Family Limited Partnerships: The Year in Review
In November 2005, one of the authors co-authored an article for The Florida Bar Journal regarding family limited partnerships (FLPs), which focused on the most recent family limited partnership cases in the context of the bona fide sale exception to §2036 of the Internal Revenue Code of 1986, as amended.1 About one year later, he co-authored a follow-up article for The Florida Bar Journal discussing FLP cases decided after the publication of the first article.2 Since the publication of the follow-up article, there have been three §2036 cases involving FLPs3 & #x2014; the IRS was victorious in all of these cases. Each of these cases contains an abundance of “bad facts” ( e.g., majority of assets transferred to the partnership, use of partnership funds for the transferor’s personal expenses, the transferor is terminally ill or in very poor health upon formation, etc.).
The purpose of this article is to discuss these recent “bad fact” cases, Estate of Erickson v. Commissioner, T.C. Memo 2007-107; Estate of Gore v. Commissioner, T.C. Memo 2007-169; and Estate of Bigelow v. Commissioner, 100 AFTR 2d 2007-6016 (9th Cir. 2007), aff’d, T.C. Memo 2005-65, which continue to provide a roadmap for practitioners and clients regarding how not to structure and operate an FLP. The article then discusses the results of a Minnesota state court case in which the court held that a trustee did not have a fiduciary duty to establish an FLP.4 Florida courts have not yet considered the issue, but it is hard to imagine that they would come to a different conclusion — although, anything is possible. Lastly, the article discusses recent changes to the Federal Estate Tax Return, Form 706, with respect to the reporting of valuation discounts and entity interests.
Estate of Erickson v. Commissioner
In May 2001, when Hilde E. Erickson was 88 years old, suffering from Alzheimer’s, and in failing health, her daughter, Karen, orchestrated the creation of an FLP. The FLP agreement provided that Karen and her sister, Sigrid, would be both general and limited partners. Hilde (acting through Karen as her attorney-in-fact), Karen’s husband, Chad Lange, and Karen, as trustee of the credit shelter trust created for Hilde’s benefit under the will of Hilde’s late husband, Arthur (the trust), would be limited partners. Hilde was to contribute virtually all of her personal assets, including $2 million of marketable securities and a Florida condominium, in exchange for an 86.25 percent interest in the FLP. Karen, Chad, and Sigrid were to each contribute partial interests in a Colorado investment condominium in exchange for a 1.4 percent, 1.4 percent, and 2.8 percent interest, respectively. The trust was to contribute another Florida condominium in exchange for an 8.2 percent interest, but it was not to contribute any of its $1 million in marketable securities.
No transfers to the FLP occurred upon the execution of the FLP agreement. In July 2001, Karen instructed Merrill Lynch and Wells Fargo to transfer Hilde’s marketable securities to the FLP. On September 28, 2001, while Hilde’s health was rapidly deteriorating, Karen executed deeds transferring Hilde’s condominium and the trust’s condominium to the FLP. On that same day, Karen, on behalf of Hilde, gifted a combined 62.07 percent limited partnership interest in the FLP to three trusts for Hilde’s grandchildren. Hilde died two days later. After Hilde’s death, the family continued to operate the FLP. The condominiums continued to be managed by the same onsite management companies, and the marketable securities continued to be managed by investment advisors at Merrill Lynch and Wells Fargo.
Karen was appointed as the personal representative of Hilde’s estate pursuant to Hilde’s will. The estate was unable to meet its liabilities for estate and gift taxes. Rather than obtaining the funds necessary to pay the taxes from the trust’s $1 million in marketable securities, Karen sold Hilde’s condominium to the FLP for $123,500 and transferred $104,000 from the FLP to the estate, the latter transfer being characterized as a partial redemption of Hilde’s FLP interests.
The court’s opinion first summarizes the principals of §2036. If a decedent makes an inter vivos transfer of property and retains certain rights or interests in the property, such as the right to possess or enjoy the property, that are not relinquished until death, the full value of the property will generally be included in the decedent’s estate.5 However, the bona fide sale exception will apply to exclude the property from the decedent’s estate if the FLP was formed for a legitimate and significant nontax reason and each transferor received an FLP interest proportionate to the fair market value of the property transferred to the FLP.6
The court first considered whether Hilde retained the right to possess or enjoy the assets transferred to the FLP pursuant to an implied understanding among the partners. The court focused on the delay in funding the FLP and the need for the FLP to provide the estate with funds to meet its liabilities. The court believed that the funding, in part two months after the FLP’s creation, and in part two months thereafter when Hilde was on her death bed, suggested a failure to respect the formalities of the FLP. The court also believed that the transfers of funds from the FLP to the estate, even though cloaked as a sale and redemption, was tantamount to making funds available to Hilde if she needed it. Therefore, the court found that there was an implied understanding that Hilde would retain the right to possess and enjoy the FLP assets.
Next, the court analyzed whether the bona fide sale exception applied. It identified factors, set forth in prior cases, indicating that a transaction was not motivated by a legitimate and significant nontax purpose. These factors include the taxpayer standing on both sides of the transaction, the taxpayer’s financial dependence on FLP distributions, the partners’ commingling of FLP funds with their own and the taxpayer’s actual failure to transfer money to the FLP.7
Despite the fact that Sigrid admitted at trial that the estate tax advantages flowing from the transaction were a motivating factor, the court entertained several possible nontax reasons offered by the estate. First, the estate argued that forming the FLP allowed the family to centralize management of family assets and to give management responsibilities to Karen. The court was not persuaded by this argument because Karen, as attorney-in-fact for Hilde, already had significant management responsibilities with respect to family assets before the FLP’s formation. Second, the estate argued that the FLP afforded greater creditor protection. The court did not agree, stating that a creditor seeking FLP funds would have a significant asset base from which to recover. Lastly, the estate argued that the FLP facilitated Hilde’s gift-giving plan. The court dismissed this argument, holding that a gift-giving plan is not a significant nontax purpose.
The court noted other facts showing the absence of a nontax purpose. The FLP was a collection of passive assets, which did not change after the formation of the FLP. The FLP was essentially formed unilaterally by Karen, who was on every side of the transaction, as attorney-in-fact for Hilde, as personal representative of Hilde’s estate, as a general partner and limited partner of the FLP, as trustee of the trust, and in her individual capacity. No family member was represented by independent counsel; the attorney hired by Karen represented the entire family.
Having found that Hilde’s transfer was not a bona fide sale, the court stated that there was no need to examine whether adequate and full consideration existed. The bona fide sale exception did not apply. Accordingly, the court held that the property transferred by Hilde to the FLP was includible in her gross estate.
Estate of Gore v. Commissioner
Sidney Gore died in January 1995, survived by his wife, Sylvia. During his lifetime, Sidney established a revocable trust providing that, upon his death, a credit shelter trust and marital trust be established for Sylvia, if she survived him. Sylvia established a revocable trust with similar provisions. On the day before Sidney died, he met with his accountant and discussed his concerns about preserving his wealth for Sylvia and future generations. Shortly after Sidney’s death, the accountant proposed the idea of an FLP to Sidney’s children, and later, to Sylvia.
In December 1996, the Gore children formed an FLP. Sylvia, who suffered from Parkinson’s disease and had, on numerous occasions, been hospitalized for disorientation and decreased levels of consciousness, did not participate in the FLP’s formation. The FLP’s certificate of limited partnership and partnership agreement identified the Gore children as the general partners, but did not identify any limited partners. Schedule A of the agreement stated that each of the Gore children had contributed $500 for his or her respective general partnership interest; however, neither child made a contemporaneous contribution to the partnership.
Shortly thereafter, Sylvia executed a durable power of attorney in favor of her daughter, Pamela. On January 3, 1997, Sylvia resigned as trustee of the revocable trust and Pamela became the successor trustee. On January 8, 1997, Sylvia executed an exercise of power and irrevocable assignment, whereby she purported to transfer all of the marital trust assets to the FLP and to make a $100,000 gift to each of the irrevocable trusts she created on that date for her children. The assignment stated, “I have or shall invest or direct investments of the assets subject to this trust in the Gore Family Limited Partnership.” It did not identify any specific assets to which it applied, and it was unlikely that Sylvia knew about the assets owned by the marital trust.
Prior to her death, Sylvia did not transfer title to any marital trust assets to fund the $100,000 gifts to the children’s trusts, and, with the exception of a bank account, she did not transfer any assets to the FLP. From its inception through Sylvia’s death, the FLP did not engage in any business or investment activity. For the first six months of 1997, Pamela deposited into the FLP account some, but not all, of the dividends paid on marital trust stocks. Interest on marital trust assets continued to be deposited in Sylvia’s account, although such assets allegedly had been transferred to the FLP. The accountant did not create the FLP’s accounting records until several months after Sylvia’s death. After Sylvia’s death, Pamela continued to use the FLP account to pay Sylvia’s personal expenses.
The court held that by the assignment, Sylvia may have effectively withdrawn the marital trust assets; however, she had not effectively transferred those assets to the FLP, because she retained dominion and control over the assets by collecting dividends and interest, retaining proceeds of the sale of certain assets, depositing income into her own bank account, and using income to pay her personal expenses. Because Sylvia, at her death, continued to own, control, and use the marital trust assets, inclusion of the assets in her gross estate was required under §2033 of the Code. The court held, in the alternative, that even if the transfer were complete, any remaining marital trust assets would be includible in Sylvia’s gross estate, because she had a general power of appointment over the marital trust within the meaning of §2041(a)(2) of the Code.
Next, the court addressed §2036, holding that the numerous bad facts indicated an implied agreement for Sylvia to retain possession and enjoyment of the marital trust/FLP assets, as well as the income therefrom. The court held that the transfer did not qualify for the bona fide sale exception. There was not an arm’s length transaction, because Sylvia technically acquired her interest from herself and the transfer represented a mere “recycling of value,” as it was used simply as a vehicle to change the form in which Sylvia held the assets of the marital trust. Accordingly, the court held that, even if the marital trust assets had been transferred to the FLP, the full values of those assets were includible in Sylvia’s estate under §2036.
Estate of Bigelow v. Commissioner
In Bigelow, the Ninth Circuit upheld the Tax Court’s holding that all of the assets of an FLP were includible in the decedent’s gross estate under §2036.
The facts of Bigelow and the Tax Court’s opinion have been discussed in previous Florida Bar Journal articles, including the co-author’s November 2005 article. Therefore, only a brief summary of the facts appears below.
A decedent’s revocable trust and his children created an FLP, with the trust contributing a piece of rental property worth $1,450,000, and each of the decedent’s children contributing $100 cash. The property was encumbered by loans, which were not assumed by the FLP and remained liabilities of the trust. Before the FLP’s creation, the decedent had a positive monthly cash flow. After the creation, the decedent had a monthly cash shortfall, which rendered the decedent unable to make the monthly payments on one of the loans. Thus, the FLP made the payments for her.
The decedent’s son, acting as the decedent’s attorney-in-fact, gifted limited partnership interests in the FLP to himself, his sisters, and the decedent’s grandchildren. The son transferred funds between the FLP and the trust numerous times, sometimes to pay property taxes on the property, and other times to pay the decedent’s personal expenses.
The Tax Court determined that the entire value of the property was includible in the decedent’s gross estate, because the facts indicated an implied agreement for the decedent to retain the income from the property and for the FLP to secure the decedent’s personal debts, and there was no nontax purpose for the transaction.
The Ninth Circuit agreed with the Tax Court that there was an implied agreement for the decedent to use the FLP assets as needed. The Ninth Circuit then addressed the applicability of the bona fide sale exception. In doing so, it viewed the bona fide sale and adequate and full consideration elements of the exception as interrelated criteria, rather than separate issues. The Ninth Circuit dismissed the IRS’ argument that, even though the partners received interests in the FLP in proportion to their contributions, the trust’s transfer to the FLP could not meet the exception because the interest the trust received (after applying the marketability discounts) was worth less than property transferred to the FLP. However, the Ninth Circuit went on to hold that an estate must demonstrate more than a proportionality of interests; it must also show a “genuine” pooling of assets and a “potential for intangibles stemming from pooling for joint enterprise.” Presumably, these requirements were not met in this case, as the decedent’s children contributed just $100 each, compared to the trust’s contribution of the property worth $1,450,000. However, after mentioning the requirements, the Ninth Circuit did not analyze them further.
Instead, it focused on the Tax Court’s findings that the transfer was not made in good faith because it impoverished the decedent, FLP formalities were not followed, and there was no nontax benefit. The court rejected the estate’s argument that the FLP protected the family from personal liability because the decedent was still exposed to liability by virtue of the trust acting as general partner and there was no concrete incident or circumstance indicating a genuine exposure to liability. Similarly, the court rejected the rationale that the FLP protected the property from partition where there was no evidence that the family contemplated a partition. The court did not see the efficient management of the property as a valid nontax reason, finding that decedent’s son, as trustee of the trust, had already been managing the property prior to its contribution to the FLP. The court also did not see the facilitation of the decedent’s gift-giving plan as a valid nontax reason. Finding that the bona fide sale exception did not apply, the Ninth Circuit affirmed the Tax Court’s holding that the value of the property was includible in the decedent’s gross estate.
In the Matter of Janice Galloway Trust
In In the Matter of the Janice Galloway Trust, Second Judicial District Court, County of Ramsey, Minnesota, Court File No. C5-04-200042, Herbert Galloway died in 1994, survived by his wife, Janice, their two children, and five grandchildren. Under the terms of Herbert’s revocable trust, which he created in 1988, three trusts were created for the benefit of Janice, a credit shelter trust, a generation-skipping tax (GST) exempt marital trust, and a GST nonexempt marital trust.
Janice also established a revocable trust. She remarried in 1998 and died in 2001. U.S. Bank was the sole trustee of the three trusts under Herbert’s revocable trust, a co-trustee with Janice of her revocable trust, and the sole executor of Herbert’s and Janice’s estates.
Upon Janice’s death, the Galloway children contacted an attorney to object to the fees charged by the estate planning attorney administering the estates of Herbert and Janice. One of the issues raised was the failure of U.S. Bank to transfer the marital trusts’ marketable securities to an FLP as a vehicle to reduce estate taxes that would be owed in Janice’s estate upon her death.
When U.S. Bank requested court approval of its fees, the Galloway children objected and sought to have U.S. Bank pay a surcharge to the trusts as compensation for breach of trust, including the failure to establish an FLP. The issue pertaining to the formation of the FLP was the only issue that went to trial in the Minnesota state court.
The court found in favor of U.S. Bank, holding that, as a general matter, a trustee does not have a duty to establish an FLP, because it is a complex, aggressive technique that is not appropriate in all circumstances. Specifically, under these facts, U.S. Bank did not have that duty because 1) the trust instrument permitted the formation of an FLP, but it was not mandatory; 2) tax minimization was not the main purpose of the marital trusts; 3) it is rare for a marital trust to invest in an FLP; 4) there was no existing family business; 5) the attorney for the family did not request creation of an FLP; and 6) an FLP would not have been in accord with Janice’s personal objectives, as evidenced by her rejection of less complex and less risky estate planning techniques suggested by her estate planning attorney, her desire to keep her financial information private from her family, and her concern over whether she had enough money to maintain her lifestyle.
The court went on to hold that even if U.S. Bank did have that duty, the Galloway children would not be able to show that the failure to create an FLP was the proximate cause of the additional estate taxes paid by Janice’s estate. That would have required a showing that 1) the FLP and corresponding valuation discounts would have sustained IRS scrutiny; 2) Janice would have consented to the creation of the FLP; and 3) U.S. Bank could create the FLP and obtain discounts without breaching its other fiduciary obligations.
Fiduciaries and professionals must be cognizant of this case, as it is possible that a similar claim could be brought by beneficiaries of a marital trust in Florida.
Changes to Estate Tax Return
For the past few years, it has been relatively easy for the IRS to identify and audit gifts of discounted limited partnership interests because if the value of the gift reported on Schedule A of the federal gift tax return reflects a discount for lack of marketability and/or a minority interest, the appropriate box must be checked under Schedule A of the return. In addition, if the box is checked, an explanation giving the factual basis for the claimed discount and the amount of discounts taken must be provided.
This year, the IRS made it easier to identify when a decedent owns limited partnership interests at death which have been discounted for federal estate tax reporting purposes. Interests in family limited partnerships, limited liability corporations, and fractional interests in real estate have been added to the list of interests owned by a decedent at the time of death which are to be listed on line 10(a) of part four of the return. In addition, line 10(b) of part four requires the disclosure of whether the interests owned by the decedent discussed on line 10(a) were discounted. Specifically, if the reported interest was discounted, Schedule F of the federal estate tax return needs to be reviewed for the proper reporting of the total accumulated or effective discounts taken on Schedules A, F, or G. If line 10(b) of part four was answered “yes” for any interest in miscellaneous property not reportable under any other schedule owned by the decedent, a statement must be attached which lists the item number from Schedule F and identifies the total accumulated discount taken on the interest. Further, if line 10(b) of part four was answered “yes” for any transfers described in one through five on pages 14 and 15 of the federal estate tax return instructions (i.e., transfers includible under §§2035, 2036, 2037, or 2038 of the Code), a statement must be attached to Schedule G which lists the item number from that Schedule and identifies the total accumulated discount taken on the transfer.
A common estate planning technique to reduce estate tax exposure and “freeze” an individual’s estate is the sale of entity interests (including limited partnership interests in an FLP) to an intentionally “defective” irrevocable trust (IDIT).8 In order to commence the statute of limitations on such a transaction, a taxpayer can report the sale on a gift tax return, provided that the conditions of the gift tax adequate disclosure regulations are satisfied.9 Line 12(e) of part four of the Estate Tax Return, Form 706, now addresses whether the decedent transferred or sold interests in a partnership, limited liability company, or closely held corporation during life to a trust that was 1) created by the decedent during his or her lifetime; or 2) not created by the decedent but of which the decedent possessed any power, beneficial interest, or trusteeship. In that regard, any gift and/or sale of entity interests by a decedent to an IDIT would be recognized. Consequently, when a sale of an entity interest is made to an IDIT during life, it should probably be reported on a gift tax return, as it will have to be reported at death, regardless of whether it is reported during life.
As illustrated by Erickson, Gore, and Bigelow, 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. While a properly formed and operated FLP can still be a powerful estate planning technique, the complexity and hurdles in the transaction are significant, and the IRS will probably identify them on a gift or estate tax return. Moreover, the Galloway case illustrates that one court has considered whether an institutional trustee of a marital trust has a duty to form an FLP. Query whether similar suits may follow and perhaps be expanded to include lawyers, accountants, and financial advisors—hopefully not.
1 David Pratt and 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 David Pratt, Trent S. Kiziah, and John F. Pokorny, Family Limited Partnerships: Are They Still Alive and Kicking?, 81 Fla. B.J. 28 (January 2007).
3 See Estate of Erickson v. Commissioner, T.C. Memo 2007-107; Estate of Gore v. Commissioner, T.C. Memo 2007-169; Estate of Bigelow v. Commissioner, 100 AFTR 2d 2007-6016 (9th Cir. 2007), aff’d, T.C. Memo 2005-65.
4 See In the Matter of the Janice Galloway Trust, Second Judicial District Court, County of Ramsey, Minnesota, Court File No. C5-04-200042.
5 I.R.C. §2036(a).
6 Estate of Bongard v. Commissioner, 124 T.C. No. 8 (2005).
8 See Louis A. Mezzullo, Freezing Techniques: Installment Sales to Grantor Trusts, Probate & Property (January/February 2000).
9 See Treas. Reg. §301.6501(c)-1(f).
David Pratt is a partner in the personal planning department of Proskauer Rose, LLP, in Boca Raton. Mr. Pratt focuses on estate and gift, generation-skipping transfer, and fiduciary income taxation and is board certified in both taxation and wills trusts, and estates. He is a fellow of the American College of Trust and Estate Counsel and the American College of Tax Counsel and chair-elect of the Tax Section.
Scott L. Goldberger is an associate in the personal planning department of Proskauer Rose, LLP, in Boca Raton. He received his J.D. from Georgetown University Law Center and a Master and B.S. in accounting from the University of Florida.
This column is submitted on behalf of the Tax Section, Edward E. Sawyer, chair, and Michael D. Miller and Benjamin A. Jablow, editors.