Family Limited Partnerships: Taxes, Courts, and an Uncertain Future-part I

• Publication year: 2004
• Pages: 61

33 Colo.Law. 61 Colorado Lawyer 2004.

2004, March, Pg. 61. Family Limited Partnerships: Taxes, Courts, and an Uncertain Future-Part I

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61

Vol. 33, No. 3, Pg. 61

The Colorado Lawyer
March 2004
Vol. 33, No. 3 [Page 61]

Specialty Law Columns
Estate and Trust Forum
Family Limited Partnerships: Taxes, Courts, and an Uncertain Future - Part I
by Carol Warnick
C 2004 Carol Warnick

This column is sponsored by the CBA Trust and Estate Section The column focuses on trusts and estate law topics, including estate and trust planning and administration, elder law probate litigation, guardianships and conservatorships, and tax
planning

Column Editor:

David W. Kirch, of David W. Kirch, P.C., Aurora - (303) 671-7726, dkirch@qwest.net

Carol Warnick

About The Author:

This month's article was written by Carol Warnick, Denver, Of Counsel with Holland & Hart LLP - (303) 295-8359, cwarnick@hollandhart.com.

This article discusses the Internal Revenue Service's recent successes in attacking family limited partnerships using the IRC § 2036 or "retained interest" argument. Part I
reviews case law and analyzes the Service's position. Part II of the article will address the Fifth Circuit Court's Kimbell decision and suggest ideas for protecting family limited partnerships during this period of uncertainty.

The family limited partnership ("FLP") has ascended to the summit of favored estate planning techniques in the past decade or so.1 For years, the FLP appeared to be almost invincible, although the Internal Revenue Service ("Service") volleyed numerous attacks at the FLP, only to be repeatedly defeated by the courts - that is, until recently. In several recent cases, the Service has successfully flung the so-called
"§ 2036" argument at the FLP.

The § 2036 argument involves transfers by a taxpayer that normally would place transferred assets out of the taxpayer's estate. Under § 2036 of the Internal Revenue Code ("Code"),2 in certain instances where the taxpayer retains an interest in a transferred asset, the asset is brought back into the estate for estate tax purposes. Due to the Service's success with the § 2036 argument, many practitioners are wondering if the golden age of FLPs finally has come to an end.

Part I of this article briefly examines several § 2036 cases. It also discusses current concerns that now fit hand-in-glove with the FLP. Part II of the article, which will appear in this column later this year, will examine the Fifth Circuit Court of Appeals' holding on an important § 2036 case, Kimbell v. U.S.,3 on which the court is expected to rule in 2004. Part II also will discuss what that holding may mean for the future of FLPs and other like entities, suggest ways to protect established FLPs, and address what to consider when establishing new FLPs.

FLPs and Discount
Planning

The FLP has proven to be an efficient, custom-designed vehicle to own and manage family property or business enterprises.4 Limited Liability Companies ("LLCs") can be set up to operate in the same manner as FLPs, and this discussion is equally applicable to LLCs set up in this fashion. The FLP structure traditionally has given the family patriarch or matriarch the ability to begin passing ownership on to the next generation, while maintaining control of assets in the FLP through the general partnership interest.

Although that feature alone has made the FLP appealing, another touted virtue is the FLP's ability to posture family assets for discounts, both for gifting of FLP interests and at death. Valuation discounts may attach to FLP interests because various restrictive FLP characteristics usually cause FLP interests to be worth less than the aggregate value of its underlying assets. Typically, discounts would be given for lack of marketability and for a minority interest.

The test used to determine what percentage discount would be applied to the FLP interest often is referred to as the "willing buyer, willing seller" test. This refers to the amount a willing buyer would pay a willing seller for the FLP interest, where neither party is under compulsion to buy or sell and both are knowledgeable with regard to the relevant issues of the transfer.5

A discount for lack of marketability is based on the premise that the transfer restrictions applicable to the limited partnership interest make such interest less attractive than comparable publicly traded assets under the "willing buyer, willing seller" test. This discount often is determined by comparable sales of restricted stock of publicly traded companies.

The minority interest discount applies to FLP interests because of the limited partner's limited rights with regard to the FLP's management. A limited partner typically has no voice in the FLP's day-to-day business, no power to force distributions, no ability (or a restricted ability) to withdraw from the FLP, and no rights in the FLP's underlying assets. In addition, he or she is restricted on the ability to transfer an FLP interest. Again, these restrictions make the FLP interest less attractive under the "willing buyer, willing seller" test.

FLPs and the § 2036
Argument

After being struck down in various other attempts to stop the steady march of FLPs, the Service presented an argument that the Tax Court seemed willing to accept. In Estate of Strangi ("Strangi I"),6 the Tax Court initially raised the issue by stating that the facts of the case might "suggest the possibility" of including the assets transferred by the decedent into the partnership in the decedent's gross estate pursuant to § 2036.7 Although the Tax Court declined to consider this argument in its opinion because the Service had raised this issue too close to the trial date,8 the court suggested that

[a]pplying the economic substance doctrine in this case on the basis of decedent's continuing control would be equivalent to applying § 2036(a) and including the transferred assets in decedent's estate.9

This statement foreshadows the Tax Court's blurring of the distinction between the "lack of economic substance" and the § 2036 arguments.

The Fifth Circuit Court affirmed the Tax Court's decision on appeal and reversed the Tax Court's denial of the Service's motion for leave to amend to raise the § 2036 argument, even hinting that it might favorably consider such an argument.10 The Service polished up its § 2036 argument and ultimately prevailed in Strangi II.11 Thus continued the downward spiral of cases in which the Service emerged victorious at an enormous cost to taxpayers. This is because of a Code section that was likely never contemplated by the taxpayers or seldom discussed by their attorneys as presenting a possible risk when considering the formation of the FLP.

In each of this growing series of cases, the court upheld the Service's argument that IRC § 2036 should cause the inclusion in the decedent's estate of the value of the assets the decedent contributed to the FLP. By including in the decedent's estate the value of the assets contributed, instead of the value of the partnership interests, the courts ignored the separate existence of the FLP, thus removing the ability for the estate to discount these interests. All of these cases involved egregious facts, validating the old adage that "bad facts make bad law."

Case Law Involving FLPs And § 2036(a)(1)

IRC § 2036 includes two alternative arguments for inclusion of property in a decedent's estate, which, in most cases, significantly increases the estate's tax liability. Section 2036(a), "Transfers with retained life estate," provides:

(a) General Rule. The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death

(1) the possession or enjoyment of, or the right to income from, the property, or

(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.12

The U.S. Supreme Court, in the Estate of Grace,13 declared that the purpose of
§ 2036 is

to include in a decedent's gross estate transfers that are essentially testamentary - i.e., transfers which leave the transferor a significant interest in or control over the property transferred during his lifetime.14

It therefore follows that the Service would argue that transfers by the decedents in these cases were testamentary in nature and that the decedent retained the possession, enjoyment, or right to the income of the underlying FLP assets.

In two cases, Kimbell and Strangi II,15 the courts even went beyond these arguments and looked to the § 2036(a)(2) "hook" of whether the decedent retained the right to designate the persons who would possess or enjoy such assets. Various courts also reviewed the bona fide sale exception contained within the parentheses in the body of § 2036, but have been unwilling to apply it in any of these cases, at least until Estate of Stone v. Commissioner,16 which is discussed below.

To get the flavor of the evolution of the Service's success with the § 2036 cases leading up to the high-water mark of Strangi II, a brief discussion of several significant cases is in order. These include Estate of Reichardt v Commissioner,17 Estate of Harper v. Commissioner,18 Estate of Thompson v. Commissioner,19 and Kimbell v....