Significant recent developments in estate planning.

• Author: Ransome, Justin P.
• Position: Part 2

This two-part article examines developments in estate, gift, and generation-skipping tax planning and compliance between June 2009 and May 2010. Part I, in the September issue, discussed legislative developments, estate tax reform, gift tax, and cases and rulings. Part II covers the estate tax, generation-skipping transfers, trusts, changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001, and the annual inflation adjustments for 2010 relevant to estate and gift tax.

Estate Tax

FLPs

The IRS has continued its assault on family limited partnerships (FLPs) using Sec. 2036 for estate tax purposes. Under Sec. 2036, assets that a decedent transferred during his or her lifetime are pulled back into the estate because the decedent still derived a benefit from the assets and/ or continued to control the beneficial enjoyment of the assets. An exception applies where the transferred assets are part of a "bona fide sale for adequate and full consideration for money or money's worth" (the bona fide sale exception). (1)

The test for determining whether the bona fide sale exception has been met was set forth by the Tax Court in Bongard. (2) The Bongard test requires that two criteria be met: (1) there is a legitimate and significant nontax reason for creating the FLP (the bona fide sale criterion); and (2) the transferors receive interests in the FLP proportionate to the value of their transferred property (adequate and full consideration criterion).

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The IRS is generally successful with Sec. 2036 challenges when the case involves "bad facts." This generally occurs when the decedent fails to respect the FLP as a separate entity and not the decedent's alter ego or when the decedent does not maintain sufficient assets outside the FLP to maintain his or her customary style of living. This past year's cases are a mixed bag for taxpayers.

Estate of Shurtz

In Estate of Shurtz, (3) the decedent was the heir of a family with vast holdings in timberland (45,197 acres). In 1993, the decedent's siblings and their descendants combined their undivided interests in the timberland to form Timberlands FLP. The decedent owned a one-third interest in the corporate general partner (which owned the general interests in Timber-lands FLP) and a 16% limited interest in Timberlands FLP.

After the formation of Timberlands FLP, the decedent became increasingly worried about the possibility of litigation against her immediate family members because of a "jackpot justice" mentality she believed existed in the state of Mississippi. Along with her interest in the Timberlands FLP, the decedent's other major asset was 748 acres of timberland she had inherited directly from her parents. She wanted to gift interests in that property to her children and grandchildren but did not want to create fractional interests in the timberland--one of the reasons that Timberlands FLP was created. To alleviate these concerns, an attorney advised the decedent to create Doulos FLP, the purpose of which was to: (1) reduce the decedent's estate; (2) provide asset protection; (3) provide for heirs; and (4) provide for the Lord's work (they were missionaries). Prior to establishment of Doulos FLP, the decedent transferred a 6.6% interest in the 748 acres to her husband. On December 17, 1996, the decedent's husband contributed his 6.6% interest in the 748 acres to Doulos FLP in return for a 1% general interest, and the decedent contributed her 93.4% interest in the 748 acres as well as her 16% interest in Timberlands FLP to Doulos FLP in return for a 1% general interest and a 98% limited interest.

After the formation of Doulos FLP and prior to her death on January 21, 2002, the decedent made gifts of Doulos FLP in the aggregate of 10.4% to her children and trusts for the benefit of her grandchildren. Doulos FLP maintained a capital account for each partner. Although Doulos FLP did not maintain books of account, as required by the FLP agreement, the decedent's accountant created "work papers like a trial balance" in creating partnership returns. Doulos FLP did not have its own bank account until four months after it was created. Distributions from Doulos FLP were not always proportional; however, Doulos FLP made up these amounts in subsequent years. The adult members of the decedent's larger family actively managed Timberland. The family held annual meetings in which they discussed various family business issues such as the cutting, harvesting, and reforestation of the timberland. The decedent and her husband regularly attended and participated in those meetings. The decedent and her husband also actively managed Doulos FLP, which required management similar to the management of Timberland FLP with regard to the 748 acres owned by Doulos FLP. Upon the decedent's death, the IRS sought to include the value of the assets the decedent contributed to Doulos FLP in her estate for estate tax purposes under Sec. 2036(a).

In applying Bongard, the Tax Court determined that there were legitimate and significant nontax reasons for creating Doulos FLP because: (1) the decedent had a legitimate concern about preserving the family business (i.e., asset protection); and (2) Doulos FLP facilitated the management of the 748 acres the decedent and her husband contributed to Doulos FLP (having multiple undivided ownership interests would impede the management of the timberland). The court acknowledged that only a portion of the property contributed to Doulos FLP required active management; however, citing Kimbell (4) (which contained a working oil and gas interest that comprised 11% of the total value of the FLP), it found this to be sufficient (the 748 acres amounted to 16% of the total value of Doulos FLP).

The Tax Court next determined that the full and adequate consideration criterion had been met because: (1) the partners received interests in Doulos FLP proportionate to the value of their transferred property; (2) the respective assets contributed to Doulos FLP were properly credited to each partner's respective capital account; and (3) distributions from Doulos FLP required a negative adjustment in the distributee partner's capital account.

Having determined that the bona fide sale exception had been met, the Tax Court determined that it did not need to consider whether the decedent retained an interest or right in the property contributed to Doulos FLP. Having made such a determination, the Tax Court ruled that the proper property to value in the decedent's estate was the decedent's interest in Doulos FLP, not the underlying property contributed to it by the decedent.

Estate of Black

In Estate of Black, (5) the Tax Court addressed several estate tax-related issues, two of which were of importance. One issue concerned the application of Sec. 2036 to stock transferred to an FLP; the other dealt with the deductibility of interest on a loan whose proceeds were to be used to pay federal estate taxes.

For more than 70 years, Mr. Black had been instrumental in the expansion and success of Erie Indemnity Company and took every opportunity to purchase stock in the company, to the point that he and his family became the company's second largest shareholder. Beginning in 1988, Mr. Black made gifts of stock to his son and to two trusts for the benefit of his grandsons. In the 1990s Mr. Black became concerned that his son and grandsons would dispose of the stock. His son had already pledged a large number of shares on a loan. His grandsons, who would receive the stock when they turned 25 and 30, were already in their twenties, and neither of them exhibited signs of being productive members of society. In addition, Mr. Black was concerned that because of the personal and business bankruptcies of the son's father-in-law, the in-laws' need for financial support might force the son to sell his stock. He was also worried about the stock in the event that the son and his wife divorced.

Mr. Black also wanted to keep the family's stock in one block because of a potential dispute brewing between the founder's children, who owned 76.2% of the stock; the Black family block of around 13% might be needed as a swing vote to settle any disputes. In 1993, Mr. Black, his son, and the two grandsons' trusts contributed their stock to an FLP (all the family stock except for the stock the son had pledged on the loan and 20 shares of class B stock held by Mr. Black and his son). Each partner received an interest in the FLP proportionate to the fair market value of the assets contributed.

The IRS argued that the Erie stock, not the FLP interests, was includible in Mr. Black's gross estate under Sec. 2036(a)(1). The estate argued that it had met the bona fide sale exception in Sec. 2036.

In order for the transfer to meet the bona fide sale requirement, there must be a legitimate and significant nontax purpose for the transfer. The Tax Court discussed Mr. Black's concerns about possible disposition of stock by the grandsons and by his son in order to satisfy the needs of his inlaws and his wife in the event of a divorce (which actually occurred after Mr. Black's death). The court concluded that under this unique set of circumstances, the purpose for the transfer--to perpetuate the holding of stock by the family--was a legitimate and significant nontax purpose, so the bona fide sale criterion in Bongard was met. The adequate and full consideration criterion was also met because each of the partners received FLP interests proportionate to the value of the stock they transferred. Thus, because Mr. Black's transfer of stock to the FLP constituted a bona fide sale for adequate and full consideration, the stock's fair market value was not includible in his gross estate under Sec. 2036(a)(1) or (2).

When a decedent's estate consists mostly of illiquid assets, the source of funds to pay federal and state estate taxes becomes an issue. Mr. Black's wife died shortly after he did...