GPSolo Magazine - March 2006
Focus on Formality in Family Limited Partnerships: “Hillgren v. Commissioner”
In Hillgren v. Commissioner, the Tax Court included the values of several income-producing properties in the taxpayer’s gross estate under section 2036(a), despite the transfer of these properties to a family limited partnership. Hillgren is one of the most recent in a line of cases that use section 2036(a) to attack family limited partnerships. Section 2036(a) provides that the value of the gross estate shall include the value of transferred property if the taxpayer “retained for life the possession or enjoyment of the property, or the right to the income from the property,” except if the property is the subject of “a bone fide sale for an adequate and full consideration in money or money’s worth.” The Tax Court’s ultimate decision to include the properties relied primarily on the formality of the family limited partnership in question.
The taxpayer’s estate argued that the court should not include the value of the properties in the gross estate because the taxpayer had transferred ownership to a bona fide family limited partnership for full and adequate value. The court rejected the estate’s argument, holding that the properties did not fall within the scope of the bona fide sale exception to section 2036(a). The estate also argued that the court should not include the transferred properties in the gross estate because the taxpayer did not retain the enjoyment of, or the right to the income from, the transferred properties. The court rejected this argument as well, holding that the taxpayer’s estate did not sustain its burden of proving that there was no implied agreement between the taxpayer and Mr. Hillgren, the general partner.
Although the court’s ruling is consistent with its most recent decisions under section 2036(a), its analysis is problematic for two reasons. First, it raises questions about the proper application of the first prong of the bona fide sale exception to section 2036(a). Second, the court’s focus on the parties’ post-transfer behavior could result in unequal treatment of taxpayers who die shortly after forming a family limited partnership and transferring property to it. Under its current framework, the court purports to consider the totality of the facts and circumstances surrounding both the transfer of property and the subsequent use of the property to determine whether the parties had an implied agreement that the taxpayer would retain the enjoyment of, or the right to the income from, the transferred properties. The court’s application of this framework, even when there is limited subsequent behavior to consider, suggests that the court’s inquiry ultimately turns on the formality of the family limited partnership. Although the court invalidated the partnership in Hillgren, the court’s overriding focus on the formality of the partnership suggests that properly structured and operated family limited partnerships will continue to survive, even under the court’s strict application of section 2036(a).
Section 2036(a) “does not apply if the transfer of property was part of a bona fide sale in exchange for full and adequate consideration.” To qualify under that exception, the transfer must be (1) the subject of a bona fide sale, conducted at arm’s length, and (2) for full and adequate consideration in money or money’s worth. The Tax Court held that because Mr. Hillgren acted simultaneously as general partner of Lea K. Hillgren Partnership (LKHP), as co-trustee of the taxpayer’s trust, and as creditor to the taxpayer, he “stood on every side of the transaction.” Therefore, the transfer of LKHP Properties failed the first prong.
The Tax Court’s interpretation of this exception, however, appears to conflict with the Fifth Circuit’s application of the rule. Although it is true that, in form, the transfer of the properties probably does not constitute an arm’s-length transaction, the Fifth Circuit would require the court to look beyond form and examine the substance of the transaction. Applying the approach to Hillgren, the Tax Court should have inquired whether there was an exchange of consideration between the taxpayer and Mr. Hillgren instead of simply counting the number of hats that Mr. Hillgren wore. Apparently, the Tax Court believed that the taxpayer had not parted with her interest in LKHP Properties and that Mr. Hillgren had not provided the requisite adequate and full consideration. Thus, even under the Fifth Circuit’s more lenient framework, the LKHP transaction failed to satisfy the bona fide sale prong of the exception to section 2036(a).
The court also determined that the formation of LKHP did not alter the taxpayer’s interest in the LKHP Properties and that the taxpayer was the sole recipient of distributions from LKHP while she was alive. On these grounds, the court concluded that the LKHP Properties should be included in the taxpayer’s gross estate because the taxpayer retained the full enjoyment of, and the right to the income from, them. A transferor retains the enjoyment of the property “if there is an express or implied agreement at the time of transfer that the transferor will retain the present economic benefits of the property, even if the retained right is not legally enforceable.” The court normally looks at the totality of the circumstances “surrounding the transfer and the subsequent use of the property” to determine whether an agreement could be implied from the parties’ behavior. The taxpayer’s estate, however, “bears the burden . . . of proving that an implied agreement or understanding between [the taxpayer] and his children did not exist when he transferred the property . . . to the partnership.”
In the cases leading up to Hillgren, the court reviewed the parties’ behavior before, during, and after formation of the partnership, up until the death of the taxpayer. The court concluded in each instance that the estates failed to establish the non-existence of an implied agreement. In each of those cases, however, the time from the formation of the partnership to the death of the taxpayer spanned more than one year. There was ample time to consider the parties’ subsequent use of the property to determine whether an implied agreement existed.
LKHP existed for only five months before the taxpayer’s death. Nevertheless, the court examined LKHP’s distributions and relied on the fact that in five months, Mr. Hillgren had distributed $99,383 to the taxpayer and distributed nothing to himself, despite his 25 percent profit interest. The estate argued that the court should not infer anything from Mr. Hillgren’s discretionary refusal to receive distributions because five months is simply too short a time period for the taxpayer to establish any pattern of behavior toward LKHP that could refute the existence of an implied agreement.
Under the court’s unbending rule, the estate of a taxpayer who establishes a family limited partnership, then transfers properties and dies shortly thereafter, is unable to rely on the totality of the circumstances “surrounding the transfer and subsequent use of the property,” as held in Reichardt v. Commissioner. Instead, such estates are forced to rely heavily on the circumstances “surrounding the transfer [of property]” to refute the existence of an implied agreement. Thus, the court imposes a higher burden of proof on the estates of transferors who die soon after the formation of their partnership than on the estates of transferors who live long enough to establish a pattern of subsequent behavior.
Ultimately then, the court’s inquiry into whether the LKHP Properties were includable in the gross estate centered on the facts surrounding the creation of LKHP and the transfer of properties to that entity. To the Tax Court, the examination of partnership formality is inextricably linked to the question of whether the taxpayer retained the enjoyment of, or the right to the income from, the properties.
Craig A. Tamamoto is a law student expecting to receive his J.D. from Georgetown University Law Center in May 2006. He can be reached at firstname.lastname@example.org.
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