FLP Administration Issues

By Vinu Satchit,CPA,
BDO Seidman LLP, High Point, NC, and Chair,
AICPA Tax Divisions Trust, Estate, and Gift Tax
Technical Resource Panels
FLP Operations Checklist Working Group

I n cases such as Est. of Dorothy Morganson Schauerhamer,¹ Est. of Charles E. Reichardt,²  Est. of Morton B. Harper³ and Est. of Albert Strangi,⁴ the Tax Court agreed with the Services argument that assets transferred to a family limited partnership⁵ (FLP) were includible in the transferors estate under Sec. 2036.

In general, under Sec. 2036, the entire value of a transfer is includible in a transferors gross estate when the transferor has retained (1) explicitly or implicitly, a right to possession or enjoyment of the property or the income therefrom (Sec. 2036(a)(1)); or (2) the right to designate the persons who shall possess or enjoy the property, or the income therefrom (Sec. 2036(a)(2)). The statute does not apply to transfers that are bona fide sales for adequate and full consideration in money or moneys worth (bona fide sale exception).

Whether a transferor has implicitly retained an economic benefit under Sec. 2036(a)(1) is a question of fact; the courts typically look at  all of the facts and circumstances surrounding the transfer and the subsequent use of property in making such determination.⁶

Many crucial factors relate to a FLPs formation stage, others to yearly FLP administration. The requirement to prepare an annual income tax return provides the CPA with an opportunity to detect yearly administration problems that may inadvertently imply an understanding to retain economic benefit. The checklist in Exhibit 1 and the appendix below will assist a CPA in such process.

This issue is very controversial. When contributing partners receive proportional interests in a FLP for their contributions, the courts have held that there is no gift on FLP formation. If the transfers are not gifts, many tax advisers argue that they meet the bona fide sale exception to the application of Sec. 2036.⁷ Recently, the Tax Court agreed,⁸ in a decision that carefully distinguished the facts from those in the cases mentioned above. The rulings of the Fifth Circuit⁹ (and other circuit courts) on this issue will shed further light.

Appendix: Keys to Checklist

A. Questions 110: Commingling of Assets

In Est. of Schauerhamer, the decedent had continued to deposit income from FLP assets into her personal account (in direct violation of the FLP agreement). The Tax Court found this to be highly indicative of possession or enjoyment, a belief shared by other courts in their respective decisions.¹⁰ In Reichardt, the Tax Court noted that some of the FLPs income was deposited in the decedents personal account. In Harper, delays in the actual transfer of title of FLP assets resulted in income from those assets being deposited in the decedents personal accounts (a checking account was not even opened until three months after FLP formation).

The courts have ruled that a FLPs payment of the transferors personal expenses were equally egregious violations, regardless of whether such transactions were reclassified as loans or distributions at year-end.¹¹

Questions 19 above are intended to uncover instances in which commingling of assets may occur either due to a failure to (1) transfer title to assets (which should be rectified immediately) or (2) notify lessees and third-party vendors of the change in ownership. Such matters should be corrected as soon as possible. Parties should ascertain whether new lease and/or service agreements are required for the transferred property.

A partners use of FLP assets as collateral for his or her debts and/or the mere identification of such assets as his or her personal assets (in obtaining a loan, etc.) may indicate an implied understanding. The tax adviser should make inquiries of the general partner and suggest appropriate action (if necessary).

Accounting entries: In Harper, a CPA made journal entries to segregate the decedents personal expenses paid by the FLP. The courts dismissed the entries as after-the-fact paperwork by decedents CPA that was insufficient to undo the damage caused by commingling funds.

In Strangi, distributions were initially classified as advances to the partner receiving them, and later closed out as distributions with pro rata payments made to the other partners. The Tax Court dismissed such classifications as accounting manipulations.

Mere accounting entries reclassifying transactions after the fact may not be sufficient to undo commingling of funds. Thus, the CPA must advise the client to avoid entering into transactions that commingle funds.

B. Questions 1118: Distributions

Distributions must be made within the parameters of the FLP agreement. In Strangi, disproportionate distributions to the decedenteven though allowed by the agreementindicated that those involved understood that the decedents assets would be made available as needs materialized. In that case, distributions were made to cover nursing expenses, estate administration expenses and estate and inheritance taxes.

In Harper, approximately $230,000 was distributed to the decedent, while $13,000 was distributed to other partners in the same period. In addition, the frequency of the distributions suggested that they were made contemporaneously with the personal expenses of the decedent and his estate (including the estate taxes due).

There is no bright-line prohibition against making disproportionate distributions (if authorized by the FLP agreement). However, if such distributions are made, the business reasons for making them and the fiduciary considerations taken into account by the general partner(s) must be documented. Such distributions are compelling evidence of an implied understanding when the decedent had transferred substantially all of his or her assets to a FLP (as in Harper, Reichardt and Strangi) and, thus, was relying on the distributions to meet living expenses.

Reclassifying distributions as advances (or vice versa) at year-end will not change a transactions characteristics for Sec. 2036 purposes.

An additional issue that has ignited tremendous controversy is the holding in Strangi that a FLPs assets could be includible under Sec. 2036(a)(2) (i.e., the decedent retained a power to designate the propertys beneficiaries through his position on the corporate general partners board of directors). While a complete discussion of Strangi is beyond the scope of this item, the court did not state that fiduciary constraints prevent inclusion of assets under Sec. 2036(a)(2).

The court pointed out that the decedents attorney-in-fact served dual roles on the sole corporate general partners boardone representing the decedent and one as the entitys manager. The FLP agreement provided that the general partner, whose sole manager was the decedents attorney-in-fact, could make disproportionate distributions. The corporations bylaws provided that two votes were sufficient to declare dividends (and the decedents attorney-in-fact held two votes, due to his dual roles). This produced potential access to the funds that differed from that in Byrum,¹² the seminal case in this area. (In Byrum, the decedents control over transferred stock did not warrant inclusion of the stock value in his estate.) The court noted that following Byrum in Strangi would ignore[s] factual realities, as the facts of this case belie the existence of any genuine fiduciary impediments to decedents rights. Arguably, the fallout from Byrum is not as extensive as many estate planners feared.

C. Questions 1923: Personal Use of Property

Personal use of property transferred by the transferor without paying rent to the FLP is a clear indication of an implied understanding.¹³ Even if rent is being charged, the FLPs mere accrual and reporting of rental income does not refute a finding of an implied agreement. In Strangi, the court dismissed the accrual of rent as evidence refuting an implied agreement, because the accrued rent was not paid for two years, an event inconsistent with arms-length residential leases.

Written contracts must be executed and the terms strictly adhered to. It is easy to make inadvertent slips in this area. For example, a partner may write a rent check only once every few months, the rent amount may not be renegotiated at the end of the lease (to ensure that it is fair market), etc.

D. Questions 2426: Compliance with Legal Requirements

In Harper, the court noted many examples of indifference by those involved toward the formal structure of the FLP agreement and, as a corollary toward the degree of separation that the agreement facially purports to establish. The tax adviser would be well advised to ensure that the formalities required under the agreement and state law are followed.

E. Questions 2729: Involvement of Partners Other than Transferor

In Schauerhamer, the court noted that the decedents children, who also served as general partners, testified that they were aware of the commingling of funds and took no action. In Reichardt, the decedents children, who served as the co-trustees of the trust that was the FLPs general partner, did not participate in the FLPs administration (document execution, asset management, etc.) in any meaningful way. In Harper, the general partner testified that the decedent made all decisions as to the creation of the FLPs structure and subsequent modifications. The courts have found a lack of involvement suggests that the decedents relation to his or her assets did not change in any meaningful fashion after the transfer.

Thus, it is very important that FLP decisions be made in consultation with the partners authorized to make such decisions. Even partners who are affected by such decisions should be informed when appropriate. Annual meetings to discuss investment strategy, amount and timing of distributions and other matters should be recommended (and discussions from such meetings documented).