FLP transfers were bona fide.

A's son E is the executor of her estate. In the years prior to her death, A transferred a large portion of her estate in a series of transactions to three entities:

1. A revocable living trust (T) created by A and administered by A and E as co-trustees.

2. A limited liability company (LLC), formed by A, E and his wife. T contributed $20,000 for a 50% interest. E and his wife each contributed $10,000 for 25% interests each.

3. A limited partnership (ALP) formed by T and the LLC. T contributed approximately $2.5 million in cash, oil and gas working interests and royalty interests, securities, notes and other assets, for a 99% pro-rata limited partner interest. The LLC contributed approximately $25,000 in cash for a 1% pro-rata general partner interest.

As a result of these transfers, A owned 99.5% of the partnership through the trust and the LLC. A retained over $450,000 in assets outside of the LLC and the partnership for her personal expenses.

The Estate Tax Return

At the time of A's death, the value of ALP partnership assets was approximately $2.4 million. On the return, the estate claimed a 49% discount on the value of A's ALP and LLC interests for lack of control and lack of marketability of the partnership interest. It reported her 99% partnership interest as having a fair market value (FMV) of approximately $1.2 million and her 50% interest in the LLC as having an FMV of approximately $17,000.

The IRS found that the value of the assets transferred to ALP and the LLC, rather than A's interest in these entities, was includible in the gross estate under Sec. 2036(a). The district court agreed; the estate appealed.

Analysis

Whether A's assets transferred to ALP must be recaptured into her estate for estate tax purposes depends on the application of Sec. 2036(a).That section prevents the circumvention of Federal estate tax by the use of inter vivos transactions, which do not remove the lifetime enjoyment of property purportedly transferred by a decedent. It provides two exceptions: first, it does not apply if the transfer is a bona fide sale for full and adequate consideration. The second exception applies if the decedent did not retain either the (1) possession, enjoyment or right to the transferred property or (2) the right to designate the persons who would possess or enjoy the transferred property.

Bona Fide Sale

The only case addressing the exception for a bona fide sale for full and adequate consideration in the Fifth Circuit, and the only circuit court case cited on this point, is Wheeler, 116 F3d 749 (5th Cir. 1997). The Wheeler court concluded that adequate and full consideration requires only that the sale not deplete the gross estate. Wheeler also defines the requirements of a bona fide sale and requires a court to inquire beyond the form of a transaction between family members to determine whether the substance justified the claimed tax treatment. However, just because a transaction takes place between family members does not impose an additional requirement not set forth in the statute--a transaction that is a bona fide sale between strangers must also be bona fide between members of the same family. In addition, the absence of negotiations between family members over price or terms is not a compelling factor in a determination as to whether a sale is bona fide, particularly when the exchange value is set by objective factors.

A transaction is a bona fide sale if it is made in good faith (Regs. Secs. 20.2036-1(a) and 20.2043-1(a)). 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)." (Black's Law Dictionary (West Publishing Co., 5th ed. 1979), p. 161). Bona fide is defined as "in or with good faith; honestly, openly, and sincerely; without deceit or fraud" and "[r]eal, actual, genuine, and not feigned. "When examining transaction to determine whether it is real, actual, genuine and not feigned, the court is constrained by objective factors.

Other cases: In Est. of Eugene Stone, TC Memo 2003-309, assets transferred to several family limited partnerships (FLPs) were going-concern businesses operated for a profit. The FLPs were formed for two main reasons: as a means to currently transfer management of the parents' estates to the children, who as general managers of the partnerships began to actively manage them; and to settle disputes among the children related to the businesses' operation. The decedents retained enough assets to maintain their standard of living. The Tax Court concluded that these transfers were bona fide sales for adequate and full consideration.

Other cases relied on by the IRS have as a common element in concluding, "[w]hen a family partnership is only a vehicle for changing the form in which the decedent held his property--a mere "recycling of value"--the decedent's receipt of a partnership interest in exchange for his testamentary assets" does not qualify as a bona fide sale for adequate and full consideration, because the transfer was only a paper transaction and without substance; see Est. of Thompson, TC Memo 2002-46, Est. of Harper, TC Memo 2002-121, and Est. of Strangi, TC Memo 2003 145. However, even these cases recognize that FLPs can qualify for this exception if the transaction includes elements that indicate the exchange was more than a sham or a disguised gift.

Test: The proper focus on whether a transfer to a partnership is for adequate aid full consideration is whether: (1) the interests credited to each of the partners was proportionate to the FMV of the assets each partner contributed to the partnership, (2) the assets contributed by each partner to the partnership were properly credited to the partner's respective capital accounts and (3) on termination or dissolution of the partnership, the partners were entitled to distributions from the partnership equal to their respective capital accounts. The answer to each of these questions in this case is "yes." Thus, the transaction was for adequate and full consideration.

Also, the taxpayer established the following objective facts (uncontroverted by the IRS) that support the position that the transfer to the partnership was a bona fide sale:

* A retained sufficient assets outside the ALP partnership for her own support without commingling partnership and personal assets.

* Partnership formalities were satisfied and the assets contributed to the partnership were actually assigned to it.

* The assets contributed to the partnership included working interests in oil and gas properties, which require active management. At formation, $438,000 of approximately $2.5 million in assets were oil and gas properties; approximately 71% of the oil and gas interests were working interests.

* E and A's business adviser advanced several credible and unchallenged nontax business reasons for the formation of the partnership that could not be accomplished via the living trust.

A's transfer to the partnership thus qualifies as a bona fide sale for adequate and full consideration, so as to remove the assets transferred to the partnership from the estate.

Retained Interest

Transfers are recaptured into an estate of a decedent who retained the possession, enjoyment or right to income from the transferred property or retained the right to designate who could possess, enjoy or receive income (See. 2036(a)(1) and (2)). A retained interest can be present in the form of control over the entity that is the recipient of the assets transferred (Est. of Strangi). The district court concluded that Sec. 2036(a) was applicable to A's 50% interest in the LLC, including her indirect 0.5% interest in the partnership assets resulting from the LLC's ownership of the 1% general partner interest. However, even if the transfer did not constitute a bona fide sale for full and adequate consideration, A did not retain sufficient control of the assets transferred to the LLC to make her transfer subject to Sec. 2036(a). She had only a 50% interest and her son had sole management powers over the LLC. Thus, A did not retain the right to enjoy or designate who would enjoy the LLC property.

DAVID KIMBELL, 5TH CIR., 5/20/04