FLPs Full Value Included in Estate

When he was 95, R transferred $2.8 million in securities and other assets to two family limited partnerships (FLPs) in exchange for pro-rata partnership interests. In FLP 1, R owned 95%, his daughter B owned 4% and a family owned corporation owned 1% as the sole general partner (GP). In FLP 2, R owned 62%, his son A owned 37% and a family owned corporation owned 1% as the sole GP. R retained $153,000 in personal assets, and received an annual income of $14,000 from two annuities and Social Security. At the time of transfer, R had annual expenses of $57,202, and an actuarial life expectancy of 4.1 years.

According to Rs family adviser, the primary advantages of the FLP plan included: (1) lowering the taxable value of the estate, (2) maximizing the preservation of assets, (3) reducing income taxes by having the corporate general partner provide medical, retirement, and income splitting benefits for family members, and (4) facilitating family and charitable giving. He also stated, [a]ll of the benefits above can be achieved while total control of all assets is retained by the directors of the Corporate General Partner.

 R died two years after forming the FLPs. His estate filed an estate tax return claiming a 40% discount to the value of his FLP interests, for lack of control and marketability. The IRS filed a deficiency under Sec. 2036(a) to include the full date of death value of the transferred assets. The Tax Court sustained the deficiency, concluding that R retained lifetime control and enjoyment of the transferred assets and that the transfer to the FLPs was not a bona fide sale for adequate and full consideration; see Est. of Theodore R. Thompson, TC Memo 2002-246. Rs estate appealed.

Implied Agreement

Sec. 2036(a)(1) returns an inter vivos transfer to a decedents gross estate if there is an express or implied agreement at the time of transfer that the transferor will retain lifetime possession or enjoyment of, or right to income from, the transferred property; see Regs. Sec. 20.2036-1(a). In this case, the Third Circuit affirmed the Tax Courts finding of an implied agreement between R and his family that he would continue to be the principal economic beneficiary of the contributed property and retain enjoyment sufficient to trigger Sec. 2036(a)(1). R transferred 95% of his assets to the FLP when he was 95 and did not retain sufficient assets to support himself for the remainder of his life, as calculated at the time of transfer. This supports 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. R and B sought assurances from financial advisers that R would be able to withdraw assets from the FLPs. When Rs remaining assets eventually ran low, B secured approval from the limited partnership to provide the decedent with an infusion to cover his expenses.

Rs de jure lack of control over the transferred property does not defeat the inference of an implied agreement. Although R could not formally withdraw funds from the FLPs without permission of the family owned corporate GPs, the estate concedes they would not have refused such a request. Thus, during the decedents lifetime, nothing beyond formal title changed in decedents relationship to his assets; see Strangi, TC Memo 2003-145. When a decedents relationship to the transferred assets remains the same both before and after transfer, Sec. 2036(a) returns those assets to the gross estate.

The general testamentary character of the partnership arrangements also supports the inference of an implied agreement. R transferred his investment assets when he was 95 and neither FLP engaged in business or loan transactions with anyone outside of the family.

Bona Fide Sale

Under Sec. 2036(a), an inter vivos transfer with a retained lifetime interest will not be returned to the gross estate if the transfer constitutes a bona fide sale for adequate and full consideration. Here, however, the FLPs served as a vehicle for changing the form in which the decedent held his propertya mere recycling of value, and, thus, no transfer for consideration. R contributed 99% of the total property and received back an interest the value of which derived almost exclusively from the assets he had just assigned. Further, the FLP patently fails to qualify as the sort of functioning business enterprise that could potentially inject intangibles to lift the situation beyond mere recycling. The estate conceded the primary objective of the partners in forming the Partnerships was not to engage in or acquire active trades or business. Although the FLPs did conduct some economic activity, these transactions did not rise to the level of legitimate businesses operations.

In addition to the lack of legitimate business operations, the form of the transferred assetspredominately, marketable securitiesis significant. When the transferee FLP does not operate a legitimate business, and the valuation discount provides the sole benefit for converting liquid, marketable assets into illiquid FLP interests, there is no transfer for consideration within the meaning of Sec. 2036(a).

Although a bona fide sale does not necessarily require an arms-length transaction between the transferor and an unrelated third party, it still must be made in good faith; see Regs. Sec. 20.2043-1(a). Objective indicia that the FLP operates a legitimate business may provide a sufficient factual basis for finding a good faith transfer; but if there is no discernable purpose or benefit for the transfer other than estate tax savings, the sale is not bona fide within the meaning of Sec. 2036; see Wheeler, 116 F3d 749 (5th Cir. 1997) (ignoring a transaction for estate tax purposes after finding no business or corporate purpose for the transaction); compare Kimbell, 371 F3d 257, 267 (5th Cir. 2004) (finding a bona fide sale when the transaction was entered into for substantial business and other non-tax reasons).

Rs inter vivos transfers do not qualify for the Sec. 2036(a) exception, because the FLPs did not conduct any legitimate business operations or provide R with any potential nontax benefit from the transfers. The Tax Court decision is affirmed.

Betsy Turner, 3d Cir., 9/1/04

Reflections: The court distinguished the Fifth Circuits decision in Kimbell, in which the decedent retained sufficient assets outside the FLPs for her own support, the FLP assets included working interests in oil and gas property that required active management and the business adviser advanced several credible nontax reasons for the FLPs.