Strange Days After Strangi:
Section 2036 Attack On Family Limited Partnerships
© 2003 Richard S. Amari and Jason E. Havens.1 All Rights Reserved.
CAUTION: THIS ARTICLE WAS PUBLISHED IN 2003 AND THERE HAS BEEN SIGNIFICANT DEVELOPMENT IN CASE LAW SINCE THEN. THIS ARTICLE SHOULD NOT BE RELIED UPON WITHOUT REFERENCE TO THESE MORE RECENT DEVELOPMENTS.
Does the IRS simply prefer a corporate structure over a partnership as its choice of entity? What is so strange about family limited partnerships or their use in estate planning? Have those tax-wise Texans lost their planning edge?
The IRS has attacked the use of family limited partnerships in estate planning from several angles. For many years, the IRS pursued the argument that a taxable gift occurs on the formation of a family limited partnership in the estate planning context. After consistently losing that argument, the IRS turned to other alternatives.
One IRS argument, which attacks the use of a family limited partnership in the estate planning context by arguing that the decedent has retained rights to and power over income, has succeeded – or has it? This program explores the line of cases that are most closely identified with Estate of Strangi v. Commissioner, 115 T.C. 478 (2000) (“Strangi I”), aff’d in part and rev’d in part, 293 F.3d 279 (5th Cir. 2002) (“Strangi II”), on remand, T.C. Memo. 2003-145 (“Strangi III”). Some commentators have announced these developments as the end of utilizing family limited partnerships and related techniques, such as family limited liability companies. However, many others and we view these developments differently.
This program includes some fundamental and historical material on the use of family limited partnerships. We will then summarize the IRS’ attacks on family limited partnerships. Finally, we will discuss Section 2036 of the Internal Revenue Code and its application in the family limited partnership context. This program will conclude with recommendations to address these issues in existing and prospective family limited partnerships.
II. The FLP As An Estate Planning Vehicle
The family limited partnership (“FLP”) is an entity that has gained widespread popularity for estate planning purposes over the last decade. The two primary estate planning objectives that the FLP is utilized for are asset protection and reduction of the gross estate for Federal estate tax purposes.
The FLP involves a well-established business entity, the limited partnership, as a vehicle to further estate planning goals. Traditionally, the limited partnership is an entity that enjoyed several advantages over other entities. For example, for income tax purposes the limited partnership has the advantage of pure-partnership flow-thru income taxation.2 A partnership does not pay federal income tax.3 Rather, it files an information return and each of the partners includes that partner’s share of partnership income and loss on the partner’s individual income tax return.4 An S Corporation also generally does not pay federal income tax and its income and losses flow through pro rata to its shareholders in a manner similar to corporations.5
Even though partnerships and S Corporations enjoy similar federal income tax treatment, there are some important differences.6 Also, unlike S Corporations, there is no limitation on the number of members a partnership may have, and members may include entities other than individuals. For these reasons, the limited partnership is a popular vehicle for real estate syndication, particularly those that are debt financed. A significant disadvantage of the S Corporation as a business entity for real estate syndications is that S Corporation shareholders are not able to include corporate borrowings in their basis for their shares.7 Partners in a partnership, on the other hand, do include partnership debt in their partnership interest basis.8
Another attractive attribute of the limited partnership is that, while general and limited partnership interests may be treated equally in distribution of profits and losses, holders of the limited partnership interests do not participate in the day-to-day management of the affairs of the partnership.9 Thus, the limited partnership vests in the general partner the ability to control the management of the partnership’s business free from interference of limited partners, while vesting in the limited partners the right to a pro rata share in the profits and losses of the business operated by the partnership. This is an ideal arrangement for real estate syndications where venture capital is raised from the limited partner investors while maintaining the necessary control in the general partners responsible for the success of the company. Another attribute of the limited partnership that added to its attractiveness as an investment vehicle is that limited partners are not liable for the debts of the limited partnership beyond their investment in the partnership.10 Only the general partner has this liability.11 Indeed, the limited partnership has historically been viewed as an attractive vehicle to raise money from investors who want limited liability and expect the general partner to run the business and return capital plus profits in the form of partnership distributions.
The drafters of the Uniform Limited Partnership Act saw wisdom in limiting the remedies available to the creditors of a defaulting partner in a limited partnership.12 Imagine, for example, the havoc that could be caused by a creditor seizing the partnership interest of the general partner of a real estate syndicated limited partnership to satisfy the general partner’s obligations to the creditor unrelated to the partnership’s business. The investors might find their investment in the partnership jeopardized by the creditor’s attempts to sell off partnership assets, force partnership distributions, liquidate the partnership or other similar actions. For this reason, the creditor of a partner in a limited partnership is limited to the exclusive remedy of imposing a charging order against the partner’s interest.13 Unlike a lien against other assets, a charging order cannot be used to force partnership assets to be sold, distributed, liquidated or otherwise forced into the hands of the creditors.14 More like a wage levy, the charging order requires that any partnership distributions, which would otherwise be made to the debtor partner, must instead be made to the creditor.15
Interestingly, recent legislative developments have somewhat coincidentally neutralized some of the benefits limited partnerships have historically enjoyed as a business entity. For example, thanks to the “check the box” regulations. Any “eligible entity,” which generally is any business entity other than most corporations, having two or more members, may elect to be classified as either a corporation or a partnership for federal income tax purposes.16 In Florida, both limited and general partnerships may elect to be treated as limited liability partnerships, in which case no partner will have individual liability for the debts of the partnership.17 Thus, limited liability limited partnerships no longer are required to have corporate general partners to limit liability exposure to the general partner, a problem that, prior to the “check the box” regulations, created tremendous obstacles to insuring the limited partnership was taxed as a partnership rather than a corporation.18 Another somewhat recent development was the Florida legislature’s decision to no longer tax limited liability companies having two or more members as regular corporations for state income tax purposes.19 This change, coupled with the “check the box” regulations, is largely responsible for the growing popularity of the limited liability company. The latter entity is so flexible that control can easily be placed with one person or entity, partnership taxation is easily achieved and no member is liable for the debts of the company.20 Thus, we are now starting to see a proliferation of the use of limited liability companies where the limited partnership was historically the preferred vehicle of choice.
With this as a backdrop, we can now see how the FLP has developed as an estate planning tool. The FLP is really nothing more than a plain vanilla limited partnership between family members where typically the patriarch is the general partner (or controls the entity which is the general partner) and the children, grandchildren, other family members, or trusts for those persons, are limited partners. Indeed, the “family” can be so tight that the partners may consist of an entity (such as a limited liability company or revocable trust) controlled by the client and the client or another entity controlled by the client. Whatever the case may be, it is fairly easy to “dot all the i’s and cross all the t’s” so that for state law purposes a limited partnership is formed and the client’s assets have been transferred to that partnership.
The two very important attributes of asset protection and valuation discounts which flow from the limited partnership structure is what creates the attraction to it as an estate planning tool.
An example will easily illustrate the asset protection features enjoyed by the FLP. Take, for example, the case of a neurosurgeon. Our hypothetical client is married and has jointly held assets worth 3 million dollars, an IRA worth 1 million dollars, and various other assets. The good doctor informs you that his malpractice premiums have risen from $13,000 per year to over $130,000 per year for the same coverage. Incensed over this obvious attempt by the insurance company to share in his wealth, he has decided to “go bare,” without coverage. What shall you advise him to do? Should he rely on tenants by the entireties form of ownership to protect him from his potential malpractice risks?21 This can be a fairly easy and effective way to manage his risk. This approach, however, is not without risk. What if the doctor has a judgment entered against him for malpractice for 10 million dollars and his wife, hearing of the verdict, dies of a heart attack? The protection once afforded by the tenancy by the entireties evaporates by operation of law, which transfers ownership to him on her death. What if his wife, driving her husband’s car, runs into an orthopaedic surgeon? Both will be sued. Again, we see a chink in the armor. Also, how do we plan to avoid the wasting of the applicable exclusion amount on the death of the first of them to die if assets owned in a tenancy by the entireties will pass automatically to the survivor. Perhaps we can rely on disclaimer planning, but this is not without its own pitfalls. What if the surviving spouse waits 10 months before consulting a lawyer?22 What if the surviving spouse becomes legally incompetent? Also, she may inadvertently accept benefits from the property before consulting with an attorney. These are but a few of potential problems posed by a plan which relies on qualified disclaimers to avoid wasting the applicable exclusion amount.23
Perhaps you advise the doctor to transfer the jointly titled assets to his wife (or to her living trust). If she dies first, she now has 3 million dollars worth of assets to shelter using her unified credit. Hopefully, you suggested using a QTIP trust to receive the marital portion so that the assets in both the credit shelter trust and the QTIP trust are protected by the trusts’ spendthrift provisions. If he dies first, it is a less than perfect fix. Perhaps she can disclaim the IRA, allowing your customized beneficiary designation to direct the IRA to his credit shelter trust established by his will or trust. This will avoid wasting his applicable exclusion amount, however, she loses very valuable income tax options that a surviving spouse who is a designated beneficiary enjoys. These options include the ability to roll over the account to her own IRA, defer the required minimum distributions until her required beginning date, name her own beneficiaries of the IRA, continue to own his IRA as an inherited IRA or treat his IRA as though it is her IRA.24 Assuming that the trust qualifies under the designated beneficiary rules of the final Sec. 401(a)(9) regulations, she may not be able to use her life expectancy to calculate required minimum distributions after his death due to contingent remainder beneficiaries.25 Even if she is able to use her life expectancy for calculating required minimum distributions, she loses “stretch-out” of the IRA to the extent she is forced to begin distributions by December 31 of the year following the year of his death. All this, not to mention the problems already discussed above about having to rely on qualified disclaimers to achieve the desired tax results. Now, if his wife is sued for any reason, the entire 3 million dollars transferred to her trust is exposed to her creditors. Oh, and let’s not forget this problem. What if his wife decides to become his worst nightmare? Although she probably won’t get it all in the end, imagine the leverage she has with all of those assets titled in her sole name?
Instead, you advise your client to create an FLP. He owns all of the membership interests in an LLC, which owns a 1% general partnership interest in the FLP. He and his wife (or their living trusts) each own 49½% limited partnership interests in the FLP. He and his wife then each gift 30% limited partnership interests to their two children (or irrevocable gifting trusts for the children).
With this plan, you have achieved very effective asset protection. A creditor of the doctor, his wife or both will be limited to the charging order remedy. Presumably, the general partner (LLC) will not be voting to make partnership distributions while the charging order is in place. As stated above, the creditor cannot force the sale of partnership assets, the liquidation of the partnership or otherwise force any distributions to the creditor. There is also an argument that as long as the creditor has its charging order in place, the creditor should receive the IRS Form 1099 for the debtor partner’s interest subject to the charging order.26 If partnership funds are needed while the charging order is in place, perhaps the general partner (LLC) could be paid a management fee, which in turn is paid to the doctor for managing the LLC. These wages should be exempt from levy.27 Also, loans could be considered as a way to receive partnership assets free from the charging order.
The plan is not without risk. Certainly, the entire structure must be established before the liability to the creditor exists. Otherwise, the transaction will likely be set aside as a fraudulent transfer.28 Furthermore, unlike the offshore asset protection trust, these assets are subject to U.S. Court jurisdiction. Although no reported Florida case has done so, there are rumors of circuit court decisions where the judge forbade any distributions to the debtor partner (even by wages or loans) in the presence of a charging order. The bottom line is that if the court is convinced a conspiracy exists to defraud a creditor, judgments may fly that test the bounds of well established Florida partnership law.
Let’s revisit your partnership structure and consider the transfer tax consequences. Conventional planning wisdom dictates that lifetime giving can produce overall transfer tax savings even though the estate tax and gift tax are “unified.” First, transfer taxes are avoided through gifts of present interests to the extent those gifts do not exceed $11,000 per person, indexed for inflation.29 Furthermore, all appreciation in assets gifted also avoids estate tax. Of course, this appreciation will not avoid capital gains tax which would have otherwise been avoided due to step-up in basis had the assets been inherited rather than gifted.30
Of course, human nature such that it is, people like to have their cake and eat it too. Many gifts come with “strings” attached. People are more apt to part with ownership of property if they can control the use or enjoyment of that property as long as they live. Congress determined that the estate tax should not be easily frustrated by allowing gifts with strings that allow the donor continued enjoyment or use of the property or income produced by the property, or the ability to control who gets that enjoyment or use.31
It is this central theme that is really the subject of this paper. With the FLP, however, until recently it was widely believed that, due to well established legal principles regarding property rights, the FLP transaction essentially allowed the donor to complete a gift for tax purposes, enjoy control over that property for life and avoid estate tax on that property at death.
Now back to the example of the doctor and your recommended FLP transaction. The doctor and his wife each gave a 30% limited partnership interest in a partnership worth 3 million dollars. Had they each given 30% of 3 million dollars directly, each would have made a gift of $900,000. What was given, however, was a partnership interest – a limited partnership interest at that. No willing buyer in an arms-length negotiated transaction would be willing to pay $900,000 for that interest. As previously noted, the limited partner lacks the ability to control the partnership. Save the existence of fiduciary duties owed by the general partner to the partnership and limited partners, the limited partnership interest is subject to the whim of the general partner. Not only does the limited partnership interest lack control, there is no established market for the interest to be immediately sold or otherwise disposed of. Due to these factors of lack of control and lack of marketability, the willing buyer in an arms-length negotiated transaction would demand a significant discount from the full value. In fact, this pole star of the IRS’ own regulations for determining value establishes that the fair market value of the limited partnership interest should be discounted to perhaps between 40% to 70% of the full value. Using a 50% discount, the value of the gifts by the doctor and his wife drops from $900,000 to $450,000 each. Now, when the doctor dies owning his remaining 19.5% limited partnership interest, the value of that interest should also be similarly discounted. Assuming the doctor did not previously give to his wife the LLC interest which owns the 1% general partnership interest in the FLP, then undoubtedly their should be a premium attached to that interest to reflect the ability to control the partnership, including causing its liquidation.
Obviously, the IRS has had intense objections to the use of the FLP as what it perceives an abusive exploit of the transfer tax system. The Service has thrown all sorts of mud against the wall in an effort to get something to stick. Most attacks have been to the discounts claimed for the gifted interests. Despite its fervor, the Service had enjoyed only very limited success in its attacks. If a planner did his homework and avoided some obvious pitfalls (discussed in more detail below), he or she could pretty well rest assured that the transaction would pass muster. In fact, what was previously considered an aggressive plan, FLPs owning only marketable securities, had become rather routine for many planners, and discounts of 30% to 40% were being regularly achieved.
The following sections will discuss the attacks and other planning pitfalls the planner traditionally needed to consider in structuring the FLP transaction to obtain discounts. Then, the Service’s latest assault weapon, Sec. 2036, and its success will be fully explored.
On a less than obvious note, the Service could care less about the asset protection attributes of an FLP. Lessons may be gleaned, however, from some of the approaches used by the IRS to attack the tax results sought after by planners and their clients. For example, a well schooled creditor’s attorney might adopt some of the IRS’s attacks on the FLP by arguing sham transaction, no valid business entity, the existence of an informal agreement to let the debtor use assets or the Tax Court’s “recycling of assets” theory32 to argue that a creditor should not be limited to a charging order under the particular facts and circumstances. Doctors who are considering dropping their malpractice insurance should be cautioned that even a well planned FLP transaction is not without considerable risk.
III. A Review Of The Service’s Attack On The FLP
A. Disregarding the Partnership for Transfer Tax Purposes.
Perhaps the IRS viewed FLPs as a “Y2K” issue. In seven Technical Advice Memoranda during the years 1997 and 1998, the IRS refused to recognize FLPs for transfer tax purposes.33 The IRS argued alternatively in each of the seven scenarios that special valuation rules should apply to disregard restrictions on transferability and liquidation.
- Transaction Is Testamentary.
In each of the seven Technical Advice Memoranda, the IRS asserted that the nature of the FLP transaction required treatment as a single testamentary transaction, which resulted in disregarding the FLP for transfer tax purposes. The IRS used the Estate of Murphy v. Comm’r34 as the basis for its National Office rulings. In Murphy, the Tax Court denied the use of a minority interest discount to the decedent’s closely held stock because the decedent transferred approximately two percent of her shares to her children, based on her accountant’s advice, only eighteen days prior to her death. The Tax Court therefore disregarded the FLP, and the resulting minority interest discount, for transfer tax purposes because the court found that the FLP was formed solely as a device to reduce transfer taxes.The IRS notably did not cite Frank Est. v. Comm’r35 in its seven Technical Advice Memoranda. In Frank, the decedent’s attorney-in-fact, who was the decedent’s son, transferred a portion of the decedent’s shares two days before the decedent’s death, which reduced the decedent’s percentage ownership in the closely-held company from more than 50% to thirty-two percent. The Tax Court upheld the forty-five percent combined discount taken by the decedent’s estate based on the decedent’s lack of marketability and the lack of control. The distinguishing fact might have been the lack of documentation in the Frank case, whereas the Murphy case involved letters from the accountant explaining the use of an FLP to reduce transfer taxes.
- Sec. 2703(a)(2).
The IRS’ second assertion in the seven Technical Advice Memoranda focused on the application of one of the special valuation rules of Chapter 14. Based on Section 2703, the IRS has persistently argued that (1) a gift of partnership interests should be treated as a gift of the underlying assets and (2) the partnership agreement should be treated as a restriction on the right to sell or use the underlying assets, which can be ignored under Section 2703. Section 2703(a)(2) determines the transfer tax value of “any property” transferred among family members. Most importantly, Section 2703(a)(2) disregards the value of “any restriction on the right to sell or use such property” (i.e., treats the value of any such restriction as worthless for transfer tax purposes).Section 2703 applies to rights or restrictions contained in articles of incorporation or shareholders’ agreements, as well as to implicit rights conferred in a corporation’s capital structure.36 As a result of Section 2703’s application in the corporate context, the IRS has argued that Section 2703 justifies valuation of partnership interests without regard to the restrictions imposed on the donee’s use of the underlying assets.37
Despite the IRS’ National Office position on the application of Section 2703 taken in the seven Technical Advice Memoranda, the courts have, to the IRS’ chagrin, consistently rejected this analysis.38 Case law emphasizes two fundamental aspects of the application of Section 2703. First, Section 2703 applies to transfers of “any property,” which would include intangible property such as partnership interests and need not be strictly the tangible underlying assets of the partnership. Second, the property transferred by the taxpayers in these cases was either shares of stock or partnership interests — not interests in the underlying assets.
The Tax Court summarized Section 2703’s application in Strangi I:
Respondent next argues that the term “property” in section 2703(a)(2) means the underlying assets in the partnership and that the partnership form is the restriction that must be disregarded. Unfortunately for respondent’s position, neither the language of the statute nor the language of the regulation supports respondent’s interpretation. Absent application of some other provision, the property included in decedent’s estate is the limited partnership interest and decedent’s interest in Stranco.
As we indicated in Kerr v. Comm’r, supra at 470-471, and as respondent acknowledges in the portion of his brief quoted above, the new statute [Section 2703] was intended to be a targeted substitute for the complexity, breadth, and vagueness of prior section 2036(c); and Congress “wanted to value property interests more accurately when they were transferred, instead of including previously transferred property in the transferor’s gross estate.” Treating the partnership assets, rather than decedent’s interest in the partnership, as the “property” to which section 2703(a) applies in this case would raise anew the difficulties that Congress sought to avoid by repealing section 2036(c) and replacing it with Chapter 14. We conclude that Congress did not intend, by the enactment of section 2703, to treat partnership assets as if they were assets of the estate where the legal interest owned by the decedent at the time of death was a limited partnership or corporate interest.39 Thus, we need not address whether the partnership agreement satisfies the safe harbor provisions of section 2703(b). Respondent did not argue separately that the Strangi shareholders’ agreement should be disregarded for lack of economic substance or under section 2703(a).40
B. Other Special Valuation Rules.
- Sec. 2701.
Section 2701 purports to limit “estate freezes” through the use of corporate recapitalizations and frozen partnerships. Prior to the enactment of Chapter 14, corporate recapitalizations and frozen partnerships could both be used to fix the value of a taxpayer’s estate for transfer tax purposes. Despite the enactment of Chapter 14, Section 2701 has not eliminated the use of corporations and partnerships as business and estate planning tools.Like other sections of Chapter 14, Section 2701 operates to adjust the transfer tax values of certain interests in the corporate or partnership context in order to prevent estate freezes. Section 2701 increases the value of the common partnership interests in a frozen partnership by disregarding the value of any discretionary rights or benefits that are attached to certain interests retained by the transferor. The value of the frozen interests is subtracted from the value of the transferor’s interest in the entire partnership before the transfer to arrive at the gift tax value of the common interests, i.e., the amount of the gift is equal to the transferor’s total partnership interests less the value of the retained interests. The IRS has historically valued a retained frozen interest based on several factors, including potential distributions, the right to manage and control the partnership, discretionary rights to convert the frozen interest back into an unfrozen interest, the right to compel the liquidation of the partnership, and the right to force the partnership to reacquire the frozen interest.41 Section 2701 essentially only focuses on the most definite of these benefits in valuing frozen partnership interests, consequently increasing the gift tax cost associated with frozen partnerships.
a. When Section 2701 Applies. Section 2701 applies when a person transfers a junior interest in a partnership (e.g., a common partnership interest, if there is also a frozen interest) to or for the benefit of a transferor’s “member of the family.” “Member of the family” includes the transferor’s spouse, the descendants of the transferor and the transferor’s spouse, and the spouses of any such descendants. For this purpose, parents, grandparents, and the spouses of parents and grandparents are not members of the family of the transferor.42
Section 2701 applies only if the frozen partner retains a distribution, liquidation, put, call, or conversion right in the partnership.43 Partnership interests to which these preferences are attached are classified as “senior interests.” A person may directly or indirectly retain senior interests, e.g., a parent who gives common partnership interests to children and transfers frozen interests to a trust of which the parent is a beneficiary would be subject to Section 2701.
Section 2701 applies if the transferor or an “applicable family member” retains a senior interest. “Applicable family member” includes the transferor’s spouse, any ancestor of the transferor and the transferor’s spouse, and the spouse of any such ancestor. For this purpose, descendants of the transferor or of the transferor’s spouse are not categorized as “applicable family members.”44 Therefore, Section 2701 generally applies if the transferor, or a family member in either the transferor’s generation or a higher generation, retains a senior partnership interest, and the transferred junior interest is transferred to a family member in a lower generation.
Section 2701 applies only if one or more applicable family members together hold enough partnership interests immediately before the transfer to control the partnership.45 “Control” requires at least one half of the capital or profits interests in the partnership.46 The meaning of “applicable family member” does not change for the purpose of determining control; however, Section 2701 treats any applicable family member as indirectly owning any interest held by that family member’s descendants or siblings.47
Section 2701 disregards (i.e., values at zero) the value of a discretionary liquidation, put, call, or conversion right.48 On the contrary, then, the special valuation rules of Section 2701 do not apply to a retained right required to be exercised at a specified time and amount.49 Section 2701 also does not apply to a retained non-lapsing right to convert a preferred partnership interest into a fixed share of the partnership equity; such right must be (1) expressed either as (a) a fixed percentage of the equity or (b) a fixed number of units of partnership interest and (2) subject to appropriate adjustments for changes in the partnership’s capital structure (as well as adjustments for accumulated but unpaid distributions).50
Section 2701 does not apply if the transferred interest and the retained interest represent either the same class or “proportionally the same.” In determining whether the interests are “proportionally the same,” non-lapsing differences with respect to management and liability are disregarded, as are lapses caused only by federal or state law (except when the regulations provide that lapses not be disregarded — in order to prevent abuse).51 Chapter 14 does not specially value a transfer involving interests with only minor variations between the partnership interests of limited partners and general partners (with no special frozen features), as long as the economic and beneficial attributes of the interests are identical.
b. Valuation of Partnership Interests under Section 2701. The gift tax consequences, including the existence and valuation of the taxable gift, of a transfer of partnership interests made on or after October 9, 1990 depends on the application of Section 2701. Again, Section 2701 operates to increase the value of the transferred interest. Following the increase, the gift tax value of that transferred interest might exceed the consideration paid, resulting in a gift. The application of Section 2701 can increase the apparent gift if no consideration was paid for the transferred interest.
As mentioned, Section 2701 inflates the value of the transferred common interests because Section 2701 values the transferred interest as the difference between the value of the partnership and the value of certain retained interests. This “subtraction” method of valuation determines the value of the common interests in a family partnership by subtracting the recognized value of all outstanding frozen interests from the total appraised value of the partnership.52
The frozen interests retained by “applicable family members” are valued at zero unless the frozen interests represent rights to “qualified payments.” “Qualified payments,” such as fixed rights to annual distributions, must be based on a fixed rate or with reference to a specified market interest rate. For purposes of valuing the frozen interest, a right to payments other than “qualified payments” (e.g., a non-cumulative right to an annual distribution) is valued at zero.53
Section 2701 provides that the value of the junior or unfrozen interests in a family partnership must comprise at least ten percent of the total value of the partnership. The value of the partnership, for this purpose, includes the total value of all partnership interests plus the total debt owed by the partnership to the transferor, the transferor’s spouse, their ancestors, and the spouses of their ancestors. This precludes the transferor of a common partnership interest from creating frozen interests that are worth more than 90 percent of the value of the partnership.
Section 2701 applies regardless of whether the transfer of a partnership interest occurs as a result of the restructuring an existing partnership or the initial structuring of a new partnership. If the transaction in question gives one party a senior interest and the other a junior interest, the value of the junior or common interest is determined under Section 2701.54
- Sec. 2704.
a. Lapsing Voting Rights and Liquidation Rights. Section 2704(a) provides that the lapse of either the voting right or the liquidation right will be treated as a transfer by the holder of the right, either (1) as a gift — if the lapse occurs during the holder’s lifetime — or (2) as an addition to the holder’s gross estate — if the lapse occurs at the holder’s death.55 The amount of the transfer result from the treatment of the lapsed right is calculated by determining the excess of (1) the value of all interests in the entity held by the person immediately before the lapse (determined as if the lapsed power were non-lapsing) over (2) the value of such interest immediately after the lapse. “Voting right” means a right to vote with respect to any partnership matter, including a general partner’s right to participate in partnership management.56 “Liquidation right” means any right that allows the holder to direct the partnership to acquire all or a portion of the holder’s interest, regardless of whether its exercise would result in the partnership’s complete liquidation.57
If the exercise of a voting right or a liquidation right is restricted or eliminated, Section 2704(a) generally treats that right as having lapsed.58 An event that does not actually restrict or eliminate the exercise of the rights, but merely makes the right difficult or impossible for one person to exercise, is not considered a lapse. Likewise, the transfer of a liquidation right does not cause its termination or lapse, provided that the transferee can exercise the right.59
b. Applicable Restrictions. Section 2704(b) determines the value a gift to a family member of a family limited partnership interest without regard to any “applicable restrictions” on the right of the transferor or the transferee to liquidate the partnership.60 “Applicable restrictions” mean limitations on the ability to liquidate the partnership that are more restrictive than those generally provided under applicable state law.61 Section 2704(b) disregards an applicable restriction if (1) it will lapse or (2) the transferor or the transferor’s family can remove it after the transfer.
Chapter 14, which is only effective for restrictions not in existence on October 9, 1990, causes any transferred partnership interests to be valued without regard to any applicable restrictions that are disregarded under Section 2704(b). If applicable restrictions are disregarded, the value of the partnership will usually be higher than its value if the transferor could not otherwise compel liquidation.
The application of Section 2704(b) hinges on whether a partner can liquidate the partnership under applicable state law, without regard to the provisions of the partnership agreement. State laws vary widely on this point.
1. Partnerships under Re-RULPA (2001) – The most recent revision of Revised Uniform Limited Partnership Act (RULPA) (2001), which has been adopted by a majority of the states including Florida, provides that a partnership is dissolved and liquidated only on the occurrence of events specified in the partnership agreement, upon the partnership term’s expiration, or with all partners’ written consent.62 The courts have repeatedly held that restrictions on partnership liquidation similar to those contained in RULPA (2001) are not applicable restrictions under Section 2704(b) because the restrictions are no more severe than those contained under applicable state law.
In Kerr v. Comm’r,63 the Tax Court rejected the application of Section 2704(b) to a Texas family limited partnership. The taxpayers and their children in Kerr had formed two Texas family limited partnerships, KFLP and KILP. The taxpayers contributed all of the capital and were the sole general partners. The capital of KILP was $11 million in stocks, bonds, and real estate. The capital of KFLP consisted of life insurance policies on the taxpayers’ lives and interests in KILP. The taxpayers promptly assigned part of their general partnership interests to each of their children.
The partnership agreements generally stated that:
- Partnership interests could not be transferred to anyone other than the taxpayers, their descendants, or certain entities owned by them without the consent of the partnership and all partners;
- The limited partners could not withdraw from the partnership or withdraw their capital contributions, except through ordinary distributions made pursuant to the partnership agreements or upon termination of the partnerships;
- A person could be admitted as a new partner only with all general partners’ consent; and
- The partnerships would terminate and be dissolved in 2043 (50 years after they were created), or on any earlier agreement of all partners, or the occurrence of certain acts of dissolution.
The taxpayers transferred limited partnership interests in both partnerships to the University of Texas. The taxpayers then contributed limited partnership interests to grantor retained annuity trusts created by the taxpayers, with remainder interests vested in trusts for their descendants. The taxpayers also made additional gifts of limited partnership interests to each of their children.
The taxpayers filed gift tax returns valuing the partnership interests with a 52.5 percent discount for lack of liquidity and control (plus an additional twenty-five percent discount on the KFLP interests held by KILP). The IRS rejected the discounts, asserting that Section 2704(b) disregarded the liquidation and dissolution restrictions as applicable restrictions.
The Tax Court granted the taxpayers’ summary judgment motion, which (1) allowed the discounts for lack of marketability and control and (2) rejected the application of Section 2704(b). The Tax Court held that Section 2704(b) did not apply because the partnership agreement’s liquidation restrictions were no more severe than restrictions imposed by state law. Texas law provided that a limited partnership would be dissolved on the earlier of (1) the occurrence of events specified in the partnership agreement to cause dissolution, (2) the written consent of all partners to dissolution, (3) the withdrawal of a general partner, or (4) entry of a decree of judicial dissolution. Consequently, the court held that the partnership agreement’s fixed termination date and other restrictions on dissolution and liquidation were no more restrictive than the limitations that would apply generally under Texas law, which meant that such restrictions were not applicable restrictions.64
The Kerr case represented the first judicial rejection of the IRS’s attempt to interpret Section 2704(b) broadly enough to reduce or eliminate marketability and control discounts for most family limited partnerships. This emphasizes the importance of creating a partnership in a state with favorable partnership law, such as Alaska, Delaware, Florida, or Texas.
2. Effect of Application of Section 2704(b). – Section 2704(b) does not automatically eliminate all discounts. Rather, Section 2704(b) causes valuation of the partnership interest without regard to the liquidation restrictions contained in the partnership agreement. This may not result in a significant increase in the value of the interest, as demonstrated in Estate of McCormick v. Comm’r.65
The partnership in McCormick owned real property and engaged in the construction contracting business. The deceased donor had made gifts to various family members of small percentage interests in the general partnership, which totaled about thirty percent of the partnership. The IRS argued that the value of these partnership interests was greatly enhanced because state law allowed any general partner to cause the dissolution of the partnership, thus allowing access to the liquidation value of such general partner’s partnership interest.
The Tax Court stated that state law gave a partner the right to compel liquidation. However, the exercise of such right would not necessarily result in the immediate partition of the underlying assets and receipt of partnership property in kind. The Tax Court noted that the dissolution procedure merely causes the partnership to begin winding up its affairs, and the effect of this procedure depends upon factors such as (1) the nature of the partnership’s business and assets and (2) the size of the liquidating partner’s interest.
The Tax Court concluded that the difference between a general partner’s rights and a shareholder’s rights in a corporation might be relevant in considering the amount of the discount to be applied to a minority interest in a partnership. Nevertheless, the impact of this difference on the power to compel dissolution would be insignificant where the nature of the underlying assets and business would make winding up difficult and protracted. The Tax Court stated: in McCormick:
We tend to agree with petitioners on this point because liquidation value in the setting of this case would not be readily available to the holder of a small percentage of these family partnerships. In that connection, it is less likely that a willing buyer would purchase any of the interests under consideration for the purpose of liquidating the underlying assets. It is more likely that a willing buyer would seek to invest in what appears to be a profit-making and ongoing business. The availability of assets in the event of a dissolution and/or liquidation, however, may indicate less overall risk, and support a higher value for an entity.66
Consequently, the mere fact that liquidation restrictions of a partnership are ignored as applicable restrictions under Section 2704(b) does not mean that no discounts will be available in valuing the partnership interests.
C. Annual Exclusion.
A donor’s gift of an interest in a family limited partnership should usually qualify as a present interest under the $11,000 annual gift tax exclusion of Section 2503(b). Such a gift must confer on the donee a present interest in the transferred property, which Treasury Regulation Section 25.2503-3(b) defines as “[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.” The transfer of a partnership interest should usually give the donee a present interest unless the facts and circumstances suggest that the donee lacks any present ability to use, possess, or enjoy the partnership interest.
In Technical Advice Memorandum 9751003, the IRS ruled that a gift of limited partnership interests did not qualify for the annual gift tax exclusion because the terms of the partnership agreement denied the donees any present economic benefit from their interests. The donor, a 71-year-old widow, formed a family limited partnership to which she transferred a 94.77 percent interest in a real estate parcel worth approximately $2.5 million. The donor owned the shares of the general partner, an S corporation. The corporation owned the other approximately five percent interest in the parcel of property. Various family members and trusts for minor family members contributed their interests in another property to the partnership in exchange for limited partnership interests. They had received these interests as gifts from the donor in a previous year.
That same day, and several times at later dates, the donor gave limited partnership interests to various family members and trusts for minor family members. The donor valued each gift at approximately $10,000. Following each set of gifts, the family members made various gifts among themselves, reallocating their interests so that each of the donor’s children held, directly and through their respective descendants, the same percentages of limited partnership interests. The children and descendants of the donor, after all of these transactions, owned 95 percent of the limited partnership interests, with the corporate general partner owning a five percent general partnership interest.
The limited partnership agreement contained the following major restrictions on the use, benefit, and enjoyment of the limited partnership interests:
- The general partner had “complete discretion” to distribute income and principal of the partnership to and among the partners;
- The general partner could “retain funds within the partnership for future partnership expenditures or for any other reason whatsoever”;
- No limited partner could withdraw his or her capital account;
- No limited partner could withdraw from the partnership;
- No limited partner could transfer or encumber his or her partnership interest;
- The donor could assign or otherwise transfer her partnership interests at any time without restriction;
- The transferee of a limited partner would be an “assignee” rather than a limited partner unless admission to partnership status was approved by the donor or her estate, and by partners owning more than 50 percent of the total partnership interests; if the donor and her estate were no longer partners, partnership status for a transferee required the affirmative vote of partners holding more than two-thirds of the total partnership interests.
In technical advice, the IRS stated that the gifts of limited partnership interests did not qualify for the gift tax annual exclusion. The IRS stated that the partnership agreement so severely restricted the use and enjoyment of the limited partnership interests that the limited partners had no present and immediate tangible, economic benefit.
The IRS denied that the terms of the agreement were ordinary business conditions. It noted that applicable state law allowed assignment of a partnership interest “unless otherwise provided in the partnership agreement,” and that it also allowed a limited partner to withdraw to the extent specified in the agreement. The IRS criticized the right of the general partner to retain funds within the partnership for future expenditure for any purpose whatsoever, stating that this was “extraordinary and outside of the scope of a business purpose restriction.”
On the other hand, in Private Letter Ruling 1999-44-003, a family limited partnership created by H and W, a married couple, reached a more favorable result with respect to gifts of limited partnership interests. H and W gave a percentage of limited partnership interests to each of their children. The partnership agreement stated that the general partners were solely responsible for the management of the partnership business and that they alone determined the timing and amount of any distributions. The limited partner could assign his or her partnership interest. From the date of any assignment, the assignee would be entitled to receive a pro rata share of any partnership distributions of net cash flow or other property, as well as the allocation of partnership profits, losses, and credits attributable to the assigned interest. The partnership agreement precluded a limited partner from withdrawing from the partnership.
The IRS ruled privately that gifts of limited partnership interests qualified for the gift tax annual exclusion because the partnership agreement gave the donee an unrestricted right to the immediate use, possession, or enjoyment of the partnership interest. The IRS noted that (1) the partnership agreement did not divert substantially from the provisions of state law, (2) the donors, as general partner, held no powers of management inconsistent with those contained in a standard limited partnership agreement, and (3) both the partnership agreement and state law imposed on the general partners the highest standard of conduct in the management of the partnership.
Private Letter Ruling 1999-44-003 is much more favorable than Private Letter Ruling 97-51-003, in which the IRS denied the annual exclusion for a gift of a limited partnership interest. The different results are based on differences in the two agreements. The most critical differences appear to be that:
- The partnership agreement in the 1997 ruling gave the general partner the right to withhold distributions in the partner’s “complete discretion” and “for any … reason whatsoever”; and
- The partnership agreement in the 1997 ruling precluded a limited partner from transferring or encumbering his or her partnership interest.
The Tax Court considered this issue in Hackl v. Comm’r,67 which is extremely important with respect to gifts of family limited partnership and family limited liability company interests. The taxpayers in Hackl created a family LLC to own and operate a tree farm. They anticipated that the farm would produce no current income, but would eventually produce significant capital gains. The taxpayers formed the LLC, transferred assets to it, and then assigned LLC membership interests to their children, their grandchildren, and trusts for their grandchildren.
The operating agreement appointed one of the donors as the manager of the LLC for life and gave him the right to determine when and if distributions would be made. However, any distributions had to be made to all members of the LLC in proportion to their membership interests. No member could withdraw any of his or her capital account or compel the LLC to make any distributions without the approval of the manager. Members could not withdraw from the LLC without the prior consent of the manager. A member could, however, offer to sell his or her LLC membership units to the LLC if the manager chose to buy them. A member could sell or otherwise transfer his or her interest only with the manager’s consent. Each member could vote to remove the manager and elect a successor, though an 80 percent vote was required.
The Tax Court agreed with the IRS that the taxpayers’ gifts of membership interests did not qualify for the annual gift tax exclusion because the LLC agreement’s restrictive provisions did not give the donees a present interest and also gave them no substantial economic benefits. The Tax Court emphasized that the present interest rule requires that the donee receive a “substantial present economic benefit” from the possession, use, or enjoyment of the gifted property or the income produced by it. The Tax Court found the required benefit to the donees lacking in Hackl.
In practice, some estate planning attorneys will focus on the fact that the operating agreement in Hackl gave the donee members minimal control over the economic activities and benefits of the LLC, but the terms of the agreement in Hackl are only slightly more severe than those of most FLPs and FLLCs. Most such agreements assure effective control to the donor, as the dominant family member, who then controls the operation of the enterprise. Most such agreements also limit the donees’ rights to withdraw or transfer their interests. These arrangements lose their appeal for most without the ability to control the enterprise’s future operations.
To enhance the donees’ economic benefit in an FLP or FLLC, drafters might consider permitting the donees to sell their interests. Permitting the donees to sell their interests carries little risk that they will actually do so because virtually no one would purchase a minority, non-voting interest in an FLP or FLLC. Unfortunately, the Tax Court noted that the members of the LLC in Hackl could freely assign their interests, but that the manager had to consent to the admission of an assignee as a full member. This is similar to the requirements for most family limited partnership agreements. Few donors would want assignees to become new partners without the consent of the other partners.
Drafters should take into account the annual gift tax exclusion when designing a family partnership agreement. The donor should definitely give partnership interests to the donees instead of merely adding property to the partnership and crediting it to the donees’ capital accounts. However, the donor should not retain rights to withhold distributions to the other partners greater than those otherwise allowed by state law. The donor also should not unduly restrict the ability of the other partners to transfer their own interests.
In drafting family limited partnership agreements, drafters should consider the following options:
- Give the donee partner something of a Crummey withdrawal right like that used in an irrevocable life insurance trust, i.e., a temporary right to withdraw any gratuitous additions to his or her capital account immediately after such gifts of capital account interests.
- Give the donee partners the right to sell their interests to anyone so that the donees could still obtain a fair market value price for their interests. A right of first refusal in the remaining partners or the partnership should also be considered here.
- Give the donee partner a “put” right by allowing the donee to require that the partnership or the donor buy the partnership interest for its gift tax value (as adjusted for any discounts claimed on the gift, which does not sacrifice the valuation discounts in these situations).
Require the general partner to distribute net cash flow currently, which should allow at least part of the limited partnership interest to qualify for the annual gift tax exclusion. Only the value of the income interest would qualify as a present interest in this situation.
- Allow the donee partner to withdraw from the partnership and cause dissolution of the partnership or allow the donee partner to redeem his or her partnership interest.69 The problem with this type of withdrawal right is that it could potentially significantly reduce the marketability and control discounts available on most transfers of limited partnership interests.
D. Sec. 2036.
Section 2036 is explained in the section that follows.70 In basic terms, the IRS has argued that the interests of an FLP that are retained by the decedent, which sometimes include the controlling interest of the corporate general partner, should trigger the inclusion of the entire FLP under Section 2036. This position is based primarily on the principle that the decedent’s “hand” was still in the “cookie jar.”
E. Gift on Formation.
As mentioned, the IRS has argued for years that a gift occurs upon the formation of a family limited partnership because the transferor receives partnership interests that are worth less than the value of the assets that he or she transferred to the partnership. The “gift on formation” argument is expected because of the heightened scrutiny for all intra-family transactions.
The IRS noted in Field Service Advice 1999-50-014, which involved a family limited partnership, three taxpayer counterarguments to the gift on formation theory:
- No gift occurs on formation because a partnership interest represents a proportionate interest in all of the property transferred to the partnership.
- If the formation of a family entity results in a gift, then all of the family members have made gifts because the interest received is generally worth less than the assets contributed to the partnership.
- The inability to identify the donees throws into question whether a transfer has occurred at all.
The IRS countered each of these counterarguments, of course. However, they are relevant as references in case the issue arises in the future. The IRS also noted that the gift on formation argument could be bolstered by the following IRS arguments:
- The partnership lacks economic substance and should be disregarded.71
- The partnership lacks a business purpose and should be disregarded.72
- Section 2704 applies, and the value of the interest is determined without regard to certain restrictions on the ability to liquidate the partnership.
All of these arguments have not “held water” in the courts. For example, in Strangi I, the Tax Court held that creating a family limited partnership was not a taxable gift merely because the value of the limited partnership interests received by the decedent had much lower value than his contributions. Rather, the Tax Court valued the partnership interests without regard to the transfer and withdrawal restrictions under Section 2704(b). The court stated:
Using the value reported by petitioner on the estate tax return, if decedent gave up property worth in excess of $10 million and received back a limited partnership interest worth approximately $6.5 million, he appears to have made a gift equal to the loss in value…. Following the formation of SFLP, decedent owned a 99-percent limited partnership interest in SFLP and 47 percent of the corporate general partner, Stranco. Even assuming arguendo that decedent’s asserted business purposes were real, we do not believe that decedent would give up over $3 million in value to achieve those business purposes.
Nonetheless, in this case, because we do not believe that decedent gave up control over the assets, his beneficial interest in them exceeded 99 percent, and his contribution was allocated to his own capital account, the instinctive reaction that there was a gift at the inception of the partnership does not lead to a determination of gift tax liability…. However, in view of decedent’s continuing interest in SFLP and the reflection of the contributions in his own capital account, he did not transfer more than a minuscule proportion of the value that would be “lost” on the conveyance of his assets to the partnership in exchange for a partnership interest.73 Realistically, in this case, the disparity between the value of the assets in the hands of decedent and the alleged value of his partnership interest reflects on the credibility of the claimed discount applicable to the partnership interest. It does not reflect a taxable gift.
The Fifth Circuit affirmed the Tax Court’s decision regarding the economic substance of the partnership in Strangi II. (Whether the value of the assets transferred to a family limited partnership by a deceased donor should be included in the donor’s gross estate under Section 2036(a) was a separate issue.)
When the contributing partner holds an immediate, continuing interest in the partnership’s capital, all of the other cases that have considered the gift on formation argument have rejected it.74 The gift on formation argument will succeed, however, if the percentage of the value of the assets contributed by one partner to the total of all contributed assets is greater than the percentage of that partner’s partnership interests.
IV. Review Of Sec. 2036
A. Language of Sec. 2036(a).
Code Sec. 2036(a) reads as follows:
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 the 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.
B. Excluded Transfers – Bona Fide Sale For Adequate And Full Consideration.
The parenthetical phrase in Sec. 2036(a) clearly excludes any transfer, which is “a bona fide sale for an adequate and full consideration in money or money’s worth.” If the decedent received full consideration for the property transferred, there has been no diminution in value of the decedent’s estate. The property transferred has been replaced by the property received in consideration.
The issue of whether full and adequate consideration has been addressed by several courts in the context of a sale of a remainder interest. If the decedent transfers property retaining a life estate and is paid the actuarial value of the remainder interest, there is no diminution in value of the decedent’s estate. The value of the life estate retained by the decedent plus the value of the remainder interest paid to the decedent necessarily equals the full value of the property. Nevertheless, it can certainly be argued that in order to qualify for the exclusion the decedent must be paid an amount which equals the entire value of the property.75 This argument, however, has been rejected by the Third, Fifth and Ninth Circuits which have found the exclusion applies where the decedent is paid the full value of the remainder interest.76 Two divergent lines of cases have emerged regarding the prerequisites for qualifying for the exception. The view adopted by the circuit courts is that once it is determined full and adequate consideration is received, no further inquiry need be made.77 Thus, these cases ascribe no particular significance to the portion of the exception in the statute which indicates that the sale must be “bond fide,” beyond perhaps the notion that neither the transfer nor the adequate and full consideration can be illusory or a sham.78 This argument has merit, particularly when viewed in light of the reason for the exclusion, i.e. there is no need to bring a decedent’s transfer back into the gross estate where the property transferred was replaced with property of equal value, thus avoiding a diminution in value of the estate.
The second line of cases more recently adopted by the Tax Court, however, requires the following two conditions to be satisfied before the exception can apply: (1) the transfer must be “bona fide,” meaning that the transaction is at arms length, and (2) the decedent must have received full and adequate consideration.79 These Tax Court cases arise in the context of limited partnership cases that included partnership assets in the estate of the decedent under Sec. 2036. In Strangi I, for example, the estate had argued Section 2036 was not applicable because the decedent had transferred property to the partnership in exchange for partnership interests of equal value to the property transferred. In fact, the Service had argued that the partnership interests had less value than the property transferred and that accordingly a gift had occurred on formation of the partnership. The court rejected the Service’s gift on formation argument, thus acknowledging that no diminution in value had occurred in Strangi’s estate. Yet in Strangi III, Judge Cohen finds the estate did not qualify for the exception because the sale was not at arms-length. The Court, found that the transfer merely resulted in a “recycling” of Strangi’s assets and that because Strangi stood on both sides of the transaction, he cannot claim the transfer as a bona fide sale. Oddly enough, Strangi III is appealable to the Fifth Circuit and Judge Cohen failed to acknowledge in her opinion the Fifth Circuit precedent, in Wheeler , which held that full and adequate consideration is sufficient to invoke the exception.80 In Wheeler , the Court said:
…Accordingly, the term “bona fide” preceding “sale” in Section 2036 is not, as the government seems to suggest, an additional wicket reserved exclusively for intra family transfers… In addition to arguing that “adequate and full consideration” means different things for gift tax purposes than it does for estate tax purposes, the government would also have us give “bona fide” not only a different construction depending on whether we are applying the gift or estate tax statute, but also different meanings depending upon the identity of the purchaser as a Section 2036(a) transaction. We do not believe that Congress intended, nor do we believe the language of the statute supports, such a construction.81
Although the Tax Court cases don’t say so, perhaps they can be better explained that the transactions are not a “sale” of property in the traditional sense. The exception requires there be a “bona fide sale.” The Circuit Court cases dealing with sales of remainder interests involve sales of property in the traditional sense. The transfers in the partnership cases, on the other hand, were capitalizations. There is a fundamental difference between a capitalization of an entity and a sale of property. The former situation results in a “recycling” of property into a separate entity in exchange for equity interests in that entity. For income tax purposes, different tax consequences can flow from a capitalization of an entity in exchange for equity interests versus a sale of property in exchange for property other than an equity interest. There are situations where a partner conveying property to a partnership may wish to avoid the nonrecognition of gain provisions of Code Section 721. For example, partner A transfers land worth $500,000 in which A has a basis of $100,000. Partner B contributes $500,000 of cash. The partnership develops the property into a subdivision and holds the lots for sale to customers in the ordinary course of business. The partnership agreement complies with the special allocation rules of Code Section 704(b) and the regulations promulgated thereunder. When the partnership sells the lots, the gain allocable to the built in gain will be allocated to A, and because the partnership is a dealer, the gain will be ordinary income.82 Instead, A sells the land to the partnership for $500,000. The $400,000 gain to A will be capital gain. Typically, the transferring partner will receive an installment obligation for the partnership to be satisfied out of partnership profits. If A owned more than 50% of the interests in partnership capital or profits, then Code Section 707(b)(2) would characterize the gain to A as ordinary income. Also, Code Section 707(b)(1) disallows a loss on a sale by a controlling partner to a partnership.
In a similar vein, real estate and tax shelter promoters would utilize a bifurcated contribution and distribution series of transactions to avoid gain on transactions that in reality were disguised sales. To curb these abuses, Code Section 707(a)(2)(B) was enacted to authorize the Service to promulgate regulations to establish criteria to recharacterize purported contribution and distribution transactions as sales of property or partnership interests.
Although recognition of gain or loss by the transferor is admittedly not the polestar to whether adequate and full consideration is received, the disparate treatment recognized between a transfer that is a sale for income tax purposes and one that is not should intuitively be the same in the gift and estate tax arena. Indeed, for the exception to apply, it is not enough for inadequate and full consideration be received. The literal terms of the statute require that the consideration be received in exchange for “a bona fide sale.” Although the cases seem to wrangle over whether or not the transaction is “bona-fide,” perhaps the real focus ought to be on whether or not there was a “sale.” Unless they are recharacterized as disguised sales under Code Section 707(a)(2)(B) and the corresponding regulations, contributions to partnerships in exchange for partnership interests are not sales for income tax purposes. Although it is not articulated as such, perhaps this is the notion the Tax Court has adopted with its “recycling” concept.
Whether or not the transaction occurs between related parties ought not to be the guiding factor. There are many instances where sales between related parties are respected for estate and gift tax purposes, including private annuity transactions, installment sale transactions and sales to defective grantor trusts. If a sale has occurred (the qualifier “bona fide” merely being indicative of whether the sale is illusory or a sham) and adequate and full consideration received, the literal language of the statute applies. The Tax Court result in Strangi III regarding the bona fide sale exception is arguably correct (i.e. no sale has occurred), however, the rationale is flawed and the language indicating that a sale cannot occur between related parties is dangerous when its expansive reach is pondered. Although this distinction is present, it is not mentioned or even alluded to by the Tax Court in Strangi III. Rather, the Tax Court appears to be concerned with what it perceives to be a tax-driven, abusive transaction. Thus, it adopts a subjective facts and circumstances approach of whether the transaction is sufficiently at arms-length so as to avoid tax avoidance as its primary objective.
C. Prerequisite To Applicability.
1. Transfer By The Decedent.
In order for Section 2036 to apply, there must have been a transfer by the decedent. This seems a rather basic, easily understood concept. For purposes of Section 2036, “transfer” has been defined “…as an act that depletes one’s potential §2033 gross estate and augments the wealth of one or more natural objects of one’s bounty.”83 In fact, in Wheeler the Fifth Circuit ruled that if a transfer does not occur for gift tax purposes, there can be no transfer for purposes of Section 2036.84 This argument is based on the premise that the gift tax and estate tax should be construed in pari materia.85 Of course, this concept was rejected by Strangi III which found no gift had occurred on formation of the partnership, yet included the assets transferred to the partnership in the decedent’s gross estate under Section 2036. If Strangi III is appealed , the Fifth Circuit could very easily apply its precedent in Wheeler to find that no transfer occurred for purposes of Section 2036.86
2. Retained Interests.
Section 2036(a) will apply with respect to property transferred by the decedent only if the decedent has retained either (1) a beneficial interest in the property transferred87 or (2) the right to control the beneficial interests of others.88 The two alternatives are disjunctive, either one or the other will result in inclusion in the gross estate. There are, however, important distinctions between the two concepts.
a. Decedent’s Beneficial Interest. There are two distinctive types of interest that if retained by the decedent, will trigger applicability of the section. First, if the decedent retains “the possession or enjoyment of… the property,” then the statute applies. Also, if the decedent retains “the right to income from… the property,” then the statute applies. To be sure, the beneficial interest that must be retained before the statute will apply must be in the actual property transferred. Clearly, if a person makes a gift of a home or a car but retains the use of the home or car for her life, the statute will apply. An important distinction here is that the decedent need not have a legal right to possess or enjoy the property. Rather, the applicability of the portion of the statute hinges on actual enjoyment or possession. The issue of whether the decedent has retained possession or enjoyment has been hotly litigated in situations where the decedent has given her house away but has continued to live in the house. If the decedent has in fact lived in the house for the remainder of her life, then literally the statutory prerequisite is met and the value of the house should be included in the decedent’s estate. This has consistently been the position of the Internal Revenue Service.89 The cases have mostly been resolved on a facts and circumstances basis, with some following the Service’s view that actual continued occupancy is sufficient to involve the statute.90 Others, however, look for an implied agreement or understanding to hang the Sec. 2036(a)(1) hat on, and whether the statute applies was in many cases dependant upon whether a family member continued to reside with the decedent.91 Contrast the language of the statute regarding retention of possession or enjoyment with the alternative prerequisite that the decedent retained the “right to income” from the transferred property. The use of the word “right” implies a legal right must have been retained. As will be more fully discussed below, the statutory prerequisite that there be a “right” to income is similar to the second parenthetical of Section 2036(a) which also hinges on “the right…to designate the persons who shall possess or enjoy the property or the income therefrom.”92 It was this concept, that a legal right must be retained to invoke Sec. 2036(a)(2), which the Supreme Court addressed in Byrum when it held that the term “right” connotes an ascertainable and legally enforceable power which the decedent lacked due to his fiduciary duty owed to the corporation.93 The Tax Court has shown a recent willingness to determine that a legal right can exist through an implied agreement or understanding as evidenced by the facts and circumstances surrounding the case under circumstances where the decedent transferred property to a family limited partnership and actually received partnership income for his personal living expenses despite the requirement in the partnership agreement that other partners (who were close family members) receive prorata income distributions.94
b. Decedent’s Right To Designate Other’s Beneficial Interest.
Where the decedent retains the enjoyment or use of, or right to receive the income from, transferred property, the policy reasons for including the value of the property in the decedent’s estate are clearly evident. The lifetime transfer by the decedent, coupled with the delayed enjoyment to the transfer taking place at decedents’ death, is in actuality more akin to a testamentary transfer. The policy reasons for inclusion in the decedent’s estate seem less clear where the decedent has retained no enjoyment or possession of the property, but has retained the right to designate who will possess or enjoy the property. On the surface, however, it may be justified that because we don’t know who will ultimately enjoy the benefit of the property until the decedent’s death, the transfer remains testamentary in nature. As the outward bounds of this provision are reached, however, the justification appears blurred. Remember, at the outset, that the decedent must have retained the “right,” again a term that Byrum says connotes a legally enforceable and ascertainable power.95 The proscribed right can be clearly seen in a situation where the decedent transfers property to a trust in which she, as trustee, has the power to accumulate income and distribute income and principal among beneficiaries in her discretion. What if, however, the trustee is an independent trustee and the decedent may remove and replace the trustee without cause? The Service originally took the position that in such a case the decedent retained the right indirectly and that is sufficient to invoke the statute.96 The Service lost this position in Estate of Wall, a case where attorney’s fees were awarded against the Service for maintaining that position.97 Consequently, the Service retreated from its position, but insisted that the replacement trustee must be independent.98
Is the power held by the decedent to accumulate income a proscribed power to designate who benefits such that Sec. 2036(a)(2) is invoked? Clearly, O’Malley has held if the accumulated income may ultimately pay to the remainder beneficiary other than the current income beneficiary, then the power to accumulate will invoke Sec. 2036(a)(2).99 What is far less clear, however, is the situation where the accumulated income will either be paid ultimately to the income beneficiary or the beneficiary’s assignee. In Struthers v. Kelm, the Eighth Circuit ruled Sec 2036(a)(2) applicable due to the decedent’s power as trustee to accumulate income despite the fact that the trust instrument provided distributions during decedent’s life to her daughter and then the remainder to the daughter, and local law provided daughter had the right to dispose her remainder interest by will if she died intestate before her mother, or to her heirs at law if she died intestate before her mother.100 Professors Stephens, Maxfield, Lind, Calfee and Smith make a cogent argument that a power to accumulate which merely affects the time of enjoyment of property but not the persons who will enjoy the property, notwithstanding the wrongly decided Struthers case and dicta in O’Malley, should not trigger inclusion under Sec. 2036(a)(2).101 Unfortunately, the Tax Court ignores this distinction in its recently decided Strangi III case.102 Discussed in more detail below, Judge Cohen in Strangi III included assets in the decedent’s estate, which the decedent had transferred to a limited partnership during life, under Sec. 2036(a)(2). The Court found that Strangi, acting through his son-in-law, Gulig, who held a durable power of attorney for Strangi, had the power to vote the general partnership interests to affect the timing in which partnership distributions would be made, thus triggering inclusion under Sec. 2036(a)(2). It is notable that in Strangi III the general partner had a right to cause distributions or accumulation of income, but there is no right to shift the income from one partner to the other or to non-partners. Eventually, all of the income will be paid pro rata to partners or to partners’ successors and assigns. Thus, the power is one merely to affect the timing of income. Judge Cohen’s decision adopts the positions of Struthers and the dicta in O’Malley, but is devoid of any discussion about the issue.
D. Period of Retained Interest.
The preceding sections have discussed the nature of interests that must be retained to invoke the inclusion rule of Section 2036(a). Retaining a proscribed interest, however, is not sufficient in and of itself to trigger applicability of the statute. The interest must have been retained for a certain period for the statute to be triggered. The Code actually refers to three periods:
- the decedent’s life,
- any period not ascertainable without reference to the decedent’s death, and
- any period which does not in fact end before the decedent’s death.103
The first period is obvious. A transfer by a person of her house retaining a life estate is an easy example. That involves retaining use of the house for her life. The latter period also is straightforward. If a person transfers property to a trust and retains the right to use that property, or the right to received the income form the property, for a period of ten years, Section 2036 will cause inclusion if the person dies within that ten year period.104 The middle period, the one not ascertainable without reference to the decedents death, is necessary to prohibit easy avoidance of the statute.
For example, assume a decedent had transferred property to a trust, retaining the right to receive the income from the property for a period which ends immediately prior to his death. Neither the first nor the third periods would apply to cause inclusion. Because the period for which the interest is retained cannot be determined without reference to the decedent’s death, Section 2036(a) applies to include the value of the property in the decedent’s gross estate.105
What if the decedent transfers property and retains the right to use the property for a period that begins one year after the date of transfer and which ends at his death? Both the second and third periods would apply to trigger inclusion under the statute.106
E. Amount Included In The Gross Estate.
If the policy reason behind Section 2036 is to treat transfers subject to its reach as testamentary in nature, then it is intuitive to include the full date of death value of the property transferred. There is authority, however, for the proposition that only a portion of property transferred will be included in the gross estate.107 If a decedent transferred property in trust and retained the right for her life to receive twenty-five percent of the income earned from the trust, then the amount to be included under Section 2036(a)(1) would be twenty-five percent of the date of death value of the trust principal.108 On the other hand, it is equally clear that more than the value of transferred property can be included under Section 2036. For example, if a decedent transfers property into trust retaining for life the discretionary power as trustee to distribute to herself the trust’s income, §2036 applies to include the date of death value of the trust’s corpus, even if that corpus includes accumulated income.109 This result applies even though the decedent never transferred the accumulated income.
Finally, there is an important distinction when property is included under Section 2036(a)(1) versus Section 2036(a)(2). In the latter case, the full date of death value is always included in the gross estate. This fact has particular significance under Strangi III, where the Tax Court held the assets of the limited partnership includable under Section 2036(a)(2).110 If that decision is correct, then the result might be full inclusion of the partnership’s assets where, if inclusion was only under Section 2036(a)(1), then arguably only a pro rata portion of the partnership assets equal to the decedent’s retained partnership interest percentage should be included.
F. Sec. 2036(b) (Anti-Byrum).
In United States v. Byrum,111 the decedent transferred stock of three corporations which he controlled to a trust for the benefit of his children. The trust instrument appointed an independent trustee and gave the trustee discretion to pay income and principal to the decedent’s children. The decedent retained the right to vote the stock that was transferred to the trust. The trust retained the stock until the decedent’s death. Although the decedent controlled the corporations, each corporation had significant interests held by unrelated minority shareholders. The Service maintained that the value of the stock should have been included in the decedent’s gross estate under Section 2036(a)(2). The Service’s position is that through the decedent’s power to affect the board of directors’ dividend policies, the decedent effectively had the power to control the beneficial enjoyment of the trust’s income. The Supreme Court rejected the Service’s position, essentially holding that the decedent had not retained a right that was both ascertainable and legally enforceable. The Court also determined that the decedent’s “control” over the corporations’ dividend policies was constrained by fiduciary duties to the corporations and other shareholders. Also, the Court stated that the decedent had no control over the customary vicissitudes of the corporations’ businesses which would significantly affect the trust’s income. This case was legislatively overturned by Code Section 2036(b), which has been dubbed the “anti-Byrum” provision, but only for transfers to controlled corporations. That section operates to treat the direct or indirect retention of voting rights in a “controlled corporation” (generally at least 20% of combined voting power) as the retention or enjoyment of transferred property for purposes of Section 2036(a)(1).
Until Strangi III, it was generally believed that Byrum stood for the proposition that a fiduciary duty owed by a general partner to the partnership would preclude inclusion of an FLP’s assets in the general partner’s gross estate. See the discussion below for a more detailed discussion of this issue under Section 2036.
V. Cases Applying Sec. 2036 To FLPs Based On Facts And Circumstances
A. Estate of Schauerhamer v. Comm’r.112
1. Formation Facts.
The decedent in Schauerhamer was diagnosed with cancer in November 1990. The decedent met with an estate planning attorney in early December 1990. On December 31, 1990, the decedent, along with her three children and their spouses, met with the estate planning attorney and implemented the following plan. First, three partnership agreements were executed and certificates of limited partnership were filed with the State of Utah.
Second, each of the decedent’s children owned a four percent general partnership interest. The decedent owned a one percent general partnership interest and a 95% limited partnership interest. The partnership agreement stated that each child would contribute four dollars (for his or her four percent general partnership interest) and the decedent would contribute $95 (for her one percent general partnership interest and her 95% limited partnership interest). Third, the decedent served as managing partner of each partnership.
The decedent contributed various assets, in undivided one-third interests, to the three partnerships. It appears that the assets contributed were “business” assets. There is no indication that the children made any contribution of assets to the partnerships. The decedent made thirty-three gifts of limited partnership interests, each with a value of a “$10,000 interest in the partnership.” On January 1, 1991, the decedent made gifts identical to the former thirty-three limited partnership interests.
2. Operational Facts.
The most damaging facts in Schauerhamer arose from the operation of the FLP. Each partnership’s initial capital was deposited into a partnership bank account. The partnership agreements required that all income from the partnership be deposited into a partnership account. However, the decedent deposited such income and income from other sources into an account held jointly between her son’s wife and her.
Additionally, the decedent did not maintain any records to account separately for the partnership and non-partnership funds. The decedent utilized the account as her personal checking account and paid personal and partnership expenses from the account. The decedent also transferred additional assets to the partnerships on November 5, 1991, which was thirty-eight days prior to her death. Again, there is no indication that the children made any contribution of assets to the partnerships.
3. Application of Section 2036.
Section 2036 applied in Schauerhamer. The Tax Court held that the facts established that an implied agreement existed among the partners. The decedent owned the assets subsequently transferred to the partnerships and collected the income the assets generated. In violation of the partnership agreements, the decedent deposited the partnership income into an account that she used as a personal checking account and commingled partnership income with income from other sources. The Tax Court stated that “[s]uch deposits of income from transferred property into a personal account are highly indicative of ‘possession or enjoyment.’”
The decedent managed the assets and income generated by the assets exactly as they had been managed in the past. The Tax Court stated that “[w]here a decedent’s relationship to transferred assets remains the same after as it was before the transfer, section 2036(a)(1) requires that the value of the assets be included in the decedent’s gross estate.”
B. Estate of Reichardt v. Comm’r.113
1. Formation Facts.
The decedent in Reichardt, immediately after being diagnosed with terminal cancer, and his son met with a certified public accountant on June 5, 1993. On June 17, 1993, the decedent executed his revocable trust and a family limited partnership agreement. The decedent and his children were the co-trustees of the revocable trust; it appears that each trustee had independent authority to act on behalf of the trust. The revocable trust was the limited partnership’s only general partner.
The certificate of limited partnership was filed on June 21, 1993. The decedent then transferred all of his property, except for his car, personal effects, and a nominal amount of cash, to the newly-formed partnership.
The decedent was also the beneficiary and co-executor (with his children) of his wife’s estate. He signed deeds individually and on behalf of his wife’s estate which conveyed the estate’s and his interests in various pieces of real estate, including his residence, to his revocable trust. He also signed deeds as trustee conveying such real estate to the limited partnership.
Within the next two months, the decedent transferred to the trust and then to the partnership the following assets: investment accounts, a note receivable, and approximately $33,000 in cash. At least $20,540 of the cash was attributable to rental income from the real property that the decedent had previously contributed to the partnership. Again, a portion of the real estate contributed to the partnership was owned by the decedent’s wife’s estate. His wife was the beneficiary of her late uncle’s estate. When a portion of the real estate was sold, the proceeds were paid to the decedent’s wife’s estate; the funds were then contributed directly into the partnership’s bank account.
2. Operational Facts.
The decedent controlled and managed, or allowed the co-owners to control and manage, the partnership assets in the same manner before and after he transferred such assets to the partnership. The decedent used the same brokers and asset managers before and after he transferred the property to the partnership. The decedent was the sole individual who signed partnership checks and documents. While some of the real property owned by the decedent was conveyed to the partnership, the co-owners of such property continued to manage such property. Additionally, the decedent continued to live in the residence contributed to the partnership, he did not pay any rent to the partnership.
The decedent’s accountant made adjusting entries in the partnership’s accounting records in an attempt to classify items of income and expense between the decedent and the partnership. There was no evidence that the partnership or the decedent transferred any funds to the other as a result of the adjusting entries.
3. Application of Section 2036.
Section 2036 applied in Reichardt. First, the decedent did not “curtail” his enjoyment of the transferred property after he formed the partnership. Nothing changed except bare legal title to the assets. The decedent managed the trust, which managed the partnership. He was the only trustee who signed the articles of limited partnership, the deeds, the transfer of lien, and any document that could be executed by one trustee on behalf of the trust. He was the only trustee who opened brokerage accounts or signed partnership checks. He did not open any accounts solely on behalf of the trust.
Second, the decedent commingled partnership and personal funds. He deposited some partnership income into his personal account, and he used the partnership’s checking account as his personal account. The decedent also lived in the residence before and after he contributed it to the partnership, and he did not pay rent to the partnership for his right to live in such residence. Third, the decedent transferred nearly all of his assets to the trust and subsequently the partnership. The Tax Court stated that “[t]his suggests that decedent had an implied agreement with his children that he could continue to use those assets.”
C. Estate of Thompson v. Comm’r.114
1. Formation Facts.
The decedent in Thompson executed a durable power of attorney in favor of his children, Robert Thompson and Betsy Turner. In an effort to reduce their father’s estate tax exposure, Robert and Betsy consulted with various advisors regarding the establishment of two family limited partnerships on behalf of the decedent. His two children and their families then formed the Turner Partnership (“Turner FLP”) and the Thompson Partnership (“Thompson FLP”). The financial advisor worked for the company that was the licensee for Fortress Financial Group, Inc., the same group that was involved with the Strangi family in Strangi.
The Turner FLP was established under Pennsylvania law for the benefit of Betsy and her husband, George Turner, and their family. The Turner Corporation served as the corporate general partner and owned a one percent interest in the Turner FLP. The decedent was a 95% limited partner, and Mr. Turner was a three-and-one-half percent limited partner. Regarding the Turner Corporation, the decedent owned 490 shares, Betsy and Mr. Turner each received 245 shares, and an unrelated tax-exempt entity received the remaining twenty shares.
The Turner FLP and Turner Corporation were formed on April 21, 1993, and were funded in the same year. The Turner FLP was funded as follows. The decedent contributed marketable securities with an approximate value of $1,286,000, in addition to notes receivable from Betsy’s children. Mr. Turner contributed $1,000 in cash, as well as real property located in Vermont with a value of $49,000. The Turner Corporation issued a non-interest bearing note in favor of the decedent for its interest in the Turner FLP.
After being advised that the initial contribution of assets to the partnership might have unnecessarily triggered gain under IRC § 721 (the investment company rules), the partnership agreement was retroactively amended (via an undated amendment) to allocate gains, losses, and distributions from the property located in Vermont to Mr. Turner, the original contributor of such property.
The Thompson FLP was established under Colorado law for the benefit of Robert and his family. The Thompson Corporation was the corporate general partner, owning a one percent interest. The decedent was a sixty-two-and-one-quarter percent limited partner, and Robert was a thirty-six-and-three-quarters percent limited partner. Regarding the Thompson Corporation, the decedent and Robert each owned 490 shares, with Robert H. Thompson and an unrelated party receiving the remaining twenty shares.
Similar to the Turner entities, the Thompson FLP and Thompson Corporation were formed on April 21, 1993 and were funded in the same year. The Thompson FLP was funded as follows. The decedent contributed marketable securities with an approximate value of $1,118,500, in addition to notes receivable from Robert’s family members. Robert contributed his interest in mutual funds with an approximate value of $372,000, as well as his Norwood ranch that was appraised at $460,000.
2. Operational Facts.
Before forming the entities, the decedent and his children agreed that decedent “would be taken care of financially.” Before and after the formation of the partnerships, Betsy and Robert consulted with the financial advisors regarding the decedent’s accessibility to assets in the partnerships for purposes of continuing the decedent’s practice of giving around Christmas time to various family members. Based upon such consultations, distributions were made from the partnerships in 1993, 1994, and 1995 in order for the decedent to continue his gifting.
The decedent contributed the majority of his assets to the partnerships. Thus, distributions from the partnerships were made for purposes of satisfying the decedent’s personal expenses. Regarding the Turner FLP, investment strategies for assets did not change upon the transfer of assets to the partnerships. Also, the same advisors were employed, trading activity of the account was recognized as not even “moderately” traded. The Turner FLP owned insurance policies on the lives of Betsy and Mr. Turner, and paid annual premiums on such policies.
The Turner family engaged in a real estate venture involving Lewisville Properties, a modular home construction venture. The Turner FLP financed the purchase and construction costs through a margin loan made on the Turner FLP account.
Betsy and Mr. Turner assigned their interest in a real estate partnership to the Turner FLP; however, after such assignment, the partnership interest remained titled in the name of Betsy and Mr. Turner rather than in the name of the Turner FLP. The Turner FLP engaged in various loans to the Turner children and grandchildren. Monthly interest payments owed on the notes were often late or never paid. No enforcement action was taken regarding the repayment of the interest. No loans were made to anyone outside of family members.
During the funding process, Robert contributed his Colorado ranch to the Thompson FLP and entered a lease for such property, paying rent of $12,000 per year. Robert maintained the ranch in the same manner before and after the contribution (i.e., raised and trained mules on the ranch). Any income from the sale of the mules went to Robert rather than the partnership. However, the Thompson FLP claimed losses in various years from the operation of the ranch. After the decedent’s death, distributions were made from the partnerships to fund specific bequests set forth in decedent’s will. Additionally, the partnerships provided funds to pay for the decedent’s estate taxes.
3. Application of Section 2036.
Section 2036 applied in Thompson. The Tax Court recognized that an “implied agreement” existed among the decedent and his children that allowed the decedent to retain the benefit and enjoyment of the assets transferred to the FLPs during his lifetime.
First, the decedent transferred the majority of his assets to the partnerships and retained an insufficient amount for his support. Thus, a distribution from the partnerships was necessary, and was made, to satisfy the decedent’s personal expenses. The Tax Court reasoned that transfers from the partnerships to the decedent could only have been explained if the decedent had at least an “implied understanding that his children would agree to his requests for money from the assets he contributed to the partnerships, and that they would do so for as long as he lived.”
Second, assets were “formally” transferred from the decedent to the partnerships. However, there was no meaningful change in the composition of the asset portfolio or in the decedent’s relationship to the assets. The decedent was still the “principal economic beneficiary” of the contributed property after such contribution. The Tax Court recognized that only a “legal title” change occurred with respect to the property transferred. Property transferred to the partnerships was merely “recycled,” meaning that the form of ownership of the property had changed (from individual ownership to entity ownership) but the decedent’s relationship to such assets had not.
Third, the decedent’s family members also engaged in this “recycling” of their assets through the partnerships. The assets contributed to the partnerships were not pooled with the other partners’ contributions. Specifically, although the partner transferred property to the partnership, he or she continued to receive the sole benefit of income generated by such property after the contribution rather than having income generated by the partnership property disbursed to the partners according to their partnership percentages.
The taxpayer in Thompson has appealed the Tax Court’s decision to the Third Circuit Court of Appeals.
D. Estate of Harper v. Comm’r.115
1. Formation Facts.
The decedent in Harper was an attorney specializing in entertainment law. However, he had experience in the areas of tax, trusts, and estates law. The decedent was diagnosed with two different types of cancer in 1983 and in 1989. The decedent was the sole trustee of his revocable trust. His two children were the successor trustees.
It is not exactly clear when the decedent decided to form a limited partnership. However, it was formed in 1994 with an effective date of January 1, 1994 stated in the preamble of the partnership agreement. There was also a provision in the partnership agreement indicating that the partnership would commence upon the filing of a certificate of limited partnership, which occurred on June 14, 1994.
From June 17 to June 20, 1994, the decedent was hospitalized. The medical records indicate that he was “well-known to have metastatic colonic carcinoma and prostatic carcinoma.”
The decedent’s revocable trust was named as the initial 99% limited partner. His two children were named as the general partners, with his son holding a six-tenths of one percent interest and his daughter holding a four-tenths of one percent interest. His son was also designated to serve as the managing partner of the partnership.
The partnership agreement required the decedent’s revocable trust to contribute the “Portfolio,” but the general partners were not obligated to make any capital contribution to the partnership. The “Portfolio” was not defined in the partnership agreement. However, there was no dispute that it consisted of securities held in various investment accounts, shares in a company known as “Rockefeller Center Properties, Inc.,” and a note receivable. The decedent contributed the “Portfolio” to the partnership. The value of the assets contributed to the partnership represented approximately 94% of the decedent’s assets. The decedent did not contribute his personal effects, a checking account, his automobile, or his residence to the partnership.
There were conflicting provisions regarding distributions from the partnership. One provision gave the managing general partner the “sole and absolute” discretion to make distributions to the partners. Another provision required distributions of “Ordinary Net Cash Flow” to be distributed to the partners based on their proportionate interests in the partnership.
The decedent gave 60% of his limited partnership interests (owned by his revocable trust) to his children in an assignment with an effective date of July 1, 1994. The gifted limited partnership interests were designated as “Class B” limited partnership interests. The partnership agreement was amended so that the decedent’s remaining thirty-nine percent limited partnership interest (owned by his revocable trust) became a “Class A” limited partnership interest which was entitled to a “Guaranteed Payment” of “4.25% annually of its Capital Account Balance on the Effective Date.”
The decedent commenced the funding of the partnership on July 26, 1994, which continued for approximately four months. In a letter dated September 29, 1994, the decedent instructed one of his brokerage firms to sell all of the securities in his revocable trust’s investment account and use the proceeds to repurchase the same securities in a partnership account. On September 23, 1994, the decedent’s son, as general partner, opened a checking account in the name of the partnership. A deposit of interest was made into the account, and various distributions were made to the partners. In January 1995, the decedent entered hospice care in Oregon. He died on February 1, 1995.
2. Operational Facts.
A certified public accountant was engaged after the decedent’s death to prepare financial books and tax returns for the partnership. The accountant established a general ledger for the partnership to categorize and account for partnership transactions as of June 14, 1994, the date of the entity’s formation. Capital accounts and ledger accounts were established for partners to reflect partnership distributions.
The accountant established an account named “Receivable from Trust.” The account was created to reflect amounts received by the decedent’s revocable trust after the partnership’s formation. Such amounts should have been received by the partnership, but were not so received because of the delay in transferring assets to the partnership and opening the partnership account. The “Receivable from Trust” account balance was treated as a distribution to the decedent’s revocable trust. No funds were actually transferred between the revocable trust and partnership.
3. Application of Section 2036.
Section 2036 applied in Harper. The circumstances in Harper were very similar to those in Schauerhamer and Reichardt. Again, the decedent commingled partnership and personal funds. The partnership account was opened more than three months after the partnership was formed. Prior to the account’s opening, partnership income was deposited into the decedent’s revocable trust account, resulting in an unavoidable commingling of funds.
The Tax Court concluded that the decedent’s action illustrated lack of respect for the entity as a true business enterprise. The court focused on (1) engaging the accountant only after decedent’s death, (2) the delay in opening the partnership account, and (3) the delay in the transferring assets to the partnership. The court stated that the “partners had little concern for establishing any precise demarcation between partnership and other funds during decedent’s life.”
As in the other cases, the decedent transferred the majority of his assets to the partnership. Thus, the distribution of partnership funds indicated an implied understanding that the partnership would “not curtail decedent’s ability to enjoy the economic benefit of assets contributed. Distributions from the partnership to the decedent’s revocable trust were found to be contemporaneously used for the decedent’s personal expenses.
The partnership was viewed as an alternate vehicle for the decedent to provide for his children at death (i.e., an estate plan). The Tax Court focused on the testamentary characteristics of the partnership: The decedent made all decisions regarding the creation and structure of the partnership, the decedent continued to be the principal economic beneficiary, and there was little change in the portfolio composition. Any practical effect of the partnership was not meant to occur until after the decedent’s death. The court also noted the decedent’s advanced age, serious health conditions, and experience as an attorney.
E. Church v. United States.116
1. Formation Facts.
The decedent in Church and her children entered the “Agreement of Stumberg Ranch Partners, Ltd.” on October 22, 1993, which was governed by Texas law. The purpose of the partnership was to provide centralized management of their interests in the W.R. Stumberg Ranch to preserve the ranch for future generations, in addition to asset protection from creditors in the event of tort claims. The decedent and her children were limited partners of the partnership. Stumberg Ranch, L.C. served as the general partner of the partnership, with each of decedent’s children owning a 50% interest to reflect their management positions with respect to the ranch. Stumberg Ranch, L.C. was not yet formed when the partnership agreement was executed on October 22, 1993.
Each limited partner contributed his or her undivided interest in the ranch to the partnership. The decedent also contributed approximately $1 million in securities to the partnership, which she had inherited from her mother and husband. The limited partners owned 57% of the ranch, while members of another family owned the remaining forty-three percent. Three parties owned the 57% interest: the decedent owned 62% of the 57%, individually, two percent, as trustee, and the decedent’s children each owned eighteen percent.
The limited partners conveyed their interests in the ranch to the partnership on October 22, 1993. In addition, the decedent’s son, pursuant to a durable power of attorney, transferred the decedent’s securities to the partnership on the same date. The decedent died suddenly on October 24, 1993, two days after the assets were contributed to the partnership. At the time of her death, the decedent had cancer that was initially diagnosed in July 1990. However, the decedent was in clinical remission during the last six months of her life. Thus, her sudden death due to a heart failure was considered unrelated to the cancer.
Although the partnership was technically formed on October 22, 1993 upon the execution of the partnership agreement, the full organization of the partnership was not established until after the decedent’s death. The certificate of limited partnership was filed on October 26, 1993. Although the certificate stated that it was signed and executed on July 1, 1993, the Tax Court found this to be a clerical error. The court believed the certificate of limited partnership was likely signed on October 22, 1993, the date that the partnership agreement was signed. However, the mistake was likely due to the fact that the partnership agreement, which was indeed executed on October 22, 1993, had an effective date of July 1, 1993. Regardless, the Tax Court held that the execution date of the certificate of limited partnership was immaterial.
The corporate general partner was organized in March 1994. The decedent’s PaineWebber account, consisting of her marketable securities, was transferred to the partnership account in the same month.
2. Operational Fact.
The partnership agreement allocated profit or loss to the partners in proportion to their partnership percentages and contributions.
3. Application of Section 2036.
Section 2036 did not apply in Church. The Tax Court held that the purpose of the partnership was to preserve the family ranching enterprise for present and future generations. No express or implied agreement existed through which the decedent retained the use, possession, or enjoyment of the partnership’s property.
VI. Cases Applying Sec. 2036 To FLPs Based On Structure Of FLP Agreement
A. Kimbell v. United States.117
Kimbell is the first case to include assets transferred to an FLP by a decedent under Sec. 2036 based on the structure of the partnership agreement. The discussion above revealed several cases where the IRS successfully argued for inclusion in the gross estate based on a finding that under the facts and circumstances an informal agreement existed between the partners that allowed the decedent to have continued enjoyment or possession of the property transferred to the partnership.118 On the other hand, the Kimbell decision was based on the express terms of the partnership agreement.
The facts of Kimbell truly illustrate the axiom that “bad facts make bad law.” The decedent, Ruth A. Kimbell, had created a revocable living trust. Seven years later, when she was 96 years old, the decedent initiated an FLP transaction. The trust and the decedent’s son and daughter-in-law formed a limited liability company (“LLC”). The membership interests of the LLC were held 50% by the trust and 25% each by the son and daughter-in-law. LLC transferred 1% of the capital of the partnership in exchange for a 1% general partner interest. The trust transferred the balance of the capital in exchange for a 99% limited partnership interest. The decedent died two months after the partnership was created. The following specifics of the partnership agreement were detailed by the Court: The partnership had a term of 40 years. The general partner had discretion over distribution of partnership income. The general partner was relieved of any fiduciary duty to the partnership and its partners. Limited partners holding at least 70% partnership interests could vote to remove the general partner, in which case a replacement could be elected by holders of a majority in interest of the limited partnership interests.
Although the opinion does not discuss the nature of the assets transferred by the decedent to the partnership, on audit the IRS determined that for federal estate tax purposes the trust’s 99% limited partnership interest was worth $2,463.000. The estate had reported the value of that interest at $1,257,000 (apparently claiming a discount of just under 50%).
The estate paid the additional tax and interest asserted by the notice of deficiency in the amount of $837,089 and filed a claim for refund. The Service denied the refund and the estate filed suit in the Federal District Court. Both the government and the estate filed motions for summary judgment.
With this factual framework, the court began its analyses. The court’s analyses of Section 2036 departs from the grammatical structure of the text of the statute. The court outlined its analyses as follows:
[U]nder the plain language of §2036(a), “all property to the extent of any interest therein which decedent had “at any time” transferred is part of the estate unless the property interest qualifies for an exception to the general rule of inclusion. The two exceptions provided by §2036(a) are (1) transfers which are “bona fide sale[s] for an adequate and full consideration” (the “Bona Fide Sale Exception”) and (2) transfers after which the decedent retains neither the “possession or enjoyment of, or the right to income from the Property “nor” the right neither alone or in conjunction with any other person, to designate the persons who shall benefit or enjoy the property” (the “Retained Income or Rights Exception”).119
The first “exception” discussed by the court was the bona fide sale exception. The court had little difficulty finding this exception does not exist. Recall the discussion above that there are two divergent lines of cases regarding the prerequisites for qualifying for this exception.120 The view adopted by the Circuit Court is that once it is determined full and adequate consideration exists, no further inquiry need be made.121 The Court, without recognizing the divergent authority, adopted the second line of cases more recently adopted by the Tax Court by agreeing with the decision in Harper122 that “applicability of the [bona fide sale] exception rests on two requirements: (1) [a] bona fide sale, meaning an arm’s-length transaction, and (2) adequate and full consideration.”123 The court relied on Blacks Law Dictionary to note that an “arm’s-length” transaction is one between two unrelated parties who are presumed to have roughly equal bargaining power. In dispelling with the notion that a bona fide sale occurred when the partnership was formed, the court said, “Indeed, one cannot even find two parties, much less two parties conducting an arm’s length negotiation leading to a “bona fide sale.”124 Essentially, the court concluded that because the decedent owned 50% of the LLC, which owned 1% of the partnership, and a 99% limited partnership interest, the decedent was dealing with herself, which is the opposite of an arm’s-length transaction.
Like Strangi, the Kimbell decision is appealable to the Fifth Circuit. The Kimbell case, unlike Strangi III, actually cites Wheeler for authority that no “bona fide sale” occurred. The opinion in Kimbell fails to recognize, however, that Wheeler actually rejected the notion that a bona fide sale cannot occur with an intra-family transfer. In other words, Wheeler adopts the first line of cases which hold that a bona fide sale only requires the presence of adequate and full consideration and the requirement that the sale be at arms-length was rejected by Wheeler.125 The court does distinguish the facts of Kimbell from the facts of Wheeler, stating in the latter case IRS actuarial tables were used to value the remainder interest transferred by the decedent to his two sons. Nevertheless, this distinction is without merit.
That actuarial tables were used to value the interest transferred is not determinative of whether a sale occurred. Indeed, most sales occur without referring to the IRS actuarial tables to determine value. In Wheeler, a remainder interest was involved. A remainder interest is a temporal interest that relates to life expectancy. Thus, you must refer to actuarial tables to determine the value of the remainder interest. If A transfers property to B in exchange for a partnership interest in P, assuming A and B are unrelated, clearly a sale has occurred and the measure of consideration can be calculated without referring to actuarial tables. Likewise, even if A were related to B, the sale would produce taxable income to A. The Internal Revenue Code does not exclude sales of property between related parties from income tax consequences.
As discussed above, it could be that the court’s use of the “recycling theory” to disallow the bona fide sale exception is a recognition that no “sale” occurred. Kimbell was a classic contribution of capital to a partnership. Thus, no sale occurred. On the other hand, there was no diminution in value to Kimbell’s gross estate as a result of the transfer. If diminution in value were the sole determinative factor, then it seems Congress could easily have achieved this by predicating the exception on transfers that are made in exchange for an adequate and full consideration.
Having easily dispelled with the “bona fide sale” exception, the Court next considered whether the transferor retained the enjoyment of property. The Court recognized the line of cases that hold an express or implied agreement to allow the transferor to retain the economic benefits of the property is sufficient to invoke Section 2036(a)(1).126 The Court then took one step further by finding the express terms of the partnership agreement itself provided for the proscribed enjoyment by the decedent.” The Court also found that the agreement gave the decedent the right to designate the persons who would benefit from the income of the partnership, thus invoking Section 2036(a)(2).127 The Court reasoned that the trust could remove LLC as general partner and appoint the trust as the general partner.128 Because the partnership agreement gives the general partner “sole discretion” to make partnership distributions, the trust (and thus the decedent) had sole discretion to make partnership distributions.
The estate had argued that the decedent’s fiduciary duties precluded the decedent from controlling decisions about partnership distributions, relying on Byrum as authority for its proposition.129 The court distinguished Byrum on its facts, stating “Assuming such fiduciary duties exist, to whom does a party which owns 99% of the partnership owe them? The fiduciary argument falls flat.”130
The Court also claimed that Byrum “… was expressly overruled by Congressional enactment of § 2036(b)…”131 This argument, however, fails to recognize that § 2036(b) only overrules Byrum for transfers of stock to controlled corporations. That section does not apply to any entities other than corporations.
The significance of Kimbell is that it is the first decision in which a court held that the powers given the general partner by a partnership agreement invoked the provisions of Section 2036(a). This significance notwithstanding, the Court’s analyses of Section 2036 leaves much to be desired. In fact, there is scant discussion of the statutory requirements.
For Section 2036(a)(1) to apply, the decedent must have retained the possession or enjoyment of, or the right to income from, the property she transferred to the partnership. There is no discussion as to whether the decedent actually enjoyed or possessed the transferred property. Nor is there any indication whether income was distributed to the decedent. The fact that the Court perceived that the decedent had the unqualified right to distribute income to herself was, in the Court’s opinion, in itself sufficient to invoke the statute.
More curious is the Court’s application of Section 2036(a)(2). That section applies when the tranferor retains the “right… to designate the persons who shall possess or enjoy the property or the income therefrom.” Again, the Court considered that decedent could remove LLC and appoint herself (through the trust) as general partner, and in that capacity decide whether to accumulate or distribute income. Recall, Byrum taught us that the “right” must be one that is a legally enforceable and ascertainable power. In Kimbell, decedent held 99½% of the partnership interests (considering the trust held 50% of the LLC’s 1%). It is odd that the Court determines the children’s interests to be so miniscule that they should be ignored when applying the “bona fide sale” exception, yet important enough to be considered as interests held by other persons to whom income could be distributed or from whom withheld for purposes of applying Section 2036(a)(2). Furthermore, there is no discussion whether the power to accumulate income, which merely affects the time of enjoyment of property but not the persons who will enjoy the property, is sufficient to invoke that portion of the statute.
Likewise, the absence of certain facts makes it difficult to determine how distinguishable the Kimbell case was from Byrum. True, the partnership agreement waived the fiduciary duty of the general partner. Perhaps this alone is sufficient. In Byrum, there were also significant equity interests held by non-related persons. In Kimbell, the other equity interests only totaled ½% and were held by the decedent’s children. There is no indication whether there were any factors, such as in Byrum, like the vicissitudes of an ongoing business enterprise, that could have affected the general partner’s ability to make distributions. The opinion does make a vague reference to certain restrictions on distributions by the general partner under the partnership agreement132, however, the Court evidently did not deem those to be a significant limitation on the general partner’s right to distribute income.
B. Estate of Strangi v. Commissioner.133
Strangi III is the only other case to apply Section 2036(a) to include assets transferred by a decedent to an FLP based on the structure of the partnership agreement. The facts of Strangi III are strikingly similar to those of Kimbell.
Like in Kimbell, the partnership in Strangi III was created only two months prior to the decedent’s death. The decedent, Albert Strangi, was in ill health. He had given his son-in-law, Gulig, an attorney with estate planning experience, a durable power of attorney to handle his affairs.134 Gulig had attended a seminar on the tax advantages of utilizing family limited partnerships in estate planning.135 The next day, Gulig, utilizing the power of attorney, formed SFLP, a limited partnership, and Stranco, Inc., a corporation.136 Stranco was designated the general partnership of SFLP and had sole authority over the management of SFLP’s business affairs.137 The partnership agreement gave Stranco the authority to make distributions of partnership income, however, the agreement required Stranco to manage the partnership affairs in good faith and in a prudent and business like manner.138 Gulig transferred substantially all of Strangi’s wealth, including personal use assets worth $9,876,929 (mostly cash and securities) to the partnership and Mr. Strangi received in exchange a 99% limited partnership interest.139 Stranco was capitalized with $100,000 pro rata by the decedent and his four children. Strangi received a 47% interest in Stranco and each of his children received 13.25%. Each of the children gifted a ¼ % interest in Stranco stock to a charity. Stranco contributed the $100,000 to SFLP in exchange for a 1% general partner interest.140 Gulig was employed to manage the day-to-day affairs of Stranco and SFLP. In fact, Gulig handled all matters of SFLP and Stranco, including forming the entities and transferring all of the properties and operating the entities.
After the decedent died, Gulig, as executor of the estate, filed the estate tax return, reporting the decedent’s interest in the entities at a fair market value of $6,585,281.141 The return claimed a 40% discount in valuation of those interests.142 The Service issued a notice of deficiency for the amount of the discount. The estate filed a petition with the Tax Court.
After Strangi died, Gulig made several distributions from SFLP, including those to pay the decedent’s funeral expenses, estate administration expenses, debts of the decedent, for back surgery for the decedent’s housekeeper and for payment of decedent’s Federal and state estate and inheritance taxes.143 While the decedent lived in his house, which was transferred to SFLP, rent was accrued on the books but not paid until after his death.144
During the first trial before the Tax Court, the Service argued that the partnership should be ignored and the discount disallowed because the partnership lacked economic substance. Alternatively, the government argued that a gift had occurred on formation of the partnership because Strangi had received partnership interests worth less than the value of the assets transferred. The government had also attempted to raise the Section 2036 argument at trial, but the Tax Court refused to consider this argument finding that the Government had not timely raised this argument in its pleading.145
The Tax Court ruled in favor of the estate on all grounds, but reduced the amount of the discount to 31%.146
The IRS appealed the Tax Court’s decision to the Fifth Circuit Court of Appeals. The Fifth Circuit affirmed the Tax Court on all issues except the Section 2036 issue. Finding that the Tax Court should have considered the Section 2036 issue, the Fifth Circuit remanded the case to the Tax Court for reconsideration of that issue.147
The Court interpreted the SFLP agreement as granting Stranco, as managing general partner, the sole discretion to determine distributions.148 The Court also determined that Gulig was delegated that discretionary authority under the management agreement, and that because Gulig was decedent’s attorney in fact, that decedent had the discretionary authority, through Gulig, to make distributions from the partnership.149
The Court initially determined that because decedent, acting through Gulig, had the right to distribute partnership income to himself, the decedent retained the right to income from the property transferred to the partnership.150 Thus, the Court, as in Kimbell, found that the structure of the partnership agreement causes inclusion under Section 2036(a)(1), without the necessity of looking for an implied agreement or understanding.
Having concluded the structure of the partnership agreement granted the decedent the proscribed right to income from the property, Judge Cohen also concluded that under the facts and circumstances test, the evidence suggested an implied agreement to allow Strangi the continued use or enjoyment of the property, despite his demise only two months after the partnership formation.151
The factors cited by the Court as indicating the existence of an implied agreement included: (1) transfer of a majority (in this case, 98%) of decedent’s assets to the partnership, (2) continued occupancy of the decedent’s residence, (3) expenditure of funds to pay decedent’s personal expenses, including his housekeeper’s surgery, funeral expenses, estate administration expenses, debts, a specific bequest to decedent’s sister and estate and inheritance taxes, (4) use of documents supplied by Fortress through a seminar touting the estate tax savings emanating from its documents, with little input from other family members, and (5) decedent’s advanced age and failing health.152
The estate attempted to counter by arguing that the partnership charged rent for decedent’s use of the residence which, although not paid until after decedent’s death, was accrued on the books and reported on the partnerships’ tax return. Also, whenever distributions were made to pay decedent’s expenses, they were done so pro rata in accordance with the partnership agreement.
The Court was unimpressed with the partnership’s accrued rent. The Court noted that a lessor dealing at arm’s length would not have agreed to accrual of rent for more than two years prior to being paid.153 The Court was equally unimpressed with the pro rata partnership distributions, especially given that the only other interest held in the partnership was Stranco’s 1% interest. This interest was considered too de minimus to give substance to the pro rata distributions.154
Having included the partnership’s assets in the decedent’s gross estate under Section 2036(a)(1), the Court could have stopped there. It chose not to. Pointing to the fact that the Service and the estate argued the Section 2036 (a)(2) issue extensively, the Court decided to address the applicability of that portion of the statute as an alternative to its findings related to Section 2036(a)(1).155
The estate cited Byrum for the proposition that decedent’s powers to distribute income were so constrained by his fiduciary duties as to not rise to the level of a legally enforceable right. Judge Cohen found Strangi III distinguishable from Byrum. She summarizes these differences by stating “Here, the rights held by decedent are of a different nature and were not accompanied by comparable constraints. In our view, the constraints alleged by the estate are illusory.”156
The Court found it significant that in Byrum there existed an independent trustee with sole authority to decide whether to distribute from the trust.157 Strangi, on the other hand, could make those decisions on his own, acting through his attorney in fact, Gulig. This distinction fails to consider that, by its terms, Section 2036(a)(2) will apply to a proscribed power even if the decedent can only exercise that power with others. Thus, in Byrum, it was not the existence of the independent trustee that saved the retained power from inclusion, rather it was constraints and limitations on the exercise of the power that were so significant so as to preclude the power from becoming an enforceable right.158 The Court did address the latter concept by noting in Byrum the existence of various vicissitudes of a business enterprise which could influence or limit the decedent’s ability to cause dividends to be paid from the corporation. In contrast, the Court concludes that because there was no business enterprise owned by SFLP, there were no similar economic or business realities that could affect distributions.159
The argument that the lack of a business enterprise precludes economic or business realities that could affect distributions obviously ignores our recent state of the economy. Tell that to the scores of retirees who have been forced to alter their lifestyles due to the adverse economic conditions of the stock market. Many have been forced from retirement to supplement the loss of income caused by the economic downturn. Undoubtedly, economic conditions of the stock market can affect the ability to make distributions just as certainly as can the vicissitudes of a business enterprise. Likewise, the general partner’s ability to make distributions can be affected by “the need to safeguard the long-term viability of the partnership, to account for outstanding debt, fees, and expenses to act consistently with FLP policies, purposes, and long-range plans, and to consider the limited access afforded by certain capital markets (e.g., the need to accumulate funds to qualify for minimum investor thresholds).”160
The Tax Court’s decision heavily relies on the fact that any fiduciary duties owed by the decedent ran only in favor of close family members.161 In Byrum, on the other hand, there existed significant interests held by unrelated parties in a business setting that increased the opportunity for “… a realistic possibility for enforcement and an objective business environment against which to judge potential dereliction.”162 The Court concluded that because the only interests in the partnership not held by Strangi were his children’s 52% interest in Stranco and the charity 1% interest in the partnership, there was no realistic probability that decedent’s actions would be challenged.163
In essence, the Court adopted a facts and circumstances approach to determine whether the fiduciary duties imposed upon Strangi were a significant limitation on Strangi’s power to affect beneficial enjoyment of partnership income. In doing so, the Court assumes without discussion that this is the approach sanctioned by Byrum. The Court compared the facts and circumstances of the limitation imposed by fiduciary duties in Byrum compared to Strangi.
It has been argued that the Supreme Court in Byrum adopted a “bright-line” test rather than a “facts and circumstances approach.”164 The “bright-line” approach recognizes that if the power is subject to fiduciary duties, the legal ability of other partners to challenge the general partner’s decisions regarding partnership distributions is a sufficient limitation to preclude the general partner’s power to distribute from being elevated to an ascertainable and legally enforceable right. It is the existence of the legal right to challenge that creates the limitation. The facts and circumstances approach adopted by Strangi looks to whether there is a likelihood that the right to challenge will in actuality be perceived as a threat to the general partner so as to constrain his or her decisions regarding partnership distributions. Those arguing that Byrum intended a bright-line test argue that many have structured their estate plans based on the view that Byrum stands for this proposition and that taxpayers should be able to rely on clear rules in drafting their estate plans.165 This view is supported by the Court’s edict in Byrum, that:
Courts properly have been reluctant to depart from an interpretation of tax law which has been generally accepted when departure could have potentially far-reaching consequences. When a principal of taxation requires reexamination, Congress is better equipped than a court to define precisely the type of conduct which results in tax consequences.166
Commentators of this view have suggested that the Court’s discussion in Byrum of the business vicissitudes that provide limitations on the decedent’s power to affect beneficial enjoyment of income was simply an explanation of the rationale for the bright-line test rather than conditions precedent to avoiding the statute.167
The opposing view argues that it is not too difficult to distinguish true viable business enterprises from the typical, tax-motivated, abusive FLP that is “… formed solely for estate-planning purposes…” and “tend to jump off the page as such.”168
If the Tax Court truly means to say that fiduciary duties owed only to family members cannot form the basis of a significant limitation on the general partner’s powers so as to avoid inclusion under Section 2036, then it ignores well settled estate planning concepts. The Service has previously ruled that a trustee’s power to distribute income subject to an ascertainable standard of health, support and maintenance will not cause inclusion under Section 2036(a)(2).169 In that ruling, the fiduciary duty to distribute in accordance with the ascertainable standard was owed to the trustee’s daughter. Why should the fiduciary constraints in this scenario be treated any differently than in the FLP context? Certainly, the Tax Court doesn’t mean to imply that children will not sue their parents. Even if a parent feels that his or her child will not sue for breach of fiduciary duty, what guarantees are there that the child’s interest won’t be assigned to a person (like an in-law for example) who may be more likely to hold the parent’s feet to the proverbial fiduciary fire? The better view is that the existence of the potential, the very fact that it may happen, is sufficient to preclude the power to distribute from being elevated to a right.
Also, let’s not lose sight of the argument that a power to accumulate or distribute income which merely affects the time of enjoyment of income rather than the persons who will enjoy the income is not sufficient to trigger Section 2036(a)(2). Strangi III is devoid of any discussion of this issue.170
Having concluded the decedent retained possession and enjoyment of the partnership property, the right to income from the property and the right to designate others who may enjoy that income, the Court next looked at whether the bona fide sale exception would save the day for the Strangi estate.
The Court wastes little time with this argument. The Court likened the facts to those of Harper and followed Harper’s ruling that to qualify for the exception there must be “(1) A bona fide sale, meaning an arm’s length transaction, and (2) adequate and full consideration.”171 No recognition was given to the competing authority adopted by the Circuit Courts.172 Like Kimbell, Strangi III is appealable to the Fifth Circuit and, curiously, Strangi III fails to even mention Wheeler, which held that an arms-length transaction is not a prerequisite to the exception. The Court found that Strangi, through Gulig, essentially dealt with himself in forming the partnership, thus dispelling any notions that the transaction was at arms-length.173
The Court also adopted the “recycling” theory to find a lack of full and adequate consideration174, citing Thompson and Kimbell,
Finally, having concluded Section 2036 applies to cause inclusion in the decedent’s estate, the Court considered the amount to be included. The estate argued that Section 2036(a) only requires inclusion of the property transferred to the partnership to the extent that the decedent retained an interest in that property.175 Because the IRS failed to establish the extent, if any, of the retained interest, argued the estate, it failed to sustain its burden of proof.176
Apparently, the estate tried an all or nothing approach, going for nothing. It failed. Noteworthy is the fact that the Court recognized Regs. Sec. 20.2036-1(a) that provide, “If the decedent retained or reserved an interest or right with respect to a part only of the property transferred by him, the amount to be included in his gross estate under Section 2036 is only a corresponding portion.”177 Thus, the Court only included 99% of the net asset value of SFLP and 47% of the value of Stranco’s assets.178 This is noteworthy because it implies that in an FLP situation where substantial limited partnership interests have been gifted, Section 2036(a)(1) will operate to include only the percentage retained by the decedent. The Court did not address the argument that inclusion under Section 2036(a)(2) results in full inclusion of the partnership assets.179
VII. What To Do About Strangi
A. Existing Partnerships.
Undoubtedly, virtually every FLP that now exists is at risk for inclusion of the full value of its assets in the estate of a contributing partner under a logical extension of the holdings in Kimbell and Strangi III. A notice of appeal was filed in Kimbell on May 15, 2003. As we go to press, Strangi III has not yet been appealed. The taxpayer filed a motion to file a motion for reconsideration of Judge Cohen’s decision on August 21, 2003. The Service filed an objection to that motion to file a motion to amend the petition. Under the Federal Rules of Appellate Procedure, an I.R.C. Code Sec. 7483 notice of appeal must be filed within 90 days of the final decision of the Tax Court.180 The 90-day period is tolled if a motion for reconsideration is filed.181 The 90 day period will commence to run when the court enters an order disposing of the taxpayer’s motion for reconsideration because that date will be more than 90 days after the date of Judge Cohen’s entry of the decision on May 20, 2003.182 It is not clear if Strangi III will be appealed. Rumor has it that due to a procedural glitch in the notice of deficiency, the actual tax dollars at stake is not great. At least we will get a decision out of the Fifth Circuit in Kimbell. Even if Strangi III is not appealed, because Strangi III is also appeal able to the Fifth Circuit we should get a good reading of that court’s determination from the Kimbell appeal of both Section 2036(a)(1) and 2036(a)(2) issues. In any event, it will likely be several months before there is a decision. In the mean time, because of the size of the net thrown by these decisions, we should not sit on our laurels concerning our existing FLPs. Letters should be sent to each client for whom a FLP transaction was done advising the client of the risks posed by the cases and urging the client to schedule a conference to discuss planning options. Because each FLP is unique, the options will vary from client to client. In this context, we must be prepared with ideas for each client who contacts us.
There are really two distinct planning considerations. Actually, by now clients should have been contacted to advise them regarding the Section 2036(a)(1) risk posed by Schauerhamer, Reichardt, Thompson and Harper. Paragraph B.1. of this Section outlines what actions should be taken for new partnerships to avoid the Section 2036(a)(1) risk and much of that advice is pertinent for existing partnerships. What recommendations should we consider for existing partnerships to avoid the risks posed by Kimbell and Strangi III under Section 2036(a)(2)? Messrs. Gans and Blattmachr set forth many insightful ideas, which are heavily borrowed from.183
1. Transfer all Partnership Interests.
One sure way to avoid inclusion under Section 2036 is to transfer ownership of all interests in the partnership. If the client has no interest in the partnership, then there can be no basis for inclusion under Section 2036. The partnership interests could be gifted. Gifts of the limited partnership interest would enjoy valuation discounts. Obviously, the general partnership interests would not. In fact, a premium could attach to reflect the value of the control feature. In any event, perhaps the gift tax could be sheltered by the unified credit. If client is married, a split-gift election will allow use of both credits. In many situations, gift tax will not be avoidable by use of the unified credit.
Another concern is that if the client dies within three years of the gift, Section 2035 will operate to disregard the gift and Section 2036 will not be avoided.
Another transfer potential for married clients is for client to gift all partnership interests to client’s spouse. If the client’s spouse is a U.S. citizen, the marital deduction will shield the gift from gift tax. Again, if client dies within three years of the transfer, Section 2036 will not be avoided. This option is only available if the spouse did not also transfer property to the FLP. If the spouse also contributed to the FLP, Section 2036 will cause full inclusion in spouse’s estate. If spouse predeceases client and leaves the partnership interests to client in spouse’s will, the partnership interests will be transferred back to client. Because these interests were not “retained” by client, Section 2036 should not cause inclusion at client’s death. This result should be the same if the transfers are to a credit shelter trust or marital trust, even if client is the trustee.
For the client who is not married (or at least happily married) and who is not willing to utilize unified credit or incur a gift tax, you could consider a sale of the partnership interests. Depending on the client’s basis in the partnership interests, the sale will produce a taxable gain. The purpose of a sale is to qualify the transfer for the bona fide sale exception to Section 2035. Unfortunately, in United States v. Allen,184 it was determined that to qualify for the bona fide sale exception the amount of consideration to be paid is the amount equal to the amount that would have been included in the transferor’s gross estate had the transfer not been made. If Section 2036(a)(2) would have caused inclusion of the full value of the partnership’s assets, then the consideration required to be paid is greater than the fair market value of the partnership interests transferred because the limited partnership interests will be discounted. Thus, the sale would produce a gift from the purchaser to the transferor.
For the married client, a sale to the spouse might produce an acceptable result because the resulting gift from spouse to client caused by the consideration paid in excess of value would be saved from tax by the marital deduction. Thus, the sale technique could avoid the Section 2035 problem, assuming the spouse did not also transfer property to the FLP.
For the unmarried client willing to accept the Section 2035 risk but unwilling to accept the gift tax exposure, consider having the client gift the partnership interests to an irrevocable gift trust in which client retains the power to alter the beneficial interests. The power to alter the beneficial interests would render the gift incomplete for gift tax purposes.185 The client should not act as trustee or his power as trustee to vote the partnership interests to alter the beneficial interests in partnership income will cause inclusion under Section 2036(a)(2). The client could safely retain the power to remove the trustee and replace the trustee with an independent trustee.186
For the client who is simply unwilling to relinquish control, Mssrs. Gans and Blattmachr suggest a gift of the limited partnership interests to an incomplete gift trust, with the client retaining only a 1% general partner interest. The suggestion is that because the limited partnership interest is owned by the trust and not the decedent, the transaction qualifies for avoidance of Section 2036(a)(2) under Byrum because, unlike in Strangi III, decedent does not own the 99% limited partnership interest.187 Thus, under Section 2036(a)(1) only the 1% pro rata share of the assets would be included in the client’s gross estate. Although this outcome is indeed suggested by Strangi III, the reasoning seems flawed. If Kimbell and Strangi III correctly stand for the proposition that decedent’s power to vote the general partner interest to accumulate or make distributions is the prerequisite to invoking Section 2036(a)(2), the fact that the 99% limited partnership interest is held by the trust does not alter the fact decedent holds the power to affect beneficial enjoyment of income. Thus, inclusion should occur under Section 2036(a)(2) in the amount of the full value of the partnership’s assets.
2. Amend the Partnership Agreement.
For the client who is willing to give up control, but unwilling to part with ownership interests in the partnership or incur a gift tax, it may be possible to achieve avoidance of Section 2036 by amending the partnership agreement to avoid the client holding tainted voting rights. Caution must be exercised in the manner in which this is achieved. See the discussion in paragraph B below where it is suggested a new partnership could be drafted to prohibit client from voting on distributions or liquidations. To be sure, if such an amendment were made to an existing partnership, the disappearance of the voting rights would produce a taxable lapse under I.R.C. Section 2704(a). The same objective could be achieved by amending the partnership agreement to create two classes of partnership interests. A non voting limited partnership interest could be created. The voting limited partnership interests would be a minimal interest. For example, after the amendment, client would own the original general partner interest (say a 1% interest), a 1% voting limited partnership interest, and the remaining limited partnership interests would be non voting. The amendment would not produce a taxable lapse under Section 2704(a) because client continues to own all partnership interests and the voting rights that were held before the amendment. Client could then gift the 1% general partner interest and 1% voting limited partner interest. The taxable gift values of these interests would be minimal. After the gift, client would only own non voting interests which, assuming he lives for at least three years, would avoid Section 2036. Perhaps the Service could argue that the client continues to hold the power to join with other partners in an amendment to the partnership agreement to make his partnership interests voting again in an attempt to bootstrap onto Section 2036(a)(2)(ie. a power, held in conjunction with others, to affect enjoyment of the income). The client could sell the voting interests to avoid Section 2035 under the bona fide sale exception as suggested above. Alternatively, client could give the interests to an incomplete gift trust to avoid gift tax, also discussed above.
Another amendment to the partnership agreement that could be considered to address the client unwilling to part with control would create ascertainable standards of distribution. See paragraph B.2.d. below for a discussion of this approach.
3. Inject Business Enterprise.
Consider having the partnership engage in a business enterprise if it does not already do so. It could start one anew. Client might also be able to transfer an existing business to the partnership. Take care with the latter approach, however, because if partnership interests are held by others, this would produce a taxable gift without discounts. The existence of a business enterprise would interject business vicissitudes that might be viewed as a limitation on the client’s ability to make partnership distributions. The business enterprise probably should have significant value in relation to the partnership’s assets. For example, a lemonade stand in a partnership which owns 10 million dollars in marketable securities probably would not have much impact. Although Judge Cohen suggested in Strangi III that the lack of a business was a major distinguishing factor from Byrum, this factor in the end analyses really ought not be a determinative factor for or against inclusion.
4. Add Additional Unrelated Partners.
If partnership interests were sold to unrelated persons, Judge Cohen suggested in Strangi III that the fiduciary duties owed to those partners would be sufficient to invoke the doctrine in Byrum to avoid Section 2036. Judge Cohen viewed a charity’s 1% of a 1% general partner interest too miniscule to be of consequence. If the facts and circumstances approach is the correct one, how much of an interest is sufficient? Intuitively, at least ten percent seems significant, however, the very mental manipulation one must exercise to figure out how much is enough is good reason for the courts to avoid this approach in the first place. If the duty is owed to anyone, even a family member, the right of the other partner to question the general partner’s actions should prohibit the general partner’s powers from being elevated to a legally enforceable and ascertainable right. In all likelihood, finding unrelated partners is not likely to be a workable solution in most cases.
5. Liquidate The Partnership.
If all else fails, perhaps the partnership could be liquidated. The assets received in liquidation could then be contributed to a new partnership that has been adeptly constructed in accordance with the suggestions outlined in paragraph B below.
B. Prospective Partnerships.
New planning opportunities using FLPs have not vanished due to Kimbell and Strangi III. Indeed, asset protection planning is a growing concern, particularly for doctors facing ever increasing insurance premiums as a result of the “malpractice crisis.” The FLP remains a viable tool for this purpose. Unless creative creditors’ counsel are able to convince the Florida courts to depart from the well established rule that the charging order is the creditor’s exclusive remedy with respect to the debtor’s interest in the FLP, it is unlikely that Kimbell and Strangi III will have any impact on the use of the FLP as an asset protection vehicle. Nevertheless, planners forming FLPs for asset protection purposes should not ignore the transfer tax consequences and, assuming the client is willing to pay for the additional planning costs, the planner should structure the asset protection FLP with the transfer tax issues in mind.
Thus, the ideas that may be considered to address the § 2036(a) issues for new partnerships include the following:
1. § 2036(a)(1) Considerations.
a. Avoid deathbed formations. The partnership in each of Kimbell and Strangi III were formed approximately two months prior to the decedent’s death at a time when the decedent’s failing health was known. Although the decedent in Church died only 2 days after the partnership agreement was executed, her death was unexpected even though she had breast cancer, which was in clinical remission. Of course, we take our clients as we get them and often this is an issue we have little control over.
b. Avoid transfers of personal use assets. If this cannot be avoided, then the transferring partner should pay fair market value rental for the use of the asset. Have fair market value established by an appraiser. Rent should be paid currently and not accrued on the books. Judge Cohen in Strangi III was unimpressed with accrual of rent which was paid more than 2 years after decedent’s death.
c. Do not transfer substantially all of the assets to the partnership. The client should retain ownership of sufficient assets to pay all reasonably foreseeable personal living expenses, estate administration expenses, funeral expenses and estate taxes. In fact, there should be no reasonably foreseeable need to tap the partnership assets to pay for the client’s personal consumption needs. Distribution to the client should be avoided if at all possible.
d. “Dot all the i’s” and “cross all the ts.” The FLP and general partner entity (e.g. corporation or LLC) should be formed properly under state law. New accounts should be established in both entities. Federal taxpayers identification number for both entities should be obtained. After proper entity formation, funding should occur immediately through proper execution and recording, if necessary, of transfer documents. Retitling of accounts and securities should be promptly accomplished.
e. Establish a partnership term that the client can reasonably be expected to outlive. In Kimbell, the court made note of the 40 year partnership term. Ruth Kimbell would have had to live until age 136 to see the termination of the partnership. Obviously, if the client in fact dies while the partnership is still alive, the transfer would have been for a period which did not in fact end before client’s death. Thus, the reasonable term would not necessarily save the transaction from Section 2036, however, an unreasonable term makes the FLP look more like a testamentary vehicle. Besides, this is an easy “give me,” and in the world after Strangi III, the more we “give” in terms of addressing the issues raised by the Tax Court the better off we are.
f. The partnership agreement should confirm the general partner’s fiduciary duties to the partnership and the partners. Likewise, the bylaws of the general partner corporation or regulations of the general partner LLC should confirm fiduciary duties. Consider providing an arbitration clause for resolution of entity disputes, with the losing party being required to pay the arbitrator’s fees and costs of arbitration.
g. Respect the entity documents. If the general partner is a corporation, hold separate meetings for shareholders and directors. Elect officers and directors annually. Keep minutes. For the partnership, provide accountings to other partners. Hold partnership meetings. Discuss future potential business or investment opportunities. Document the discussions in the minutes. If distributions are made (avoid them if possible), make them pro rata. Advise your client to respect the different entities. The client should avoid paying personal expenses out of partnership accounts. The client should not commingle personal assets with partnership assets. Tax returns should be timely filed. Capital accounts should be maintained for each partner.
h. Keep the entities active and in good standing in the state of formation.
i. If gifts of partnership interests are to be made, property execute assignment documents and actually deliver them to the donees, but only after the partnership has been properly formed and all assets transferred to the partnership. The client should not make additional contributions to the partnership after the gifts of partnership interests are made. Timely file gift tax returns reporting the gifts and comply with the adequate disclosure regulations.
j. Avoid loans of partnership funds to partners. If loans become necessary, provide proper documentation, such as promissory notes, adequate interest and, if possible, adequate security. Repayment terms should be reasonable and respected.
2. § 2036(a)(1) and (a)(2) considerations.
a. Avoid ownership of any partnership interest by the client. If the client does not retain enjoyment or possession of partnership property, the right to receive income from partnership property, or the right to designate the persons to receive income from partnership property, then § 2036 can’t apply. Of course, this is much easier said than done. There are “Catch 22” problems with trying to accomplish this. How does the client transfer assets to the partnership and gift the partnership interests (so as to obtain discounts) while avoiding the ownership of the interests? For married clients, Messrs. Gans and Blattmachr suggest that if the client transferred the assets to the partnership and the partnership interests were initially issued in spouse’s name, the gift on formation is shielded by the marital dedication and Section 2035 would not apply if the client died within 3 years because client never owned the partnership interest.188 Likewise, at spouse’s death, Section 2036 should not apply because spouse made no transfer.189 Query whether, if faced with these facts, might Judge Cohen be inclined to hold that substance over form dictates a finding that client in fact had the right to the partnership interest due to the contribution and made a transfer of that interest to the spouse? Also, what happens if spouse dies first and the partnership interests are transferred to client from spouse’s will. Arguably, those interests were not “retained” by client and Section 2036 should not apply at client’s subsequent death. The result should be the same if spouse’s will leaves the interests in a credit shelter trust or marital deduction trust.
b. Avoid Tainted Voting Rights. If the client is not married, client could consider structuring the governing documents such that client is precluded from voting on any partnership distribution or liquidation. Thus, in a “Strangi III like” formation, the documents would prohibit client from voting client’s stock in the corporate general partner and from voting client’s limited partnership interests to distribute or liquidate. Section 2036 cannot apply under Strangi III if the decedent never had the right to vote to make distributions from the partnership or to liquidate the partnership.
Of course, for clients who will not consider giving up control, this in not a viable solution. This option also runs the risk that the Service argues the client could vote with other partners to amend the partnership agreement to remove the voting restrictions, thus invoking Section 2036(a)(2).
c. Utilize Bona Fide Sale Exception. Strangi III rejected the argument that a sale for full and adequate consideration occurred on formation of the partnership, finding that there was merely a “recycling” of the decedent’s assets. Consider having other family members contribute property at the same time for partnership interests. There is language in Strangi III that suggests that if this occurred, there would be a “pooling” of assets rather than “recycling” of assets, thus qualifying the transactions for the bona fide sale exception. It is important that the other family members make contributions with their independent assets. If the client gifts the assets to be contributed by them to them, there is a risk that the transaction will be collapsed under the step transaction doctrine. Recall, however, the troubling language in Kimbell that this exception requires a bona-fide sale between unrelated parties. Thus, there is no assurance that even the existence of substantial interests obtained by family members would assure a bona-fide sale. If a pooling transaction is utilized, there is an increased risk that the Service might successfully argue its gift on formation argument. Strangi III found no gift on formation because the decedent essentially owned the partnership interests on formation. Also, be careful to avoid the mistake made in Thompson. In order to avoid gain on formation under the investment company rules due to diversification of interests, the agreement in Thompson required distributions from contributed property to be allocated to the partner contributing that property. The Service successfully argued that because of that language, there was no genuine pooling of interests and the bona fide sale exception to Section 2036 did not apply. A better result would have been achieved if the partners simply contributed a diversified portfolio to begin with without the damaging partnership language. The investment company problems and Section 2036 problems would have been avoided.
d. Create Standards of Distributions. For clients who refuse to give up control, consider creating ascertainable standards of distribution. For example, the agreement could define distributable cash so as to exclude contributed property, borrowed funds and cash generated by sales of contributed property. The agreement would then require distribution of distributable cash no less often than annually. Alternatively, the agreement could set thresholds for distributions. For example, if the partnership earns at least $X, then Y% of the earnings over $X will be distributed no less often than annually. Another choice would be to prohibit distributions altogether. A power held by the client which is limited by an ascertainable standard should be sufficiently limited so that it is not elevated to a legally enforceable and ascertainable right.190 Some caution should be exercised as it is uncertain whether ascertainable standards exercisable in favor of the creator of the power will save the day. Also, the Service might argue that the client has the power to vote with the other partners to amend the agreement to remove the restrictions, thus invoking Section 2036(a)(2).
e. Inject Business Enterprise. Clearly, if some operating business enterprise having a substantial value in relation to the partnership assets owned by the partnership would be helpful. If the client’s ability to make partnership distributions were subject to the vicissitudes of the business enterprise, the Service would have a much more difficult time distinguishing Byrum on its facts than it did in Strangi III. The lack of this factor was heavily relied upon by Judge Cohen to find that the decedent in Strangi III had no significant limitations imposed upon his power to distribute due to his fiduciary duties to the partnership.
f. Include Substantial Interests Held by Unrelated Partners. If the partnership were formed with unrelated partners who make substantial capital contributions in return for partnership interests, the Service will have a more difficult time arguing Byrum does not apply. Also, such a pooling of interests with unrelated persons increases the likelihood that the bona fide sale exception applies, but also increase the risk of a gift on formation argument.
g. Treat Like an Existing Partnership. The partnership agreement could be structured a la Strangi III to avoid the gift on formation argument, and then any of the techniques discussed in paragraph A above regarding existing partnerships can be employed.
1. The authors wish to acknowledge Tamara Morgan for her invaluable dedicated assistance.
2. See, 712 T.M., Partnership Taxable Income; Allocation of distributive Shares; Capital Accounts.
3. See Id. and I.R.C. §§ 701 and 702.
4. See Id.
5. I.R.C. §§ 1363(a) and 1366(a)(1).
6. See 700-2nd T.M., Choice of Entity.
7. See, e.g., Reser v. Comm’r, T.C. Memo 1995-572, aff’d in part, 112 F. 3d 1258 (5th Cir. 1997).
8. See I.R.C. § 722 and Treas. Reg. § 1.752-1(b).
9. See Revised Uniform Limited Partnership Act (2001) § 503 and Fla. Stat. § 60.137.
10. See Revised Uniform Limited Partnership Act (2001) § 303(a) and Fla. Stat. § 620.129.
11. See Revised Uniform Limited Partnership Act (2001) § 403(b) and Fla. Stat. § 620.125.
12. See Revised Uniform Limited Partnership Act (2001) § 703 and Fla. Stat. § 620.153.
13. See Givens v. National Loan Investors L.P., et al., 724 So. 2d 610 (5th DCA 1998).
14. See Id.
15. See Id.
16. See Regs. § 301.7701-3(a).
17. See Fla. Stat. §§ 620.187 and 620.9001.
18. See 700-2nd T.M., Choice of Entity.
19. See Fla. Stat. § 220.02.
20. See Id. and Fla. Stat. § 608.4227.
21. See, e.g., Cacciatore v. Fisherman’s Wharf Realty, Ltd., 821 So. 2d 1251 (4th DCA 2002).
22. Qualified disclaimers must be filed within 9 months of death. See I.R.C. § 2518.
23. See 800-1st T.M., Estate Planning.
24. See 355-5th T.M., IRAs, SEPs and Simples.
25. Choate, Natalie B., Life and Death Planning For Retirement Benefits (5th Ed. 2003 revised).
26. See Rev. Rul. 77-137, 1977-1 C.B. 178.
27. See Fla. Stat. § 222.11(1); c.f. Brock v. Westport Recovery Corp. 832 So. 2d 209 (4th DCA 2002).
28. See Fla. Stat. § 726.108.
29. I.R.C. § 2503(b).
30. See I.R.C. § 1014(a).
31. See I.R.C. § 2036(a).
32. See Discussion at V.
33. Tech. Adv. Memo. 9736004, 9735003, 9730004, 9725002, 9723009, 9719006, and 9842003.
34. T.C. Memo. 1990-472.
35. T.C. Memo. 1995-132.
36. Treas. Reg. § 25.2703-1(a)(3).
37. See, e.g., Tech. Advice Memo. 97-19-006 (1997), 97-23-009 (1997), 97-30-004 (1997), 97-36-004 (1997).
38. See, e.g., Gulig v. Comm’r, 293 F.3d 279 (5th Cir. 2002); Church v. United States, 268 F.3d 1063 (5th Cir. 2001), aff’g per curiam, 85 A.F.T.R.2d 2000-804 (W.D. Tex. 2000).
39. See also Estate of Church v. United States, 85 AFTR 2d 2000-804, 2000-1 USTC par. 60,369 (W.D. Tex. 2000).
40. pp. 18-19 of actual opinion on U.S. Tax Court site: http://www.ustaxcourt.gov/InOpHistoric/STRANGI.TC.WPD.pdf.
41. See Rev. Rul. 83-20, 1983-2 C.B. 170.
42. I.R.C. § 2701(e).
43. I.R.C. §§ 2701(a)(1)(B), 2701(b)(1).
44. I.R.C § 2701(e)(2).
45. I.R.C § 2701(b)(1)(A).
46. I.R.C § 2701(b)(2).
47. I.R.C § 2701(e)(3)(B).
48. I.R.C § 2701(c)(2)(A).
49. I.R.C § 2701(c)(2)(B)(i).
50. I.R.C § 2701(c)(2)(C).
51. I.R.C §§ 2701(a)(2)(B), 2701(a)(2)(C).
52. I.R.C §§ 2701(a)(3)(A), 2701(c)(3)(A), 2701(c)(3)(B).
53. I.R.C § 2701(a)(3)(A).
54. I.R.C § 2701(e)(5).
55. Treas. Reg. § 25.2704-1(a)(1).
56. Treas. Reg. § 25.2704-1(a)(2)(iv).
57. Treas. Reg. § 25.2704-1(a)(2)(v).
58. Treas. Reg. § 25.2704-1(c).
59. Treas. Reg. § 25.2704-1(c).
60. Treas. Reg. §§ 25.2704-1(a)(2)(i), 25.2701-2(b)(5)(iii).
61. Treas. Reg. § 25.2704-2.
62. Revised Uniform Limited Partnership Act, as amended 1997, §§ 601, 801.
63. 113 T.C. 449 (1999).
64. See also, e.g., Knight v. Comm’r, 115 T.C. 506 (2000); Estate of Harper v. Comm’r, T.C. Memo. 2000-202 (2000); Church v. United States, 268 F.3d 1063 (5th Cir. 2001), aff’g per curiam, 85 A.F.T.R.2d 2000-804 (W.D. Tex. 2000).
65. T.C. Memo. 1995-371 (1995).
66. See also Estate of Barudin v. Comm’r, T.C. Memo. 1996-395 (1996).
67. 118 T.C. 279 (2002).
68. See Fondren v. Comm’r, 324 U.S. 18, 21 (1945); Comm’r v. Disston, 325 U.S. 442 (1945).
69. See Wooley v. United States, 736 F. Supp. 1506 (S.D. Ind. 1990).
70. See discussion at IV.
71. See ACM Partnership v. Comm’r, 157 F.3d 231 (3rd Cir. 1998), cert. denied, 119 S. Ct. 1251 (1999); Estate of Murphy v. Comm’r, T.C. Memo. 1990-472 (1990).
72. See Comm’r v. Tower, 327 U.S. 280 (1946); ASA Investerings v. Comm’r, T.C. Memo. 1998-305 (1998).
73. See Kincaid v. United States, supra at 1224.
74. See Estate of Jones v. Comm’r, 116 T.C. 121 (2001); Church v. United States, 268 F.3d 1063 (5th Cir. 2001), aff’g per curiam, 85 A.F.T.R.2d 2000-804 (W.D. Tex. 2000).
75. See, e.g., Estate of Gradow v. United States, 11 Cl. Ct. 808 (1987), aff’d, 897 F.2d 516 (Fed Cir 1990).
76. Estate of D’Ambrosio v. Comm’r, 101 F.3d 309 (3d Cir. 1996), cert. denied, 520 U.S. 1230 (1997); Wheeler v. United States, 116 F.3d 749 (5th Cir. 1997); Estate of Magnim v. Comm’r, 184 F.3d 1074 (9th Cir. 1999).
78. See, e.g., Wheeler, supra.
79. See, Estate of Strangi v. Comm’r, 115 T.C. 478 (2000), aff’d in part and remanded in part, 293 F.3d 279 (5th Cir 2002), on remand T.C. Memo 2003-149; Estate of Harper v. Comm’r, T.C. Memo 2002 – 121; Estate of Thompson v. Comm’r, T.C. Memo 2002 – 246.
80. Wheeler, supra.
81. Wheeler, supra.
82. I.R.C. § 704(c).
83. Dodge, 50-5th T.M., Transfers With Retained Interest In Powers (page A-48).
84. Wheeler, supra.
85. See, Merrill v. Fahs, 65 S. Ct. 655, 656 (1945).
86. See, e.g., Church v. United States, 2000-1 USTC par. 60, 369 (W.D. Tex. 2000), aff’d. without published opinion 268 F.3d 1063 (5th Cir. 2001).
87. I.R.C. Code Sec. 2036(a)(1).
88. I.R.C. Code Sec. 2036(a)(2).
89. See, e.g., Rev. Rul. 78-409, 1978-2 CB 234.
90. See, e.g., Estate of Whit v. Comm’r, 751 F.2d 1548 (11th Cir. 1985), cert. denied, 474 US 1005 (1985); Lee v. United States, 86-1 USTC ¶ 13, 649 (WD Ky 1985).
91. See, e.g., Estate of Trotter v. Comm’r, 82 TCM (CCH) 633 (2001); Estate of Baggett v. Comm’r, 62 TCM (CCH) 333 (1991); Estate of Rapelji v. Comm’r, 73 TC 82 (1979).
92. I.R.C. § 2036(a)(2).
93. United States v. Byrum, 408 U.S. 125 (1972).
94. See, Estate of Schauerhamer v. Comm’r, 73 TCM (CCH) 2855 (1997); Estate of Reichardt v. Comm’r, 114 TC 144 (2000).
95. Byrum, supra at 132-35.
96. See, Treas. Reg. § 20. 2036-1(b)(3); Rev. Rul. 79-353, 1979-2 CB 325; Rev. Rul. 81-51, 1981 CB 458.
97. See, Estate of Wall v. Comm’r, 62 TCM (CCH) 942 (1991).
98. See, Rev. Rul. 95-58, 1995-2 CB 191.
99. United States v. O’Malley, 383 US 627 (1996).
100. Struthers v. Kelm, 218 F.2d 810 (8th Cir 1955).
101. Stephens, B. Richard et al, Federal Estate and Gift Taxation (8th Ed. 2002).
102. Estate of Strangi v. Comm’r, T.C. Memo 2003-145.
103. I.R.C. Code Sec. 2036(a).
104. Treas. Reg. § 20. 2036–1(b)(1); Estate of Nicol v. Comm’r, 56 TC 179 (1971); Estate of Cooper v. Comm’r, 74 TC 1373 (1980).
105. See, e.g., Bayliss v. United States, 326 F.2d 458 (4th Cir. 1964).
106. Reg. Sec. 20. 2036-1(b)(1)(ii).
107. See, e.g., Rev. Rul. 79-109, 1979-1 CB 297.
108. See, Comm’r v. Estate of Dwight, 205 F.2d 298 (2d Cir.), cert. denied 346 US 871 (1953).
109. See, United States v. O’Malley, 383 US 627 (1966).
110. Strangi, supra.
111. 408 U.S. 125 (1972).
112. T.C. Memo 1997-242.
113. 114 T.C. 144 (2000).
114. T.C. Memo 2002-246.
115. T.C. Memo 2002-121.
116. 2000 USTC (CCH) ¶ 60, 369 (W.D. Tex. 2000), affirmed, No. 00-50386 (5th Cir. July 18, 2001).
117. 244 F. Supp. 2d 700 (N.D. Tex. 2003).
118. See this discussion at V.
119. Kimbell, at 703.
120. See discussion at IV.
122. Estate of Harper v. Comm’r, T.C. Memo 2002-121.
123. 244 F. Supp. 2d at 702.
124. Kimbell, at 703.
125. Wheeler, at 749.
126. Kimbell, at 703.
127. See Id.
128. See Id.
129. See Id.
130. See Id.
131. Kimbell, at 704.
132. Kimbell, at 703.
133. T.C. Memo 2003-145.
134. See, Estate of Strangi, 115 T.C. 479-80.
135. See Id.
136. See Id.
137. See Id.
138. See Id.
139. See Id.
140. See Id.
141. See Id.
142. See Id.
143. See Id.
144. See Id.
145. See Id.
146. See Id.
147. Estate of >Strangi v. Comm’r, 393 F.3d 279 (5th Cir. 2002).
148. Strangi at 153.
149. See Id.
150. See Id.
151. See Id.
152. Strangi at 153, 154.
153. Strangi at 154.
154. See Id.
155. See Id.
156. Strangi, at 158.
157. Strangi, at 158.
158. See, Brant J. Hellwig, Estate Tax Exposure of Family Limited Partnerships Under Section 2036, 38 Real Prop. Prob. & Tr. J. 169 (2003).
159. Strangi, at 159.
160. J. Joseph Korpics, For Whom Does Kimbell Toll – Does Section 2036(a)(2) Pose a New Danger to FLP?, 98 J. Tax’n 162 (2003).
161. See Id.
162. Strangi, at 159.
163. See Id.
164. See, Jonathan G. Blattmachr and Mitchell M. Gans, Strangi’s Strange Reading of Section 2036(a)(2): A Critical Analyses and Planning Suggestions.
165. See Id.
166. Byrum, at 135.
167. See Blattmachr and Gans at 8.
168. See Hellwig, at 198.
169. Rev. Rul. 73-143, 1973-1 C.B. 407.
170. See discussion at IV.C.2.6.
171. See, Strangi at 160.
172. See discussion at IV.B.
173. See, Strangi at 160.
174. See Id.
175. See, Strangi at 161.
176. See Id.
177. See Id.
178. See Id.
179. See discussion at IV.E.
180. Fed. R. App. P.13.
182. See Id.
183. See, Jonathan G. Blattmachr and Mitchell M. Gans, Strangi’s Strange Reading of Section 2036(a)(2): A Critical Analyses and Planning Suggestions.
184. 293 F.2d. 916(10th Cir.), cert. denied, 368 U.S. 944 (1961).
185. See Treas. Reg. § 25.2511-2.
186. Rev. Rul. 95-58, 1995-2C.B.191.
187. See Gans and Blattmachr at 22.
188. See, Gans and Blattmachr at 27.
190. See, Jennings v. Smith, 161 F.2d 74 (2nd Cir. 1947) and Rev. Rul. 73-143.