The Ebb and Flow of the Federal Tax Role of Fiduciary Duties in Family Limited Partnerships: From Byrum to Bongard

• Author: Carter G. Bishop
• Position: Professor of Law, Suffolk University Law School, Boston, Massachusetts.
• Pages: 61-118

Page 61

This Article was completed while I was a Visiting Professor at George Washington University Law School, where I received superb research assistance from Kathryn A. Todryk, J.D. 2008. My understanding of law in general has been enriched by an ongoing dialogue with my colleague and friend, Professor Daniel S. Kleinberger.

The fiduciary duty impact theory, developed by the Supreme Court of the United States in its 1972 opinion in United States v. Byrum,¹ has been one of the most important and controversial developments in estate taxation involving transfers to family-controlled entities.² In 2003, the Tax Court's decision in Estate of Strangi v. Commissioner (Strangi III)³ sent shock waves throughout the estate planning community when it became the first case to reject the family limited partnership estate planning technique by expanding the reach of Internal Revenue Code (Code) section 2036.⁴ The expansion was largely achieved by rejecting Byrum's fiduciary duty impact theory,⁵ which had been utilized, with the Internal Revenue Service (Service) sanction, to negate the application of section 2036.⁶Faced with mounting failures on other theories,⁷ the Service reversed Page 62 course and turned to section 2036 in an attempt to distinguish Byrum factually.⁸

In many ways, Strangi III presented government-friendly facts. Albert Strangi made a deathbed transfer of 98% of his personal and investment assets to a family limited partnership,⁹ which was formed and managed by his son-in-law under a power of attorney.¹⁰ Under this set of facts, the constraining fiduciary duty feature of Byrum was not well served. There was no transfer of an operating business with a substantial unrelated minority ownership interest to add substance and real meaning to the fiduciary duties.¹¹ No matter how strenuously argued, fiduciary duties owed in a friendly family limited partnership are simply too rarely enforced to add meaning.¹² Unfortunately, armed with its Strangi III victory, the Service ramped up the Byrum-slayer theory, applied it to very different facts in Estate of Bongard v. Commissioner,¹³ and was rewarded with an unwarranted victory.¹⁴ Unlike the deathbed investment-asset transfers in Strangi III, the Bongard transfers were made by a healthy businessman of his ownership in a successful, operating business.¹⁵ He made the transfers along with a substantial cadre of unrelated Japanese corporations.¹⁶

This Article analyzes the origins and legacy of the fiduciary duty impact theory to challenge conventional Bongard-styled wisdom. It chronicles the statutory development of section 2036 and the fiduciary duty impact theory to demonstrate that the theory arose to deal with specific instances of control over property transferred to family members, rather than transfers to a family entity controlled by the transferor. For this reason, the theory was not initially utilized to attack transfers to controlled entities. The theory's recent deployment arose because of the failure of Page 63 other theories, not because of its logical force. As a result, Bongard and its likely progeny are aberrations; they are not a proper basis for extending the theory to contravene a valid and existing Supreme Court Byrum opinion. As in 1976 when it enacted section 2036(b) to negate Byrum in the context of transfers of voting stock while retaining the vote,¹⁷ Congress, and not the Courts, must remedy the alleged estate tax abuse in the form of family limited partnerships.¹⁸

I Introduction

Family limited partnerships¹⁹ have become ubiquitous asset protection²⁰ and estate tax planning reduction vehicles,²¹ and they now share center stage attention at the Service,²² along with the venerable tax Page 64shelter.²³ Given the vigorous audit attention, past Service losses under various theories,²⁴ and its new victories under section 2036,²⁵ is the hype and promise a myth or a reality? Can taxpayers truly transfer all or most of their assets to an entity controlled by a family member and achieve adequate estate tax savings, justifying the probable significant professional costs to defend these positions? The professional defense costs are easily quantifiable, but are the estate tax savings as easily quantifiable? Specifically, are the realistic requirements necessary to achieve such savings adequately known by family practitioners and, if so, are wealthy family members willing to abide by the complex rules associated with the management structures of the family controlled entities? For the most part, this Article is a story about the estate tax-saving virtues and the necessary professional and personal costs to assure those savings reasonably.²⁶ The long lesson is that carefully orchestrated transfers of an operating business to a family limited partnership for valid business reasons may and should continue to escape the clutches of section 2036,²⁷ unless and until Congress expands its reach.²⁸

II Nature and Tax Motivation of Family Entities

Section 2001 imposes an estate tax on the taxable estate of every decedent.²⁹ The taxable estate is determined by reference to the gross estate,³⁰ reduced by applicable deductions.³¹ The decedent's gross estate includes "the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated."³² The decedent's estate tax is then reduced by all applicable credits, the most important being the unified Page 65 credit.³³ For persons dying in 2006, the unified credit essentially exempts all taxable estates valued at or less than $2,000,000.³⁴ Moreover, because all property passing to a surviving spouse reduces the taxable estate by way of a marital deduction,³⁵ the joint taxable estate of both spouses can normally be structured so that the exemption amount of each spouse can be utilized.³⁶ This means that the estate tax does not apply to gross joint estates valued at less than $4,000,000.³⁷ However, single or joint estates exceeding $2,000,000 or $4,000,000, respectively, require further estate tax structures and planning. The marginal tax rate on estates over the unified exemption amount is 46% for estates created in 2006 and 45% for estates created in 2007, 2008, and 2009.³⁸ Accordingly, for each $1,000,000 in the value of the gross estate over the applicable exemption levels, the applicable estate tax equals $460,000 for persons dying in 2006.³⁹

Because the estate credit is "unified" with the gift tax, a taxpayer may not escape or reduce taxes simply by making outright gifts of property in Page 66 an effort to ensure that the transferred property is not included in the gross estate on the date of death because the property is not owned on that date.⁴⁰Stated another way, property owned at death is subject to the estate tax,⁴¹whereas property transferred by gift, not owned at death, and not included in the gross estate, is subject to an offsetting gift tax.⁴²

One mitigating estate and gift principle provides that present interest gift transfers are not subject to a gift tax, provided the value of such gifts does not exceed $10,000 to any one donee in any one calendar year.⁴³ If married, the gift is treated as made equally by each spouse, and thus the annual exclusion increases to $20,000.⁴⁴

A central and continuing problem with the gift transfer exclusion is that property of immense value cannot easily be fractionalized.⁴⁵ To enable fractionalization, transfers of assets to a family limited liability entity are useful.⁴⁶ In such cases, small ownership interests in the entity itself can be transferred, rather than a fractionalized interest in the underlying assets.⁴⁷ This is particularly beneficial in the case of an operating business, but it applies to all assets, including investment assets.⁴⁸ Small gifts in the entity ownership can then occur, valued at less than the applicable $10,000 or $20,000 per year, per donee, threshold limitation.⁴⁹

In addition, the formation of family limited partnerships has other value beyond asset fractionalization. First, as a reaction to the Byrum case, Page 67 section 2036(b) applies only to controlled corporations.⁵⁰ It does not apply to unincorporated entities, such as partnerships.⁵¹ As a result, the retention of true voting control with regard to transferred assets does not itself pull back the full value of the transferred asset as it would if the transfer were to a corporation alone.⁵² Of course, such transfers to family limited partnerships must still avoid the rather wide net of section 2036(a), but the mere retention of the right to vote the transferred assets does not itself trigger section 2036(a). As long as the asset is permanently transferred, with no strings attached at the time of the transfer (express or implied), the transferor does not personally retain possession or enjoyment within the meaning of section 2036(a)(1).⁵³ Moreover, unless the decedent did not retain the right to designate another person to have the possession or enjoyment of the property or income from the property, section 2036(a)(2) is not triggered.⁵⁴

Because careful estate planners structured transfers to family limited partnerships to avoid the catch of...