As we discussed in our March 2004 Tax and Trusts & Estates UPDATE, in recent years the IRS has had some success in the courts arguing that, where certain circumstances exist, the full undiscounted value of the assets transferred to a family limited partnership ("FLP") should be included in the transferor's estate upon his or her death under Internal Revenue Code ("Code") Section 2036 (Estate of Strangi v. Commr.).1 On May 20, 2004, the IRS was dealt a significant defeat in this area by the decision of the U.S. Court of Appeals for the Fifth Circuit in Kimbell v. U.S.2 However, less than four months later, on September 1, 2004, the Third Circuit (which includes New Jersey) counterbalanced that defeat by giving the IRS a significant victory in Estate of Thompson v. Comm'r.3
Code Section 2036 essentially provides that if someone transfers property and retains for himself the possession or enjoyment of the property or the right to income from it, or retains the right to designate others who will possess or enjoy the property or the right to income from it, then these "strings" over the property cause it to be included in the transferor's estate for estate tax purposes upon his or her death. There is, however, an exception to this general rule if the transfer to the FLP constituted a "bona fide sale" for "adequate and full consideration." The applicability of this exception has been a key issue in FLP cases and was addressed again in both Kimbell and Thompson, the former concluding that it applied and therefore delivering a victory to the taxpayer, and the latter concluding that it did not apply and therefore delivering a victory to the IRS.
Both cases involved transferors in their mid-90s who, together with family members, formed FLPs and transferred significant assets to the FLPs in exchange for limited partnership interests, and whose estates reported those interests at discounted values on the estate tax return after death. The Kimbell case involved the transfer to a FLP of approximately $2.5 million of assets consisting of cash, oil and gas interests, securities, notes and other assets. The Thompson case involved the aggregate transfer of approximately $2.8 million of assets consisting of securities and notes receivable to two FLPs.
The Fifth Circuit in Kimbell concluded that the bona fide sale exception of Code Section 2036 applied. With respect to the bona fide sale component of the exception, the court explained that a transfer is a bona fide sale if it is entered into for a genuine business purpose and the transferor actually parts with her interest in the transferred assets and the FLP actually parts with the FLP interest issued in the exchange. The court further explained that a transaction between family members is subject to heightened scrutiny to insure that the sale is not a sham transaction or disguised gift, and this scrutiny is limited to an examination of objective facts that would confirm or deny the assertion that the transaction is bona fide or genuine. The court indicated that the mere fact that the transaction was between family members does not preclude the finding of a bona fide sale. Turning to the facts of the case, the court noted that Mrs. Kimbell retained sufficient assets outside the FLP to cover her own support, there was no commingling of FLP assets with her personal assets, the formalities of the FLP were satisfied and the transferred assets were actually assigned to the FLP, and there were significant business reasons for the FLP (including providing legal protection from creditors which her living trust could not provide and keeping the pool of capital together in one entity).
With respect to the "adequate and full consideration" component of the exception, the Kimbell court explained that the proper focus is (1) whether the interests credited to each of the partners were proportionate to the fair market value of the assets each partner contributed to the FLP, (2) whether the assets contributed by each partner to the FLP were properly credited to the respective capital accounts of the partners, and (3) whether on termination or dissolution of the FLP the partners were entitled to distributions from the FLP in amounts equal to their respective capital accounts. The court found that these requirements were satisfied in the Kimbell case. In the Thompson case, however, the Third Circuit arrived at a different conclusion. Before reaching the question of whether the exception applied, the court found that an implied agreement existed between the transferor and his family members that the transferor would retain the lifetime enjoyment and economic benefit of the assets he transferred to the FLPs. The factors that led the court to this conclusion were that the transferor transferred 95% of his assets to the FLPs and retained insufficient assets outside the FLPs to support himself for the rest of his life (he retained assets for 3.5 years of support while his life expectancy was 4.1 years); the family members sought assurances from financial advisors that the transferor would be able to withdraw assets from the FLPs to make gifts to the family; the FLPs actually made distributions to the transferor to cover his expenses; the transferor's children testified that they would not have refused the transferor's request for distributions; and the general testamentary character of FLP arrangement as evidenced by the transferor's age, the fact that the FLPs did not engage in business or loan transactions with anyone outside the family, and the type and volume of assets transferred. The court also noted in its discussion of the facts that the FLPs sold securities to partially fund bequests in the transferor's will and pay his estate taxes.
The court then addressed the bona fide sale exception. With respect to the "adequate and full consideration" component of the exception, the court embraced a somewhat different analysis than the Fifth Circuit in Kimbell. Rather than focusing on whether the partners received proportionate FLP interests for their transfers, the court observed that (1) the FLPs did not engage in legitimate business transactions, (2) the form of the transferred assets consisted mainly of marketable securities, and (3) the transferor's estate was diminished in value when he transferred assets in exchange for discounted FLP interests. With respect to the bona fide sale component of the exception, the court rejected the theory that an arm's length transaction is required to avoid automatic inapplicability of the exception. Rather, the court explained that a "bona fide" transaction requires "good faith," which in turn requires non-tax reasons for the transaction.
While the Kimbell and Thompson cases are very significant to legal practitioners for their respective analyses of the bona fide sale exception to Code Section 2036, what our clients and friends should know is that these cases merely reaffirm the importance of properly structuring and maintaining a FLP, particularly the importance of having and documenting significant business reasons for creating the FLP. The Strangi case, discussed in our March 2004 Tax and Trusts & Estates UPDATE, is still on appeal in the Fifth Circuit, and the legal community is watching to see if Kimbell could serve as the precedent necessary for the Fifth Circuit to rule against the IRS in that case. While certainly under aggressive attack by the IRS, we continue to believe that the FLP can be an effective and viable estate planning tool if it is structured and maintained properly under factual circumstances that do not cause the arrangement to fall within the purview of the cases where the IRS has been successful. In particular, lifetime transfers of properly structured FLPs continue to provide significant estate tax savings. As we have advised in the past, clients with FLPs should review their documentation and their partnership maintenance practices with a view to avoiding the sort of facts that have allowed the IRS to successfully challenge FLPs.
****************************
1. 115 T.C. 478 (2000), aff'd. in part, rev'd. and remanded in part, 293 F.3d 279 (5th Cir. 2002), on remand, T.C. Memo 2003-145.
2. 371 F.3d 257 (5th Cir. 2004).
3. No. 03-3173; 2004 U.S. App. Lexis 18473; 2004 WL 1933613.
