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

• Publication year: 2004
• Pages: 91
• Citation: Vol. 33 No. 9 Pg. 91

33 Colo.Law. 91 Colorado Lawyer 2004.

2004, September, Pg. 91. Family Limited Partnerships: Taxes, Courts, and an Uncertain Future-Part II

Vol. 33, No. 9, Pg. 91

The Colorado Lawyer
September 2004
Vol. 33, No. 9 [Page 91]

Specialty Law Columns
Estate and Trust Forum
Family Limited Partnerships: Taxes, Courts, and an Uncertain Future - Part II
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 two-part article discusses the Internal Revenue Service's recent attacks on family limited partnerships using the IRC § 2036 or "retained interest" argument. Part I of the article reviewed case law and analyzed the Service's position. Part II addresses the Fifth Circuit Court's Kimbell decision and suggests how to protect family limited partnerships during this period of uncertainty.

This is the second of a two-part article that addresses the use of family limited partnerships ("FLPs") in estate planning. Part I, which was published in this column in March 2004, discussed cases leading to the momentous Tax Court decision in 2003 in Strangi II.1 As addressed in Part I, Kimbell v. U.S.2 was one in a line of cases leading to the Strangi II decision.3 The Fifth Circuit Court handed down the second Kimbell decision on May 20, 2004. That decision proved to be a tremendous victory for the taxpayer, with hints of a bright future for FLPs in general.4

Part II of this article discusses the Kimbell case and reviews the Fifth Circuit Court's analysis. The Kimbell case is of particular interest because it provides guidance for Colorado practitioners who are establishing FLPs or family LLCs.

Discussion of Kimbell Case

The Kimbell decision was the first of the pre-Strangi cases to focus its analysis on Internal Revenue Code ("Code") § 2036(a)(2).5 As discussed in detail in Part I,6 the so-called "§ 2036 argument" concerns transfers by a taxpayer that normally would place transferred assets out of the taxpayer's estate.

This case involved a limited liability company ("LLC") formed by Ruth Kimbell, her son, and daughter-in-law. Kimbell owned a 50 percent interest in the LLC, and her son (who was the manager of the LLC) and daughter-in-law each owned 25 percent interests.7 Kimbell and the new LLC formed an FLP. The LLC contributed one percent of the capital in the FLP and took back a one percent general partnership interest; Kimbell contributed 99 percent of the capital and took back a 99 percent limited partnership interest.8 Two months after forming the FLP, Kimbell died at the age of 96.

The estate valued Kimbell's limited partnership interest at a discounted value of $1.257 million, but the Internal Revenue Service ("Service") valued the same interest at $2.463 million.9 The issue came before the U.S. District Court for the Northern District of Texas on a motion for summary judgment filed by the Service.10 The Service argued that the property transferred by Kimbell should be included in her estate under § 2036(a).11 The district court agreed,12 holding that none of the exceptions to § 2036(a) applied to keep the property from coming back into Kimbell's estate.

The facts in Kimbell were not favorable to the taxpayer, which makes the Fifth Circuit Court's decision even more momentous. The appellate court analyzed the case in a very different fashion from the district court. Thus, certain specific facts that were instrumental to the district court's decision were considered to be unimportant to the Fifth Circuit Court.

The Fifth Circuit Court presented its holdings in the first paragraph of the opinion in rather strong language.13 It concluded that the lower court erred in finding as a matter of law that: (1) family members cannot enter into a bona fide transaction; and (2) a transfer of assets given in return for a pro rata partnership interest does not constitute a transfer for full and adequate consideration.14

The opinion also stated that the lower court erred by failing to consider what the Fifth Circuit Court called "uncontroverted record evidence" supporting the taxpayer's position that the transfer to the partnership constituted a bona fide sale.15 As noted, Kimbell was decided originally on a motion for summary judgment. The Fifth Circuit Court pointed out that factual evidence, submitted by the taxpayer in the form of affidavits signed by the decedent's son and business advisor, was uncontested and, therefore, could not be ignored.16

The Fifth Circuit Court did not address the application of the bona fide sale for full and adequate consideration to transfers to the LLC that served as the general partner of the FLP. Surprisingly, however, the court went out of its way to note that even if the bona fide sale exception did not apply to those transfers, Kimbell did not retain sufficient control for her transfer to fall under the § 2036(a) umbrella.17 She held only a 50 percent interest in the LLC, and her son was designated manager of the LLC.18

The Fifth Circuit Court's reasoning provided a significant contrast to the district court's analysis. The partnership agreement provided that 70 percent of the limited partners could remove the general partner, and Kimbell retained a 99 percent limited partnership interest. Thus, because Kimbell could remove and replace the general partner, the district court had assumed that Kimbell retained control sufficient to invoke § 2036(a).19

The Fifth Circuit Court's Kimbell opinion provides a detailed explanation of § 2036(a). The court states that § 2036(a) prevents circumvention of the federal estate tax by making lifetime transfers that do not really remove from the transferor his or her lifetime enjoyment of the transferred property.20

The court cites two exceptions that would allow a transfer to escape the reach of § 2036(a). The first exception is a transfer that is a bona fide sale for full and adequate consideration.21 The second exception is where the transferor does not retain: (1) the possession or enjoyment of the transferred property; or (2) the right to designate who would possess or enjoy the property.22 These exceptions are addressed below as part of a detailed analysis of the Kimbell case.

Exception: Bona Fide Sale for Full and Adequate
Consideration

The first stated exception to § 2036(a) discusses the bona fide sale for adequate and full consideration in money or money's worth. The district court had determined that Kimbell's transfer of assets for § 2036 purposes failed for two reasons. First, in the district court's opinion, it was a transfer among family members and, thus, could not be arms-length and a bona fide sale. Second, the pro rata interest Kimbell received in exchange for her contribution did not reflect adequate consideration.23

The district court tried to distinguish a previous Fifth Circuit Court case, Wheeler v. United States,24 and instead relied on the Tax Court's opinion in Estate of Harper v. Commissioner.25 However, the Fifth Circuit Court relied heavily on Wheeler, which it analyzed in such a way as to refute the district court's reasoning.

Full and Adequate
Consideration Analysis

The Wheeler case involved an individual who sold a remainder interest in a ranch to his sons for a price based on the ranch's actuarial value obtained from tables created by the Service. The Service tried to bring the value of the ranch back into the decedent's estate, arguing that the transfer was merely part of a...