Family limited partnerships: are they still alive and kicking?

• Author: Pratt, David

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 [section]2036 of the Internal Revenue Code of 1986, as amended. (1) Since that article was published, there have been two [section]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 [section]2036 cases and lost only four, many cases involving [section]2036 are settled with favorable results to the taxpayer.

The purpose of this article is to discuss the two most recent [section]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 [section]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...