Ninth Circuit Affirms Transferred Residential Property Must Be Included in Gross Estate

The Ninth Circuit, affirming the Tax Court, has ruled that the full fair market value of residential property must be included in the decedent’s gross estate, finding that the decedent retained income and economic enjoyment from the property and that the inter vivos transfer of the property was not a bona fide sale for adequate and full consideration under Sec. 2036(a) (Estate of Bigelow, 9th Cir., 9/14/2007, aff’g TC Memo 2005-65).

Facts

Virginia A. Bigelow (Bigelow) gave each of her three children a 1/175th undivided interest in her residence (the Sand Point Road property) in 1990 or 1991. In 1991, she executed a trust agreement and deed, transferring her remaining 98.2857% undivided interest in the property to a trust over which she and her son were co-trustees. In 1992 Bigelow had a stroke, and later that year the trust listed the Sand Point Road property for sale.

In January 1993, Bigelow’s three children entered into an exchange and leaseback agreement with Peter and Margaret Seaman, who also owned a residence (the Padaro Lane property). Under the exchange agreement, the trust and the children transferred the Sand Point Road property to the Seamans. The property was appraised at $1.325 million. The Seamans paid the children $125,000 for the Sand Point Road property and transferred the Padaro Lane property, valued at $1.2 million, to the trust. The trust then leased the Padaro Lane property back to the Seamans for a monthly rent of $3,500 until the Seamans could build a new house on the Sand Point Road property. The children also transferred their interests in the Sand Point Road property to the Seamans and received $68,630 in return.

The trust and the children formed a family limited partnership (FLP) in December 1994. The FLP’s stated purpose was to engage in the business of owning and operating residential real property. The trust was the sole general partner and a limited partner, and the children were limited partners. The trust transferred the Padaro Lane property to the FLP. The FLP agreement provided that the property would be encumbered by a mortgage with Great Western Savings and a line of credit with Union Bank on the property, on which Bigelow was personally liable. Bigelow, however, agreed to hold the FLP harmless for those obligations. Despite the fact that Bigelow was personally obligated to make the loan payments to Great Western, the FLP made the monthly payments on her behalf and the trust paid $750 to Union Bank for the line of credit.

Bigelow died in August 1997 and her son, as trustee, signed a statement of ownership in which he certified the division of the FLP shares, which reflected the gifted interests by the decedent during her lifetime. At the time of her death, the trust owned a 1% general partnership interest and a 45% limited partnership interest in the FLP.

The decedent’s son made transfers between the FLP and the trust 40 times from April 6, 1995, to August 8, 1997. The estate characterized the transfers as loans. However, the loans were interest free and were not accompanied by a promissory note. Bigelow’s son transferred funds from the FLP to the trust to repay earlier advances and to pay the decedent’s expenses. When Bigelow died, the trust owed the FLP for a loan in July 1997 and for funeral expenses.

In November 1997, the FLP sold the Padaro Lane property and received approximately $949,500 after the decedent’s debts were fully paid. The FLP distributed the proceeds to the partners, including the trust, in December 1997. Up to that point, the FLP had not made formal distributions to the partners. The FLP terminated in December 1998.

The executor of the estate signed gift tax returns for 1994–97 and the decedent’s estate tax return in November 1998. The IRS audited the return and issued a notice of deficiency on October 29, 2001. The Service concluded that the full value of the Padaro Lane property, instead of the value of the decedent’s interest in the FLP discounted for lack of control and marketability, should have been included
in the gross estate because she had retained possession, enjoyment, or right to income from the asset she transferred to the FLP under Sec. 2036(a).

The Tax Court upheld the deficiency, finding that Bigelow’s use of the FLP income to replace income lost as a result of the Padaro Lane property transfer to the FLP showed that there was an implied agreement between the decedent and her children that she would retain the right to the income from the Padaro Lane property. The court also found that the transfer of the Padaro Lane property was not made in good faith because (1) the transfer would have impoverished the decedent absent an agreement that the FLP would supplement her income, (2) the children did not implement partnership formalities, and (3) there was no evidence that the FLP was formed for a nontax purpose. The estate appealed.

Holding

Citing Estate of Thompson, 382 F3d 367 (3d Cir. 2004), and Estate of Korby, 471 F3d 848 (8th Cir. 2006), the Ninth Circuit affirmed the Tax Court, finding that the court did not commit clear error in determining that the decedent retained the economic benefit from the transferred property under Sec. 2036(a)(1) because (1) she continued to use the Padaro Lane property to secure her debt and (2) the FLP paid the monthly payments to Great Western even though the decedent was obligated to make those payments.

The Ninth Circuit also ruled that the Tax Court correctly determined that there was an implied agreement between the decedent and her children that the FLP would supplement her financial needs, finding that partnership formalities were not observed. The court noted that the decedent’s capital account was debited in annual updates to reflect yearly gifts made to the children and grandchildren between 1994 and 1997, but her account was not debited annually to reflect the payments made to Great Western during that period. Further, the other partners did not benefit from such an informal and ad hoc access to the FLP funds.

In addition, agreeing with the Third Circuit in Thompson, the Fifth Circuit in Kimbell, 371 F3d 257 (5th Cir. 2004), and the Tax Court in Estate of Harper, TC Memo 2002-121, the Ninth Circuit concluded that “an inter vivos transfer of real property to a family limited partnership, which inherently reduces the fair market price of the resultant partnership interests, does not per se disqualify the transfer from falling under” the exception in Sec. 2036(a). However, the court observed that the estate must be able to show more than a propor-tional exchange between the property’s fair market value and the partnership interests; the estate must also show a genuine pooling of assets and a potential for intangibles resulting from pooling for joint enterprise to avoid Sec. 2036(a) (see Thompson, 382 F3d at 381). The court also stated that the “validity of the adequate and full consideration prong cannot be gauged independently of the non-tax-related business purposes involved in making the bona fide transfer inquiry.” Therefore, bona fide sale and adequate and full consideration are interrelated criteria.

The court ruled that the Tax Court did not err in concluding that, absent an implied agreement, the transfer of the Padaro Lane property to the FLP would have impoverished Bigelow. The court observed that the “transfer left her unable to meet her financial obligations whereas prior to the transfer she had applied the $3,500 monthly rental income under the Seamans’ lease toward her monthly expenses.” In addition, the court agreed with the Tax Court that the disbursements to the trust were not loans because the partnership formality of properly accounting for those disbursements by rebalancing the partners’ capital accounts was not observed.

Finally, the court found that the Tax Court did not err in finding that the FLP did not provide any non-tax-related benefits to Bigelow. It did not provide her with any liability protection because her trust was a limited partner and a general partner. The court also determined that there was no evidence that the FLP’s “partners reasonably faced any genuine exposure to liability that might have validated the partnership formation for a non-tax purpose.” The court ruled that the FLP was created to facilitate the transfer of the Padaro Lane property to the decedent’s children and grandchildren as a testamentary substitute, “with the advantage of lowering the gross estate by applying the discounts for lack of control and marketability.” Accordingly, the Ninth Circuit agreed with the Tax Court that the transfer of the Padaro Lane property was not a bona fide sale for adequate and full consideration under Sec. 2036.

Implications

Given the facts of the case, the outcome in favor of the IRS is not surprising. Although there is nothing new or novel about the Bigelow case, it serves as a reminder that courts will look to substance over form when taxpayers create FLPs as estate-tax-saving vehicles. The mere fact that the decedent creates a partnership recognized under state law does not automatically mean it will be recognized for federal estate tax purposes. In addition to following partnership formalities, there must be objective evidence indicating a business reason or potential nontax benefit for the creation of the partnership.

In addition, if substantially all of the decedent’s assets are transferred to the FLP, leaving the decedent impoverished and dependent on the FLP to pay her living expenses, the courts have ruled that the decedent has retained economic benefits from the transferred assets under Sec. 2036(a) and have disallowed the discounted value of the assets.

However, if properly structured, FLPs remain a viable estate planning tool if one keeps in mind the pitfalls causing them to be disregarded by the IRS and the courts.

Editor Notes:

David J. Kautter, CPA Ernst & Young LLP Washington, DC

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

If you would like additional information about these items, contact Mr. Kautter at (202) 327-8878 or david.kautter@ey.com.