FLPs v. Tax Courts: Bongard case highlights Family Limited Partnership challenges.

The IRS has challenged family limited partnerships on a number of grounds, without much success, in recent years.

Recent cases against FLPs rely on violations under Sec. 2036(a), where the IRS disputed the unchanging relationship between the donor and the assets transferred to the FLP.

But a recent ruling in Bongard v. Commissioner, (124 TC No. 8), provides an analysis of the Tax Court's interpretation of Sec. 2036(a) and its applicability in establishing an FLP.

Past IRS Scrutiny

Many early FLP challenges focused on the applicability of restrictions on control and transfer of interests within the partnership agreement. These restrictions are what appraisers rely on to support valuation discounts.

Most notable was the IRS use of Sec. 2704(b) and Reg. 25.2704-2(a) in challenging the validity of FLPs. The 5th Circuit Court's decision in Kerr v. Commissioner, (292 F.3d 490, 89 AFTR 2d 2002-2838), helped dissuade the IRS from continuing on this path.

Another avenue the IRS has tried with some success focused on the annual gift tax exclusion under Sec. 2503(a) and whether a gift of a partnership interest is itself entitled to the benefit of the annual gift tax exclusion.

In Hackel v. Commissioner, [118 TC 279 (2002)], the IRS argued that a gift of a partnership interest is not really a transfer of (present) value since it is subject to restrictions on transferability and is reliant on the general partner for income distributions.

The IRS was successful, but the win did not hinder the will of advisers. While the case is being appealed, planners must consider its implications and structure partnership agreements accordingly.

The Evolving Sec. 2036 Challenge

In certain instances, where a taxpayer retains the right to the assets subsequent to the transfer, the IRS has argued that their full value should be included in the donor's estate. Early cases where the IRS had success using Sec. 2036(a) include Reichardt v. Commissioner, [114 TC 144 (2000)], and Strangi v. Commissioner [115 TC 478 (2000)].

Raising the Bar

Cases subsequent to Reichardt and Strangi have gone one step further. Recent rulings describe the need for a legitimate (non-tax) business purpose for the partnership, such as management expertise, security and preservation of assets, and avoidance of personal liability.

The Bongard Case

Wayne C. Bongard, a successful business owner, died in 1998. His estate's 706, filed Feb. 15, 2000, reported that the federal estate tax owed was $17,004,363. A notice of deficiency totalling $52,878,785 was issued Feb. 4, 2003.

In 1980, Bongard started Empak, a Minnesota corporation. Bongard was the company's sole shareholder until a few years later, when he transferred a number of shares to an irrevocable trust for the benefit of his children.

The business flourished and Bongard's advisers began preparing the company for a potential liquidity event, either through a public or private offering. In 1996, Bongard and his children's trust exchanged their stock in Empak for Class A (voting) and Class B (non-voting) member interest in WCB Holdings, a Minnesota LLC. After the exchange, Bongard and the trust owned the same proportionate interest in WCB as they did in Empak (86.39 percent and 13.61 percent).

In Bongard, the IRS argued that this was not an arm's-length transaction since one could not occur between related parties. Upon analysis, the Tax Court ruled against the IRS in its contention that the transfer to WCB was not a bona fide sale for adequate and full consideration.

Later in 1996, the Bongard Family Limited Partnership was formed, whereby Bongard and the children's trust transferred their Class B member interest in WCB to the FLP in exchange for partnership interests. The exchange left Bongard with a 99 percent LP interest and the trust with a 1 percent GP interest. In a letter to his children, Bongard expressed his reasons for forming the FLP, including concern for asset protection and tax benefits.

A year later, Bongard gifted his wife a 7.72 percent LP interest. The court noted, "This was the sole transfer of the FLP during its existence and that the FLP never diversified its assets during the decedent's life, never had an investment plan, and never functioned as a business enterprise or otherwise engaged in any meaningful economic activity. Additionally, the FLP did not perform a management function for the assets it received and never engaged in any businesslike transactions."

The Tax Court concluded that the record did not support any non-tax reasons for the FLP's existence. The court disregarded the formation of the FLP and the value of its underlying assets (the WCB Class B member interest) was included in the gross estate of the decedent under Sec. 2036(a). Also, any value apportioned in the gift to his wife was brought back into the estate using the three-year rule under Sec. 2035(a).

Careful Planning is Key

FLPs continue to be legitimate planning devices as long as attention is paid to recent rulings interpreting how the partnerships should be structured and managed.

By Philip R. Lieberman, CPA 

Philip R. Lieberman CPA/ABV, ASA is a director of valuation services at Long Beach-based Windes & McClaughry, A/C, and a member of the CalCPA Estate Planning Committee. You can reach him at [e-mail]. For more information on the Estate Planning Committee, visit www.calcpa.org/estate.