Estate of Stone: Victory for Family Limited Partnerships

The Family Limited Partnership (“FLP”) has been a common estate planning technique for the nation’s wealthy. For years it allowed families to avoid some tax liability when transferring assets to heirs by first placing those assets in a FLP. And for years the U.S. Tax Court ruled in favor of these tax-minimizing vehicles. The IRS responded by fighting those who might use the FLP to avoid paying taxes on the full and undiscounted value of their estate. While the IRS’s early opposition hinged on the valuation discount applied to FLP interests, recent cases have focused on the inclusion of a FLP’s underlying assets in a taxpayer’s estate via §2036.

Section 2036(a)(1) Defined

According to §2036: (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 … [emphasis added]. The “bona fide sale” exemption is important to our topic today. In essence, a FLP must be operated as a real business opportunity to qualify for the “bona fide sale” exception.

A Brief History of Section 2036(a)(1) Challenges in the Tax Court

The IRS has raised a number of considerations in its recent challenges of FLPs. Such considerations include whether or not the taxpayer respected the FLP’s formality on both a formation and operational basis, whether or not the taxpayer contributed assets for personal use to the FLP, and whether or not the taxpayer maintained assets outside of the FLP sufficient to maintain a pre-FLP lifestyle.

The Estate of Thompson v. Commissioner (2002) illustrates the first success of the IRS.[1] The deceased created two FLPs, one for each of his children. The Tax Court, however, found that the deceased had retained benefits from the assets that he had transferred to the FLP. It rejected the family’s argument that the exchange for limited partner interests was a bona fide sale; instead, the Court deemed the transfer a “recycling of value.” Accordingly, the Tax Court stated that the asset contributions had “no legitimate business purpose” and held that the value of all the assets in the estate should be taxed at the full amount.

The next big win for the IRS came in the Appeals Court in Strangi II (2003).[2] Continuing its assault on FLPs in relation to §2036, the IRS found favor in the Appeals Court because the Tax Court found that the transferor continued to enjoy the benefits of the assets transferred and derived his economic support from the assets; thus, the Tax Court concluded that the FLP had no business purpose.

A third case that illustrates the success of the IRS is Kimbell v. US.[3] The IRS now had two strategic assault methods in its use of §2036. The first method focused on demonstrating that the FLP had no operational aspects, and the second method attempted to demonstrate that the FLP contained an “implied understanding” that the transferor would retain benefit or control of the assets. Because the deceased retained “legal right” in the FLP’s documents to control partnership assets, the Tax Court found that the FLP was in violation of §2036 and would pay taxes on the full value of the assets.

Estate of Stone – Taxpayer Victory

In spite of a series of victories, such as those summarized above, the IRS’ §2036 argument was not victorious in Estate of Stone.[4] In its November 7, 2003 decision, the Tax Court provided much needed clarity related to confusion surrounding §2036. Relevant background information includes:

• Five FLPs were formed several months prior to the deaths of Mr. and Mrs. Stone;
• At death, Mr. Stone held the majority of the general and limited partner interests in each of the FLPs;
• Each FLP held various assets, including real estate and preferred stock in the family-owned operating company;
• Each of the Stone children received small general partner interests in return for their respective contributions on the date of formation of the FLPs, while Mr. Stone retained sufficient general partner interest to hold a simple majority of the general partner interests in aggregate. Mrs. Stone held only limited partner interests;
• The estate tax returns claimed aggregate minority and marketability discounts of 43% on Mr. Stone’s interests; and,
• Four of the five FLPs had made non-pro rata distributions to the estate to pay Mr. Stone’s estate tax.

At first reading, the fact set in this case has similarities to the §2036 challenges raised in Thompson, Kimbell, and Strangi. These include death soon after formation of the FLP, distributions from the FLP used to pay the estate taxes, distributions that were not made on a pro-rata basis, retention of significant FLP interests, as well as retention of the controlling general partner interest.

As noted in the decision, “In order to resolve the parties’ dispute under §2036(a)(1), we must consider the following three factual issues presented in each of the instant cases:

1. Was there a transfer of property by the decedent?
2. If there was a transfer of property by the decedent, was such a transfer other than a bona fide sale for an adequate and full consideration in money or money’s worth?
3. If there was a transfer of property by the decedent that was other than a bona fide sale for an adequate and full consideration in money or money’s worth, did the decedent retain possession or enjoyment of, or the right to income from, the property transferred?”[5]

As to the question regarding the transfer of property, the Court concluded “… that Mr. Stone and Ms. Stone each made a transfer of property under §2036(a).[6] As to question (2), the IRS argued that the transfer did not qualify under the bona fide sale exception, citing that the average 43% discounts claimed for tax purposes conflicted with the exception’s stipulations, which describe an exempt transfer as “a sale for adequate and full consideration only if that received in exchange is ‘an adequate and full equivalent reducible to money value.’”[7] Several facts which proved critical to the Tax Court’s approval of the transfers as bona fide sale exceptions included the following:

• Each member of the Stone family retained independent counsel and had input regarding the structure of the FLPs. However, Mr. and Mrs. Stone ultimately decided which, if any, assets would be transferred to each of the FLPs.;
• The Stones retained sufficient assets outside of the FLPs to maintain their accustomed standards of living;
• The transfers of issue did not constitute gifts by the Stones but instead were pro-rata exchanges;
• The primary motivation behind the transfers was investment and business concern related to the management of certain assets held by the Stones; and,
• The FLPs had economic substance and operated as joint enterprises for profit through which the children actively participated in the management and development of the respective assets.[8]

The Tax Court concluded that the transfers of assets by Mr. and Mrs. Stone to the FLPs were for adequate and full consideration in money or money’s worth. Furthermore, unlike in Estate of Harper, in which the Tax Court indicated that the creation of the partnerships was not motivated primarily by legitimate business concerns, the Court stated that the transfers executed by Mr. and Mrs. Stone failed to constitute unilateral recycling of value.[9]

As to question (3), because the transfers qualified under the bona fide sale exemption, the Tax Court deemed unnecessary the consideration of whether or not the decedents retained possession or enjoyment of or rights to income from the transferred property.

Conclusion

In spite of Thompson, Kimbell, and Strangi, among others, the FLP’s viability as an effective estate planning tool appears intact based on Estate of Stone. As stated earlier, a FLP must be operated as a real business opportunity to qualify for the “bona fide sale” exception and that seems to be the linchpin in these cases.u

Endnotes

¹ Estate of Thompson – T.C. Memo. 2002-246 (September 26, 2002)

² Estate of Strangi – T.C. Memo. 2003-145 (May 20, 2003)

³ Kimbell v. U.S. – No. 7:01-CV-0218-R, USDC ND TX., Wichita Falls Div. (January 14, 2003)

⁴ Estate of Stone v. Commissioner – T.C. Memo. 2003-309 (November 7, 2003)

⁵ Ibid.

⁶ Ibid.

⁷ Ibid.

⁸ Ibid.

⁹ Estate of Harper – T.C. Memo. 2002-121 (May 15, 2002)

Reprinted from Mercer Capital’s Value Matters™ 2003-08, December 4, 2003.