SC Lawyer, March 2004, #8. Taxation of family limited partnerships: breaking the fall.

• Author: By Robert F. August

South Carolina Lawyer

2004.

SC Lawyer, March 2004, #8.

Taxation of family limited partnerships: breaking the fall

South Carolina LawyerMarch 2004Taxation of family limited partnerships: breaking the fallBy Robert F. AugustIn the combined cases of Estate of Eugene E. Stone III v. CIR and Estate of Allene W. Stone v. CIR, TC Memo 2003-309 (Chiechi, J.), the U.S. Tax Court held that the Internal Revenue Service (Government) was required to respect five family limited partnerships (Stone LPs) established by the decedents in determining the federal estate tax liability of the estates. The government asserted estate tax deficiencies against the estates of more than $4,000,000 on the theory that the value of assets owned by the partnerships, rather than the value of the decedents' interests in the partnerships, was the proper basis for determining estate tax. The tax court has previously held in the government's favor on this theory in a series of cases beginning in 1997. The Stone case is the first taxpayer victory in this area in the tax court and reaffirms that family limited partnerships can be viable and effective estate planning tools.

The background

Beginning in the early 1990s, family limited partnerships became popular and widely-used estate planning vehicles. Because federal estate taxes are imposed upon the fair market value of a decedent's assets as of the date of death, many taxpayers began to use family limited partnerships to reduce the value of their estates. Rather than continuing to own assets outright, taxpayers would contribute assets to limited partnerships in which family members were partners. Upon the death of a family member, the estate would include partnership interests rather than the assets themselves. Because the partnership agreements would typically contain significant restrictions on the transfer of partnership interests and limitations on the ability of limited partners to participate in management, business valuation experts would apply substantial valuation discounts in valuing the partnership interests.

For example, in the Stone case, the taxpayers' valuation experts found that an average 43 percent valuation discount should be applied to the Stone LP interests included in the estates. If a 43 percent discount were applied to a limited partnership interest representing partnership assets with a value of $20,000,000, then the value of the assets subject to estate tax would be $11,400,000 ($20,000,000 x .57). Assuming the estate was in the top estate tax bracket (currently 50 percent), the amount of estate tax savings resulting from the use of a family limited partnership would be equal to 50 percent of the difference between $20,000,000 and $11,400,000, or $4,300,000.

The tax court's prior decisions

In a series of cases beginning in 1997, the tax court had ruled that the assets owned by family limited partnerships in which the decedent held an interest were includable in the estate of the decedent under § 2036 (a)(1) of the Internal Revenue Code of 1986, as amended, (Code). Section 2036(a)(1) provides as follows:

(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 the income from, the property, . . . .

In general the tax court found in several cases that the transfers by decedents of assets into family limited partnerships were not bona fide sales for an adequate and full consideration and that there was an implied agreement among the family members that the decedent would retain the possession or enjoyment of the assets or right to the income from the assets contributed to the partnership. Mostly this was found to have occurred in cases in which the partnerships were formed immediately prior to death and the parties did not respect the formalities of the entities.

In the first such case, Estate of Schauerhamer v. CIR, TC Memo 1997-242, the decedent formed and funded three family limited partnerships. However, the decedent continued to deposit the income received from rental properties she had transferred to the partnerships into her personal checking account where it was co-mingled with income from other sources. The decedent's children were aware of this arrangement but made no objection. The assets in the partnerships continued to be managed by the decedent in the same manner before and after formation of the partnerships. The court also found that the family essentially ignored the partnership agreements and the partnerships themselves in conducting their affairs. After examining the entire record, the tax court concluded that the decedent had retained "possession or enjoyment" of the assets she transferred to the partnerships within the meaning of § 2036 (a) (1). See also Estate of Reichardt v. CIR, 114 TC 144 (2000).

Notably absent from the tax court's opinion in Schauerhamer was any discussion of whether or not the transfer of assets to a family limited partnership constituted a "bona fide sale for an adequate and full consideration in money or money's worth," which transfers are specifically excluded from the application of § 2036. Around the same time as these tax court opinions were issued, the U.S. District Court for the Western District of Texas in Church v. United States, 85 AFTR 2d 2000-804 (W.D. Tex. 2000), aff'd, 88 AFTR 2d 2001-5352 (5th Cir. 2001), held that the transfer of assets to a family limited partnership with a "bona fide business purpose" in exchange for a pro-rata interest in the partnership constituted a transfer for "full and adequate consideration in money or money's worth." The Church court found that because there was no gift on the formation of the partnership, § 2036 was inapplicable. Thus, the tax court found itself in conflict with the holding in Church, which was later affirmed on appeal.

In its next § 2036 case involving family limited partnerships, the tax court did address the bona fide sale exception. In Estate of Harper v. CIR, TC Memo 2002-121, the court found the exception inapplicable because the decedent in that case, "independently of any other anticipated interest-holder, determined how HFLP was to be structured and operated, decided what property would be contributed to capitalize that entity, and declared what interest the trust would receive there-in, . . . He essentially stood on both sides of the transaction and conducted the partnership's formation in the absence of any bargaining or negotiating whatsoever." The Harper court noted that the decedent had been diagnosed with cancer prior to the partnership's creation, the children made no contributions to the partnership and the decedent contributed 94 percent of her net worth to the partnership.

The Harper court agreed that no gift occurred upon the formation of the partnership; however, the Harper court disagreed with the Church decision's blanket assertion that the absence of a gift makes § 2036 inapplicable. According to the Harper decision, if a taxpayer wants to avoid the application of § 2036, the taxpayer must qualify for the bona fide sale exception, and in addition, the Harper court held the taxpayer must show something more than a pro rata exchange of assets for partnership interests (or lack of a gift) in order to qualify for the exception. Specifically, the Harper court found that in Church the partners other than the decedent made more than de minimis contributions to the partnership. The court held that in situations where other persons do not "make contributions of property or services in the interest of true joint ownership or enterprise, there exists nothing but a circuitous 'recycling' of value" and, thus no bona fide sale. The tax court reached similar conclusions in Estate of Thompson v. CIR, TC Memo 2002-246, and in Estate of Strangi v. CIR, TC Memo 2003-145.

The facts of Stone

The facts of the Stone case are complicated and occupy 98 of the court's 114 page opinion in the case. In summary, Mr. and Mrs. Stone had four adult children. Around 1992 the children became involved in litigation among themselves over the management of the family's business and certain trusts which Mr. and Mrs. Stone had created during their lifetimes. Each child had his own attorney representing him in the litigation. Mr. and Mrs. Stone were not parties to the litigation and were only aware of it in very general terms. Around 1994 the children attempted to settle the litigation. However, a 1994 settlement agreement failed to resolve the disputes in part because it was not possible to find independent trustees to take over the trusts. The children continued to discuss settlement, and as the discussions progressed the need for a comprehensive settlement plan became apparent.

One of the children originally suggested family limited partnerships as a means to help divide Mr. and Mrs. Stone's assets into four distinct groups and allow for each child to take over management of each group. For example, two of the children had an interest in developing two separate tracts of real estate owned by Mr. and Mrs. Stone. One child had an interest in continuing to manage the family corporation, and the fourth had an interest in managing the securities and bonds owned by Mr. and Mrs. Stone. The children put together a new settlement agreement that included an agreement among themselves to use their reasonable best efforts to persuade their parents to adopt the estate plan which they had agreed to, including the formation of five limited partnerships, one for each of the children and a fifth to own certain assets that all of the children had an interest in participating in decisions about.

Mr. Stone's counsel (David A. Merline, former South Carolina Bar president), met with Mr. Stone to discuss the plan put forth by the children, and with Mr. Stone's approval, counsel drafted five limited partnership agreements. The limited partnership agreements were circulated among the children, and their attorneys reviewed the partnership agreements. The children and their attorneys submitted proposed changes to Mr. Stone's counsel. Those changes to which Mr. Stone agreed were incorporated into the documents. Mr. Stone met with his attorney approximately a dozen times to discuss these matters. Also, Mr. and Mrs. Stone hired certified public accountants to do cash flow analyses of their assets and to advise them about what assets they should retain in order to continue living in the lifestyle to which they had become accustomed.

Around the fall of 1996, the children signed an amended and restated settlement agreement and began negotiations over exactly which assets were to go into which partnership as well as their respective values. In January 1997, Mr. Stone was diagnosed with cancer of the gall bladder. By April of 1997 the children had agreed on the assets to be contributed to the partnerships, with Mr. Stone's approval, and the Stone LPs were funded.

Immediately after the partnerships were funded, each child took steps to change the way the assets in his partnership were managed. For example, one child immediately began developing the parcel of real estate held by his partnership. Another sold all of the securities held in her partnership's brokerage account and retained a new investment manager.

Mr. Stone died in June 1997, just two months after the Stone LPs were funded, and Mrs. Stone died about 16 months later in October 1998.

The court's holding and analysis

In Stone the tax court found that the transfers of assets by Mr. and Mrs. Stone to the Stone LPs in exchange for pro rata partnership interests did constitute "bona fide sales for an adequate and full consideration in money or money's worth" and therefore § 2036(a)(1) was inapplicable. The court applied the "facts and circumstances" rule it had adopted in Harper and found Stone to be distinguishable from the situations upon which it had previously ruled.

Perhaps the most significant distinction between Stone and the prior cases was the fact that the Stones' children intended to and did participate actively in the management of the assets contributed to each of the partnerships. All four of the children immediately took steps to change the way in which the assets were managed as soon as the assets were transferred to the partnerships. In nearly all of the prior cases, the decedent continued to manage the assets contributed to the partnerships as general partner. In Stone the court found that by contributing their services to each of the partnerships, the children added significant value to the partnerships and thus Mr. and Mrs. Stone did "substantially more than change the form in which [Mr. and Mrs. Stone] held his [and her] beneficial interest in the contributed property." Instead, the court found that the children intended to and did contribute substantial services to the partnerships and as such the partnerships "operated as joint enterprises for profit through which the children actively participated in the management and development of the respective assets of such partnerships during their parents' lives (and thereafter)."

The court also noted that Mr. and Mrs. Stone did not transfer substantially all of their assets to the Stone LPs but instead took pains to be sure they retained sufficient assets to enable them to maintain their "respective accustomed standards of living." The court found that the creation of the Stone LPs was "motivated primarily by legitimate business concerns," and did not constitute a "unilateral value recycling." The court found numerous business purposes for the creation of the five Stone LPs. It found the Stone LPs were created as vehicles for the management of the assets during Mr. and Mrs. Stones' lifetimes, as vehicles for settling the litigation and as vehicles to help prevent future litigation after Mr. and Mrs. Stone's deaths. The court also noted that there were arm's-length negotiations which occurred between the children and with Mr. and Mrs. Stone in connection with the creation and funding of the partnerships. The court found it particularly significant that Mr. Stone and the children consulted with their attorneys and actively negotiated the terms of the partnership agreements and the selection of assets to be contributed to each partnership. The fact that neither the parents nor the children unilaterally made decisions unopposed by the other was a key factor to the court.

Conclusion

The recent decisions of the tax court prior to Stone left many practitioners wondering if family limited partnerships were dead as an estate planning tool. Given the widespread use of family limited partnerships, advisors and taxpayers alike have been following the tax court's decisions in this area very closely. Stone is the first case in which the taxpayer has prevailed on the § 2036 issue in tax court in a family limited partnership case. Not only is Stone a major taxpayer victory, it is essential reading, and the only currently available guidance as to the scope of the bona fide sale exception to § 2036.

Robert E. August is a shareholder in the law firm of Merlline & Meacham, P.A. in Greenville where he practices in the areas of taxation, estate planning, mergers and acquisitions and partnership and liability company law.

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