FLP administration issues.

In cases such as Est. of Dorothy Morganson Schauerhamer, (1) Est. of Charles E. Reichardt, (2) Est. of Morton B. Harper (3) and Est. of Albert Strangi, (4) the Tax Court agreed with the Service's argument that assets transferred to a family limited partnership (5) (FLP) were includible in the transferor's estate under Sec. 2036.

In general, under Sec. 2036, the entire value of a transfer is includible in a transferor's gross estate when the transferor has retained (1) explicitly or implicitly, a right to possession or enjoyment of the property or the income therefrom (Sec. 2036(a)(1)); or (2) the right to designate the persons who shall possess or enjoy the property, or the income therefrom (Sec. 2036(a)(2)). The statute does not apply to transfers that are bona fide sales for adequate and full consideration in money or money's worth (bona fide sale exception).

Whether a transferor has implicitly retained an economic benefit under Sec. 2036(a)(1) is a question of fact; the courts typically look at "all of the facts and circumstances surrounding the transfer and the subsequent use of property" in making such determination. (6)

Many crucial factors relate to a FLP's formation stage, others to yearly FLP administration. The requirement to prepare an annual income tax return provides the CPA with an opportunity to detect yearly administration problems that may inadvertently imply an understanding to retain economic benefit. The checklist in Exhibit 1 on p. 353 and the appendix on p. 355 will assist a CPA in such process.

Exhibit 1: FLP administration checklist

Commingling of assets                          Yes    No    Comments

1.  Does the FLP have its own bank
    (or financial institution) accounts?       --     --
2.  Is the income from FLP assets deposited    --     --
    directly in FLP accounts within a
    reasonable time of receipt of such funds
    (as opposed to being deposited in a
    partner or third-party accounts and
    subsequently transferred to FLP
    accounts)?                                 --     --
3.  Are income items from FLP assets
    reported in the FLP's name and
    employer identification number (e.g.,
    on Forms 1099 and Schedules K-1)?          --     --
4.  If the FLP owns shares of a closely
    held business, are dividends
    attributable to these shares being paid
    directly to the FLP (as opposed to
    being paid to the transferor and
    subsequently redeposited by him or
    her into the FLP account)?                 --     --
5.  If the FLP owns rental properties,
    are the rent checks being made out
    to it (and nut the transferor,
    regardless of whether the transferor
    reimburses the FLP for the amounts
    received)?                                 --     --
6.  Are all the deposits being made to
    FLP accounts related strictly to the
    FLP's activities (as opposed to
    personal sums being deposited in FLP
    accounts, then transferred to a
    partner or third party)?                   --     --
7.  Are any personal expenses of the
    partners being paid directly from the
    FLP (regardless of whether they are
    reclassified as distributions or loans
    at year-end for tax return and/or
    bookkeeping purposes)?                     --     --
8.  Are expenses related to FLP assets
    still being invoiced to the transferor
    (regardless of who pays such expenses)?    --     --
9.  Are FLP assets being used as collateral
    for any partner's personal or business
    debts (other than loans of the FLP
    guaranteed by the partner)?                --     --
10. Have the transferors stopped
    identifying the contributed assets as
    their personal assets on personal
    financial statements, credit
    applications, insurance applications,
    etc.?                                      --     --

Distributions

11. If distributions were made during
    the year, was the decision to make
    them made by parties authorized by
    the FLP agreement to make such
    decisions?                                 --     --
12. If distributions were made during the
    year, were they consistent with the
    agreement's terms?                         --     --
13. If distributions were made during the
    year, was their frequency consistent
    with the agreement's terms?                --     --
14. Is the timing of the distributions
    related to the partners' needs for
    funds to pay personal expenses, make
    gifts and make other personal
    disbursements (when compared to
    prior years or if made in proximity
    to correspondence documenting the
    need for funds)?                           --     --
15. Has any partner given directives to
    any financial institution (holding
    FLP funds) to make direct transfers
    to persons or entities for a
    partner's personal expenses,
    including for personal income taxes
    (regardless of any direction to
    classify these as distributions or
    loans to partners for accounting
    purposes)?                                 --     --
16. In exercising his or her discretion
    to make distributions, does the
    general partner take into
    consideration the FLP's business
    needs and the limited partners'
    needs (and document such
    considerations in writing)?                --     --
17. Are all partners being informed of
    distributions and checks being
    mailed/delivered to them in a timely
    and uniform manner?                        --     --
18. Have all distributions and other
    items of income or deduction been
    properly allocated among the
    partners in accordance with their FLP
    interests, taking into account Sec.
    704(e)?                                    --     --

Personal use of property

19. If FLP assets are being rented or
    leased by any of the partners, are
    there written contracts acknowledging
    such activities?                           --     --
20. If FLP assets are being rented or
    leased by any of the partners, are
    the contract terms (e.g., duration of
    rent/lease term, amount of rent/lease
    paid, etc.) similar to contracts
    entered into by unrelated parties?         --     --
21. If FLP assets are being rented or
    leased by any of the partners, are the
    rents due collected in a frequency
    comparable to third-party rentals or
    leases (as opposed to mere accruals on
    books)?                                    --     --
22. If FLP assets are being rented or
    leased by any of the partners, are
    the partner and the FLP abiding by the
    terms of the rental/lease
    agreement?                                 --     --
23. Has the FLP loaned money to a partner?
    If so, do such loans contain terms and
    payment schedules equivalent to
    arrangements that would be expected
    with a third party? Are such loans
    documented?                                --     --

Compliance with legal requirements

24. Are rental/lease/loan and other
    agreements being renegotiated and
    renewed on expiration of the original
    agreements? (The permanent file must
    contain updated documents.)                --     --
25. Are all required state legal filings
    for the FLP being filed (e.g., certain
    states require notification of
    transfers of FLP interests)?               --     --
26. Are the FLP books and records
    maintained in accordance with the FLP
    and operating agreements?                  --     --

Involvement of partners other than transferor

27. Are tax returns being filed properly
    (and signed by a partner with signatory
    authority) each year?                      --     --
28. Are copies of annual accountings
    (balance sheet/income statement)
    and/or tax returns and/or a brief
    synopsis of yearly activity being
    provided to all partners?                  --     --
29. Have the partners held periodic or
    special meetings to discuss FLP
    business, including investment
    strategies, future expenses,
    management fees, distributions and
    other issues (if any)? Are the
    proceedings documented?                    --     --

This issue is very controversial. When contributing partners receive proportional interests in a FLP for their contributions, the courts have held that there is no gift on FLP formation. If the transfers are not gifts, many tax advisers argue that they meet the bona fide sale exception to the application of Sec. 2036. (7) Recently, the Tax Court agreed, (8) in a decision that carefully distinguished the facts from those in the cases mentioned above. The rulings of the Fifth Circuit (9) (and other circuit courts) on this issue will shed further light.

Appendix: Keys to Checklist

A. Questions 1-10: Commingling of Assets

In Est. of Schauerhamer, the decedent had continued to deposit income from FLP assets into her personal account (in direct violation of the FLP agreement). The Tax Court found this to be "highly indicative" of possession or enjoyment, a belief shared by other courts in their respective decisions. (10) In Reichardt, the Tax Court noted that some of the FLP's income was deposited in the decedent's personal account. In Harper, delays in the actual transfer of title of FLP assets resulted in income from those assets being deposited in the decedent's personal accounts (a checking account was not even opened until three months after FLP formation).

The courts have ruled that a FLP's payment of the transferors' personal expenses were equally egregious violations, regardless of whether such transactions were reclassified as loans or distributions at year-end. (11)

Questions 1-9 above are intended to uncover instances in which commingling of assets may occur either due to a failure to (1) transfer title to assets (which should be rectified immediately) or (2) notify lessees and third-party vendors of the change in ownership. Such matters should be corrected as soon as possible. Parties should ascertain whether new lease and/or service agreements are required for the transferred property.

A partner's use of FLP assets as collateral for his or her debts and/or the mere identification of such assets as his or her personal assets (in obtaining a loan, etc.) may indicate an implied understanding. The tax adviser should make inquiries of the general partner and suggest appropriate action (if necessary).

Accounting entries: In Harper, a CPA made journal entries to segregate the decedent's personal expenses paid by the FLP. The courts dismissed the entries as "after-the-fact paperwork by decedent's CPA" that was insufficient to undo the damage caused by commingling funds.

In Strangi, distributions were initially classified as advances to the partner receiving them, and later closed out as distributions with pro rata payments made to the other partners. The Tax Court dismissed such classifications as "accounting manipulations."

Mere accounting entries reclassifying transactions after the fact may not be sufficient to undo commingling of funds. Thus, the CPA must advise the client to avoid entering into transactions that commingle funds.

B. Questions 11-18: Distributions

Distributions must be made within the parameters of the FLP agreement. In Strangi, disproportionate distributions to the decedent--even though allowed by the agreement--indicated that "those involved understood that the decedent's assets would be made available as needs materialized." In that case, distributions were made to cover nursing expenses, estate administration expenses and estate and inheritance taxes.

In Harper, approximately $230,000 was distributed to the decedent, while $13,000 was distributed to other partners in the same period. In addition, the frequency of the distributions suggested that they were made contemporaneously with the personal expenses of the decedent and his estate (including the estate taxes due).

There is no bright-line prohibition against making disproportionate distributions (if authorized by the FLP agreement). However, if such distributions are made, the business reasons for making them and the fiduciary considerations taken into account by the general partner(s) must be documented. Such distributions are compelling evidence of an implied understanding when the decedent had transferred substantially all of his or her assets to a FLP (as in Harper, Reichardt and Strangi) and, thus, was relying on the distributions to meet living expenses.

Reclassifying distributions as advances (or vice versa) at year-end will not change a transaction's characteristics for Sec. 2036 purposes.

An additional issue that has ignited tremendous controversy is the holding in Strangi that a FLP's assets could be includible under Sec. 2036(a)(2) (i.e., the decedent retained a power to designate the property's beneficiaries through his position on the corporate general partner's board of directors). While a complete discussion of Strangi is beyond the scope of this item, the court did not state that fiduciary constraints prevent inclusion of assets under Sec. 2036(a)(2).

The court pointed out that the decedent's attorney-in-fact served dual roles on the sole corporate general partner's board--one representing the decedent and one as the entity's manager. The FLP agreement provided that the general partner, whose sole manager was the decedent's attorney-in-fact, could make disproportionate distributions. The corporation's bylaws provided that two votes were sufficient to declare dividends (and the decedent's attorney-in-fact held two votes, due to his dual roles). This produced potential access to the funds that differed from that in Byrum, (12) the seminal case in this area. (In Byrum, the decedent's control over transferred stock did not warrant inclusion of the stock value in his estate.) The court noted that following Byrum in Strangi would "ignore[s] factual realities," as the "facts of this case belie the existence of any genuine fiduciary impediments to decedent's rights." Arguably, the fallout from Byrum is not as extensive as many estate planners feared.

C. Questions 19-23: Personal Use of property

Personal use of property transferred by the transferor without paying rent to the FLP is a clear indication of an implied understanding. (13) Even if rent is being charged, the FLP's mere accrual and reporting of rental income does not refute a finding of an implied agreement. In Strangi, the court dismissed the accrual of rent as evidence refuting an implied agreement, because the accrued rent was not paid for two years, an event inconsistent with arm's-length residential leases.

Written contracts must be executed and the terms strictly adhered to. It is easy to make inadvertent slips in this area. For example, a partner may write a rent check only once every few months, the rent amount may not be renegotiated at the end of the lease (to ensure that it is fair market), etc.

D. Questions 24-26: Compliance with Legal Requirements

In Harper, the court noted many examples of "indifference by those involved toward the formal structure of the FLP agreement and, as a corollary toward the degree of separation that the agreement facially purports to establish." The tax adviser would be well advised to ensure that the formalities required under the agreement and state law are followed.

E. Questions 27-29: Involvement of Partners Other than Transferor

In Schauerhamer, the court noted that the decedent's children, who also served as general partners, testified that they were aware of the commingling of funds and took no action. In Reichardt, the decedent's children, who served as the co-trustees of the trust that was the FLP's general partner, did not participate in the FLP's administration (document execution, asset management, etc.) in any meaningful way. In Harper, the general partner testified that the decedent made all decisions as to the creation of the FLP's structure and subsequent modifications. The courts have found a lack of involvement suggests that the decedent's relation to his or her assets did not change in any meaningful fashion after the transfer.

Thus, it is very important that FLP decisions be made in consultation with the partners authorized to make such decisions. Even partners who are affected by such decisions should be informed when appropriate. Annual meetings to discuss investment strategy, amount and timing of distributions and other matters should be recommended (and discussions from such meetings documented).

(1) Est. of Dorothy Morganson Schauerhamer, TC Memo 1997-242.

(2) Est. of Charles E. Reichardt, 114 TC 144 (2000).

(3) Est. of Morton B. Harper, TC Memo 2002-121.

(4) Est. of Albert Strangi, TC Memo 2003-145, appeal pending to the Fifth Circuit.

(5) In this item, "FLP" also refers to a limited liability company; in general, the discussion applies to both types of entities.

(6) See Est. of Schauerhamer, note 1 supra. An analysis of the decisions in notes 1-4, supra, produces a list of facts and circumstances that show all implied understanding to retain economic benefit.

(7) For an excellent discussion, see Mulligan, "Courts Err in Applying Section 2036(a) to Limited Partnerships," 30 ETPL 486 (October 2003).

(8) Est. of Eugene E. Stone III, TC Memo 2003-309.

(9) The Fifth Circuit's rulings are critical, because a disproportionately high number of FLPs are formed within its geographic jurisdiction (due to its previous taxpayer-friendly rulings on FLP issues). In addition, its much-awaited ruling in Est. of Strangi, note 4 supra, may make it the first appeals court to weigh in on the issue.

(10) In Est. of Harper, note 3 supra, the Tax Court noted that commingling of funds is the "most heavily relied upon" factor in Est. of Reichardt, note 2 supra, and Est. of Schauerhamer, note 1 supra.

(11) See the discussion in the Appendix, under "Accounting entries," on the effect of reclassifying entries,

(12) Marian A. Byrum, 408 US 125 (1972).

(13) See Est. of Reichardt, note 2 supra.

Vinu Satchit, CPA, BDO Seidman LLP, High Point, NC, and Chair, AICPA Tax Division's Trust, Estate, and Gift Tax Technical Resource Panel's FLP Operations Checklist Working Group