By Stephen A. Frost

Family limited partnerships (FLPs) have been popular for more than a decade. However, despite having previously issued technical advice memoranda to the contrary, the IRS has successfully challenged the taxation of FLP interests under Section 2036 of the Internal Revenue Code of 1986, as amended (Code), when such interests are held at death. Taxpayers who have created an FLP (and their advisors) and fail to become intimately familiar with such challenges risk significant federal estate tax exposure.

If the IRS successfully challenges the taxation of FLP interests under Code § 2036, up to the entire value of the FLP’s net assets may be included in the decedent’s gross estate for federal estate tax purposes. Significant increases to the decedent’s federal estate tax liability and the thwarting of tax planning can consequently result. 

This article focuses on the federal estate tax implications applicable to any taxpayer who created a FLP and retains an interest in the FLP at death. The purpose of this article is to help such taxpayers and their advisors recognize the federal estate tax exposures under Code § 2036 and recommend possible mitigation measures.

Typical FLP Structures Assumed
This article assumes the presence of one of several typical FLP structures, which involve one of the following (or a variation thereof): First, a taxpayer and his or her spouse create a FLP. Each individual receives a one percent general partnership interest and a 49 percent limited partnership interest in return for the contribution of property to the FLP. The taxpayer and his or her spouse subsequently give some of the limited partnership interests to family members and retain the general partnership interests and some of the limited partnership interests until death. Second, a single taxpayer creates the same structure as that described above, but uses a trust or other entity in lieu of limited partnership interests held by the spouse. Finally, in addition to the limited partnership shares created by the taxpayer and his or her spouse (or an entity), the children of the taxpayer and his or her spouse contribute assets to the FLP in return for limited partnership interests. The IRS may attempt to apply Code § 2036 to any of these assumed structures upon the taxpayer’s death. It is also assumed that the IRS’ challenges will be resisted by the decedent’s executor.

Code § 2036 Provisions
Code § 2036(a) provides that “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 with reference to his or her death or for any period which does not in fact end before his death—

• the possession or enjoyment of, or the right to income from, the property, or
• the right, either alone or in conjunction with any other person, to designate the persons who shall possess or enjoy the property or the income therefrom.”

The IRS may attempt to challenge the estate tax treatment of an interest in an FLP under Code § 2036(a)(1) or Code § 2036(a)(2), or both. The executor may defend against such challenges directly by showing a decisionmaker why those subsections do not apply. The executor may also attempt to avoid the application of Code § 2036 altogether by showing that the creation of the FLP was in fact a bona fide sale for adequate and full consideration in money or money’s worth.

The Bona Fide Sale for Adequate and Full Consideration Exception
Code § 2036 provides for a general exception which will exclude partnership interests, whether general or limited, from challenges under the statute. Pursuant to Code § 2036(a), Section 2036 does not apply when the property in question was transferred in a “bona fide sale for adequate and full consideration in money or money’s worth.” With proper planning, the contribution of assets to an FLP can be treated as such a sale under some circumstances.

A sale is “bona fide” when it is made for a legitimate and significant non-tax reason. A significant purpose must be an actual motivation, not a theoretical justification. The significant non-tax reasons of a transferor may be accepted by the IRS and/or the courts. Others may not. Therefore, careful consideration and documentation of all of the non-tax reasons for creating a FLP may become outcome determinative. Such documentation should be done contemporaneously with the creation of the FLP or as soon as possible thereafter if the FLP already exists. It is not yet clear which non-tax reasons are sufficient to carry the day. Nor is it clear that an active business purpose for the FLP must exist.

A sale is for “adequate and full consideration” when: (a) the transferor receives a share in the FLP which is proportionate to her contribution; (b) the transferor receives capital account credit equal to the fair market value of the property contributed to the FLP; and (c) all liquidating distributions from the FLP are made in accordance with the partners’ positive capital accounts after considering allocations and distributions for all periods.

If the bona fide sale exception under Code § 2036(a) is not met, the executor must defend under Code §§ 2036(a)(1) and (a)(2).

IRS Challenges Under Code § 2036(a)(1)
A successful challenge under Code § 2036(a)(1) may occur when the deceased taxpayer retained the income from or the use and enjoyment of the property transferred to the FLP. Such retention or use and enjoyment may have resulted from an implied agreement, regardless of the limited partnership agreement’s express provisions. Treasury Regulation § 20.2036-1(a).

In cases where the IRS successfully challenged the taxation of FLP interests under Code § 2036(a)(1), the relevant limited partnership agreement and other operating documents in such cases were often in order, but the limited partnership was often not operated in accordance with the limited partnership agreement with the partners’ tacit consent. The improper funding or operation of an FLP often leads to successful challenges by the IRS under Code § 2036(a)(1). The most common flaws giving rise to challenges are:

• Non-pro rata distributions from the FLP to the decedent during his or her lifetime;
• Commingling of FLP assets (especially bank accounts) with the decedent’s assets during his or her lifetime;
• Use of FLP assets to pay the decedent’s personal expenses during his or her lifetime;
• Use of FLP assets to pay the decedent’s estate taxes and administration expenses upon his or her death;
• The decedent’s use of FLP assets during his or her lifetime, including the rent-free use of a residential home;
• The contribution of substantially all of the decedent’s financial assets into the FLP during his or her lifetime and/or the retention of too few financial assets outside of the FLP;
• The contribution of the decedent’s personal assets during his or her lifetime, especially a residential home, into a FLP;
• No changes to the investment portfolio once the FLP is created; and
• Essentially no change to the decedent’s use and enjoyment of the assets contributed to the FLP during his or her lifetime beyond the change of formal title.

Taxpayers subject to a successful challenge under Code § 2036(a)(1) should consider dissolving the FLP and starting over. At the very least, the taxpayer should get the partnership agreement and other documents in order, true up the capital accounts, remove personal assets from the FLP, stop paying personal expenses, and pay fair market value for the use of any partnership assets that cannot be removed from the FLP.

IRS Challenges Under Code § 2036(a)(2)
A successful challenge under Code § 2036(a)(2) may occur when a taxpayer creates a limited partnership and retains a general partnership interest at his or her death. This type of attack may be used even though all of the partners have respected the legal formalities and followed the limited partnership agreement to the letter. It initially caught estate planners off guard because in Strangi v. Comm’r, 417 F.3d 468, 96 AFTR2d 2005-5230 (5th Cir. 2005) (“Strangi II”), aff’g TC Memo 2003-145, the United States Tax Court expressly rejected the private letter rulings which had started the explosion of FLPs, and rejected the application of U.S. v. Byrum, 408 U.S. 125 (1972).

It is axiomatic that a limited partnership is controlled by the general partner. This individual often controls all aspects of the partnership’s investments, operations and distributions. Such control may be deemed to be the retention of control over the income from or use and enjoyment of limited partnership assets. Therefore, the unlimited control of a general partner who created the limited partnership may cause the value of all of the limited partnership’s assets to be included in the general partner’s gross estate under § 2036(a)(2). This is particularly true when the general partner can determine when and to what extent distributions are to be paid by the FLP.

The limited partnership agreement can limit the general partner’s power by requiring ascertainable business standards for distributions and limited partner consents for certain major acts. However, it is not clear that anything short of ridding the taxpayer of her general partnership interest prior to her demise will be sufficient. In the meantime, Strangi II remains the law of the land.

No taxpayer willingly relinquishes control over a limited partnership. Yet, the risk of estate taxation is so high that only the bravest taxpayer may be willing to take such risks. The faint of heart should either sell the general partnership interest to a family member for adequate and full consideration or give it to a trusted family member. If the general partnership interest is sold for adequate and full consideration, the bona fide sale exception under Code § 2036 should apply. Obviously, an appraisal would be needed to support the transfer price. If all or any portion of the general partnership interest is merely given away, this issue will not go away for three years because the value of the interest would be returned to the gross estate under Code § 2035.

Conclusion
Taxpayers who retain either the benefit of assets contributed to an FLP in contravention of the partnership agreement or a general partnership interest in a self-created FLP need to be educated about the estate tax risks of doing so. Failing to appreciate the developing case law in this area can be extraordinarily expensive and lead to an FLP flop.

Reprinted with permission of the Illinois CPA Society, May 2009, "Practical Advantage"

This publication has been prepared by Hinshaw & Culbertson LLP to provide information on recent legal developments of interest to our readers. It is not intended to provide legal advice for a specific situation or to create an attorney-client relationship.