For much of the last decade, the Internal Revenue Service has engaged in a frontal assault on the use of family limited partnerships (FLPs) and other closely held entities for estate-planning purposes. In its pronouncements, audits and litigation, the IRS has taken the position that an FLP can be disregarded for estate and gift tax purposes, notwithstanding the fact that the entity was valid under state law.1
Over the years, the IRS has asserted several alternate theories in its attempts to disregard an entity. The Service's arguments have included assertions that the entity lacks economic substance, that the entity should be ignored under a “substance over form” analysis, and that the entity lacks a business purpose. The IRS also has argued that the creation of a pro rata partnership resulted in a “gift on formation,” alleging that because the value of the partnership interests received in exchange for a pro rata contribution to the entity was worth less than the value of the assets contributed, value “disappeared” and a gift occurred. The IRS also has asserted that a partnership agreement is a restriction on “the right to sell or use” the assets transferred to the partnership, which should be ignored under Internal Revenue Code Section 2703. The IRS has lost each of these arguments when courts have found an entity to be validly existing under state law and when interests received by the partners on formation are proportionate to the fair market value of the assets contributed.2 In recent cases, the IRS has dropped these arguments as cases proceeded to trial.3
But the IRS has also had some victories. And in the last year, courts have issued a series of decisions that refine their acceptance of several of the arguments advanced by the Service to challenge FLPs. Those arguments include a derivative of the traditional “gift on formation” argument and the Service's argument that the entity can be effectively ignored under certain circumstances for estate tax purposes under IRC Section 2036. These recent cases and their predecessors provide practitioners with insight into the formation and operation facts that may impact whether the Service will be successful in a given situation. They also demonstrate that preparation for a dispute with the IRS begins at the estate planning level.
GIFT ON FORMATION
The IRS's very first successes against FLPs came with a derivative of the “gift on formation” argument. Several courts found that a gift occurred when an entity was formed, when a portion of a senior family member's original capital contribution was credited to a next generation family member's capital account at the same time.4 In those cases, courts found the senior family member made an “indirect gift” in the form of a capital contribution for the benefit of other partners. The argument appears to be easily avoided under current case law, by making sure that, when a partnership is formed, the fair market value of the assets contributed by each partner is properly credited to that partner's capital account and the interests received are proportionate to the value of the assets contributed.5
THE 2036 ARGUMENT
A second argument — that IRC Section 2036 applies to the assets contributed by a decedent to the partnership — has provided the IRS with its greatest successes. Section 2036(a) provides that “the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death:
the possession or enjoyment of, or the right to the income from, the property,
the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.”
The essence of the IRS's 2036 argument is that, because of the way the partnership was either structured or operated, the decedent effectively retained the possession or enjoyment of, or the right to the income from, the property transferred to the partnership. Almost all of the cases have addressed the application of Section 2036(a)(1) to partnership assets, leaving for the courts the primary questions of (1) whether the creation of the partnership and transfer of assets to it was a “bona fide sale for full and adequate consideration” and, if not, (2) whether the decedent retained the possession or enjoyment of, or the right to the income from, the property transferred to the partnership.6
With a few exceptions, the application of IRC Section 2036 has come down to whether non-tax reasons existed for the creation of the partnership and whether the taxpayer respected the entity's integrity. In each case decided in the IRS's favor, the court examined the facts and circumstances regarding the creation and operation of the partnership and held that, because of the way the partnership was formed and operated, the decedent retained the enjoyment of the property transferred to the partnership during his lifetime, and therefore the property should be included in the decedent's estate under Section 2036(a). The common element in many of these cases was a court's finding that the partners failed to respect the integrity of the partnership. This lead to a finding of fact that the decedent had retained the right to use and enjoy the property contributed to the partnership just like it was his own.
The decisions addressing the application of IRC Section 2036 in the last year provide some guidance on both the “bona fide sale for full and adequate consideration” issue and the “retained interest” issue. Although courts have used slightly different terminology, recent decisions suggest that the bona fide sale test is met when a significant and real non-tax reason exists for creating a partnership. The adequate-and-full consideration test also appears to be met when, upon formation, (1) the interests in the partnership received are proportionate to the fair market value of the assets contributed, (2) the value of the assets contributed by each partner are properly credited to that partner's capital account, and (3) upon dissolution, the partners' capital account is distributed to the partners. This standard was established by the Tax Court in Estate of Stone7 and adopted by the U.S. Court of Appeals for the Fifth Circuit in Kimbell.8 However, a review of the post-Kimbell cases issued in the last year demonstrate the range of factual scenarios in which the IRS is asserting its Section 2036 argument, and the courts are applying the section.
In Turner,9 the U.S. Court of Appeals for the Third Circuit addressed the “bona fide sale” test. The court, on Sept. 1, 2004, upheld the Tax Court's application of IRC Section 2036(a)(1) to two FLPs created with most of a decedent's assets, several years before his death.
In affirming the Tax Court's decision to apply Section 2036 to include the assets the decedent had transferred to the partnerships in his estate, the appeals court found, based upon the manner in which the partnerships were operated, that there was an implied agreement between the decedent and his children that allowed him to retain the economic benefit of the contributed property. The court noted that the decedent transferred assets to the partnership that would have been required for his support, and his children agreed to his requests for money or the property that he had contributed. (The partnerships distributed a total of nearly $100,000 to the decedent, which he used to make gifts to family members and to pay personal expenses.) Therefore, the court found, the partnerships were created primarily as an alternative vehicle for implementing his estate plan.
In affirming the Tax Court's finding that the “bona fide sale for full and adequate consideration” exception of IRC Section 2036 had not been met, the appeals court specifically found that there had been no non-tax reason for creating the partnerships. Quoting the Tax Court, the appeals court also noted that the Tax Court properly concluded that there had been no transfers for consideration because the transactions “were not motivated by … legitimate business concerns.”
Many family partnerships hold marketable securities as their principal asset, so it's of particular interest to many practitioners that the appellate court made reference to the holding of an untraded portfolio of marketable securities in the partnership as a negative factor in a Section 2036 analysis. The court stated: “In addition to the lack of legitimate business operations, the form of the transferred assets — predominantly marketable securities — is significant to our assessment of the potential non-tax benefits available to decedent as a result of the transfer. Other than the favorable estate tax treatment resulting from the change in form, it is difficult to see what benefit could be derived from holding an untraded portfolio of securities in this family limited partnership with no ongoing business operations.”
In reaching this conclusion, the court relied on several cases (Church, Stone and Kimbell) for the proposition that some benefit other than estate tax savings must be present for the investment to be considered bona fide. Each of those cases though, involved entities owning a substantial amount of marketable securities. The common theme of the relied-upon cases is that family management and control of assets — including marketable securities — was an important non-tax reason supporting the bona fides of the entity at issue.
The Tax Court further refined the “bona fide sale for full and adequate consideration” exception in its March 15 decision in Estate of Bongard.10 Although the facts of Bongard are complex, the case provides valuable insight into the current thinking of many of the Tax Court judges, almost all of whom weighed in on the opinion.11 Specifically, it shows the varied views of a number of the judges on the “gift on formation” issue, the “bona fide sale” issue, and the “adequate and full consideration” issues.
In 1996, Wayne Bongard and a trust he had created for the benefit of his children (the ISA Trust) formed a limited liability company (WCB Holdings) to consolidate the Bongard family's shares of Empak Corporation in a holding company; their goal was to position Empak for a liquidity event, such as a merger or a private or public offering of stock. Both Bongard and the ISA Trust received a pro rata share of the voting and non-voting units. Bongard and the ISA Trust subsequently contributed a portion of their non-voting WCB Holdings membership units to an FLP. Bongard received a 99 percent limited partnership interest and the ISA Trust received a 1 percent general partnership interest in exchange for the contributions. About a year later, Bongard transferred a 7.72 percent limited partnership interest to his wife and at the same time, entered into a post-marital agreement.
On Nov. 16, 1998, Bongard died unexpectedly of a heart attack at 58. The IRS asserted that the Empak stock transferred to WCB Holdings should be included in his gross estate and that both WCB Holdings and the partnership should be ignored under IRC Section 2036.
The entire Tax Court reviewed the case, and 10 judges issued the majority opinion.12 Addressing the IRS's 2036 argument, the majority had to decide on the initial issue of whether the creation of WCB Holdings and the partnership qualified as a “bona fide sale for adequate and full consideration.” The majority concluded that each element of the test is satisfied if (1) there is “a legitimate and significant non-tax reason” for the creation of the entity, and (2) the interests received are proportionate to the value of the property contributed to the entity. The majority stated that the “significant purpose must be an actual motivation, not a theoretical justification.” They also noted that “legitimate non-tax purposes are often inextricably interwoven with testamentary objectives.”
The majority also concluded that the creation of WCB Holdings in anticipation and furtherance of a corporate desire to pursue a liquidity event was a legitimate and significant non-tax reason for creating the entity. Thus, the majority determined that the creation of WCB Holdings was the result of an arm's length transaction and was bona fide. The majority also concluded that the “adequate and full consideration” component was satisfied because Bongard and the ISA Trust each received an interest in WCB Holdings in proportion to the value of the assets contributed. Their respective capital accounts were properly credited with the contribution, and distributions from WCB Holdings and required a negative adjustment in the distributee's capital account. Thus, the majority held that the stock transferred to WCB Holdings was not includable in Bongard's gross estate, because the “bona fide sale for adequate and full consideration” exception to IRC Section 2036(a) was satisfied.
With respect to the transfer of non-voting WCB Holdings units to the partnership, the majority determined that the transfer of WCB Holdings units was not motivated by legitimate or significant non-tax reasons. Evidence at the trial demonstrated that the non-tax reasons for the creation of the partnership included: (1) a desire for the partnership to serve as a family investment vehicle once the liquidity event occurred; (2) creditor protection; (3) facilitation of the post-marital agreement with Bongard's wife; and (4) greater flexibility than a trust. But the majority opined that, because the partnership never invested or diversified its assets following Bongard's contribution of WCB Holdings units, the non-tax reasons were not legitimate or significant.
Although no assets of the partnership were distributed to Bongard during his life, the majority stated that his practical control over the partnership (through his positions as the chief executive officer and sole board member of Empak) constituted an understanding among the parties involved that he retained the right to control the WCB Holdings units transferred to the partnership. Accordingly, the majority held that IRC Section 2036(a)(1) included the value of WCB Holdings units held by the partnership on Bongard's death proportionate to his 91 percent limited partnership interest. The majority also held that the gross estate included the value of WCB Holdings units held by the partnership that was proportionate to the 7.72 percent limited partnership interest transferred to Bongard's wife due to the application of IRC Section 2035(a).
In a concurring opinion, Judge David Laro (joined by Judge L. Paige Marvel) opined that the adequate and full consideration exception should apply “only where the transferor's receipt of consideration is of a sufficient value to prevent the transfer from depleting the transferor's gross estate.” In a separate concurrence and dissent, Judge James S. Halpern wrote that the majority had incorporated an “inappropriate motive test” into the “bona fide sale” exception. Concurring in part and dissenting with respect to the application of Section 2036(a)(1) to the partnership, Judge Carolyn P. Chiechi (joined by Judge Thomas B. Wells and Judge Maurice B. Foley) said that the majority was wrong to hold that there was an implied agreement that allowed Bongard to retain enjoyment of the partnership property, noting that the reason the partnership never invested or diversified its assets following Bongard's contribution of WCB Holdings units to the partnership was that he died before the liquidity event could occur. Judge Chiechi also noted that the majority decision to apply Section 2036 to WCB Holdings because of Bongard's alleged “control” was contrary to the Supreme Court's decision in United States v. Byrum.13
BIGELOW AND KORBY
The recent decisions in Bigelow14 and Korby15 don't add new insights to the 2036 legal analysis, but do continue to demonstrate that failing to respect the integrity of the partnership will make it hard for the entity to withstand scrutiny.
In Bigelow, the facts found by the court to warrant inclusion based upon an “implied agreement” finding included: (1) use of partnership funds to pay personal expenses including living expenses and a loan; (2) the absence of distributions to partners other than the decedent; (3) the use of partnership assets to secure a loan obligation of the decedent's revocable trust; and (4) failure to keep accurate partnership books and records.
In Korby, the court pointed to the decedents' financial dependence on distributions from the partnership, and to the fact that distributions were made only to Austin and Edna Korby while they were alive and on an as-needed basis, despite the fact that the Korbys transferred almost all of their limited partnership interests shortly after the entity was formed to trusts for their sons.
The most recent decision to address Section 2036 is the Tax Court's May 26 ruling in Estate of Schutt.16 In it, the Tax Court addressed the application of IRC Section 2036 to two Delaware business trusts, created a year before the decedent's death, between the decedent and the Wilmington Trust Company (which served as the trustee of seven trusts held for the benefit of the decedent's children and grandchildren).
One of the business trusts held DuPont stock; the other, Exxon stock. More than 50 percent of the contributions to each Delaware business trust came from the seven trusts managed by Wilmington Trust. The primary purpose for creating the Delaware business trusts was to preserve the decedent's buy-and-hold philosophy with regard to the DuPont and Exxon stock. In particular, the DuPont stock and the Exxon stock also had been held by the family for many years. Entity formalities were adhered to, and there was no commingling of personally owned assets and the assets owned by the Delaware business trusts. The decedent retained substantial assets outside of the trusts. The decedent also was the trustee of the trusts, which was akin to holding the position of a general partner.
In addressing the IRS's argument that both Section 2036(a)(1) and (a)(2) should be applied to the assets of the business trusts, the court focused on the “bona fide sale for full and adequate consideration” exception. The court examined the test under both the “legitimate and significant non-tax reason” standard set forth in Bongard and, the Third Circuit's references in Turner for the need for some potential advantage to the transferor other than estate tax benefits.
The court held that objective evidence, both in the form of contemporaneous documentation and testimony, supported the estate's position that a significant motive for the creation of the business trusts was to perpetuate the decedent's buy-and-hold investment philosophy and that this motive was a “legitimate and significant non-tax reason” within the meaning of Bongard. The court distinguished the Schutt entities from those in Turner, about which the Third Circuit had noted that the mere holding of an untraded portfolio of marketable securities is generally a negative factor in assessing the potential non-tax benefits resulting from a transfer to a family entity. In Schutt, the court found that the creation of the business trusts had allowed the decedent to impose his specific, well-documented buy-and-hold investment philosophy on the very substantial assets contributed by the Wilmington Trust Company Trusts.
FORMATION & OPERATION
Although these recent cases give practitioners much needed guidance regarding the application of Section 2036 to FLPs, the battles in this area are far from over. Of particular interest to practitioners is the effect of Section 2036 (a)(2) on general partner rights held by a decedent, which the courts have not yet fully addressed.17 Factors examined by the courts in deciding whether to apply Section 2036 are case-specific, and continue to be developed through litigation. However, the recent cases and their predecessors provide practitioners with a window to view the formation and operation facts that may impact whether Section 2036 applies in a given situation.
“Formation” facts examined by the courts have included: (1) the non-tax reasons for creating the entity; (2) whether the other partners made real contributions of property or services; (3) whether the decedent had sufficient assets outside of the partnership to live on; (4) whether personal use assets were placed in the partnership; (5) whether fiduciary obligations were negated in the partnership agreement; (6) whether partners other than the decedent had the opportunity to comment on and provide input with respect to the terms of the partnership agreement; (7) whether partners other than the decedent had the opportunity to decide what assets would be contributed to the partnership; and (8) the discretion regarding distributions provided to the decedent general partner.
“Operational” facts examined by the courts include whether: (1) partnership assets were commingled with the decedent's personal assets; (2) distributions were made in accordance with the terms of the partnership agreement; (3) the entity was treated and respected as a separate entity; (4) personal expenses of the decedent were paid from the partnership or whether distributions were made for personal needs; (4) proper books and records of the partnership have been kept; and (5) estate taxes and administration expenses were paid directly from the partnership.
- See for example, Private Letter Ruling 9736004 (June 6, 1997); PLR 9735043 (June 3, 1997); PLR 9735003 (May 8, 1997); PLR 973004 (Aprl 3, 1997); PLR 9725018 (March 20, 1997); PLR 9725002 (March 3, 1997); and PLR 9723009 (Feb. 24, 1997).
- See for example, Estate of Strangi v. Comm'r, 115 T.C. 478 (2000), aff'd on this issue; Gulig v. Comm'r, 293 F.3d 279 (5th Cir. 2002); Knight v. Comm'r, 115 T.C. 506 (2000); Church v. United States, 85 A.F.T.R.2d (Research Institute of America) 804 (W.D. Tex. 2000), aff'd without published opinion, 268 F.3d 1063 (5th Cir. 2001) (per curiam), unpublished opinion available at 88 A.F.T.R.2d 2001-5352 (5th Cir. 2001); Estate of Jones v. Comm'r, 116 T.C. 121 (2001).
- See for example, Lappo v. Comm'r, 86 T.C.M. (CCH) 333 (2003); Peracchio v. Comm'r, 86 T.C.M. (CCH) 412 (2003).
- See for example, Shepherd v. Comm'r, 115 T.C. 376 (2000); Senda v. Comm'r, T.C. Memo 2004-160 (July 12, 2004) (appeal to 8th Cir. pending).
- See, Estate of Jones v. Comm'r, 116 T.C. 121.
- See, Harper, 83 T.C.M. (CCH) 1641 (2002); Estate of Strangi, 115 T.C. 478 (2000); Reichardt, 114 T.C. 144 (2000).
- Estate of Stone v. Comm'r, 86 T.C.M. (CCH) 551 (2003).
- Kimbell v. U.S., 371 F.3d 257 (5th Cir. 2004).
- Turner v. Comm'r, 382 F.3d 367 (3rd Cir. 2004).
- Estate of Bongard v. Comm'r, 124 T.C. No. 8 (March 15, 2005).
- Judge Mary Ann Cohen did not participate in the decision.
- The majority opinion was authored by Judge Joseph R. Goeke. Judges joining in the majority included Chief Judge Joel Gerber, Judge John O. Colvin, Judge Harry A. Haines, Judge James S. Halpern, Judge Mark V. Holmes, Judge Diane L. Kroupa, Judge Stephen J. Swift, Judge Michael B. Thornton, Judge Juan F. Vasquez and Judge Robert A. Wherry.
- U.S. v. Byrum, 408 U.S. 125 (1972).
- Estate of Bigelow v. Comm'r, T.C. Memo 2005-65 (March 30, 2005).
- Estate of Korby v. Comm'r, T.C. Memo 2005-102 and 2005-103 (May 10, 2005).
- Estate of Schutt v. Comm'r, T.C. Memo 2005-126 (May 26, 2005).
- See, Kimbell v. U.S.; Estate of Strangi v. Comm'r 85 T.C.M. (CCH) 1331 (2003) (appeal to 5th Circuit pending).
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