Presented to the Arizona Forum for the Improvement of Taxation
January 11, 2005
By Thomas J. Murphy
Murphy Law Firm, Inc.
THE BIG NEWS – IRC 2036 is where all the action will be taking place. The IRS seems to have finally given up on some of its creative – and lame – theories, such as gift on formation or the 2703 look-only-to-the-underlying-assets arguments. Instead, the IRS has followed the promptings of the Tax Court in the Strangi I and Thompson cases by applying the retained use or control theory of 2036(a)(1) & (2). Likewise, expect the IRS to emphasize the “implied agreement” concept that the courts have been very receptive to in cases such as Thompson and Harper – this will be an easy way for the IRS to maneuver around the burden of proof set forth in IRC 7491.
THREE POINTS TO KEEP IN MIND:
#1. Bad facts make bad law. In the ten years or so that the case law has been developing in this area, the IRS has never – not once – challenged an FLP that was properly formed and maintained. Every reported case or TAM has involved FLPs with serious defects that made for an inviting target.
#2. It is better to FLP’ed and lost than to never have FLP’ed at all. Within the past two years, highly placed IRS officials have publicly stated that they will likely concede a discount in the range of 25% to 35%. But this may change in light of the Strangi, McCord and Thompson cases. Yet I recently received a closing letter that let stand a discount well in excess of this and my colleagues throughout the country continue to receive settlements in excess of this although the IRS is getting more aggressive since Strangi.
#3. Very divided courts. It is difficult to reconcile the opinions recently issued by federal circuit courts in the Thompson and Kimbell cases. Strangi is “only” a memorandum decision, very unusual for a case that blazes new ground and creates such attention. The Shepherd case (115 TC 30 (2000) and the McCord case each generated five opinions in the Tax Court’s decisions. In McCord, the trial judge had the case taken away from him and was relegated to a dissenting opinion.
IRC SEC. 2036(A)
“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 the 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…(1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or income therefrom”. See also Reg. 20.2036-1.
Turner v. Commissioner, aka Estate of Thompson, 5th Circuit, No, 03-3173 (Sept 1, 2004) affirming TCM 2002-246 (2002). Typical of recent cases. Considered to be an IRS victory but includes several discussions that should prove helpful to taxpayers.
FACTS: A 93 year old woman creates two FLPs that were done at the behest of her children who had purchased FLP kits from the much-maligned Fortress Financial Group. Mom funded each FLP with $1.4M and only kept $153,000.00. Had $14,000 annual income but $57,000 in living expenses.
The Fifth Circuit rules, for a number of reasons, that the FLPs must be included in mother’s estate and with no discount. First, the Court found an implied agreement existed among the family members. The estate conceded at trial that the children would have withdrawn whatever funds were needed for mother’s care. The trial court had found that the $153,000 was insufficient to cover mother’s needs and there had been distributions made from the FLPs for that purpose.
Second, the FLP agreements were amended to provide that any income or profits from a particular asset would be attributed to the partner who contributed the asset. The son had contributed a Colorado ranch to the FLP and retained nearly all of the $550,000 proceeds when it was later sold. All income from the raising of mules on the property went to another partner. The Court emphasized that there was no pooling a assets.
Third, the Court could not find a business purpose to the transaction. It emphasized that, as to the marketable securities that made up most of the assets, there was little activity and “no substantial change in investment strategy”.
Fourth, the Court noted that, in the months after mother’s death, $700,000 was withdrawn from the FLPs to fund bequests in mother’s will and to pay estate taxes.
The Court refused to disregard the FLPs as urged by the IRS but, for the reasons set forth above, it held that IRC sec. 2036(a) required inclusion of the FLP assets in mother’s gross estate.
Estate of Kimbell. Fifth Circuit, No. 03-10529 (May 20, 2004) reversing federal district court in 244 F Supp 2d 700 (DC, Texas, 2003)
FACTS: In January 1998, Ruth Kimbell, 96 years old, created a limited liability company with her son. Each contributed $20,000 to the LLC and took back a 50% membership interest with the son as the managing member. Later that same month, a limited partnership was created. Mrs Kimbell contributed $2.5 million in cash and shares of the family owned oil and gas business. She took back a 99% limited partnership interest. The LLC contributed $25,000 for a 1% general partnership interest. Mrs Kimbell retained $450,000 in liquid assets outside of the FLP/LLC. She died in March 1998. In December 1998, Mrs Kimbell’s estate tax return was filed, claiming a 49% discount.
The only issue before the 5th Circuit was whether Mrs Kimbell’s contributions to the LLC and FLP constituted a bona fide sale for full and adequate consideration. If so, IRC 2036 expressly provides for an exception. The issue was whether this bona fide sale exception applied to these facts. The 5th Circuit ruled that it did apply.
Prong #1 – full and adequate consideration
The 5th Circuit adopted a two-prong test in determining whether the bona fide sale exception applied. The first prong centers around whether full and adequate consideration was received by Mrs Kimbell. In other words, was the asset received of roughly equivalent value to the asset given up? The IRS argued that the estate’s position was wildly inconsistent in that it claimed full and adequate consideration when the FLP was formed and then claimed a 49% discount two months later. Fortunately for the taxpayer, the Court saw through this in a very well-stated portion of its opinion that has been widely quoted by commentators:
“The business decision to exchange cash or other assets for a transfer-restricted, non-managerial interest in a limited partnership involves financial considerations other than the purchaser’s ability to turn right around and sell the newly acquired limited partnership interest for 100 cents on the dollar. Investors who acquire such interests do so with the expectation of realizing benefits such as managerial expertise, security and preservation of assets, capital appreciation and avoidance of personal liability. Thus, there is nothing inconsistent in acknowledging, on the one hand, that the investor’s dollars have acquired a limited partnership interest at arm’s length for adequate and full consideration and, on the other hand, that the asset thus acquired has a present fair market value, i.e. immediate sale potential, of substantially less than the dollars just paid – a classic informed trade-off.”
This hits the nail on the head. Something of considerable value to the partner may be of no value to someone else or the general investing public. These non-monetary benefits are real and the Court was convinced that they did exist. For instance, the court acknowledged the need to avoid fractionalizing of interests as the interests pass through generations or the need to avoid family squabbles by requiring partners to use mediation and arbitration.
In other words, are there non-tax reasons for the creation of the entity? Two particular issues that the Court accepted and emphasized leapt out at me. One concerned the need for creditor and lawsuit protection. The Kimbell FLP was heavily invested in oil and gas working interests that created significant exposure to environmental issues. I have been preaching this for years – the creditor protection afforded an Arizona limited partnership by virtue of ARS 29- 341 is a unique and extremely important feature in the estate planning realm. This alone is ample reason for many of my clients to establish an FLP and the Kimbell case solidly adopts this as a justifiable rationale for creating one.
The second issue that caught my attention was when the Court pointed out the need to keep property characterized as separate property in the event of a grandchild’s divorce, which had already happened in the Kimbell family.
These types of considerations are hard to put a price tag on but Kimbell emphasizes that they are real and must be recognized as a valid non-tax reason for creating an FLP.
The IRS put forth a couple other theories that indicated there was no bona fide sale. One theory was that the son only had a 1% interest that could be disregarded for estate inclusion purposes. The Court flatly rejected this, stating that there was no minimum percentage interest. Surprisingly, the IRS apparently did not stress an argument that the trial court found convincing: the partnership agreement allowed for the removal of the general partner if 70% of the partners agreed. This was fatal to the taxpayer in Strangi but was apparently never raised with the 5th Circuit.
The second theory was that the son had complete managerial control both before and after the FLP’s formation. The IRS maintained that this showed that there was no change in how the family ran its operation so that the entity could be ignored for estate tax purposes. But this too was swiftly rejected the Court, going so far as to label it “irrelevant”. It only mattered that the son was the sole manager after the FLP’s formation. What may have happened before formation was of little importance.
The Court tried to come up with a workable standard in determining what will be considered full and adequate consideration. It cited three factors: 1) pro-rata interests, 2) properly maintaining capital accounts and 3) rights to a pro-rata distribution upon termination or dissolution.
Prong #2 – Relinquishing possession and control
If the first prong is met (full and adequate consideration), the second issue is whether the transferor, Mrs Kimbell, actually parted with the property. For an FLP, this really means whether the partnership was properly funded with pro-rata capital accounts and with following the requisite formalities (filing of tax returns, separate bank account, etc.).
One aspect that seemed very important to the Court was that Mrs Kimbell had retained a sizeable portion of her assets, approximately $450,000.00, and kept them outside of the FLP. This meant that she had ample resources on which to live so that she did not have to rely on the FLP for income and hence did not have to involve herself in partnership activities.
Estate of Strangi (aka Strangi II), TCM 2003-145 (2003). Currently on appeal to the 5th Circuit. Decedent had 99% LP interest and a 47% interest in corporate GP with a charity holding a 1% interest. Dangerous language that equates the management rights of a GP with the 2036(a) retained interest. Distinguishes Byrum. Finds implied agreement among family members.
Estate of Stone, TC Memo 2003-309. Provides a nice factual comparison to Thompson and is frequently cited in that opinion. Tax Court finds IRC 2036 does not apply because the statutory exception regarding full and adequate consideration was met. Children were actively involved in the management of the five FLPs and has their own interests to protect. Parents had also retained a sizeable amounts of funds to provide for their living expenses.
Estate of McCord, 120 TC 13 (2003). It doesn’t get much more complicated than this case that had it all – formula clauses, two classes of LP interests, assignees, charities, call rights, allocation by LPs of gifts, contingent obligations on LPs to pay estate taxes and so on. Still, McCord did fairly well – 10 to 15% minority discount depending on the type of asset and a 20% marketability discount. Has been appealed to the 5th Circuit.
Estate of Harper, TCM 2002-121. Tax Court includes the FLP in decedent’s estate by finding an implied agreement. The record “shows a consistent pattern of acting in response to particular needs of decedent or his estate”.
Estate of Abraham, TC Memo 2004-39. Another implied agreement found by the court as well as no reason for formation other than estate tax considerations.
THE DO’S AND DON’TS OF FLPS
Do not commingle partnership assets. Make sure all bank and brokerage accounts are titled in the name of the FLP. And do not use the FLP account to pay for personal expenses. This includes post-mortem expenses – funeral, estate taxes, costs of administration, etc.
Respect the entity and play by the rules. File the 1065 each year. Make sure the partners are paying taxes on the K-1 income. File annual reports with the Secretary of State (FLPs) or Corporation Commission (LLCs). Hold annual meetings and keep minutes. Make sure the capital accounts are accurate and continually adjusted to reflect gifting or additional contributions.
Pro-rata distributions. Easier said than done but extremely helpful. A huge weapon is taken out of the IRS’s hands if this is followed. Loans to partners are perfectly OK but make sure there are signed notes with, if possible, some collateral. In view of the recent Hackl decision, some commentators suggest creating a Crummey-type withdrawal right so that any gifted interests will qualify as a present interest and therefore a completed gift.
Do not transfer all major assets into the FLP. Never transfer the house. If a vacation property is transferred, make sure reasonable rent is paid. Make sure there is a separate checking account with sufficient funds and income to pay for foreseeable living expenses. Otherwise, the IRS will take the position that there is an implied agreement among the partners that the FLP will pay for these personal expenses and argue for inclusion in the decedent’s estate.
Use a qualified valuation expert and be consistent. Avoid, at all costs, an expert using outdated data and studies or who overlooks or minimizes factors that would impact valuation. At a minimum, the expert should be using the surveys in the most recent May/June edition of Partnership Spectrum (www.PartnershipProfiles.com). Make sure the expert fully understands and discusses the default provisions of the applicable statutes and the impact that this will have for 2704 purposes. Make sure, at the outset, that the expert is willing to testify to defend his/her positions. Make sure that the valuations are consistent – the gift tax returns should jibe with the estate tax return and there should be no significant change in valuation after that point. The Tax Court makes no secret that it is very skeptical of these guys – see, most recently, Hess v. Commissioner, TC Memo 2003-251, and Estate of Deputy, TC Memo 2003-176 where taxpayers still made out quite well, and Estate of Leichter, TC Memo 2003-66, where the estate got creamed.
Always emphasize the fiduciary duties of the general partner. A key battleground in the 2036 fight. In the partnership agreement, be very hesitant to lessen any statutory duty that the GP may owe to the other partners. Be familiar with United States v. Byrum, 408 US 125 (1972) and Rev Rul 81-15. Be particularly diligent if using an LLC since the Arizona LLC statutes are silent as to fiduciary duties as between members.
Be careful with removal powers. When drafting the partnership agreement, try to structure the agreement so that the parents do not, by themselves, have a large enough percentage interest to remove the GP. Or, if this cannot initially be done, then keep this in mind when gifting LP interests so that, over time, the children will have a large enough combined share to preclude the GP’s removal without their consent.
Emphasize the non-tax reasons for the FLP’s existence. In my opinion, the creditor protection afforded under ARS 29-341 & -655 alone is sufficient. Bramblett v. Commissioner, 960 F2d 526 (5th Cir, 1992). I am amazed that very few taxpayers have made an issue of this in the reported cases. There are many other reasons – the need to avoid gifting cash that can lead to spoiled children or broken marriages, the ability to keep the property within the family, the need to avoid fractionalizing interests in real estate and other property and obtaining economies of scale through the consolidation of assets.
If at all possible, avoid deathbed planning. IRS considers “deathbed” to mean formation of FLP within six months of death. But do not overlook the cause of death – even if terminal was the onset of death much sooner than expected? And concede the obvious – there is nothing wrong with having tax savings as a primary motivating force.
Consider bringing in third parties as partners. Gift a small percentage interest to charities. Use an irrevocable trust as a limited partner to hold the children’s interest and have a private or corporate fiduciary as trustee. This makes it harder to the IRS to claim that all partners/family members are acting in collusion or as part of an implied agreement. Very helpful on the Byrum issue.
Consider having children contribute for their LP interests. The children then have more of a monetary stake in the entity and make it harder for the IRS to claim that Dad as GP could do whatever he pleased. A large enough contribution may also bring it within the “bona fide sale” safe harbor of IRC 2036(a).
Do-It-Yourselfers are asking for trouble. The Tax Court in Strangi and Thompson are very wary of the “Family Fortress” kits being sold to the semi-sophisticated who tried to form and maintain FLPs on their own. And the Court has repeatedly emphasized the importance of observing the formalities, often overlooked or ignored by the DIYers.