Sec. 2036 and FLPs.

At the University of Miami's Heckerling Institute's annual conference on estate planning, held earlier this year, Mary Lou Edelstein, the IRS National Coordinator for Family Limited Partnership Appeals, emphasized that the IRS has coordinated all family limited partnership (FLP) discount cases at the Office of Appeals level and will actively seek to determine whether a FLP's underlying assets are includible in a transferor's estate under Sec. 2036(a), without a discount. Ms. Edelstein noted some red flags, including whether (1) the parties respected the technical formalities of a FLP in its creation and operation, (2) the transferor used personal assets (e.g., his or her residence) to fund the FLP and (3) the transferor retained sufficient assets to maintain a reasonable standard of living, without having to rely on the FLP'S assets.

Valuation Discounts

FLPs are a mainstay of estate and succession planning, to manage and preserve wealth within a family and to pass family assets to a younger generation at reduced values for transfer tax purposes. Typically, in such arrangements, wealthy individuals contribute various assets (e.g., businesses, real estate and marketable securities) to a partnership formed with their children and receive partnership interests in exchange. Later, the parents often gift some or all of the limited partner (LP) interests to their children, while retaining the general partner (GP) interests (which frequently can be as low as 1%).

Although the children may end up with a majority (or greater) interest in the FLP, control over the FLP's assets remains in the parents' hands because the parents retain the GP interests. In gifting LP interests rather than the underlying assets, the parents take advantage of valuation discounts (historically 30%-40%), which, in effect, enable them to transfer their assets from their estate to their children at significantly reduced values for gift tax purposes. The parents gain because the value of the LP interest may be less than its proportionate share of the underlying partnership assets. This is based on the LP'S lack of control and marketability, because of its inability to reach the FLP'S capital and profits and the inability to unilaterally sell such an interest.

The IRS, in seeking to eliminate (or at least reduce) valuation discounts claimed on gifts of LP interests, has put forth various arguments. Some are based on general tax concepts like the business-purpose doctrine, step-transaction doctrine or gift-on-creation of the FLP; others are based on Secs. 2703 and 2704. For the most part, the IRS has been unsuccessful, as the Tax Court and other courts have typically sided with the taxpayers; see, e.g., Jones Est., 116 TC 121 (2001), Knight, 115 TC 506 (2000), Church, DC TX, 1/18/00, Kerr, 113 TC 449 (1999) and Est. of Strangi, 293 F3d 279 (5th Cir. 2002). Recently, however, two cases suggest that the IRS may be changing its tactics and using a more powerful argument.

Sec. 2036

Instead of focusing on the values that taxpayers report on their gifts of FLP interests, the Service is now seeking to include, via Sec. 2036(a), a FLP'S underlying assets in the estate of the contributing taxpayer. Under this section, the decedent's gross estate includes any property that he or she transferred during his or her life (except when the transfer was "a bona fide sale for an adequate and full consideration"), in which, at the time of death, he or she retained "(1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right ... to designate the persons who shall possess or enjoy the property or the income therefrom."

In Estate of Grace, 395 US 316, 320 (1969), the Supreme Court suggested that Sec. 2036(a)'s primary purpose is "to include in a decedent's gross estate transfers that are essentially testamentary--i.e., transfers which leave the transferor a significant interest in or control over the property transferred during his lifetime." Sec. 2036(a) is designed to put back into a decedent's estate transfers in which nothing has really changed for the taxpayer, and he or she may be simply trying to avoid hefty estate taxes at death.

Est. of Thompson. The first development suggesting that the IRS's changed its approach was Est. of Thompson, TC Memo 2002-246, in which the decedent had formed two FLPs, one with his son, the other with his daughter. There had been an implied agreement among the family members that the decedent would continue to benefit from and enjoy the property he had contributed. Thus, the court found that, under Sec. 2036(a)(1), the date-of-death values of all of the assets the taxpayer had contributed to the FLPs (approximately two years before his death) were includible in his estate.

The court also rejected the estate's argument that the decedent's original contribution to the FLPs in exchange for LP interests was a bona fide sale for adequate and full consideration that avoided the Sec. 2036(a)(1) inclusion. The court said that the decedent's receipt of LP interests was merely a "recycling of value" (i.e., a mere change in the form of ownership of the contributed assets), because the contributions had no legitimate business purpose.

Thompson follows on the heels of Est. of Harper, TC Memo 2002-121 (and its predecessors, Est. of Reichardt 114 TC 144 (2002), and Est. of Schauerhamer, TC Memo 1997-242), which also found that assets contributed to a FLP were includible in a decedent's estate under Sec. 2036(a)(1). (For more details on Harper, see Pannese, Tax Clinic,"Tax Court Upholds FLP Disallowance, TTA, October 2002, p. 628, and on Harper and Thompson, see Holtz, Personal Financial Planning, "FLP Issues and Opportunities," p. 223, this issue). However, Thompson is significant because its facts do not portray the same degree of shoddiness apparent in the other cases (i.e., partners not respecting the partnership form, late filing of an LP certificate, commingling personal and partnership funds, significantly disproportionate distributions, etc.) How little has to go wrong with a FLP before the Tax Court finds for estate inclusion under Sec. 2036(a)(1) remains to be seen. At a minimum, Thompson suggests that taxpayers would be wise to retain enough assets for sufficient support (as well as for gifts, if applicable) for a significant period of time.

Est. of Strangi. The second development suggesting that Sec. 2036(a) is the IRS's new approach is the Fifth Circuit's recent remand of Est. of Strangi (now called Gulig), with instructions to the Tax Court to consider the case in light of that provision. In Strangi, two months before he died, the decedent, through his son-in-law (who was authorized to act as his attorney-in-fact), formed a FLP in which he contributed substantial assets for a 99% LP interest and a 47% interest in the 1% corporate GP. The decedent's children contributed their own funds for the other 53% interest in the 1% GP. The partners then unanimously agreed to have the decedent's attorney-in-fact handle all matters as to the operation of the FLP and the GP.

In its original decision, the Tax Court (115 TC 478 (2000)) sided with the taxpayer as to all of the IRS claims, suggesting only that the IRS should have raised the Sec. 2036(a) issue. It said, "the actual control exercised by [the decedent's attorney-in-fact], combined with the 99-percent limited partnership interest in [the FLP] and the 47-percent interest in [the corporate GP], suggest the possibility of including the property transferred to the partnership in decedent's estate under section 2036."

The Tax Court may have been considering Sec. 2036(a)(2) as a means of including the FLP assets in the decedent's estate, see Hellwig, "Estate of Strangi, Section 2036, and the Continuing Relevance of Byrum," 96 Tax Notes 1259 (8/26/02). Specifically, Sec. 2036(a)(2) provides for inclusion of any property in a decedent's gross estate that he or she transferred during his or her life, in which, at the time of death, the decedent retained "the right ... to designate the persons who shall possess or enjoy the property or the in. come therefrom." On remand, the court may find that the decedent's voting rights, coupled with the attorney-in-fact (deemed as acting on his behalf), retained "the right ... to designate the persons who shall ... enjoy the property" of the FLP and, thus, may rule for including such property in the estate under Sec. 2036(a)(2). Alternatively, the court may find inclusion under Sec. 2036(a)(1), as it did in Thompson.

If, in "Round 2" of Strangi, the court accepts Sec. 2036(a)(2), that could mean that a parent setting up a FLP should avoid any ownership in the GP interest (even a minority indirect interest).

Conclusion

The IRS is currently focusing much of its efforts based on its victory in Thompson (and its predecessors) and its hoped-for victory in Strangi, now that the Tax Court is reconsidering that case.

FROM IRA C. OLSHIN, CPA, J.D., LL.M., NEW YORK, NY