Family limited partnerships: to qualify or not to qualify for the bona fide sale for full and adequate consideration exception under section 2036.

• Author: Pratt, David

The last article written by the authors regarding family limited partner ships ("FLPs") for The Florida Bar Journal discussed Estate of Thompson v. Commissioner, T.C. Memo 2002-246. (1) The article focused on [section] 2036(a)(1) of the Internal Revenue Code of 1986, as amended, and the formation and operations of an FLP. Since Thompson, there have been a number of cases that have addressed FLPs and the issues relating to [section] 2036 of the Code, (2) and there have been many excellent articles published which discuss such cases and the "retained possession or enjoyment" of the transferred property test or "right to the income" from the transferred property test enunciated in [section] 2036(a)(1). (3) The "trend" within such recent cases is whether [section] 2036 does not apply because the donor's transfer of property to the FLP qualifies for the "bona fide sale for full and adequate consideration in money or money's worth" exception (bona fide sale exception). The purpose of this article is to analyze the recent FLP cases in the context of the bona fide sale exception, and to discuss planning considerations to avoid the potential application of [section] 2036 by satisfying the bona fide sale exception. (4)

Section 2036 and the Bona Fide Sale Exception

Section 2036(a) provides, in relevant part, that

[t]he value of the gross estate for federal estate tax purposes 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 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 the income from, the property ..., (5) (emphasis added).

The italicized portion of [section] 2036(a) is the focus of this article.

Kimbell v. United States

In Kimbell v. United States, 371 F.3d 257 (5th Cir. 2004), the Fifth Circuit Court of Appeals held that the district court erred in its determination to deny the estate's request for a refund of estate tax and interest paid, and that Mrs. Kimbell's transfer of property to the FLP qualified for the bona fide sale exception, and that such transferred property was not includible in her estate under [section] 2036. (6) The Fifth Circuit relied primarily on Wheeler v. United States, 116 F.3d 749 (5th Cir. 1997), and addressed the issue as an objective inquiry. Pursuant to Wheeler, adequate and full consideration under [section] 2036 "requires only that the sale not deplete the gross estate." (7) As a rule, unless a transfer that depletes the entire gross estate is coupled with a transfer that augments the gross estate, there is no "adequate and full consideration" for purposes of the estate or gift tax. (8) Since Wheeler, a taxpayer's testamentary or tax savings motive for a transfer alone does not trigger [section] 2036(a) recapture if objective facts demonstrate that the transfer was made for full and adequate consideration. (9)

Wheeler also addressed whether a sale is "bona fide" for purposes of [section] 2036. The examination was whether the sale was a bona fide sale or a disguised gift or sham transaction. (10) The court stated that it should inquire beyond the form of the transaction (i. e., transactions between family members) to determine whether the substance of the transaction justifies the tax treatment requested. (11) In determining that the transaction was a "real, actual and genuine" (12) transaction, the Fifth Circuit recognized that the appropriate contributions were made to the FLP by the partners, and that the partners received a corresponding pro-rata interest in the FLP, (13) and that the preservation of the family ranching business for the Kimbell family was a genuine business purpose to form the FLP. (14)

The court cited and discussed both Church v. United States, 2000 USTC (CCH) [paragraph] 60, 369 (W.D. Tex. 2000), affirmed No. 00-50386, July 18, 2001 (5th Cir. 2001), and Estate of Stone v. Commissioner, 86 T.C.M. (CCH) 551 (2003), both of which involved a transfer of property to an FLP or FLPs qualifying as a bona fide sale. The Fifth Circuit stated that the focus on whether a transfer to an FLP is for adequate and full consideration is: 1) whether the interests credited to each of the partners were proportionate to the fair market value of the assets contributed; 2) whether the assets contributed by each partner to the FLP were properly credited to the respective capital accounts; and 3) whether on termination or dissolution of the FLP the partners were entitled to FLP distributions in amounts equal to their respective capital accounts. (15) The Fifth Circuit answered each of these questions in the affirmative.

The Fifth Circuit determined that the district court ignored record evidence in support of the taxpayer's position that the transaction was entered into for substantial business and other nontax reasons. The Fifth Circuit relied on the following facts to determine that the transfer to the FLP was a bona fide sale: (1) Mrs. Kimbell retained sufficient assets outside of the FLP for personal expenses and did not commingle FLP assets with personal assets; (2) formalities with respect to the formation of the FLP were adhered to and the assets contributed to the FLP were retitled accordingly; (3) the assets contributed to the FLP included working interests in oil and gas properties which required active management; and (4) several credible nontax reasons for the FLP formation were present that could not be accomplished through Mrs. Kimbell's revocable trust. (16)

Turner v. Commissioner

In Turner v. Commissioner, 382 F.3d 367 (3d Cir. 2004), the taxpayer in Thompson (17) appealed the Tax Court's decision in favor of the Internal Revenue Service to the U.S. Court of Appeals for the Third Circuit. The court affirmed the decision of the Tax Court. Turner involved two FLPs, one for each of Mr. Thompson's children.

Referring to Estate of Harper v. Commissioner, T.C. Memo 2002-121, the Third Circuit stated that the bona fide sale exception will be denied when there exists nothing but a circuitous "recycling" of value and when the transaction does not appear to be motivated primarily by legitimate business concerns. (18) The court concluded that there was no transfer for consideration under [section] 2036. Although the FLPs did conduct some economic activity, it was not enough to support any valid, functioning business enterprise.

The Third Circuit referred to the specific activities conducted on behalf of the FLPs to conclude that no valid business was conducted. Intrafamily loans made on behalf of one of the FLPs with interest payments being late or not paid were addressed as being a way to use the decedent's money as a source of financing the needs of family members, rather than a way to use the money for a business purpose. Regarding the other FLP, the only active operations involved the ranch owned by the FLP, which was not operated as an income producing business either before or after the property was contributed to the FLP. Income generated with respect to the property went to the contributor of the property, rather than to the FLP. This was a "putative business arrangement" which "amounted to no more than a contrivance and did not constitute the type of legitimate business operations that might provide a substantive nontax benefit for transferring assets to the FLP." (19)

The Third Circuit also addressed the form of the assets transferred to the FLPs, which was predominantly...