Lessons of Thompson and Kimbell

In September 2004, the Third Circuit presented the Service with a major victory in its ongoing war on family limited partnerships (FLPs). In Betsy Turner (Est. of Theodore Thompson), 3rd Cir., 9/1/04, affg TC Memo 2002-246, the decedent, age 95, transferred substantially all of his assets (primarily, marketable securities and personal notes) to two FLPs. He died two years later. The estate claimed a 40% discount for these partnership interests for lack of control and marketability.

Tax Courts Decision

In 2002, the Tax Court found that, although the partnerships were valid, the transferred assets had to be included in the decedents estate at their full value, for three primary reasons:

• The transferor retained enjoyment and economic benefit of the transferred assets. For example, partnership distributions were made to him for the purpose of making annual exclusion gifts.

• The transferors receipt of a partnership interest in exchange for his assets was not full and adequate consideration.

• The transactions were not made for a legitimate business purpose; the only apparent purpose was the reduction of estate tax liability. (For a discussion, see Holtz, Personal Financial Planning, FLP Issues and Opportunities, TTA, April 2003.)

The Third Circuit agreed with the Tax Courts findings that the family had an implied agreement that Thompson would continue to have economic control over the transferred property. This fact alone was enough to pull the transferred assets back into his estate under Sec. 2036(a)(1).

This case was particularly important for the Service in light of its recent defeat in David A. Kimbell, Sr., 371 F3d 257 (5th Cir. 2004), in which the Fifth Circuit found that the transfer of assets in return for the limited partnership interest was for full and adequate consideration (preventing the imposition of Sec. 2036(a)(1)). The court noted that Ms. Kimbell received an interest credited to her capital account for the fair market value of the assets contributed, and that she was entitled to distribution of same on partnership termination.

Lessons

The estate planner should keep in mind the following when using FLPs:

1. Ensure that the transferor retains sufficient assets to support himself or herself. In the absence of this, the transfer would be called into question, because it implies that the assets of the transferee entity will be used to pay personal living expenses. In Kimbell, the Fifth Circuit found that the transferor retained ample assets to provide for her own support.

2. Document a business purpose for the transfer. The court found no compelling business purpose when the partnerships held an untraded portfolio of securities and engaged in no other business operations. Also, the partnership made various personal loans to family members. No loans were made to nonfamily members, and the family loans were not managed in a businesslike way. For example, there was no timely collection of interest payments, no active pursuit to collect on delinquent loans, etc. On the other hand, in Kimbell, the Fifth Circuit found that the transfer was properly documented as being motivated by a desire for centralized active management and protection from environmental legal claims. Active management was required, due to investments in oil and gas interests.

3. If future annual exclusion gifts will be made, consider the potential source of such transfers. In Thompson, the partnership made distributions to the transferor so that he could make annual exclusion gifts. This fact is problematic under Sec. 2036(a)(1), which provides that the gross value of the estate will include transferred assets from which the decedent has retained the possession or enjoyment of, or the right to the income from, the property.

4. Sec. 2036(a) does not apply if the transfer was for full and adequate consideration. In Thompson, the Third Circuit noted that a bona fide sale must be made in good faith, which means that the transferor must receive some benefit other than estate tax savings. The fact that the primary investment was marketable securities that remained largely untraded convinced the Third Circuit that the transferor did not receive any other benefit. This should be compared with Kimbell, in which the transferor received active management of her oil and gas holdings.

Conclusion

Kimbell succeeded where Thompson failed. Those engaging in FLPs should pay careful attention to the warning signs that have been posted for some time. There should be:

• A business purpose for the transfer and the transferee entity.

• A transfer for adequate consideration.

• Segregation of accounts, which limits personal enjoyment of FLP assets.

Estate planners should document that the transferor has retained sufficient assets to support himself or herself, separate and apart from the FLP assets. Thompson demonstrates that estate planners must continue to look at the fundamental requirements for creation and operation of FLPs. For an additional discussion of these issues, see Eyberg and Raasch, FLP Planning after Strangi, Kimbell and Thompson,, this issue.

From R. Milton Howell III, CPA, Davenport, Marvin, Joyce & Co., L.L.P., Greensboro, NC