FLPs receive boost: Fifth Circuit decision stems the tide of recent taxpayer losses.

The Fifth Circuit reversal in Kimbell v. U.S., Dec. 03-10529 (5/20/04) leaves the IRS bloodied, but unbowed, in its ongoing valuation discount struggle to expand retained interests principles to LLCs and family limited partnerships under IRC Section 2036.

The decision stems the recent tide of taxpayer losses on these issues.

Kimbell Case Background

The Kimbell appeal arose after the District Court granted a summary judgment for the IRS and denied the taxpayer's summary judgment request over the issues of whether or not the transfer of property to an FLP formed two months prior to death, in exchange for partnership interests, was for full and adequate consideration and whether or not the decedent had retained control under IRC Sec. 2036.

Two months prior to her death, Ruth Kimbell created an FLP with her revocable living trust as its 99 percent partner and an LLC as its 1 percent partner. The FLP was owned by the LLC and the decedent's revocable living trust.

Kimbell was the 50 percent owner of the LLC; her son (the petitioner in the case and manager of the LLC) and his wife each owned 25 percent of the balance.

The LLC contributed 1 percent of the capital and was the general partner while the trust contributed 99 percent of the capital. Valuation discounts of 49 percent underscore the case.

The decedent retained about $450,000 in cash outside of the entities. No elements of mismanaging assets, improper treatment of cash flow or failure to transfer assets were present.

IRC Sec. 2036(a) provides that an interest is included in the gross estate of a transferor who retains either the possession or enjoyment of, or the right to income from, the property, or the right, either alone or in conjunction with any person, to designate the persons who shall possess the property, or the income therefrom, unless the transfer was for full and adequate consideration.

What the Court Decided

Applying IRC Sec. 2036, the District Court considered (1) whether or not there was a bona fide sale in the transfer of assets to the partnership controlled by the son; and (2) whether or not an express or implied agreement existed that the decedent would retain the economic benefit of the property.

The District Court, citing Harper v. Comr. 83 T.C.M. 1641, found there was not a bona fide sale in the transfer of assets to the partnership because the sale was between related parties.

The District Court rejected the taxpayer's assertion that the partnership was governed by fiduciary principles. [U.S. v. Byrum 408 US 125 (1972)]. Kimbell forebode the broader anti-Byrum application in Strangi II T.C. Memo. 2003-145.

Fifth Circuit Overturns Decision

The Fifth Circuit reversed on both grounds, vacated the District Court decision, and directed the District Court to consider whether the decedent's interest was an assignee or partnership interest.

The Fifth Circuit applied the business judgment approach to the consideration test when unrelated parties consider entering into a partnership, exchanging the benefit of management and the partnership agreement for reduced freedom and control over their investments.

It rejected the application of a fair market value test. The court ruled that this standard applies in the family context "unless (1) the evidence demonstrates a sham transaction, motivated solely by tax avoidance, or (2) Congress or the courts change long-established law.

The Fifth Circuit found that the partnership was not a facade to "recycle value" and held that the transfer of assets to the partnership was a bona fide sale.

The court noted that the decedent retained sufficient assets outside of the partnership; the partnership formalities were satisfied and the assets were actually assigned to the partnership; the assets contributed to the partnership included working interests in oil and gas properties, which do require active management; and that there were several credible and unchallenged non-tax business reasons for the formation of the FLP that could not be accomplished via the decedent's trust.

Non-tax purposes included increase of family wealth; support of annual gifts without fractionalizing assets; promote family ownership; protect against creditors and divorce interference; support planning not available through a trust; and promote family knowledge of the business.

The court rejected the retained interest application to the FLP because the transfer was within the exception of fair and adequate consideration and refused to impose the retained interest doctrine to the LLC under IRC Sec. 2036(a)(1) and (2) because the decedent did retain sufficient votes or contractual rights to control the LLC.

What it Means

Just as Strangi does not knock out investment FLPs and LLCs (whether formed near death or not), Kimbell does not sanction entity creation near death, without regard to business purpose, in disregard of formalities or with virtually all of the decedent's estate.

The IRS has invested a lot of audit energy to challenging FLP and LLC discounts, and will look for more decisions in other circuits.

In addition, the appeal of Strangi II will be rendered in a few months by the Fifth Circuit. The Kimbell decision includes some language reflecting factual differences between that case and Strangi, but the Fifth Circuit may reign in some of the more overreaching implications of Strangi II, particularly the rejection of fiduciary principles and extension of IRC Sec. 2036(a)(2) in a context that could apply to virtually any group of owners in an entity.

By Keith Schiller, Esq.

Keith Schiller, Esq. is an attorney with the Schiller Law Group in Orinda. His website is www.cpas411.com.