Family Limited Partnerships: Are They Still Alive and Kicking?
Approximately one year ago, one of the authors coauthored an article for The Florida Bar Journal regarding family limited partnerships (FLPs). The article focused on the most recent family limited partnership cases in the context of the “bona fide sale for full and adequate consideration in money or money’s worth” exception to §2036 of the Internal Revenue Code of 1986, as amended.1 Since that article was published, there have been two §2036 cases involving FLPs,2 and the IRS was victorious in both those cases. Indeed, the IRS continues to aggressively challenge FLPs, especially cases which contain the common thread of “bad facts” ( e.g. , commingling of assets, majority of assets transferred to the partnership, patriarch/matriarch is terminally ill or in very poor health upon formation, etc.). However, even though the IRS has now successfully litigated 12 §2036 cases and lost only four, many cases involving §2036 are settled with favorable results to the taxpayer.
The purpose of this article is to discuss the two most recent §2036 cases, Estate of Disbrow v. Commissioner,
T.C. Memo 2006-34, and Estate of Rosen, T.C. Memo 2006-115 . Indeed, these cases provide a roadmap for practitioners and clients regarding “how not to” structure and operate an FLP. The article then discusses the results of a recent questionnaire regarding FLPs which was used in connection with a Florida Bar Real Property, Probate and Trust Law Section sponsored CLE seminar held in Tampa on October 6, 2006. While the results of such questionnaire cannot necessarily be extrapolated into solid statistical evidence, they are very enlightening, as they clearly indicate that many FLP cases have been settled with very favorable results to the taxpayer.
Estate of Disbrow v. Commissioner
When her husband died in 1993, Lorraine Disbrow became the sole owner of the residence she had shared with her husband, which she continued to use as her primary residence until her death. Being unfamiliar with financial matters and ownership responsibilities pertaining to the residence (which her husband handled when he was alive), Mrs. Disbrow hired a legal team to assist her. One of these advisers was the attorney Mrs. Disbrow had retained to probate her husband’s will, and he advised her to transfer the residence to a family general partnership. He told her that if she made such a transfer, she could give all of her interest in the partnership to her family, continue to live at the residence as a tenant of the partnership, and prevent the residence from being subject to estate tax.
Mrs. Disbrow (being almost age 72 and in poor health), together with her children and their spouses, executed a general partnership agreement forming “Funny Hats” in December 1993. Mrs. Disbrow received a 28.125 percent partnership interest, and everyone else received a 7.1875 percent partnership interest (except for her one unmarried son who received a 14.375 percent partnership interest). These percentage interests were assigned to each partner despite the fact that Mrs. Disbrow was the only person to make a contribution to the partnership — that contribution being the residence. In January 1994, Mrs. Disbrow gave her entire partnership interest to her children and their spouses.
From January 1994 through December 2000, Mrs. Disbrow rented the residence from the partnership pursuant to standard one-year lease agreements in which certain common pretyped, prolandlord provisions were crossed out ( e.g., “Tenant may not alter, decorate, change or add to the Premises”). Each lease agreement stated the amount of rent to be paid, when it was to be paid, and what would happen if it was not paid.
Mrs. Disbrow died in February 2000 and, in November of that year, Funny Hats sold the residence to Mrs. Disbrow’s son and then liquidated. After the executors filed a federal estate tax return, the IRS issued a notice of deficiency. The issue before the tax court was whether Mrs. Disbrow retained lifetime possession and enjoyment of the residence after transferring it to Funny Hats under §2036(a)(1). The court found that she did.
The court reviewed the lease agreements and found that they gave Mrs. Disbrow the same rights in the residence that she had enjoyed before transferring it to Funny Hats. In particular, the lease agreements 1) contained no relevant limitation on Mrs. Disbrow’s use of the residence; 2) gave her the right to “peaceably and quietly have, hold and enjoy” the residence for the term of the lease; 3) allowed her to alter, decorate, change, or add to the residence; and 4) gave her the right to sublet all or a part of the residence, assign the lease, and permit any other person to use the residence.
The court then determined that there was an implied understanding and agreement between Mrs. Disbrow and Funny Hats as to her continued possession and enjoyment of the residence after its transfer to the partnership. This conclusion was based on the facts and circumstances surrounding both the transfer itself and Mrs. Disbrow’s subsequent use of the residence: 1) Mrs. Disbrow transferred the residence to Funny Hats when she was almost 72 years old and in poor health; 2) the transfer was made to a partnership that was not operated for profit but, instead, used only as a conduit for the payment of expenses related to the residence; 3) any funds that Funny Hats did receive (which, for the most part, came from Mrs. Disbrow) were used to pay indirectly the same types of expenses that Mrs. Disbrow had paid directly before the transfer; and 4) Mrs. Disbrow transferred the residence to the partnership on the advice of counsel to minimize her estate taxes. Thus, it appeared that Mrs. Disbrow had understood that transferring the residence to, and entering into lease agreements with, Funny Hats was merely a mechanism for removing the residence from her gross estate while allowing her to retain beneficial ownership of it.
The court also determined that Mrs. Disbrow’s relationship to the residence following its transfer to the partnership was not that of a tenant. Mrs. Disbrow was frequently delinquent in paying, or failed to pay, rent. Funny Hats never sent her a late notice, accelerated her installment payments, made a written demand for payment, sought her eviction, or asked her to post a security deposit. Mrs. Disbrow also directly paid the taxes and insurance for the residence.
Further, as admitted at trial by a partner of Funny Hats, the children and their spouses wanted Mrs. Disbrow to continue to use and possess the residence as she had before its transfer and wanted her to live at the residence for as long as she could. Although Mrs. Disbrow’s estate argued that Funny Hats could have evicted Mrs. Disbrow from the residence at the end of a year by not renewing her lease for the next year, little weight was given to this argument, as the partners of Funny Hats were all members of Mrs. Disbrow’s immediate family, and the record gave the court no reason to find that they would have evicted her from the residence.
Finally, the court concluded that Mrs. Disbrow did not pay full rental value for possession and enjoyment of the residence. Her estate argued that she shared the residence with others and that she was required only to pay a portion of the fair rental value of the residence. The court, however, found no credible evidence establishing that someone other than Mrs. Disbrow used the residence. There was no agreement (other than the lease agreements) that governed the use of the residence, and the lease agreements contained no provision permitting any other individual to use any part of the residence. The court also found inconsistencies between the estate’s claim of Mrs. Disbrow’s shared usage and the manner in which Funny Hats and Mrs. Disbrow’s estate reported the rental for federal tax purposes.
Estate of Rosen v. Commissioner
In June 1974, Lillie Rosen created a revocable trust known as the Lillie Sachar Rosen Investment Trust (the “Lillie Investment Trust”). Mrs. Rosen acted as trustee until she began suffering from dementia and Alzheimer’s disease in 1994, at which time her two children became successor trustees pursuant to the trust’s terms. Mrs. Rosen’s daughter, under a “springing” power of attorney, also became her mother’s attorney-in-fact. In 1994, Mrs. Rosen’s son-in-law, an attorney, attended a seminar on FLPs. Following this seminar, the son-in-law contacted Mrs. Rosen’s estate planning attorney (Feldman) and discussed creating an FLP as a way to reduce the value of Mrs. Rosen’s estate for estate tax purposes.
Thereafter, Feldman structured the Lillie Rosen Family Limited Partnership (the LRFLP) and, in July 1996, a partnership agreement was executed. Mrs. Rosen’s children signed as both general partners (her son signing in his individual capacity and her daughter signing in her capacity as trustee of a trust she created) and as limited partners (in their capacities as co-trustees of the Lillie Investment Trust).
As general partners, Mrs. Rosen’s son and the trust created by Mrs. Rosen’s daughter each received a 0.5 percent general partnership interest (after each contributed approximately $12,000 in cash), and the Lillie Investment Trust received a 99 percent limited partnership interest (after it contributed approximately $2.4 million in cash and marketable securities). Between October 1996 and January 2000, Mrs. Rosen’s daughter, as her mother’s attorney-in-fact, gave Mrs. Rosen’s descendants (as well as spouses of some descendants) a total of approximately 65 percent of the limited partnership interest in the LRFLP. As a result, when Mrs. Rosen died in July 2000, the Lillie Investment Trust held approximately 35 percent of the limited partnership interest in the LRFLP, which the partnership redeemed following her death.
The court addressed two issues. First, whether the bona fide sale for adequate and full consideration exception (the bona fide sale exception) to §2036(a) applied. Second, whether Mrs. Rosen had retained the lifetime possession and enjoyment of the assets transferred to the LRFLP (the §2036(a)(1) prong). The court decided both issues in favor of the IRS.
As stated in Bongard v. Commissioner, 12 T.C. 95 (2005), the bona fide sale exception is met when the record establishes the existence of a legitimate and significant nontax reason for the transfer and the transferor receives partnership interests proportionate to the value of the property transferred. Because the court concluded that the first prong of this test was not met, it did not discuss the second prong.
In order to qualify as a “legitimate and significant nontax reason” ( i.e., the first prong of the bona fide sale exception), the reason for creating the partnership must be “an important one that actually motivated the formation of that partnership from a business point of view” and not a “theoretical justification” for its formation.3 Based on the facts presented, the court determined that no such nontax reason existed.
In reaching this conclusion, the court focused on both the LRFLP’s formation and operation. First, when the LRFLP was formed, its partners did not negotiate or set any terms of the LRFLP. Feldman never discussed the structure and formation of the LRFLP with Mrs. Rosen’s children, and he never met with or spoke to Mrs. Rosen about the partnership (at the relevant time underlying the formation of the LRFLP, Feldman did not know whether Mrs. Rosen was competent, but he did know that her health was not good). Feldman also determined who would be the initial general and limited partners, what each initial partner would contribute, and which assets Mrs. Rosen would contribute.
There were other facts concerning the LRFLP’s formation that were also problematic. When the partnership was formed, Mrs. Rosen was 88 years old and in failing health, and Mrs. Rosen’s daughter (as her mother’s attorney-in-fact, co-trustee of the Lillie Investment Trust and general partner of the LRFLP) stood on all sides of the transaction. The manner in which the initial capital was contributed to the LRFLP also raised red flags. While the LRFLP agreement was signed on July 31, 1996, Mrs. Rosen did not make her initial contribution until October 11, 1996, and her children did not make their initial contributions until October 24 and 30, 1996. In addition, the reported contributions of assets by Mrs. Rosen’s children were de minimis in relation to the assets contributed by Mrs. Rosen.4 Further, Mrs. Rosen’s daughter (as her mother’s attorney-in-fact and co-trustee of the Lillie Investment Trust) transferred substantially all of Mrs. Rosen’s assets to the LRFLP leaving her with insufficient funds to meet her financial obligations.
Second, the LRFLP did not operate as a valid, functioning business. Although it did have some economic activity consisting of its receipt of dividend and interest income, sale of a small portion of its portfolio, and its reinvestment of the proceeds of matured bonds, it was not significant enough to characterize the LRFLP as a legitimate business operation. Moreover, the LRFLP did not maintain the books of account required by the partnership agreement, comply with all of the other terms of the partnership agreement ( e.g., no capital contributions were made by any of the partners at the signing of the LRFLP agreement), hold formal or documented meetings between the general partners, or operate the way a bona fide partnership would have operated ( e.g. , while the LRFLP agreement was signed on July 31, 1996, and a certificate of limited partnership was filed five days later, the amount of each partner’s contribution to the capital of the LRFLP was not set until October 11, 1996, at the earliest).
In its defense, Mrs. Rosen’s estate argued that there were three nontax reasons for the formation of the LRFLP. The first was to create centralized management. The court, however, concluded that Mrs. Rosen already had centralized management through the Lillie Investment Trust, which held almost all of her assets and allowed her (or a successor trustee) to manage and control those assets. The second was to limit Mrs. Rosen’s liability. This claim also fell on deaf ears because there was no evidence that the LRFLP was formed with any such intent and applicable law appeared to give Mrs. Rosen’s creditors the same foreclosure rights against the LRFLP vis-à-vis the Lillie Investment Trust. The third was to facilitate Mrs. Rosen’s gift giving and to preserve the value of her gifts. The court, however, determined that this is not a significant nontax purpose that could characterize Mrs. Rosen’s transfer of assets to the LRFLP as a bona fide sale.
After concluding that the bona fide sale exception did not apply, the court then held that Mrs. Rosen had retained the lifetime possession and enjoyment of the assets transferred to the LRFLP. As in Disbrow, the court focused on the facts and circumstances surrounding both the transfer of assets to the partnership and how those assets were subsequently used. Here, substantially all of Mrs. Rosen’s assets were transferred to the LRFLP at a time when she was 88 years old and in poor health, pursuant to the advice of estate planning counsel.
Following the transfer, Mrs. Rosen’s relationship to her assets also did not change. The partnership used the assets it received from Mrs. Rosen to pay the same types of expenses and conduct the same type of gifting Mrs. Rosen did before the transfer. Finally, the distributions that had been made from the LRFLP to Mrs. Rosen were held not to be loans because the indicia that otherwise would have created a true debtor-creditor relationship was absent.
The results of the aforementioned cases and the other §2036 cases in which the IRS was victorious appear to indicate that taxpayers who own assets in FLPs may be required to include the full value of such assets in their gross estate when there are “bad facts” concerning the formation and operation of the FLP. However, the reality is that the IRS settles many FLP cases with very favorable results to the taxpayer. The balance of this article discusses what appears to be the practical aspects of audited FLP cases.
Family Limited Partnership Questionnaire
As indicated above, a review of the court cases, such as the ones discussed above, and informal announcements from the IRS may give the impression that the IRS is routinely denying and litigating all valuation discount cases concerning FLPs. In preparation for a Florida Real Property, Probate and Trust Law Section sponsored CLE seminar held in Tampa on October 6, 2006, two of the authors (David Pratt and Trent Kiziah) sent a three-page questionnaire regarding FLP audits to approximately 350 Florida lawyers who presumably have experience in estate tax matters.5 The questionnaire sought information on the lawyers’ actual audit experience with the IRS on FLP valuation cases. While the results of the questionnaire cannot be viewed as statistical evidence, the results are enlightening.
Of the 350 e-mails sent, there were 41 responses, constituting a 12 percent response rate. The initial question asked was “Have you participated in an IRS audit in which the valuation of a FLP (or similar entity, such as a LLP) has been at issue?” Thirty-four percent or roughly one-third of the 41 respondents answered the question in the negative. Twenty-seven respondents answered “yes” to the initial question.
In an abundance of caution, only completed audits are reviewed, thereby narrowing the number of responses to 22. In all 22 completed audit matters, the IRS granted a valuation discount! Because published opinions indicate to the contrary, one should not draw the conclusion that the IRS always grants discounts. However, these 22 responses do support the conclusion that the IRS does grant valuation discounts for FLP interests where appropriate. Furthermore, the valuation discounts seem to be reasonable, as summarized below.
Of the 22 responses, one respondent indicated a discount was granted, but did not indicate the amount of the discount, leaving only 21 responses which are further analyzed. The lowest reported discount was 10 percent;6 the highest was 55 percent.7 The average discount was 29.93 percent or roughly 30 percent. The mean discount was also 30 percent.
Seven of the 21 discounts (one-third) were at 30 percent. While one-third of the discounts were 30 percent, and while 30 percent represents the mean and the average, one-third of the discounts exceeded 30 percent. Of course, on the other hand, one-third of the discounts were below 30 percent. Only two responses (a 10 percent and an 18 percent) were below 20 percent. In other words, 90 percent of the discounts were 20 percent or higher. Two-thirds of the discounts were 30 percent or higher.
Of the 21 responses, seven consisted solely (100 percent) of real property and two consisted 95 percent of real property (hereinafter real estate FLPs). The percentage discounts for the real estate FLPs were 10 percent, 20 percent, 30 percent, 30 percent, 30 percent, 30 percent, 30 percent, 32 percent, and 55 percent. Both the lowest discount of 10 percent and the highest discount of 55 percent occurred in the real estate FLPs. The average and the mean discounts for these real estate FLPs was 30 percent. In only two of the nine cases did the discount fall below 30 percent.
There was one FLP that consisted 90 percent of marketable securities, one FLP that consisted 95 percent of marketable securities and seven FLPs that consisted solely (100 percent) of marketable securities (hereinafter marketable securities FLPs). Similar to the average and the mean for the real estate FLPs, the average and the mean for marketable securities FLPs was 30 percent. The percentage discounts for the marketable securities FLPs were 18 percent, 20 percent, 25 percent, 25 percent, 30 percent, 35 percent, 35 percent, 39.5 percent, and 44 percent. In four of the nine cases, the discount percentage fell below 30 percent. A greater share of the discounts fell below 30 percent in the marketable securities FLPs than the real estate FLPs. In only two of the nine real estate FLPs, or 22 percent, did the discounts exceed 30 percent; while in four of the nine marketable securities FLPs, or 44 percent, did the discounts exceeded 30 percent. In other words, it could be argued that it is twice as likely that the discount will exceed 30 percent if the FLP involves stocks and bonds than if the FLP consists solely of real property. Because that conclusion is incongruent with our understanding of how the IRS and the courts are analyzing the FLP cases, however, that conclusion is probably not sound.
Regarding the nine real estate FLPs, the length of the FLP did not impact the amount of the valuation discount. To illustrate, in one case the FLP had been in existence for one year and a 30 percent valuation discount was granted, while a 30 percent discount was also granted for the FLP which had been in existence for 30 years.
With respect to the nine marketable securities FLPs, in four cases the respondents did not answer the question as to the length of the partnership. As to the remaining five, the responses are as follows: three months — 39.5 percent discount; 6 months — 20 percent discount; 10 months — 18 percent discount; 10 months — 35 percent discount; and 7 years — 25 percent discount. Interestingly, while it is believed that the IRS is denying discounts for near death transfers, these actual audit results hold to the contrary.
Twenty respondents answered the question of whether there was an active business. Of the 20, only four active businesses existed. In all four cases, the FLP consisted solely of real property; the granted discounts were 30 percent, 30 percent, 32 percent, and 55 percent.
In five responses, the FLP consisted mostly of real property and the respondent indicated the business was not active; in those cases, the discounts were 10 percent, 20 percent, 30 percent, 30 percent, and 30 percent. It could be said that the inactive real estate FLPs saw a slightly lower discount than the active real estate FLPs. Note, however, there were three 30 percent discounts in the inactive real estate FLPs. None of the marketable securities FLPs were considered to be active.
In seven of the 27 cases, or roughly 22 percent of the cases, bad facts existed. In these cases, the discounts were 18 percent, 20 percent, 20 percent, 30 percent, 30 percent, 30 percent, and 39.5 percent. Note, the average discount of 26.78 percent is slightly below the 30 percent average discounts discussed above. It should also be noted that in each of these cases, there were also “good” facts that existed.
In the first case, no partnership agreement even existed. The decedent’s estate and the IRS agreed to a fractional interest discount of 20 percent. Thus, it could be argued that this case is not an FLP case. In the second case, the partnership documents were “not in order” according to the respondent and that fact resulted in the discount not being as high as it could have been. A 30 percent valuation discount was nevertheless given. In the third case, a 20 percent valuation discount was granted even though the taxpayer was terminally ill when the partnership was formed and the taxpayer died six months later. In a fourth case, a 30 percent discount was given even though the taxpayer was terminally ill at formation and the FLP loaned money to the estate to pay the estate taxes.
In a fifth case, probably the worst “bad facts” case submitted: 100 percent of the FLP consisted of stocks and bonds; only family members were partners; no active business was involved; 10 months passed between formation and the death of the senior generation member, who was the sole contributor to the FLP; the FLP loaned money to the estate to pay the estate taxes; and the partners never met to discuss the formation of the FLP. An 18 percent discount was granted. The respondent noted that the “amount of discount was affected by these factors but principal issue was lack of business purpose.”
In case number six, only family members were partners in the FLP, which consisted solely of marketable securities. The limited partnership made a distribution to pay the estate taxes, only three months passed from the time of the partnership creation and time of the taxpayer’s death, and no active business was involved. Even under all of these bad facts, the LP units received a 39.5 percent discount. Finally, in case number seven, the decedent was elderly when the partnership was formed and only two years passed between formation and the taxpayer’s death. On a positive note, the partnership operated correctly, i.e., meetings held by partners with investment advisor and attorney on a regular basis. The matter was settled at a 30 percent discount.
One should cautiously approach the results of the questionnaire. Because they are completed audits, they may not reflect the manner in which the IRS is currently handling audits. The survey did not ask the respondent to indicate which IRS audit office handled the audit. Thus, it is impossible to determine if certain audit offices grant lower or higher discounts than others. No attempt was made to verify the accuracy of any of the surveys. For privacy reasons, the survey did not request information on the value of the FLP. Thus, it is possible that many of the audits involved insignificant valuation disputes and the IRS was willing to make greater concessions than if the FLP had more significant value. However, in a few cases, we know that the FLP consisted of assets valued at more than $10 million. Lastly, human memory is frail. As time passes, the memory combines different audit matters and figures fluctuate in the mind. With all of these limitations in mind, however, it is still accurate to say that the IRS is routinely granting significant valuation discounts for FLPs, even in those cases containing numerous bad facts.
Conclusion
As illustrated by Disbrow and Rosen, egregious bad facts will result in IRS victory under §2036. Planners should use these and the other litigated §2036 cases as a roadmap they do not want to follow when structuring FLPs. However, when only a few bad facts exist, coupled with some good facts, it appears, at least based on the questionnaire discussed in this article, that the IRS is settling some FLP cases with discounts favorable to the taxpayer.
1 David Pratt & Jennifer E. Zakin, Family Limited Partnerships: To Qualify or Not to Qualify for the Bona Fide Sale for Full and Adequate Consideration Exception Under §2036, 79 Fla. B.J. 53 (November 2005).
2 See Estate of Disbrow v. Commissioner, T.C. Memo 2006-34; Estate of Rosen, T.C. Memo 2006-115.
3 Rosen, T.C. Memo 2006-115 at 55.
4 The court even hinted that Mrs. Rosen arguably funded the LRFLP by herself, given the timing and amount of certain cash gifts that she had made to her children.
5 The questionnaire was sent, via e-mail, to Florida board certified tax and wills, trusts and estates attorneys and Florida fellows of the American College of Trust and Estate Counsel. If you want a copy of the questionnaire, please send a request, via e-mail, to David Pratt at [email protected].
6 The 10 percent discount response failed to provide sufficient explanation of the discount.
7 In the 55 percent discount response, the respondent noted there was a long history of internal management struggle and that the significant discount is probably reflective of this internal management dispute.
David Pratt is a partner in the personal planning department of Proskauer Rose, LLP, in its Boca Raton office. Mr. Pratt specializes in estate and gift, generation-skipping transfer, and fiduciary income taxation and is board certified in taxation and wills, trusts, and estates. He is also the chair-elect designate of the Tax Section.
Trent S. Kiziah serves as senior vice president of United States Trust Company, N.A., where he serves as the southeast regional financial and estate planner and as trust counsel. He is board certified in wills, trust, and estates.
John F. Pokorny is an associate in the personal planning department of Proskauer Rose, LLP, in its New York City office. Mr. Pokorny received his J.D. from Brooklyn Law School and has an LL.M. in taxation from New York University.
This column is submitted on behalf of the Tax Section, Mark E. Holcomb, chair, and Michael Miller, editor.
