety of formalities, including failing to open a bank account for several years, failing to hold any partnership meetings and comingling personal funds with partnership funds; and
· There was no change in the way the assets were handled or in Dr. Liljestrand’s relationship to the assets.
What lesson can be learned from the late Dr. Liljestrand’s travails? Simply put, attention to detail and formalities are important. The good news for practitioners is there were so many problems with the FLP in this case that it’s difficult to say that any new law has been created. Rather, it’s a potent reminder of what can go wrong.
FLPs and family limited liability companies remain an effective tool in business and family succession, where appropriate. It’s key, however, that the older generation transfer assets that they don’t need to maintain their lifestyle and that the younger generation, to whom the ownership interests will eventually pass, be involved in the FLP from the time of formation, including ongoing partnership operations. Many families use these entities to transition not only ownership, but also management of family assets to the next generation. Including the younger family members in decision making is an important part of establishing FLPs and can help to avoid results such as those suffered by Dr. Liljestrand’s family.