When we bet on a sure thing, we hope to end up with more than when we started. When we bet on the benefits of family entities like family limited partnerships (FLPs), however, we hope to end up with less than when we started. Despite attacks by the IRS, estate planners continue to use these entities to make taxable value disappear-by qualifying for discounts on the value of the property subject to estate and gift taxes.
Recent pro-taxpayer cases have increased the odds of success in this area, but there are traps for the unwary and the greedy. Learning from those who have already played their cards will increase your chances of winning the discount game. When all the shuffling is done, be sure you have the trump card: business purpose.
The Stakes
Think of gift and estate tax planning with FLPs on a spectrum of possible outcomes. On one end there is the active business, like a family owned grocery store. This is the surest bet. A discounted gift or estate tax value for a noncontrolling interest in the grocery store will stand up to IRS scrutiny, because there is a lot more to running a grocery store than just transferring property at a discounted value.
At the other end of the spectrum are the "bad-fact" FLPs that are the surest losers. Bad-fact FLPs include those that appear to be motivated purely by tax planning: those established on the taxpayer's death-bed; where personal and entity funds are commingled; when distributions to the taxpayer setting it up are disproportionate to her ownership interest; or when the taxpayer transfers the bulk of her assets to the entity and has nothing else to live on. The big risk with these bad-fact FLPs is that the IRS will say that all of the underlying assets of the FLP attributable to the taxpayer's interest are subject to estate tax in the taxpayer's estate without any discounts, including those FLP interests the taxpayer thought she had safely given away during her life.
Like most things in life, however, FLPs usually fall somewhere between the two extremes. The key is to move the FLP to the active-business side of the spectrum. To accomplish this, the FLP should demonstrate objective business purpose.
Where The Action Is
Although the IRS continues to challenge lifetime gifts of discounted FLP interests, the real action is in the estate tax context. Internal Revenue Code Section 2036(a)(1) imposes estate tax on transferred property over which the decedent retained the right to income, and Section 2036(a)(2) imposes estate tax on transferred property over which the decedent retained the right "alone or in conjunction with any person" to decide who can enjoy the property.
The U.S. Tax Court's Strangi III shows the way to a safe harbor. In that case, the court ruled that any control held alone or in conjunction with others is subject to 2036 unless sufficient other facts show that the FLP (i) was controlled by an independent third party, (ii) had third-party investors, or (iii) faced genuine business pressures causing the owners to treat it like a real business. Along with the Strangi III safe harbor, there is also an exception to 2036 that applies to a "bona fide" transaction for full consideration.
The Kimbell Case
Mrs. Kimbell set up an FLP and transferred approximately $2.5 million of her property to it in exchange for 99% of the limited partnership interests. A separate entity held the 1% general partnership interest that controlled the FLP. Mrs. Kimbell owned half of the control entity, and her son and daughter-in-law owned the balance. Mrs. Kimbell also retained about $450,000 of other assets in her own name. She died at age 96 a few months after establishing the FLP. The Fifth Circuit concluded that the Kimbell family had engaged in a bona fide transaction for full consideration and thus fell within the exception to Section 2036.
Kimbell And The Business Purpose Trump Card
The court applied an "objective inquiry" (from its own 1997 Wheeler decision) in considering whether Mrs. Kimbell fell within the exception for a bona fide transaction for full consideration. The court said that the exception requires the taxpayer to have parted with property in exchange for roughly equivalent interests in the FLP. Moreover, when family is involved, transactions are subject to "heightened scrutiny" based on an analysis of the objective facts to ensure that the transaction is real and not a sham. A tax planning motive will not itself doom a transaction so long as it is otherwise genuine. However the court, citing long-standing U.S. Supreme Court authority, stated that a transaction engineered only for tax planning with no business purpose will be ignored.
Based on its objective inquiry, the court found that the Kimbell transaction fit within the exception because (1) Mrs. Kimbell received FLP interests equivalent to the value of the assets she contributed, and (2) the transaction was genuine.