Valuation Services, Inc.
The Internal Revenue Service (the "IRS") won another estate tax case dealing with a family limited partnership ("FLP"). In Estate of Concetta H. Rector (T.C. Memo. 2007-367), the Tax Court held that the assets transferred by Ms. Rector (by way of her trust) to a FLP must be included in her gross estate under Internal Revenue Code Section 2036(a).1 The Tax Court held that she retained the possession or enjoyment of, or the right to the income from, property transferred to the FLP. The Tax Court further ruled that the "bona fide sale for an adequate and full consideration" exception to Section 2036(a) did not apply in this case. Accordingly, no valuation discounts were applicable in valuing Ms. Rector's interest in the FLP as all of the assets transferred by Ms. Rector were included in her gross estate. A full copy of the case can be found at http://www.ustaxcourt.gov/InOpHistoric/rector.TCM.WPD.pdf.
Despite the ramifications of the Tax Court's holding in Estate of Concetta H. Rector, estate tax practitioners and financial advisors should not be discouraged from recommending the use of FLPs as part of a client's estate tax planning strategy. Instead, this case (as well as other cases dealing with Section 2036(a)) underscores the importance of proper upfront planning and maintenance on the part of taxpayers.
As this article will explain, the perceived abuses of using FLPs have been attributable to the taxpayers' failure in properly setting up and maintaining their FLPs in a business-like manner. The Tax Court's rationale in this case should be viewed as a learning tool for planning for, setting up, and operating FLPs. The Rector case, as well as other recent and similar cases, can be used as a road map as to how not to establish and maintain an FLP.
Background on FLPs
The term "Family Limited Partnership" (or FLP), a commonly used term by financial planners or attorneys, refers to a limited partnership formed to hold the family business or investments, with the idea that the parents will make gifts of their limited partnership interests to their children. Because the limited partnership interests are, in theory, illiquid investment assets and the owners of these assets have limited or no control over the business affairs of the FLP, they should be subject to valuation discounts for federal gift and estate tax planning purposes. Although this article discusses the use of limited partnerships, the same concepts and theories may also apply to the use of limited liability companies.
An FLP can be an effective estate planning tool that may (1) help reduce income and transfer taxes, (2) allow taxpayers to transfer an ownership interest to other family members while maintaining some degree of control of the business, (3) help ensure continued family ownership of the business, and (4) provide liability protection for the limited partner(s).
Due to the popularity and the potential abuse of using FLPs as estate planning vehicles, the IRS has relied on different theories to win cases against taxpayers using FLPs purely for tax avoidance reasons.2 In the past several years, the IRS has focused on relying on Section 2036(a) in its assault on FLPs. Such notable cases where the IRS was successful in arguing that the transferred assets in the FLPs should have been included in the decedent's gross estate include Estate of Ida Abraham, T.C. Memo. 2004-39, and Estate of Lea K. Hillgren, T.C. Memo 2004-46, Estate of Strangi, T.C. Memo. 2003-145, Estate of Thompson, T.C. Memo. 2002-246, Estate of Harper, T.C. Memo. 2002-121, Estate of Bongard, 124 T.C. 95 (2005), and Estate of Lillie Rosen, T.C. Memo. 2006-115.
During 2007 alone, the IRS successfully asserted the "retained interest" argument in three cases. In Estate of Hilde E. Erickson,3 two days before an aged mother suffering from advanced Alzheimer's disease died, all of her assets were transferred to an FLP. Soon after that, in Estate of Sylvia Gore4, problems with the timing of transferred assets and improper management of an FLP easily helped the Tax Court shoot down another FLP. Finally, just before the Rector case was decided in late 2007, in Estate of Virginia Bigelow5, a taxpayer again transferred substantially all of her assets and improperly managed the FLP. All of these earlier 2007 cases have very similar facts to that of the Rector case.
In Estate of Concetta H. Rector, as in the earlier 2007 cases, the Tax Court held that the transferred assets in the FLP should have been includible in Ms. Rector's gross estate under Section 2036(a).
Estate of Concetta H. Rector
The decedent, Concetta Rector, was born in 1906 and married John Rector, Sr. She was the beneficiary of a marital trust and a bypass trust funded through his estate in 1975 (the original revocable trust was split into two sub-trusts - Trust A and Trust B). Ms. Rector created a revocable trust in 1991 and transferred all of the Trust A assets to that revocable trust. In 1998, at the age of 92, Ms. Rector became a full-time resident of a convalescent hospital (she died approximately three years later). Around the time that she was admitted to the hospital, Ms. Rector and her sons formed Rector Limited Partnership (the "RLP"). The RLP agreement listed Ms. Rector as a 2% general partner and a 98% limited partner. The RLP was funded with virtually all of her assets (through the revocable trust, Trust A) and held over $8.8 million in liquid investments. The key, important facts regarding the RLP were:
• Decedent and her sons formed the RLP without negotiating the terms of a partnership agreement.
• Decedent formed the FLP at age 92 while a resident of a convalescent hospital.
• Decedent was the only person that contributed assets to the RLP.
• Neither of decedent's sons had separate counsel as to the formation of the RLP or as to the structuring and drafting of the RLP agreement.
• As the general partner, decedent had broad powers of management and control.
• Decedent transferred virtually all of her assets (through the revocable trust) to the RLP.
• The RLP operated without a business plan or an investment strategy, and it did not trade or acquire investments. The RLP also issued no balance sheets, income statements, or other financial statements. Statements of activity and capital accounts were not regularly maintained.
• The RLP's partners did not hold formal meetings.
• The RLP made distributions to its partners, but the distributions made were not based on the ownership percentages of the partners; also a significant portion of the distributions funded the decedent's living expenses and tax liabilities.
• The decedent's annual income from the other trust (irrevocable trust, Trust B) was insufficient to cover decedent's annual expenses.
• The RLP opened a credit line account and borrowed on the credit line to help pay decedent's estate tax liability.
Shortly after forming the RLP, Ms. Rector gave each of her sons (through her revocable trust) an 11.11% limited partner interest in the RLP. Approximately two years later, Ms. Rector assigned her 2% general partner interest to the 1991 revocable trust. On January 4, 2002, Ms. Rector's trust transferred a 2.754% limited partner interest in the RLP to each of her sons. When she passed away, Ms. Rector (through the revocable trust) owned a 70.272% limited partner interest and a 2% general partner interest in the RLP. The estate tax return reported that the fair market value of the 1991 revocable trust (which owned the interest in RLP) was $4,757,325, which reflected a 19% overall valuation discount. The IRS claimed that the assets transferred to the RLP should have been fully includible in the gross estate of Ms. Rector. The Tax Court ruled in favor of the IRS.
The main issue in this case was whether Section 2036(a) would apply so that the fair market value of the underlying assets held by the RLP should have been included in Ms. Rector's gross estate. The Tax Court (Judge Laro) held that Ms. Rector retained the enjoyment and the right to income from the transferred assets held by the RLP. The Tax Court found that the RLP agreement reflected an understanding among Ms. Rector and her sons that she would retain her interest in the transferred assets by virtue of her ability to control those assets. The Tax Court also found that Ms. Rector and her sons agreed implicitly that the transferred assets (and the income produced from those assets) would continue to be used for her economic benefit (by virtue of the fact that she transferred practically all of her wealth to the RLP, the income from Trust B was insufficient to cover her annual living expenses, she never requested that the corpus from Trust B be used for the balance, and everyone understood that the RLP would take care of the deficit).
The Tax Court also held that the transfer of her assets to the RLP in exchange for the entire interest in the RLP was not "a bona fide sale for an adequate and full consideration" within the meaning of Section 2036(a). The Tax Court cited two main reasons for its rationale: (i) the formation of the RLP involved no change in the underlying pool of assets or the likelihood of profit and (ii) the decedent's transfer of the assets to the RLP was not made in "good faith," meaning that it was not made for a legitimate and significant nontax business purpose.
Finally, the Tax Court affirmed that the Section 6662(a) accuracy-related penalty should be applied for failure to include adjusted taxable gifts made by Ms. Rector.
Potential Solutions on Minimizing the Section 2036(a) Issue
The Estate of Concetta H. Rector is another classic "bad facts" case where the taxpayer failed to treat the FLP as a legitimate operating business6. The outcome of this case should not be a surprise to anyone who has followed the series of victories enjoyed by the IRS in cases where bad fact patterns have served to negate any estate tax planning benefits associated with FLPs. As we all know, with bad facts come bad results.
Despite the potential implications, estate tax planners and financial advisors should not be discouraged from recommending FLPs to their clients. As discussed earlier, with proper upfront planning and continuing maintenance, FLPs can be an effective estate planning tool. The Tax Court's rationale in Estate of Concetta H. Rector (like the other cases that came before it) should be viewed as guidance as to how to set up and operate FLPs (or better yet, how not to set up and operate FLPs). Some of the lessons learned from this case are:
• Plan Ahead of Time - The FLP planning process should be started as early as possible. A decedent's advanced age and poor health condition at the time of the formation/funding of the FLP will most likely raise a "red flag" in the eyes of the IRS. Mrs. Rector was 92 years old and living in a convalescent home at formation of the FLP. In the Erickson case, Mrs. Erickson had advanced Alzheimer's disease at formation of the FLP. By planning in advance, taxpayers could avoid creating such 'death bed' FLPs.
• Avoid Transferring All Assets - Taxpayers should avoid transferring all of their assets in the FLP. Instead, they should retain sufficient assets to cover personal and living expenses as well as expenses that may be incurred upon death. The client and financial advisors should analyze and document the client's needs for these personal and living expenses before establishing the FLP. If the client transfers all or essentially all of his/her assets (which are needed to cover living expenses), it creates the appearance that an implied agreement exists with the other partners that, until the client's death, his/her requests for money from the assets contributed to the FLP will be met. This implied agreement that the client would retain enjoyment and economic benefit of the property transferred would likely trigger the application of Section 2036(a). Documented spreadsheets and analyses will go a long way in proving to the IRS that the family entity is a bona fide business entity and that proper and prudent business forethought was taken in establishing the entity.
• Pool Together Other Family Assets in the Formation of the FLP - If possible, other family members, not just the senior generation members, should also make contributions in the formation of the FLP. This "collective effort" by all of the partners supports the premise that the entity is a true business collaboration of investors and not just one person's desire to transfer assets to others. Further, to the extent possible, have separate independent counsel negotiate the terms of the FLP agreement by and for each of the various partners. This helps support the argument that the FLP was formed like a business venture entered into by prudent and informed investors seeking to make a profit.
• Consider Having an Independent Third Party as the General Partner - The general partner (or managing member) of the FLP should be someone other than the original contributor at risk, his or her agent, or a family member who might clearly be subject to "implicit" control of the contributor. In other words, it is recommended that the general partner or managing member be an independent trustee/party where a bona fide fiduciary relationship could exist. If such arrangement is not feasible, then the original contributor at risk should not be given too much control over voting rights, the unlimited ability to remove and appoint new general partners/managing members or extensive power to amend the partnership/operating agreement. These control attributes of the entity and the associated rights of the various partners should be reviewed by legal counsel and even business valuation professionals before the agreement is executed.
• Form and Maintain the FLP Like a Typical Business - FLPs should be formed and maintained like typical operating businesses. Partners of the FLP should hold formal meetings and provide periodic investor updates, among other things. Moreover, it is advisable for taxpayers to change service providers (e.g., bankers, brokers, property managers, etc.) after transferring the assets to the FLP. To avoid the appearance that the transferred assets are being merely recycled through the FLP for purposes of Section 2036, taxpayers should change the investment strategy of the securities holding if most of the assets held by the FLP are marketable securities. The FLP should also conduct transactions with third parties instead of dealing with only family members or other related parties. By conducting some, if not all, business transactions with third parties, taxpayers would lower the risk that the FLP will be viewed as a tax avoidance vehicle than a valid business enterprise.
Additionally, if partners were entering into a joint venture with a third party where both of them were contributing assets, it is advisable to contribute assets at the same time, at the formation of the entity. This should be the case with an FLP. Do not delay in funding the entity with assets. Only after the funding has occurred should gifting of any ownership interests take place. In fact, some practitioners recommend that the entity be "seasoned" before gifting takes place. Some period of time should lapse before a gift of an ownership interest occurs. Letting a tax year end before the gift is made is also a good idea. By allowing the entity to season and by waiting to make the gift, problems with a gift on formation can be avoided.
• Make Stipulated Distributions - Taxpayers should avoid making priority or special cash distributions on the income of the FLP to help support their elderly loved ones. All distributions should be made according to equity ownership percentages. If taxpayers are considering making gifts to their loved ones, taxpayers should consider making gifts of ownership interests in the FLP instead of using cash or other assets. If structured properly, taxpayers would be eligible for valuation discounts on the gifted interests for lack of control and marketability. Furthermore, after the death of the taxpayer, it is advisable for the general partner of the FLP to avoid making distributions too soon to the taxpayer's estate and the family members. Both before and after the taxpayer's death, it is important for the FLP to function like a normal business enterprise to avoid a Section 2036 problem. Personal expenses of the family members should never be paid from the FLP. As mentioned above, these expenses should be paid from sources completely outside of the FLP.
Overall, these practical suggestions for setting up and maintaining an FLP should help taxpayers dodge the presumption that there was retained control over the contributed assets of an FLP. Perhaps one lesson to be learned from the Estate of Concetta H. Rector case is that it might be helpful for estate tax practitioners and related professionals to periodically follow-up on their clients after the formation of an FLP to make certain that the manner in which they operate their FLP does not undermine the overall estate plan.
Because of the opportunity to qualify for valuation discounts, the use of FLPs has been and continues to be a popular estate-planning and wealth preservation vehicle that allows taxpayers to transfer appreciating or income-producing assets to their loved ones. The growing number of litigated cases on the Section 2036(a) topic has provided adequate guidance on how to minimize exposure to these issues. To benefit from the advantages of using an FLP, taxpayers and their advisors will need to take the necessary measures to avoid being exposed to the Section 2036(a) trap.
1According to Section 2036(a), "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 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." Section 2036(a) includes in the decedent's gross estate the fair market value of all property interests transferred (other than for full and adequate consideration in money or money's worth) by a decedent during his or her life where he or she has retained for life the possession or enjoyment of the property.
2Beginning in 1997, the IRS, through the issuance of technical advice memoranda (also referred to as the "Sham TAMs") and private letter rulings, stepped up their attack on the use of FLPs. Relying on Sections 2703 and 2704 of the Internal Revenue Code, the IRS attempted to negate the beneficial use of FLPs for estate tax purposes.
3Estate of Hilde E. Erickson, T.C. Memo. 2007-107.
4Estate of Sylvia Gore, T.C. Memo. 2007-169.
5Estate of Virginia Bigelow v. Commissioner, 503 F.3d 955 (9th Cir. 2007).
6It is interesting to note that even with the application of a relatively minor 19% overall discount to the value of the interest in the RLP, the Estate of Concetta Rector was not able to fly under the IRS' radar screen.