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E-Alert - Taxpayers Using FLPs Continue to Trip Over Section 2036
The IRS has scored three more victories in 2005 regarding the application of IRC § 2036 in family limited partnership and family limited liability company cases.
The first case, Estate of Bongard v. Comm’r., 124 T.C. 8 (March 15, 2005), involved a taxpayer who owned a successful, closely-held company involved in the design, development, manufacture, and marketing of plastic products in the semiconductor and data storage industries.
In 1986, the taxpayer initiated his estate planning and as a part of this process he placed some closely-held stock in a trust for children. In the 1990’s, the company’s board of directors and advisors decided to pool all of the family’s stock under a holding company, WCB Holdings, LLC (“WCB”), in order to facilitate a future private or public offering of the stock for liquidity reasons.
In 1996, the taxpayer and the trust for children transferred some of their WCB membership interests to the Bongard Family Limited Partnership (BFLP). The reasons stated for creating BFLP and making this transfer were: (1) a method of giving assets to the taxpayer’s family members without deterring them from working hard and becoming educated, (2) protection of the estate from frivolous lawsuits and creditors, (3) greater flexibility than using trusts, (4) a means to limit expenses if any lawsuits should arise, (5) tutelage with respect to management of the family’s assets, and (6) tax benefits with respect to transfer taxes. The taxpayer, who appeared to be in good health, died unexpectedly at age 58 while on a hunting / business trip in 1998.
Inclusion of the full fair market value of transferred assets in a decedent’s estate under IRC § 2036 occurs where the decedent made a lifetime transfer of assets, the transfer does not take the form of a bona fide sale for adequate and full consideration, and as a part of the transfer the decedent retains an interest or right enumerated under IRC § 2036(a)(1), (a)(2), or (b). The court held that the “bona fide sale exception” to the application of IRC § 2036 applied in the case of the transfer of the closely-held company shares to WCB, given the legitimate and significant non-tax reason for the transfer (facilitation of future offering of company stock), but that it did not apply to the transfer of the WCB membership interests. The court held that BFLP never diversified its assets during the taxpayer’s life, didn’t have an investment plan, and did not engage in any meaningful investment activity. The relationship of the taxpayer and the children’s trust to the assets contributed to BFLP was the same before and after the contribution to the partnership.
The second case, Estate of Bigelow v. Comm’r., T. C. Memo 2005-65 (March 30, 2005), involved a taxpayer who transferred her residence to a trust in 1991. The taxpayer suffered a stroke in 1992 and moved out of her home. Prior to and after her stroke the taxpayer made gifts of a fractional interest in the residence to her three children. In 1993, the trust exchanged the taxpayer’s former residence for rental real estate for investment real estate. The trust borrowed $350,000 against the new property to pay off the existing loans on the former residence and it also obtained a $100,000 equity line of credit secured by the new property.
In 1994, the trust contributed the investment property (but not the debt secured by the property) to a family limited partnership. The trust was the sole general partner of the family limited partnership and the trust owned the majority of the limited partnership units. Before creating the partnership the taxpayer had income in excess of her monthly expenses. After the creation of the partnership the taxpayer experienced a monthly income shortfall – approximately $1,000 upon formation, growing to $2,700 about three years later.
Even though the taxpayer had maintained liability for the loans on the property, the partnership made the monthly mortgage payments. In addition, the partnership paid some of the taxpayer’s living expenses. The taxpayer’s son made forty transfers between the partnership and the trust during a period of a little over two years.
In December of 1994 and 1995, the son, as agent under the taxpayer’s power of attorney, made gifts of partnerships units to himself, his siblings, and the taxpayer’s grandchildren. The taxpayer died in 1997 and the partnership was terminated approximately one year later.
The court held that IRC § 2036 applied because there was an implied agreement between the taxpayer and the taxpayer’s son for the taxpayer to retain the income and enjoyment of the rental property after it was contributed to the FLP. The court further held that the parties failed to respect partnership formalities – they did not maintain partnership or partner’s capital accounts, the partnership balance sheet improperly showed the $350,000 mortgage as a partnership liability, and the partnership capital accounts were not adjusted to account for the lifetime distributions on behalf of the taxpayer.
The final case is actually the consolidation of two related cases, Estate of Edna Korby v. Comm’r., TC Memo 2005-102, and Estate of Austin Korby v. Comm’r., TC Memo 2005-103. The facts are as follows: From 1993 until the time of their deaths in 1998, Austin and Edna were in poor health. Austin had suffered a stroke and had diabetes and heart problems and Edna had Alzheimer’s disease. In 1993 the two of them formed a revocable living trust with Austin and one of their four sons as co-trustees. In 1994, Austin, Edna, and their four sons formed a family limited partnership, with the revocable living trust as a 2% general partner. Austin and Edna contributed virtually all of their assets, other than their residence, to the FLP. Subsequent to creation of the FLP, Austin and Edna made gifts of the limited partnership units to four irrevocable trusts (24.5% each) set up for the benefit of their sons.
Later in 1995, the partnership bought an annuity showing the trust as owner, the husband as annuitant and the sons as contingent beneficiaries. Substantial distributions from the partnership were made to the living trust (and used to pay household expenses) or paid directly to the nursing home, medical care providers, drug stores, utility companies, and insurance companies. The estate later claimed that these distributions, which ranged from 27% to 50% of the partnership income in any given year, were for management fees.
The court held there was no bona fide sale exception to the application of IRC § 2036 in this case and that there was an implied agreement that Austin and Edna retained a lifetime benefit over the partnership income. The court held there was no evidence that the distributions from the partnership were intended to be guaranteed payments to Austin and Edna for services in managing the partnership.
As with many other IRS FLP victories in recent years, the taxpayers in these cases could have easily avoided the application of IRC § 2036 by properly structuring the transaction, respecting partnership formalities, and administering the partnership income and assets as provided under the partnership agreements. Our office has substantial expertise in structuring and managing limited partnerships to avoid application of IRC § 2036 and maximizing valuation discounts. In light of the IRS’s recent victories in this arena, all taxpayers that are currently employing FLPs as a means to reduce gift and estate taxes should have periodic reviews of their partnership agreements, as well as the actual administration of the partnership.
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