Tax Court Upholds FLP Disallowance

In Estate of Harper, TC Memo 2002-121, the Tax Court ruled that a limited partnership formed by a decedent and funded with a majority of his assets was defective; thus, the property was includible in his estate. The court also upheld the IRS’s valuation of the estate’s assets.

Background

A typical family limited partnership (FLP) is an excellent estate planning tool. Through gifting, it allows for the transfer of assets to younger family members, with significant discounts. A FLP is generally established by an older family member transferring assets tax free in exchange for a partnership interest. Partnership interests are then gifted or sold to younger family members.

Sec. 704 mandates that a transfer of a FLP interest be "real" and that a donee acquire control with no strings attached. If restrictions abound when compared to unrelated limited partners dealing at arm’s length in a traditional business setting, the donee’s interest will not be recognized for income tax purposes. Also, Sec. 2036 provides that if a decedent has not relinquished dominion and control over his or her interest, the property’s value is includible in his or her estate.

In Harper, Morton Harper created a FLP and contributed a majority of his assets to it. The FLP’s purpose was to acquire, buy, sell and manage securities.

The FLP’s general partners were the taxpayer’s son (0.4%) and daughter (0.6%); his revocable trust owned a 99% limited partnership interest. Under the partnership agreement, the son served as the managing general partner, which should have given him full control of the partnership.

The partnership agreement also elaborated on the general partners’ limits and noted approximately 11 items that the general partners could not perform, unless they first obtained the written approval of majority in interest of the limited partners (i.e., Morton Harper’s approval). For example, the general partners could not (1) admit a general or limited partner, (2) dissolve the partnership, (3) sell or reinvest 5% or more of the portfolio and (4) issue or sell new partnership interests. The agreement also detailed the timing and form of distributions.

The FLP’s funding came from the decedent’s revocable trust, which comprised cash and securities valued between $1.6 and $1.7 million. The general partners made no contributions. At a later date, the revocable trust gifted 60% of its interest to the children, identified as a Class B limited partnership interest, entitled to 60% of partnership income and losses. The remaining interest was identified as a Class A limited partnership interest, entitled to 30% of partnership income and losses and a guaranteed payment of 4.25% of its capital account.

Gift and estate returns were filed for the decedent. The gift tax return reported the 1% general partnership interest and the 60% limited interest given to the decedent’s children. The estate tax return reported the decedent’s gross estate with the remaining 39% limited partnership interest.

The Service issued statutory notices in the alternative: in one, all of the FLP’s assets were included in the estate, resulting in a $331,171 estate tax deficiency; in the other, there was a $150,496 estate tax deficiency and a $180,675 gift tax deficiency.

What Went Wrong?

The Tax Court held that Sec. 2036(a) required the entire partnership interest to be included in the decedent’s estate. It found that (1) the taxpayer commingled partnership funds and (2) disproportionate distributions were made favoring the decedent. The court cited numerous examples of total disregard of the partnership entity and opined substance over form. In effect, the partnership served as the taxpayer’s alter ego; he never truly relinquished dominion or control over his assets.

Conclusion

From a planning perspective, a partnership agreement should not be overly restrictive, because this can inhibit a taxpayer from obtaining a significant valuation discount. Also, the entity must be respected; its assets should not be commingled with other assets. The terms and conditions spelled out in the partnership or other agreement must be followed. Whether the opinion will be overturned on appeal is unknown; regardless, practitioners should avoid the Harper fact pattern.

From Danny A. Pannese, CPA, MST, CVA, CSEP, Associate Professor of Accounting, Sacred Heart University, Fairfield, CT