FLP planning after Strangi, Kimbell and Thompson.

EXECUTIVE SUMMARY

* Since Byrum, the use of FLPs to transfer enormous amounts of wealth at minimal estate and gift tax costs has become a popular estate planning tool; the IRS has started to vigorously litigate eases it perceives as being highly abusive.

* Partnership agreements should be reviewed on a regular basis to ensure that their provisions conform to current Federal and state statutes.

* CPA financial planners should compute the amount of assets needed to be held outside the FLP, as well as the nontax financial benefits received by transferring assets to it.

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While tax advisers cheered the Fifth Circuit's pro-taxpayer decision on family limited partnerships in Kimbell, they are holding their collective breath far that court's decision in Strangi, and working to avoid another Thompson decision.

This article discusses these cases, their importance, the practitioner community's response and actions to take while awaiting the results of the Strangi settlement.

A transfer to a family limited partnership (FLP) is an example of an estate planning technique that has drawn the IRS's scrutiny. This article examines this strategy as it relates to retained rights under Sec. 2036(a)(1) and (2).

Transfers with Retained Life Estate

Sec. 2036(a), the general rule under Sec. 2036, Transfers with Retained Life Estate, provides:

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 or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death--

(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 the income therefrom. (Emphasis added.)

Generally, the bona fide sale exception (the parenthetical language in Sec. 2036(a)) bars inclusion in the gross estate. Transfers that fall under this exception are exempt from Sec. 2036's application. However, to qualify, a two-prong test must he met; the transfer must be:

1. For adequate and full consideration; and

2. Bona fide.

Cases

Byrum

In 1972, the Supreme Court issued Byrum, (1) a landmark decision involving retained rights under Sec. 2036. The Court focused on the fiduciary duties of a majority shareholder and director; it concluded that Sec. 2036(a)(2) only reached those rights for which the decedent controlled beneficial enjoyment, and which were legally enforceable under state law. Since then, FLPs have become a popular estate planning tool to transfer enormous wealth at minimal estate and gift tax costs (after valuation discounts). As a result, the IRS now vigorously litigates FLP cases it perceives as being highly abusive.

Strangi

The IRS enjoyed a recent victory on retained rights in Est. of Strangi, (2) a decision on remand from the Fifth Circuit, which is currently being appealed by the taxpayer to the Fifth Circuit. Strangi is probably one of the more noteworthy cases to be decided thus far in the retained rights realm.

On remand, the Tax Court held that the decedent retained sufficient beneficial enjoyment of a FLP's assets so as to cause inclusion in his estate under Sec. 2036(a)(1). Further, the court held that the assets could have been included under Sec. 2036(a)(2), because the decedent, through his attorney-in-fact, reserved control over beneficial enjoyment. The FLP's corporate general partner, who was managed by the decedent's attorney-in-fact, had complete control over distributions. The Tax Court concluded that the decedent's ability to control FLP distributions and to join with the other partners to cause a partnership liquidation, constituted sufficient control to cause inclusion of the assets in his gross estate under Sec. 2036(a)(2). This so-called "alternative ruling" in the IRS's favor, holding that the decedent's interests were includible via Sec. 2036(a)(2), was particularly intriguing.

Kimbell

Following closely behind Strangi was the Fifth Circuit's decision in Kimbell, (3) rendered on May 20, 2004. The court vacated a district court's holding that the decedent's transfer to a partnership was not a bona fide sale for adequate and full consideration. The Fifth Circuit also vacated the district court's grant of partial summary judgment as to whether the decedent retained an interest in property transferred to her limited liability company (LLC); it remanded the case for a determination on whether the decedent's interest in the partnership was an assignee or a limited partnership (LP) interest.

Facts: In the months immediately preceding her death, Ruth A. Kimbell entered into a series of transactions to reduce her taxable estate. First, in January 1998, she created the R.A. Kimbell Management Co., L.L.C. (RALLC). The R.A. Kimbell Living Trust (a revocable trust created in 1991 and administered by Kimbell and her son, David, as co-trustees) transferred $20,000 for a 50% interest in RALLC. David and his wife each contributed $10,000 for 25% interests. David, as RALLC's managing member, had sole managerial responsibility for its activities. In late January 1998, RALLC and the trust created R.A. Kimbell Property Co., Ltd., a FLP. RALLC transferred $25,000 to the FLP for a 1% pro-rata general partnership (GP) interest, while the trust transferred $2.5 million in cash, working interests in oil and gas ventures and other assets, for a 99% LP interest. As general partner, RALLC managed the FLP's day-to-day affairs and had exclusive authority to make distributions.

Ruth Kimbell died on March 25, 1998. At death, she effectively owned 99.5% of the FLP (through her 99% LP interest and 50% interest in the 1% GP interest). The estate claimed a 49% discount on the value of her FLP and LLC interests. On audit, the IRS adjusted her gross estate to include the FLP interests in proportion to the full fair market value (FMV) of the underlying assets. According to the Service, the transfer was not for adequate and full consideration; thus, it was subject to inclusion in the decedent's gross estate under Sec. 2036(a).

District court's holding: The district court agreed with the IRS and ruled that the decedent's transfer to the partnership was not a bona fide sale for adequate and full consideration under Sec. 2036(a); because family members were involved, the transaction could not have been at arm's length. In making this determination, the court relied on the definition of arm's-length transaction provided in Black's Law Dictionary (4)--a transaction involving two parties who are not related or not on close terms. (Emphasis added.)

Fifth Circuit's decision: On appeal, the Fifth Circuit disagreed, holding that the district court's logic would, in effect, ignore the Sec. 2036 bona fide sale exception whenever family assets were transferred to an entity for an interest proportionate to their FMV and discounts were applied.

The court also noted that the IRS had ignored the following objective tests, each of which supported the fact that the transfer to the FLP constituted a bona fide sale:

* The decedent retained sufficient assets outside of the partnership to support herself;

* Personal and partnership assets were not commingled;

* All formalities were followed and the contributed assets were actually transferred to the partnership;

* The contributed assets included oil and gas working interests that required active management; and

* There were valid nontax reasons for the transfer, such as legal protection from creditors, preservation of capital, reduction in administrative costs and continuity of management.

Because the Fifth Circuit found that the partnership assets qualified for exclusion from the estate under the bona fide sale exception, it did not address the IRS's Sec. 2036(a) retained rights argument. However, the court did address that argument in the context of the assets the decedent had transferred to the LLC. It ruled that, even if the transfer did not meet the bona fide sale exception, the decedent did not retain sufficient control of the assets she transferred to the LLC. Thus, the assets transferred to the LLC were not subject to estate tax inclusion under Sec. 2036(a).

Importantly, in assessing the bona fide nature of the exchange, the Fifth Circuit was not disturbed by the fact that the decedent surrendered control over much of her property by taking back only LP interests.

Open Issues

There is no question that Kimbell is a big win for taxpayers, particularly those in the FiFth Circuit. However, Strangi is also still viable. Several key questions need to be answered before the planning community can once again feel comfortable about advising clients as to the benefits of a FLP:

1. Was the alternative ruling in Strangi a misinterpretation of Congressional intent as enacted in Sec. 2036(a)?

2. What is the meaning of a "right" in Sec. 2036(a)?

3. Does a dissolution power that requires the consent of all partners fall within Sec. 2036(a)(2)?

4. Does a valid and enforceable fiduciary duty limitation preclude inclusion under Sec. 2036 when there are no unrelated parties?

As is discussed below, these issues were addressed in an amicus curiae brief filed in Strangi by the American College of Trust and Estate Counsel (College).

Amicus Curiae Brief

Overview

In July 2004, the College filed a Brief for Amicus Curiae (5) with the Fifth Circuit, to request the court's permission to participate in oral arguments in the Strangi appeal. The College is a professional organization of lawyers recognized as leading experts in probate, trust and estate planning. The briefs filing is of particular significance, because the College only takes such steps when it feels that established legal standards are being compromised or judicially abused. This move is a signal to the Fifth Circuit of the importance of the Strangi appeal to taxpayers and the estate/financial planning community. The College believes that if the ruling is not overturned, it will have a deleterious effect on all taxpayers who, in good faith and on the basis of established legal precedents, have created FLPs as important parts of their overall estate plans.

Position

According to the College, the Fifth Circuit extended the reach of Sec. 2036(a)(2) far beyond its legislative intent. Because the Kimbell court did not address this issue, the question remains--what type of power rises to the level of a "right" in Sec. 2036(a)(2)?

In Byrum, the Court found the terms "enjoy" and "enjoyment" to connote substantial present economic benefit. It concluded that any power to liquidate or dissolve--whether alone or in conjunction with others--was purely speculative and should not be construed as a right to control or enjoy property. For a power to rise to the level of a "right" for Sec. 2036(a)(2) purposes, it must be ascertainable and legally enforceable. (6) The Court also found the concept of voting control to be too variable and imprecise to constitute the basis per se for imposing tax liability under Sec. 2036(a). (7) It excluded from the definition of a "right" any power constrained by fiduciary duties.

The College goes to great lengths to support the fiduciary constraints principle laid out in Byrum. It argues that the fiduciary duties owed by partners to each other and to the partnership under state law would, in most cases, prevent the de facto power of the partners, acting in conjunction with each other to dissolve the partnership, from rising to the level of a "right" as required by Sec. 2036(a). (8) The likelihood of whether a partner will or will not exercise a power to dissolve the partnership is a subjective concept and not an appropriate measure of whether a power rises to the level of a "right" within the meaning of the statute. Thus, the controlling standard should be the fiduciary duty limitation read into Sec, 2036(a)(2) by the Court in Byrum. (9) Even the IRS has acknowledged that Byrum imposed a fiduciary duty limitation on Sec. 2036(a)(2)'s applicability. (10) Family relations should have no bearing on the merits of the fiduciary constraint argument, as the courts have repeatedly rejected the government's argument that family members may not enforce fiduciary duties imposed by state law. (11)

The College raises another important point--nothing in Byrum indicates that die Court would have ruled differently had the facts involved an investment entity with related equity members (rather than an actual business with unrelated shareholders). The College argues that whether or not there is an actual business and unrelated minority shareholders, the fiduciary duties imposed under state law are the same and the same legal standards should apply. (12)

Thompson

On Sept. 1, 2004, the Third Circuit affirmed the Tax Court's conclusion in Est. of Thompson (13) that the value of a decedent's estate had to include a pro-rata portion of the value of the assets of two FLPs; under Sec. 2036. The court determined that the decedent's 1993 transfers of assets to the FLPs were not bona fide sales for full and adequate consideration, because the entities conducted no legitimate business operations and provided the transferor with no potential nontax benefits. The Third Circuit could see "no clear error in the Tax Court's finding of an implied agreement between decedent and his family that decedent would continue ... to be the principal economic beneficiary of the contributed property' and retain enjoyment of the transferred property sufficient to trigger 2036(a)(1) [section]."

Facts

In April 1993, Theodore R. Thompson, then age 95, and his family formed two FLPs, and two corporations to serve as general partners. The FLPs were created as part of a package promoted by Fortress Financial Group, Inc., which touted the following advantages: (1) lowering the taxable value of the estate, (2) maximizing the preservation of assets, (3) reducing income taxes and (4) facilitating family and charitable giving.

The decedent transferred approximately 95% of his assets to the FLPs, retaining only $153,000 in assets to live on. The court determined that he did not keep sufficient assets to cover his living expenses for his actuarial life expectancy of 4.1 years at the time of transfer. The decedent's son and son-in-law each contributed real property and/or marketable securities to one of the FLPs in exchange for their respective interests. Both FLPs' assets consisted primarily of marketable securities, which they continued to hold with minimal post-transfer trading.

Thompson died on May 15, 1995; on his Federal estate tax return, his estate calculated the values of his interests in the corporations and FLPs by applying a 40% discount rate for lack of control and marketability.

The IRS claimed that a pro-rata part of each of the FLPs' assets should be included in the estate, with no discount. It argued that the FLPs should be disregarded for lack of economic substance and business purpose, and that the assets (not just the retained FLP interests) had to be included in the estate under Sec. 2036(a)(1).

Tax Court's Ruling

While the Tax Court held that the FLPs were validly formed and properly recognized for Federal estate tax purposes, it sustained the application of Sec. 2036(a)(1) to include the value of the transferred assets in the estate. The court found that an implied agreement existed under which the decedent would retain lifetime enjoyment and economic benefit of the transferred assets. It also concluded that the transfer was not exempt from Sec. 2036(a) as a bona fide sale for adequate and full consideration, because the FLPs were only a vehicle for changing the form in which the decedent held his property. The receipt of a partnership interest in exchange for his assets was not full and adequate consideration under Sec. 2036.

Third Circuit's Decision

On appeal, the Third Circuit affirmed the Tax Court's finding of an implied agreement for the decedent to retain enjoyment of the transferred property, and noted that the decedent's de jure lack of control over the transferred property did not defeat the inference of such agreement. Although the decedent could not withdraw funds from the FLPs without the consent of the corporate general partners (which were directed by his children), the estate conceded and the children testified that they would not have refused their father's distribution requests.

The court also agreed that there was no transfer for consideration under Sec. 2036(a). It noted (1) the FLPs did not engage in a valid business enterprise; (2) the primary reason for forming them was not to engage in or acquire active trades or business; and (3) although they engaged in some economic activities, those activities did not "rise to the level of legitimate business operations." Additionally, the court pointed out that the form of the transferred assets--marketable securities--supported its conclusion that there was no transfer for consideration. The court found that "[o]ther than 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."

Implications

The Strangi, Kimbell and Thompson cases provide guidance for taxpayers who are considering using FLPs in their financial and estate planning. It is clear from these cases that a FLP creator should not transfer so much of his or her assets to raise the question whether there is an implied agreement for the transferor to have access to the assets. CPA financial planners can play a critical role ira determining and documenting an individual's cashflow needs for his or her remaining life expectancy.

Tax advisers must also consider the Sec. 2036(a) bona fide sale exception. under Regs. Sec. 20.2043-1 (a), a transaction is a bona fide sale if made in good faith. Black's Law Dictionary defines a bona fide sale as "[a] completed transaction in which seller makes sale in good faith, for a valuable consideration, without notice of any reason against the sale." (14) In Kimbell, the Fifth Circuit outlined the following factors it deemed instrumental in determining full and adequate consideration:

1. Whether the interest credited to each partner was proportionate to the FMV of the assets he or she gave up;

2. Whether assets contributed by each partner were properly credited to their capital accounts; and

3. Whether partners were entitled to distributions equal to their capital accounts on partnership termination or dissolution.

In Thompson, the Third Circuit acknowledged that "while a 'bona fide sale' does not necessarily require an 'arm's length transaction,' it still must be made in good faith ... A 'good faith' transfer to a family limited partnership must provide the transferor some potential for benefit other than the potential estate tax advantages that might result from holding assets in the partnership form. Even when all the 'i's are dotted and t's are crossed," a transaction motivated solely by tax planning and with 'no business or corporate purpose' ... is nothing more than a contrivance." (15)

Nontax reasons for establishing a FLP might include, but not be limited to, protection from creditors, consolidation of investment assets for ease of management and reduced administrative cost, management succession and avoidance of family disputes. If, for example, a stated purpose of the FLP is to consolidate the family's investment assets for ease of management and reduced costs, the taxpayer should document this purpose and demonstrate the result. A CPA financial planner should quantify the cost savings and any other investment strategy benefits received as a result of transferring assets to the FLP.

Existing partnerships should also document the nontax reasons for their creation and demonstrate those benefits. In addition, existing FLPs should take immediate action and review their present structure, to determine if they possess any Strangi-like characteristics that could taint their economic viability. The partnership agreement should be reviewed on a regular basis to ensure that its provisions conform to current Federal and state statutes.

Finally, it is imperative that FLPs operate like real businesses, in substance as well as form. Among other things, they should conduct appropriate business activity, keep proper books and records, hold partner meetings, keep minutes and enforce any rights and actions against the partners.

Conclusion

When properly structured and administered, FLPs holding appropriate assets and created for the right reasons (i.e., valid nontax reasons) can provide substantial tax savings. Prudent planning, as well as attention to establishing and maintaining partnership formalities, are critical steps in achieving such savings.

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

(2) Est. of Albert Strangi, TC Memo 2003-145, on rem'd from Rosalie Gulig, 293 F3d 279 (5th Cir. 2000), aff'g in part and rev'g grad rem'g in part 115 TC 478 (2000). In the original appeal, the Fifth Circuit reversed the Tax Court's earlier decision and allowed the IRS to amend its answer to include the Sec. 2036 argument.

(3) David A. Kimbell, Sr., 371 F3d 257 (5th Cir. 2004), vacat'g and rem'g 244 FSupp2d 700 (DC TX 2003).

(4) Black's Law Dictionary (West, 7th ed., 1999), p. 103.

(5) See Brief for Amicus Curiae in Support of Neither Party on Behalf of American College of Trust and Estate Counsel (hereinafter cited as "Brief"), available at www.leim bergservices.com/pdfs/StrangiACTECAmicusCuriaeBrief.pdf.

(6) See Byram, note 1 supra, at 136.

(7) See id. at 138.

(8) See Brief, note 5 supra, at p. 2-3.

(9) See id. at p. 7.

(10) See Rev. Rul. 81-15, 1981-1 CB 457.

(11) See Est. of Charles Gilman, 65 TC 296 (1975), aff'd, 547 F2d 32 (2d Cir. 1976); and Estr of Abraham Cohen, 79 TC 1015 (1982).

(12) See Brief, note 5 supra, at p. 7.

(13) Est. of Theodore R. Thompson, TC Memo 2002-246, aff'd sub nom. Betsy T. Turner, 3d Cir., 9/1/04.

(14) Blade's Law Dictionary (West, 5th ed., 1979), p. 161.

(15) Est. of Thompson, note 13 supra, citing Gregory v. Helvering, 293 US 465, 469 (1932).

Author's note: The authors wish to thank Scott Ferretti, Senior Manager, Ernst & Young LLP, New York, NY, for his assistance in the completion of this article.

Terry Eyberg

Senior Professional

Private Client Services Group

Ernst & Young LLP

New York, NY

Barbara J. Raasch, CPA

Partner

Private Client Services Group

Ernst & Young LLP

New York, NY