Estate and gift tax valuation positions associated with family limited partnerships (FLPs) often are challenged by the Internal Revenue Service and somewhat unpredictably adjudicated by the courts. But in the last two years, taxpayers have won four key victories — starting with the Mirowski case in 2008 and continuing with the Miller, Keller and Murphy cases in 2009 — in which estates were able to prevail against the IRS challenges of FLPs because the bona fide sale exception to Internal Revenue Code Section 2036 had been satisfied.1 These cases represent a new trend because the consistency of their themes provides some further insight into the circumstances under which FLP planning has the greatest chance of withstanding a challenge by the IRS.
Indeed, this “quadrilogy”2 of FLP cases underscores the fact that practitioners structuring FLPs must keep in mind that:
- a taxpayer's estate must establish a legitimate and significant non-tax purpose for creating the FLP; active post-formation investment/management of the FLPs assets is a strong indication of such a purpose;
- for an FLP transfer to constitute a bona fide sale, taxpayers should retain sufficient assets outside the FLP to support their lifestyles; and
- courts expect FLPs to be respected like other third-party legitimate business operations, so all appropriate business formalities should be respected after FLPs are created.
Planning with FLPs is still not for the faint-hearted, because qualifying for the bona fide sale exception to Section 2036(a) is very fact-specific, and it's impossible to determine at the planning stages whether the exception has been satisfied. But the FLP quadrilogy has created the most significant beachhead that taxpayers have been able to establish in a nearly two-decade battle with the IRS over the legitimacy of FLPs and the propriety of associated valuation discounts. And because FLPs can offer clients significant tax and non-tax benefits, responsible practitioners should make themselves familiar with both the history of this battle — and all the latest maneuvers.
Declaration of War
About two decades ago, the IRS essentially declared war on the use of FLPs in estate planning. At first, the IRS tried to challenge the very legitimacy of FLPs under a number of different theories. This campaign was largely unsuccessful.
But starting about 10 years ago, the IRS' luck started to change. The Service began to challenge FLP valuation discounts using an argument based on IRC Section 2036(a) — and won several important battles.
Section 2036(a)(1) generally provides that transfers with retained life estates will be included in a decedent's gross estate. Using this argument allowed the IRS to successfully argue that the assets contributed by taxpayers into FLPs during their lifetimes should be fully includible in their estates at the date-of-death fair market value (FMV) of the underlying contributed assets — regardless of whether taxpayers continued to own any of the partnership interests upon their deaths. Applying Section 2036(a)(1) meant parents could transfer assets into an FLP and subsequently transfer, by gift or sale, partnership interests to their children or to trusts for their benefit — yet still unexpectedly have the underlying assets contributed to the FLP fully included in the parents' estate for federal estate tax purposes at death.
Section 2036(a) does, however, contain an exception for bona fide sales made for adequate and full consideration. Taxpayers have tried over the years, with some limited success, to use this exception and were able to trade victories with the IRS about whether FLP assets would be pulled back into a taxpayer's estate.
Still, because the bona fide sale exception is very fact specific and historically was sparingly applied in favor of taxpayers' estates, practitioners have wondered whether this exception, while extremely useful, could ever be relied upon when planning an FLP.
The quadrilogy of Mirowski, Miller, Keller and Murphy has helped taxpayers regain some of the ground previously lost with FLPs and has provided some additional guidance about how best to attempt to satisfy this exception.
In each of these recent cases, a taxpayer's estate was able to meet the “bona fide sale for adequate and full consideration” exception to the application of Section 2036(a), primarily by showing a legitimate and significant non-tax business purpose for the transfer of assets into the FLP. The Tax Court in these cases determined that a parent's transfer of assets into an FLP or family limited liability company (LLC) satisfied the exception and, accordingly, did not constitute a transfer with a retained interest that would cause the contributed assets to still be included in the parents' gross estate at their deaths.
Essentially, the taxpayers' estates in these cases were able to establish to the court's satisfaction that the parent/decedent's contribution of assets into the FLP or LLC was made in furtherance of legitimate and significant non-tax business purposes. These victories have helped to clarify when it might be possible for an FLP to satisfy the burden of proof necessary to withstand IRS scrutiny.
Some Victories, More Losses
Before this most recent string of victories, taxpayers had achieved limited success in arguing that the bona fide sale exception was applicable, beginning with Church v. United States, in 2000.3 In Church, the court found that an FLP was created for a valid business purpose; namely, to preserve the family ranching enterprise.
Then, in 2003, the Tax Court determined in Stone v. Comm'r that the transfer of various assets by a parent into a series of FLPs in connection with a settlement of various disputes and litigation within the family also was sufficient to satisfy the bona fide sale exception.4 The court was convinced that the FLPs were created, not for the purpose of obtaining valuation discounts, but to advance the non-tax purpose of achieving a resolution to the family disputes.
The following year, in Kimbell v. U.S., the U.S. Court of Appeals for the Fifth Circuit vacated an opinion by the Northern District of Texas finding that the taxpayer's transfer of assets into an FLP did not constitute a bona fide sale for adequate and full consideration.5 The Fifth Circuit instead held that a bona fide sale had occurred, noting that the taxpayer had retained sufficient assets outside the FLP for her own support, that partnership formalities had been respected, and that there were legitimate non-tax purposes for transferring the assets to the FLP, such as protection from creditors.
Finally, in 2005, two Section 2036(a) cases were decided mostly in favor of taxpayers. In Bongard v. Comm'r, the Tax Court held that a taxpayer's contribution of stock in a closely held business into an LLC satisfied the bona fide sale exception because the LLC was created as part of a larger financial plan to attract potential investors or otherwise stimulate the growth of the underlying business.6 But the Bongard court also determined that the subsequent contribution by the taxpayer of the newly created LLC interests into an FLP before his death did not satisfy the bona fide sale exception, because the court was not convinced that this subsequent transfer was made to further any legitimate and significant non-tax business purpose. The Tax Court pointed to the fact that, among others, the FLP did not provide the taxpayer with greater flexibility or asset protection than the LLC already provided, and did not perform a management function for the assets it received.
Then, in Schutt v. Comm'r, the Tax Court held that the transfer of stock into business trusts were bona fide sales when the record established that the taxpayer's primary motivation was to provide for centralized management of his assets in a manner that was consistent with his personal theory for investments, rather than to achieve tax benefits.7 The record strongly established the extent to which the taxpayer believed in a “buy and hold” investment philosophy, even to the extent that he was willing to allow marketable assets to become illiquid.
Before the quadrilogy, these were the handful of taxpayer victories on the Section 2036 front; taxpayers' estates actually had very little success arguing that the bona fide sale exception applied in FLP cases.
One of the most famous losses came in Strangi v. Comm'r. The taxpayer's estate argued, among other things, that the taxpayer's transfer of assets into an FLP shortly before his death satisfied the bona fide sale exception.8 The Tax Court and, subsequently, the Fifth Circuit determined that the exception was not satisfied, in part because there was an implied agreement for his retained possession and enjoyment of the FLP's assets. The Tax Court noted that the taxpayer had essentially transferred all of his assets, including his residence, to the FLP, thus leaving him essentially nothing to live on independently. The Tax Court also drew a negative inference from the fact that other family members contributed little to the FLP, noting that “[d]ecedent contributed more than 99 percent of the total property placed in the SFLP/Stranco arrangement and received back an interest the value of which derived almost exclusively from the assets he had just assigned. Furthermore, the SFLP/Stranco arrangement patently fails to qualify as the sort of functioning business enterprise that could potentially inject intangibles that would lift the situation beyond mere recycling.”
Another loss came in Thompson v. Comm'r. The Tax Court again considered the application of the bona fide sale exception in a case in which the taxpayer contributed significant assets into an FLP shortly before his death.9 While the taxpayer's children also contributed independent assets of their own into the FLP, the Tax Court noted that each of the contributing children continued to directly receive the income generated from those assets rather than the income being paid through the FLP. The Tax Court indicated that if an FLP is only a vehicle for changing the way that the family holds their assets and does not serve a valid business enterprise, then the transfer into the FLP will not fulfill the requirements of the bona fide sale exception.10
Clearly, the history with respect to the bona fide sale exception has been checkered. To make matters worse, one of the biggest practical problems with attempting to satisfy the bona fide sale exception is that one cannot determine whether this exception has been satisfied until after the taxpayer has died and the FLP has been selected for audit in connection with the estate tax return. While the exception certainly provides a goal to which to aspire to satisfy in the planning stages, it certainly cannot be presumed to have been met in the planning stages.
But the quadrilogy creates a trend of consistent victories. Better yet, it provides planners with additional guidance about the types of structures and circumstances that may support a favorable determination as to the bona fide sale exception.
The Four Big Wins
In Mirowski, the taxpayer, Anna Mirowski, was the widow of the inventor of the implantable defibrillator device. Anna, when the LLC was created, had generally been in good health. While she suffered from diabetes and a foot ulcer, these were not regarded as serious problems when the family LLC was formed. Upon advice of her estate planning professionals, she formed an LLC into which she contributed a number of assets, including cash and marketable securities, patents and royalties in connection with her husband's inventions. She retained about $7.6 million in her name for her ongoing living expenses. Anna's stated reasons for creating the LLC were to create an investment structure that could be used to consolidate her assets in a common investment vehicle, to provide a structure that could be used for her to introduce her two daughters and her grandchildren to the management of the family wealth, and to allow family members to work closely with one another in such a pursuit.
Within a few days of the creation and funding of the LLC, Anna made gifts to each of her two daughters of a 16 percent LLC interest. But, within one week of the funding of the LLC, she unexpectedly developed sepsis in connection with her foot ulcer and died. When auditing her estate tax return, the IRS argued that the underlying assets that Anna had contributed into the LLC were fully includible in her gross estate at their full, undiscounted value. As a result, the IRS asserted that a deficiency of about $14 million was due from the estate.
In the ensuing litigation, Anna's estate argued that Section 2036(a)(1) should not apply to the taxpayer's contribution of assets into the LLC because, among other things, the contribution of assets constituted a “bona fide sale for adequate and full consideration.” Although the facts of Mirowski would, at first blush, appear to have been bad, particularly in light of the close proximity between the contribution of assets to the LLC and Anna's death, the Tax Court determined that the bona fide sale exception was satisfied.
The Mirowski court held that, despite Anna's death very shortly after funding the LLC, her contribution of assets into the LLC was made to advance a legitimate and significant non-tax business purpose. The court was particularly impressed with the testimony of Anna's daughters in establishing non-tax motivated reasons as to why Anna had wanted to create the LLC, and noted that her desire to encourage joint family management of the assets was grounded in the time she spent working in her family business as a child and the family cohesiveness that created. In addition, the court was convinced that this was not an instance of a classic “death bed” FLP transfer, noting that one of the decedent's daughters, a physician, traveled to Paris to speak at a convention just two days before Anna's death, evidence in support of the assertion that Anna's death was not expected at the time.
Soon after issuing the Mirowski opinion, the Tax Court in early 2009 decided Miller v. Comm'r. Miller actually represents a double-edged sword: It found that while the taxpayer's initial contribution of assets into a family LLC constituted a bona fide sale, her subsequent contribution did not satisfy the exception. Thus, as in Bongard, when the court ruled differently about two different transfers on the bona fide sale exception, Miller presents a good example of the factors that might ultimately sway the court when making its determination.
In Miller, Valeria Miller had been a widow for three years. During her husband Virgil Sr.'s lifetime, he'd developed his own unique style of investing and picking stocks and had actively traded a large portfolio of assets for several years. He had also introduced his son, Virgil, Jr., to this investment philosophy and the two of them had devoted a significant amount of time to actively trading the family assets.
After Valeria's husband passed away, there was a period of several years during which Valeria's assets remained in her personal investment account in a more passive manner. Valeria eventually decided to create a family LLC, which would be managed using her husband's style of investment. Valeria made an initial contribution of about $3.96 million on April 2002 into the LLC as an initial funding. Valeria hired Virgil, Jr. as the manager of the LLC, and he devoted 40 hours per week of his time to actively manage the LLC's portfolio. When she made the initial contribution, Valeria was in good health and had no major health concerns. But during the next two years, her health began to deteriorate and she had to undergo numerous medical procedures in connection with a heart condition and a broken hip. In May 2003, Valeria made a second contribution into the LLC of her remaining assets. Valeria died less than one month after this second contribution. In connection with the estate tax return audit, the IRS argued that all of the assets contributed into the FLP were fully included in the taxpayer's estate under Section 2036(a)(1). The taxpayer's estate argued that both the first and second contributions satisfied the bona fide sale exception.
The Tax Court analyzed the contributions and concluded that the first, and major, contribution into the LLC satisfied the bona fide sale exception because it was made in furtherance of a legitimate and significant non-tax business reason: the creation of a vehicle that would actively manage the LLC's assets in the style that the taxpayer's husband had developed. The court was particularly impressed with the fact that Virgil Jr., as manager, was actively engaged on a daily basis in the investment of the portfolio of assets. He was paid a fee by the LLC for these services and he devoted his full-time attention to the investments. The court noted that, although the LLC's activities did not rise to a level of a “business” under federal income tax rules, such a showing was not required to satisfy the bona fide sale exception. The court also pointed out that Valeria retained sufficient assets outside of the LLC to pay her day-to-day living expenses without having to rely on distributions from the LLC.
But the court determined that the bona fide sale exception did not apply to the second contribution to the LLC. The court noted that Valeria contributed the balance of her assets into the LLC at a time when her health was clearly deteriorating. The court determined that the second contribution was made not to advance a legitimate and significant business purpose, but rather merely to obtain the benefits of estate tax valuation discounts. It also indicated that there was evidence of an implied understanding that Valeria had retained a right to the income of the LLC because it would be inconceivable to presume that if Valeria ran out of assets other than her interests in the LLC, Virgil Jr. would deny her distributions out of the LLC. Although the second contribution did not meet the bona fide sale exception, Miller provides some good guidance regarding the circumstances under which the exception may or may not be satisfied.
Keller presents a particularly interesting example of a pro-taxpayer case, because the court decided that contributions into an FLP satisfied the bona fide sale exception to Section 2036(a), even though the partnership contributions were not made until long after the taxpayer passed away. In Keller, Maud O'Connor Williams was widowed in 1999. After her husband's death, she began having serious discussions with her advisors about how to protect and dispose of some of her assets. She was particularly concerned with the possibility of losing family assets through divorces, as one of her daughters had previously gone through a long and expensive divorce.
The idea to create an FLP to protect family assets and make it easier to pass assets down through the generations was discussed throughout 1999, during which time Maud's health was declining but not failing. In September of that year, a spreadsheet was created illustrating how a partnership could be funded by various trusts, and a draft partnership agreement was prepared. Discussions about how to fund the partnership continued into January 2000. Maud was diagnosed with cancer in March 2000. Shortly thereafter, on May 9, 2000, she signed the documents creating the partnership, and her accountant cut a check for $300,000, which she was expected to sign the following week and which was to be used to initially fund the partnership, though it was intended that she would fund the partnership with significant additional assets. Maud died unexpectedly on May 15, 2000, before she had a chance to sign the check, and all efforts to fund the partnership were put on hold. Maud's estate tax return was filed reporting her assets at their full value without taking the position that the partnership had been created or funded.
About a year after Maud's death, her advisors heard about Church, in which the court had recognized the existence of a partnership that was not funded at the time of the taxpayer's death. They quickly moved to fund the partnership formally, using community property bonds. They also filed an amended estate tax return taking the position that the partnership had been in existence at Maud's death, and that a refund was due. Despite the fact that the partnership had not been funded until nearly a year after Maud's death, the Keller court recognized the entity as fully formed before her death. The court also said that the transfer of assets into the partnership satisfied the bona fide sale exception to Section 2036(a) because the primary purpose of the partnership served a legitimate business purpose: to protect family assets in the event of divorces. The court also pointed to the fact that Maud retained well over $100 million in assets outside of the partnership as additional evidence that a bona fide sale had occurred. Keller highlights the importance of a well-documented legitimate business purpose in a 2036(a) analysis; clear evidence of a business purpose was strong enough to overcome the fact that the assets were contributed to the FLP long after the taxpayer's death.
The most recent case in which a court held that a transfer of assets into an FLP satisfied the bona fide sale exception was Murphy v. U.S., decided on Oct. 9, 2009.11 The decedent, Charles H. Murphy, Jr., became involved in his family's businesses in the banking, timber, oil and gas industries at an early age, and continued his involvement as an adult. As a result of Charles' efforts and leadership over time, the family businesses substantially increased in value. Charles attempted to get his children involved in the management of the family assets, but became concerned that his children did not appear to share his business philosophy of holding assets over the long-term and actively participating in their management. Also, two of his sons developed financial problems, and had to sell or pledge family assets either given to them as gifts or held in trust for their benefit. Charles decided that he wanted to explore ways to transition management of the family assets to his children in a manner that would pool the assets under centralized management and protect the assets from being dissipated.
Upon advice of an attorney, Charles established an FLP in 1997 to accomplish his business goals. At the time the FLP was formed, he was 77 years old, in good health, and traveling extensively. In 1998, Charles transferred about $90 million into the FLP, and retained about $130 million for himself. In late 2001, Charles began experiencing chest pains and decided to undergo surgery to correct a heart problem. While the surgery went well, Charles subsequently developed a staph infection and passed away on March 20, 2002. With respect to his estate tax return, the IRS asserted that the estate had undervalued certain assets, including Charles' interest in the FLP, and issued a Notice of Deficiency of about $34 million.
When the case went to court, the IRS argued that the value of the property Charles had contributed to the FLP should be includible in his gross estate under Section 2036(a)(1). But the Murphy court followed the reasoning in Schutt, finding that the transfer of assets to an FLP to provide centralized management in accordance with the taxpayer's long-term investment philosophy constituted a legitimate non-tax business purpose, so the transfer into the FLP was a bona fide sale. The court's decision also was supported by the fact that Charles had retained enough assets outside of the FLP to support his own lifestyle. This factor has been consistently referenced in other recent cases, such as Miller and Keller.
Clearly, these cases articulate principles that practitioners should keep in mind when structuring FLPs.
First, it is imperative that the taxpayer's estate be able to establish a legitimate non-tax purpose for creating the FLP. It may be sufficient, for example, for the decedent to hold a specific and long-standing business belief that will be furthered by the creation of the FLP. Anne Mirowski's belief dating back to her childhood was that it was important for family to jointly manage assets. Valeria Miller desired to maintain the same investment philosophy her husband had been using for years. Also note that a legitimate business purpose need not necessarily be based on a long-standing belief to be effective. See Maud O'Connor Williams' concerns about divorce in Keller.
Secondly, to further support that an FLP transfer constitutes a bona fide sale, taxpayers should retain sufficient assets outside of the FLP to support their lifestyles. This factor was specifically noted in Miller, Keller, and Murphy. While this factor is not conclusive, if it is not present, it will be more difficult to establish that the bona fide sale exception to Section 2036(a) will be satisfied.
Finally, it is worth noting that because courts expect FLPs to be respected as any other legitimate business operation, we always must ensure that the appropriate formalities are respected after an FLP is created. Active post-formation investment of the FLPs assets is also a factor that may support such a finding. Thus, unlike in Strangi, a taxpayer interested in using FLPs as part of his estate plan should not continue freely using the assets contributed to the FLP.
Planning with FLPs can be challenging indeed. But these guidelines should help taxpayers position themselves in the best possible light.
— The authors thank Rebecca E. Wertzer, an associate at the firm, for her valuable contributions to this article.
- Mirowski v. Commissioner, T.C. Memo 2008-74 (March 26, 2008); Miller v. Comm'r, T.C. Memo 2009-119 (May 27, 2009); Keller v. Comm'r, 2009 U.S. Dist. LEXIS 73789 (Aug. 20, 2009); Murphy v. United States, 2009 U.S. Dist. LEXIS 94923 (Oct. 2, 2009).
- Quadrilogy is not really a word, but we like it. According to Wikipedia, “An invented term ‘quadrilogy’ has been used for marketing series of movies, basing the prefix on Latin prefix quadri- … The Alien and Die Hard series have also been released in sets under the title The Alien Quadrilogy (the films for which the term was coined) and The Die Hard Quadrilogy.”
- Church v. U.S., 2000 U.S. Dist. LEXIS 714 (W.D. Tex. 2000), aff'd 2001 U.S. App. LEXIS 30161 (5th Cir. 2001).
- Stone v. Comm'r, T.C. Memo 2003-309 (Nov. 7, 2003).
- Kimbell v. U.S., 371 F.3d 257 (5th Cir. 2004).
- Bongard v. Comm'r, 124 T.C. 95 (2005).
- Schutt v. Comm'r, T.C. Memo 2005-126 (May 26, 2005).
- Strangi v. Comm'r, T.C. Memo 2003-145 (May 20, 2003), aff'd 417 F.3d 468 (5th Cir. 2005).
- Thompson v. Comm'r, T.C. Memo 2002-246 (Sept. 26, 2002), aff'd 382 F.3d 367 (3d Cir. 2004).
- There have been numerous other cases in which the Internal Revenue Service successfully argued that Section 2036(a)(1) applied to transfers to family limited partnerships (FLPs). See, for example, Estate of Turner v. Comm'r, 382 F.3d 367 (3d Cir. 2004); Estate of Abraham v. Comm'r, T.C. Memo 2004-39 (Feb. 18, 2004), aff'd 408 F.3d 26 (1st Cir. 2005); Estate of Hillgren v. Comm'r, T.C. Memo 2004-46 (March 3, 2004); Estate of Rosen v. Comm'r, T.C. Memo 2006-115 (June 1, 2006); Estate of Bigelow v. Comm'r, 503 F.3d 955 (9th Cir. 2007). Note also that on Sept. 16, 2009, the Tax Court decided Malkin v. Comm'r, in which the court determined that there was no legitimate non-tax purpose for the taxpayer's transfer into two FLPs. Although the taxpayer's estate attempted to argue, among other things, that the FLPs were created to centralize management of the family's wealth, the court pointed out that the decedent himself contributed all or almost all of the assets, so the FLPs were not being used to pool family assets for centralized management. The court, therefore, held that in the absence of a legitimate and significant non-tax purpose for creating the FLPs, Section 2036(a)(1) applied to cause the taxpayer's contributions into the FLPs to be included in his gross estate.
- Murphy v. U.S., 2009 U.S. Dist. LEXIS 94923 (W.D. Ark. Oct. 9, 2009).
N. Todd Angkatavanich, far left, is a partner and Edward A. Vergara is an associate in the New York, Greenwich and New Haven, Conn., offices of Withers Bergman LLP