As the IRS continues to litigate family limited partnership (FLP) cases, it has formulated two broad-based arguments—one argument rooted in estate tax and one in gift tax—that the courts now routinely recognize to negate the estate planning benefits of FLPs. Whether the IRS will be successful in challenging a particular FLP structure depends upon the facts of the case.
For estate tax purposes, the IRS uses Sec. 2036 to pull assets transferred to an FLP back into a decedent’s gross estate. Pursuant to Sec. 2036(a), a decedent’s gross estate includes the value of any interest in property of which the decedent had made a transfer during life to the extent the decedent retained certain rights in that property unless the transfer is a bona fide sale for full and adequate consideration (the bona fide sale exception). If the IRS is successful in arguing the applicability of Sec. 2036, the asset transferred to the FLP will be valued for estate tax purposes as if it had never been transferred to the FLP.
For gift tax purposes, the IRS uses Sec. 2511 to argue that transfers to an FLP are indirect gifts when a taxpayer creates, funds, and transfers interests in an FLP in a relatively short period of time (e.g., all on the same day). Specifically, the IRS contends that Regs. Sec. 25.2511-1(h)(1) provides that an indirect gift occurs on the transfer of assets to an entity (e.g., an FLP) in which the transferor does not receive a proportionate interest in the entity in return for the transfer. The difference between the value of the assets transferred and the value of the interest received results in a gift to the other members of the entity. If the IRS is successful in arguing that a transfer is an indirect gift, the asset transferred to the FLP is valued for gift tax purposes as if it had been transferred to the FLP after the interests in the FLP had been transferred.
Estate of Malkin, decided September 16, 2009, illustrates the IRS’s success with these two arguments. The decedent created two FLPs and four trusts. The decedent was the general partner of each FLP, and he and two of the trusts were the limited partners. The beneficiaries of the trusts were his two children. The decedent transferred family business stock to one FLP (FLP1) and family business stock as well as interests in four limited liability companies (LLCs) to the other FLP (FLP2).
In August 1998, the two trusts that were limited partners of FLP1 entered into a contract with the decedent to purchase limited partnership interests from the decedent for a cash down payment and a self-cancelling installment note (SCIN). The trusts executed security agreements granting the decedent a security interest in the limited partnership interests. In September 1999, the decedent and the trustees of the trusts authorized the decedent to pledge FLP1 assets, without limitation, to secure his personal debt. The decedent pledged to the bank almost all the stock owned by FLP1. In December 1999, the decedent executed a personal guaranty promising to use his personal assets to repay his debt and agreed to pay a fee to FLP1 equal to 0.75% of the amount required as security for his debt. A repledging of those assets to another bank occurred the following year.
On February 29, 2000, the decedent and the trustees of two trusts signed the FLP2 agreement, and the decedent transferred interests in four LLCs to FLP2 and executed an agreement to assign interests in FLP2 to the trusts. On March 1, 2000, the decedent executed the documents to establish those trusts. Thereafter, the trustees of the trusts entered into contracts with the decedent to purchase the same interests in FLP2 in exchange for cash and a nine-year note. A regular note, rather than a SCIN, was used because by that time the decedent was terminally ill. In November 2000, the decedent transferred to FLP2 stock that he had previously pledged to a bank as collateral for his personal loan.
Estate Tax Issue
The Tax Court determined that there was nothing to suggest that any express or implied agreement gave the decedent the right to retain the economic benefits of the LLC interests transferred to FLP2. The court determined, however, that there was an implied agreement that the decedent would continue to retain the right to use the stock that he transferred to FLP1 and FLP2. The decedent and the two trusts pledged the stock that he had transferred to FLP1 to secure his personal loan. According to the Tax Court, the estate failed to offer evidence that the amount of the fee paid to FLP1 was reasonable or what the purported business purpose was for FLP1 to allow the decedent to pledge its stock. A different result was not reached with regard to FLP2 merely because the stock was pledged by the decedent to the bank before it was transferred to FLP2.
The Tax Court then considered whether the bona fide sale exception applied using the test it set forth in Bongard, 124 T.C. 95 (2005). The Bongard test requires that two criteria be met: (1) there is a legitimate and significant nontax reason for creating the FLP; and (2) the transferors receive interests in the FLP proportionate to the value of their transferred property. The court concluded that the decedent had no legitimate and significant nontax reason for transferring the stock to the FLPs.
The Tax Court dismissed one business purpose advanced by the estate—to prevent the sale of any of the stock—because only the decedent transferred stock to the FLPs, and his son, who also owned a substantial amount of stock in the company, did not transfer stock to the FLPs. According to the Tax Court, the decedent did not need the FLPs to control his stock because he already controlled it. The Tax Court also dismissed the purpose of centralized management for the family’s wealth because the decedent contributed almost all the assets to the FLP; thus, there was no pooled wealth to manage. As a result, the Tax Court held that the stock transferred to the FLPs was includible in the decedent’s gross estate under Sec. 2036(a).
Gift Tax Issue
The only assets transferred to the FLPs that escaped inclusion under Sec. 2036 were the interests in the four LLCs that were transferred to FLP2. The Tax Court considered whether the decedent made an indirect gift of the LLC interests, rather than a gift or perhaps a sale of the interests in FLP2. On February 29, 2000, FLP2 was purportedly created and the LLC interests were purportedly transferred to FLP2. The trusts that were the decedent’s partners in FLP2 were not created until the next day. The Tax Court determined that a one-person partnership is not recognized under local law, so FLP2 was valid only after the trusts were formed on March 1, 2000, and the decedent could transfer his interests in the LLCs only after FLP2 was validly formed. The fact pattern is similar to the one in Shepherd, 115 T.C. 376 (2000), aff’d, 283 F.3d 1258 (11th Cir. 2002), in which the taxpayer was held to have made indirect gifts of the underlying assets, rather than gifts of partnership interests.
The estate argued that Shepherd does not apply because the trusts purchased the partnership interests from the decedent. The Tax Court dismissed this argument and concluded that the purported sale of these interests was a sham. About a week after signing the sales agreement, the decedent transferred cash to the trusts, which the trusts used two days later to pay the required down payment to the decedent. The trusts never paid any interest on the notes, the decedent died before the first payment became due, and the estate never made a demand for payments. In addition, the decedent gave his children the money to pay the interest on the FLP1 notes, so the court was not convinced that the decedent expected the trusts or his children to pay the notes for the purchase of the interests in FLP2. The court concluded that because the purported sale of the FLP2 interests to the trusts was a sham and Shepherd controls, the decedent made indirect gifts of the LLC interests, not interests in FLP2.
The Tax Court tackled the Sec. 2036 issue by reversing the approach used in most other cases. Generally, the courts determine whether the bona fide sale exception applies to the transfer; if it does not, they then determine whether there was an express or implied agreement for the decedent to retain the possession or enjoyment of the transferred property. The Tax Court’s reason for reversing the process may be that the business purposes it dismissed are similar to those found to be significant and legitimate nontax reasons in other cases. For example, in Estate of Schutt, T.C. Memo. 2005-126, the decedent wanted to preserve for the family the substantial holdings in two publicly traded companies, and in Estate of Mirowski, T.C. Memo. 2008-74, the decedent, who was the sole contributor to the FLP, wanted to jointly manage the family assets in a single pool.
The results in this case can be avoided with proper planning on the part of a taxpayer. In the case of Sec. 2036, the taxpayer must: (1) have nontax reasons for creating the FLP; (2) properly create and administer the FLP; and (3) respect the FLP and its assets as an entity separate and apart from the taxpayer. In the case of an indirect gift, the taxpayer must: (1) validly form the FLP; (2) properly transfer assets to the FLP; and (3) transfer interests in the FLP only after (1) and (2) have been completed. In addition, recent court cases have suggested that there must be some economic risk between the formation and transfer of assets to an FLP and the subsequent transfer of interests in the FLP, or the IRS may be successful in arguing indirect gift under the step transaction doctrine.
Estate of Malkin, T.C. Memo. 2009-212
Frances Schafer is executive director and Justin Ransome is a partner in the National Tax Office of Grant Thornton LLP in Washington, DC. For more information about this article, contact Ms. Schafer at firstname.lastname@example.org or Mr. Ransome at email@example.com.