Just under three months after the case Estate of Purdue v. Commissioner1 provided practitioners with guidance on best practices in connection with family limited partnerships (FLPs), the Tax Court released the memorandum decision in the case Estate of Holliday v. Comm’r,2 which serves as a reminder of the pitfalls that should be avoided. On March 17, 2016, the court determined that property transferred by a decedent to an FLP during her life was includible in her estate by virtue of Internal Revenue Code Section 2036(a). The facts and result of the case remind practitioners of the importance of properly coordinating the goals of the client with the executed plan and advising the client on proper administration once planning is complete.
Background
The decedent died a resident of Tennessee in 2009, survived by her two sons. In 2006, the decedent formed an FLP and a single member limited liability company (LLC) to serve as its general partner. The decedent transferred just under $6 million to the FLP. The contribution was made primarily on behalf of the decedent personally, as the 99.9 percent limited partner, with 0.1 percent contributed on behalf of the LLC, as general partner. Following the contributions, the decedent sold one-half of her interest in the LLC to her sons for $2,959.84 each and gifted 10 percent of her limited FLP interest to an irrevocable trust, retaining an 89.9 percent limited partner interest.
Upon the decedent’s death, the underlying value of the assets of the FLP was approximately $4 million, and the decedent’s 89.9 percent limited partner interest was reported on her estate tax return at a discounted value of approximately $2.4 million. The Internal Revenue Service assessed a deficiency of $785,019 and argued that, pursuant to IRC Section 2036(a), the decedent retained an interest in the assets transferred to the FLP such that the assets were includible in the decedent’s gross estate.
Implication of 2036(a)
In determining whether property transferred by the decedent was includible in her estate under Section 2036(a), the Tax Court applied the test articulated in Estate of Bongard v. Comm’r,3 which implicates Section 2036(a) if three conditions are met: (1) the decedent made an inter vivos transfer of property; (2) the decedent retained an interest in the property that’s enumerated in Section 2036(a)(1), Section 2036(a)(2) or Section 2036(b) that isn’t relinquished before death; and (3) the decedent’s transfer wasn’t a bona fide sale for adequate and full consideration. The IRS argued that all three conditions had been met while the estate argued the second and third condition hadn’t been satisfied.
Implied Understanding
The Tax Court noted that an individual is treated as retaining an interest if, at the time of the transfer, there was an understanding that the interest or right would later be conferred.4 Following the sale of the LLC interest and the 10 percent gift of the limited partner interest, the decedent’s remaining interest in the FLP consisted of her 89.9 percent limited partner interest. The FLP agreement required distributions be made when the general partner determined the FLP held funds in excess of those required for current operating needs. When asked what constituted “operating needs,” one of the decedent’s sons testified, “this seemed to come from some sort of boilerplate for Tennessee limited partnerships, this sort of gave you broad powers to do anything you needed to do, including make distributions. But that wasn’t necessary. No one needed a distribution.”5 From this testimony, the court inferred that an implied understanding existed between the decedent and her sons that if the decedent needed a distribution, one would be made. While no power of management was granted to limited partners under the FLP agreement, the court’s inference from the son’s testimony, when added to the language of the FLP agreement requiring distributions in certain circumstances, lead to the determination that the decedent retained an implied right to income from the property she transferred to the FLP.
Bona Fide Sale for Adequate and Full Consideration
The court next considered whether there was a bona fide sale for adequate and full consideration. In the FLP context, a bona fide sale for adequate and full consideration occurs when the record establishes a “legitimate and significant nontax reason for creating the family limited partnership and the transferor received partnership interests proportionate to the value of the property transferred.”6 The estate posited three nontax purposes for the transfer: (1) to protect the assets from personal liability in future lawsuits, (2) to protect the assets from the undue influence of caregivers, and (3) to preserve assets for the benefit of the decedent’s heirs. The court rejected each theory in turn.
First the court found that the protection of assets from future lawsuits wasn’t a significant nontax purpose. The court stated several reasons liability in future lawsuits either wasn’t a significant concern or wasn’t protected against by the planning. Specifically, the decedent had no past lawsuits against her, and her move to a nursing home in 2006 significantly limited the possibility of future lawsuits. Additionally, the decedent maintained significant wealth outside of the structure that continued to remain subject to lawsuits.
Second, although the estate demonstrated a family history of financial impropriety from caregivers, the court reasoned the decedent was less vulnerable to these improprieties than others in the family had been. The decedent was living in a nursing home, rather than with an individual caretaker and was in frequent contact with her sons, who handled her finances, all of which reduced the possibility of a caretaker taking advantage of her. Also, there was testimony that there had been no discussions involving the decedent regarding the risk of someone taking advantage of the decedent.
Finally, the court was unconvinced that the preservation of assets constituted a legitimate nontax purpose. The property had previously been held in trust, and there had been no management issues. The decedent had little involvement in setting up the structure and, according to testimony, was happy to move forward with whatever her sons suggested.
The court noted several other factors weighing against a bona fide sale:
- The decedent stood on both sides of the transaction and made the only contributions to the FLP.
- The decedent transferred her interests in the LLC to her sons the same day the FLP was funded.
- There was no negotiation or bargaining associated with the formation of the partnership, as the decedent was content to rely on the suggestions of her sons.
- The sons didn’t maintain partnership formalities, including maintaining books and records, holding formal meetings and adhering to the provisions of the FLP agreement.
For these reasons, the court determined that there hadn’t been a bona fide sale for adequate and full consideration, the conditions set forth in Bongard test were present and the assets transferred to the FLP were includible in decedent’s gross estate under Section 2036(a).
Establish Strong Factual Record
The occasionally unpredictable nature of the courts’ determinations under the facts and circumstances test of Bongard underscores the importance that practitioners and taxpayers establish facts that demonstrate the existence of a legitimate nontax reason for creating an FLP and no implied understanding between the parties. Holliday is a reminder that the estate-planning process should involve a review of client circumstances and planning goals when implementing a plan, as well as advice on adherence to proper procedures when administering the resulting plan. While there are no guarantees in court, establishing a strong factual record gives practitioners and taxpayers their best argument against an IRS attack.
Endnotes
1. Estate of Purdue v. Commissioner, T.C. Memo. 2015-249. For an overview of the case and a discussion of best practices, see James I. Dougherty and Kenneth A. Pun, “Best Practices Related to IRC Section 2036, Annual Exclusion Transfers and Graegin Loans,” WealthManagement.com (Jan. 7, 2016), http://wealthmanagement.com/estate-planning/best-practices-related-irc-section-2036-annual-exclusion-transfers-and-graegin-loans.
2. Estate of Holliday v. Comm’r, T.C. Memo. 2016-51.
3. Estate of Bongard v. Comm’r, 124 T.C. 95, 112 (2005).
4. Treasury Regulations Section 20.2036-1(c)(1)(i).
5. Holliday, supra note 2, at 10.
6. Bongard, supra note 3, at 118.
Kenneth Pun and Margaret St. John are associates at Withers Bergman LLP. N. Todd Angkatavanich is a partner at Withers Bergman LLP.