Estate of Thompson: respecting the formalities of the family limited partnership.

• Author: Pratt, David

Estate planners consistently utilize the family limited partnership (FLP) as an advanced planning technique for qualified clients. Although an estate plan involving an FLP can produce favorable estate and gift tax results (i.e., because of the applicable valuation discounts), as well as beneficial nontax results (i.e., asset protection, consolidation of assets, etc.), FLPs are often scrutinized by the Internal Revenue Service. Such scrutiny is evident based upon the recent flurry of case law addressing the treatment of FLPs for federal estate and gift tax purposes. (1) The Tax Court, in Estate of Theodore R. Thompson v. Commissioner, T.C. Memo 2002-246, recently determined that a decedent retained sufficient possession and enjoyment of property transferred to two FLPs during his lifetime to warrant inclusion of such transferred property in his estate upon his death for federal estate tax purposes. This article discusses the facts and circumstances surrounding the FLPs in Thompson and emphasizes the importance of the proper formation and maintenance t of FLPs for federal estate and gift tax purposes. (2) This article also includes a checklist that can be used by practitioners and their clients to ensure that FLPs are properly maintained.

Facts of Thompson

Theodore R. Thompson executed a durable power of attorney in favor of his children, Robert Thompson and Betsy Turner. (3) In an effort to reduce their father's estate tax exposure, Robert and Betsy consulted with various advisors (4) regarding the establishment of two FLPs on behalf of Mr. Thompson and his two children and their families: the Turner Partnership ("Turner FLP") and the Thompson Partnership ("Thompson FLP").

* Turner FLP

The Turner FLP was established under Pennsylvania law for the benefit of Betsy and her husband, George Turner, and their family. The Turner Corporation was the corporate general partner, owning a 1.06 percent interest in the Turner FLP. Mr. Thompson was a 95.4 percent limited partner and Mr. Turner was a 3.54 percent limited partner. Regarding the Turner Corporation, Mr. Thompson owned 490 shares, Betsy and Mr. Turner each received 245 shares and an unrelated tax-exempt entity received the remaining 20 shares. The Turner FLP and Turner Corporation were formed on April 21, 1993, and were funded in the same year.

The Turner FLP was funded as follows: Mr. Thompson contributed marketable securities with an approximate value of $1,286,000 in addition to notes receivable from Betsy's children. Mr. Turner contributed $1,000 in cash and real property located in Vermont with a value of $49,000. The Turner Corporation issued a non-interest-bearing note in favor of Mr. Thompson for its interest in the Turner FLP.

* Thompson FLP

The Thompson FLP was established under Colorado law for the benefit of Robert and his family. The Thompson Corporation was the corporate general partner, owning a 1.01 percent interest. Mr. Thompson was a 62.27 percent limited partner and Robert was a 36.72 percent limited partner. Regarding the Thompson Corporation, Mr. Thompson and Robert each owned 490 shares and Robert H. Thompson, an unrelated party, received the remaining 20 shares. Like the Turner entites, the Thompson FLP and Thompson Corporation were formed on April 21, 1993, and were funded in the same year.

The Thompson FLP was funded as follows: Mr. Thompson contributed marketable securities with an approximate value of $1,118,500 in addition to notes receivable from Robert's family members. Robert contributed his interest in mutual funds with an approximate value of $372,000 and his Norwood ranch, which was appraised at $460,000.

* Mr. Thompson's Federal Estate Tax Return and Notice of Deficiency

Mr. Thompson died on May 15, 1995. On Mr. Thompson's federal estate tax return, his 87.85 percent (5) limited partnership interest in the Turner FLP was valued at $875,811 and his 54.12 percent (6) limited partnership interest in the Thompson FLP was valued at $837,691. Regarding Mr. Thompson's interest in the Turner Corporation, his 490 shares were valued at $5,190 and his 490 shares in the Thompson Corporation were valued at $7,888. All of the above interests that were reported on Mr. Thompson's federal estate tax return were determined by applying a 40 percent minority interest and lack of marketability discount to the FLP assets. Additionally, Mr. Thompson's federal estate tax return reported $19,324 as his prior taxable gifts. Such prior gifts reflected Mr. Thompson's gifts of Turner FLP and Thompson FLP limited partnership units, the values of which were also determined using the same 40 percent minority interest and lack of marketability discount.

The IRS issued a notice of deficiency in the amount of $707,054. The values of Mr. Thompson's entity interests as reported on his federal estate tax return were adjusted as follows: The Thompson FLP interest was increased to $1,396,152; the value of the Turner FLP interest was increased to $1,717,977; the Thompson Corporation interest was increased to $13,977; and the Turner Corporation interest was decreased to $4,094.

Estate's Position

The estate's position was that the value of Mr. Thompson's limited partnership interests in the Turner and Thompson FLPs was included in Mr. Thompson's estate, not the underlying assets transferred to the FLPs. Additionally, the estate contended that the value of such interests for federal estate tax reporting purposes should be determined by reducing Mr. Thompson's proportionate share of the fair market value of the FLPs' assets at the date of transfer by a 40 percent discount for lack of marketability and control.

IRS' Position

The IRS contended that the full fair market value of the assets contributed to the FLPs should be included in Mr. Thompson's gross estate. Such contention was based upon two theories. The first theory suggested that the FLPs lacked economic substance and should be disregarded. (7) If the FLPs were recognized as valid entities, the second theory suggested that Mr. Thompson's retention of the economic benefit and control over the assets transferred to the FLPs warranted the inclusion of such assets in his gross estate under [section] 2036(a) of the Code.

Tax Court's Opinion

The Tax Court agreed with the IRS that Mr. Thompson retained the enjoyment and economic benefit of the property he transferred to the FLPs. Specifically, the court recognized that an "implied agreement" existed between Mr. Thompson, Betsy, Robert, and Mr. Turner whereby Mr. Thompson would retain the benefit and enjoyment of the assets transferred to the FLPs during his lifetime. (8) Such implied agreement was inferred by the court based upon the following facts.

First, before and after the formation of the FLPs, Betsy and Robert consulted with the financial advisors regarding Mr. Thompson's accessibility to assets in the FLPs for purposes of continuing his practice of gift giving around...