Paul G. Marcotte, Jr., a partner in the Bethesda, Md. law firm of Paley, Rothman, Goldstein, Rosenberg, Eig & Cooper, Chtd., reports:

On Nov. 7, the U.S. Tax Court rejected the government's latest attempt to use Internal Revenue Code Section 2036 to disregard family partnerships in Estate of Stone v. Commissioner, T.C. Memo 2003-309. The decision may provide some clues to practitioners about how to structure these entities to avoid getting caught in the Service's anti-FLP dragnet: Use the Section 2036 exception for bona fide sales.

Stone involved five limited partnerships, all formed by an elderly couple (now deceased) and their children. The Tax Court never considered the government's argument that the assets contributed to the partnerships by the parents should be brought back into their gross estates under Section 2036(a)(1) because, while living, they'd retained beneficial enjoyment of the assets. Instead, the court found the transactions fell within the exception to Section 2036 — the bona fide sale for full and adequate consideration — because the formation and funding of the Stone partnerships rose above a mere “recycling” of the parents' assets.

The Tax Court found it significant that:

  • The parents did not place all of their assets in these partnerships, but “retained sufficient assets to enable them to maintain their respective accustomed standards of living;”
  • The children actively participated in the partnerships that “had economic substance and operated as joint enterprises for profit;” and
  • All partners were represented by independent counsel throughout the formation and funding of the partnerships (indicative of arm's length negotiations).

The Stone children were key in organizing and managing the partnerships with the father. The parents provided the bulk of the partnerships' assets — but the children also contributed (some of their assets originated as gifts from the parents).

The Service had argued that the exception to Section 2036 for a bona fide sale did not apply — because the partnership interests the parent's received, after valuation discounts, were worth less than the assets they contributed. The court made short work of this argument, saying that the government's position “in effect reads out of section 2036(a) the exception for ‘a bona fide sale’…We reject such an argument.”