Another family limited partnership runs afoul of the tax and appeals courts. Lance Hall leads the estate and gift tax valuation practice of FMV Opinions, a valuation and financial-advisory services firm.

In Estate of Bigelow (T.C. Memo. 2005-65; 30 March 3005), the U.S. Tax Court ruled that a decedent's transfer of real property to a family limited partnership ("FLP") and subsequent FLP gifts were to be considered as part of the decedent's estate under Section 2036(a)(1) of the tax code. The estate in the case appealed. On 14 September 2007, the Ninth Circuit upheld the Tax Court's decision (No. 05-75957).

Background

The decedent, Virginia Bigelow, transferred her 98.3% interest in a single-family residence to a trust, with Bigelow herself and her son as trustees. The decedent's children held the other undivided interests in the residence.

The following year, the parties exchanged the property held by the trust for another rental residence and bought out the children's undivided interests. Two years later, the Trust and the decedent's children formed the FLP. The trust contributed the rental residence to the FLP and the children each contributed $100. The trust was the sole general partner.

Over the next three years, numerous gifts of FLP interests occurred. At decedent's death, the decedent owned a 44% limited partner interest in the FLP and her trust held the sole one percent general partner interest. The 44% limited interest was valued at a 37% discount from the underlying appraised value and the one percent general partner interest was valued at a 35% premium.

In addition, the loans on the rental property were retained as liabilities by the decedent. However, the rental property served as the ultimate collateral for the loans. Because the decedent was left with insufficient funds to pay off the loans, the partnership distributed funds necessary to service one of the two loans. No other distributions were made. Subsequent to Ms. Bigelow's death, a reduction in her partnership capital account was made to reflect the loan payment distribution.

In its appeal of the Tax Court's decision, the estate argued that there was no "implied agreement" for the decedent to use, enjoy or have the right to the income of the rental property, and that the transfers were completed under the "bona fide sale" exemption of Section 2036.

Analysis and decision

As a preface to its decision, the Ninth Circuit quoted Strangi (No. 03-60992; 15 July 2005): "In reviewing for clear error, we ask only whether the Tax Court's findings are supported by evidence in the record as a whole, not whether we would necessarily reach the same conclusions." The court also noted, "Section 2036(a)(1), is designed to recapture the value of certain assets transferred by the decedent during his or her lifetime where the decedent has retained economic benefits from the transferred asset."

In assessing whether the decedent "retained any economic benefits from the transferred asset", the court considered that the she didn't transfer the rental property loans to the partnership and, since she hadn't sufficient funds, the partnership effectively repaid the debt "despite no legal obligation to do so." The court also noted that "no distributions were made to any other partner before decedent's death." In addition, the transferred property was used as the collateral for the decedent's retained loans.

The Ninth Circuit also considered the fact that partnership formalities were not followed, post-death accounting adjustments were made for pre-death events, and post-death advances for funeral expenses were made. "In light of the entire record," the Ninth Circuit concluded the Tax Court "hadn't clearly erred in finding an implied agreement that decedent was to receive income from the property."

With regard to the bona fide sale exemption under Section 2036(a), the Ninth Circuit noted that the term "adequate and full consideration in money or money's worth" didn't preclude discounts for "the devaluation in the decedent's partnership interest due to a lack of control and marketability." The court quoted from the Fifth Circuit's decision in Kimbell (No. 7:01-CV-0218-R; 14 January 2003):

"The business decision to exchange cash or other assets for a transfer-restricted, non-managerial interest in a limited partnership involves financial consideration other than the purchaser's ability to turn right around and sell the newly acquired limited partnership interest 100 cents on the dollar. Investors who acquire such interests do so with the expectation of realizing benefits such as management expertise, security and preservation of assets, capital appreciation and avoidance of personal liability."

The Ninth Circuit agreed. "The validity of the adequate and full consideration prong cannot be gauged independently of the non-tax-related business purposes involved in making the bona fide transfer inquiry," it said.

In the estate's view, the non-tax purposes included limited personal liability, efficient management and ease of gifting. But the Ninth Circuit said there was "no evidence that any of the partners reasonably faced any genuine exposure to liability that might have validated the partnership formation for a non-tax purpose." Regarding efficient management, the court noted that without some active management, there was no credible non-tax reason. Finally, the Ninth Circuit held that "gift giving is considered a testamentary purpose and cannot be justified as a legitimate, non-tax business justification." As a result, the Ninth Circuit found "the Tax Court did not clearly err in determining that the transfer was not a bona fide sale for an adequate and full consideration under Section 2036's parenthetical exception."

Summary and conclusion

Bigelow follows a long line of recent cases that have found problems with the formation and operations of FLPs. It's a great example of what not to do -- and, by implication, what might be done by families faced with similar circumstances. -FWR

This is not intended or written to be used by any taxpayer or advisor to a taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. This writing is not legal advice, nor should it be construed as such.

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