GPSolo Magazine - September 2005
Sibling Rivalry: The Successful Use of Family Limited Partnerships for Wealth Transfers in “Estate of Stone v. Commissioner”
In Estate of Stone v. Commissioner, the Tax Court held that the underlying assets of five family limited partnerships were notrequired to be included in the estates of two decedents under section 2036(a)(1). This significant victory to the taxpayer is notable not only for its ultimate holding, but also for its illumination of factors contributing to the correlative finding that the pro rata transfers to the five family limited partnerships were bona fide transfers for full and adequate consideration.
Mr. Stone’s estate tax return included as part of the gross estate the date-of-death values of his respective partnership interests in five family limited partnerships. Pursuant to his will, his 1.001 percent general partnership interest and his 68.972 percent limited partnership interest passed to a newly created trust for the benefit of his wife. After Mrs. Stone’s death, her estate tax return reported the date-of-death values of all of the assets held by the trust along with the date-of-death values of her limited partnership interest in her children’s partnerships.
Following an examination, the Internal Revenue Service issued a notice of deficiency to both estates.
Section 2036 provides that the value of transferred property in which a life estate is retained must be included in the valuation of a decedent’s property for purposes of the federal estate tax in certain specified circumstances. According to the legislative history, the words “or the right to [the income]” were inserted into the predecessor of section 2036(a)(1) in a 1932 amendment, apparently to make clear Congress’s intent that the statute should also apply to cases in which the decedent was entitled to receive the income, even if the decedent did not assert his right to the income.
The Regulations interpreting section 2036(a)(1) also provide some guidance as to when the section applies. Regulation section 20.2036-1 notes that the “use, possession, right to the income, or other enjoyment” of the property is considered as having been retained by the decedent to the extent that these retained interests can be applied “toward the discharge of a legal obligation of the decedent, or otherwise for his pecuniary benefit.” Regulation section 20.2043-1 further provides that to qualify as a bona fide sale for an adequate consideration in money or money’s worth, the transfer must have been made in good faith, and the price must have been an adequate and full equivalent reducible to a monetary value.
The Service initially relied on seven alternative theories as to why the underlying assets of the family limited partnerships should be included in the valuation of the estates, but eventually dropped all of them in favor of exclusively pursuing section 2036(a)(1). With respect to section 2036(a)(1), the Service argued that both Mr. and Mrs. Stone “retained until the time of . . . death the possession or enjoyment of, or right to the income from, the assets . . . contributed to the . . . partnerships within the meaning of Internal Revenue Code Section 2036.”
The Service also alleged that the transfers to the family limited partnerships were not bona fide sales for adequate and full consideration in money or money’s worth. The Service cited substantial precedent in favor of this interpretation, arguing that the transfers were similar to several transfers that the Tax Court had recently found invalid as a “mere recycling of value and form of ownership,” including the decision in Estate of Harper v. Commissioner.
Although both estates conceded that transfers of property were made to the limited partnerships in exchange for general and limited partnership interests, both argued that the transfers were bona fide sales for full and adequate consideration within the meaning of section 2036(a). In support of that position, the estates contended that Mr. and Mrs. Stone received pro rata partnership interests in return for the assets contributed to each one. Furthermore, “because the contributions were properly credited to each partner’s capital account,” no donative transfer was made in connection with the creation of the partnerships, making section 2036(a) inapplicable in the first place.
The Tax Court’s decision broke a significant string of holdings against the taxpayer in family limited partnership estate valuation cases. The judge held that the transfers by Mr. and Mrs. Stone to the partnerships were bona fide sales for adequate and full consideration in money or money’s worth under section 2036(a). Accordingly, none of the underlying assets of the family limited partnerships were required to be included in the estate tax valuation of either decedent’s gross estate.
Relying on an early case interpreting the statute, the judge noted that such an exception is strictly limited to cases in which the transferor “has received benefit in full consideration in a genuine arm’s length transaction.” The court then found that the record established that the respective transfers at issue did not constitute gifts, primarily because the Stones were “motivated . . . by investment and business concerns relating to the management of certain of the respective assets of Mr. Stone and Mrs. Stone during their lives and thereafter [along with] the resolution of the litigation among the children.”
Moreover, after the extensive negotiating process was completed, (1) all partners of each of the five family limited partnerships held respective partnership interests that were proportionate to the fair market value of the assets that the partner had transferred to the entity; (2) the respective assets that each partner transferred were properly credited to his or her respective capital account; and (3) upon the termination or dissolution of each partnership, the partners were entitled only to distributions equal to their respective capital accounts.
In the court’s view, considered together, these circumstances lent significant support to the arguments of the estates and ultimately led to a conclusion that the transfers were bona fide transactions for full and adequate consideration within the meaning of section 2036(a). In finding that the Service’s reliance in recent cases holding against the taxpayer was fundamentally misplaced, and focusing particularly on Estate of Harper, the court noted that unlike the decedent in that case, here the five partnerships 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 of such partnerships during their parents’ lives and thereafter.
The decision illuminates three factors central to the success of utilizing the family limited partnership device in estate planning: (1) the extent to which the parties created and managed the family limited partnership as a joint enterprise for profit; (2) the degree to which the partners received interests proportionate to their contributions in the respective partnerships; and (3) the existence of substantial motives other than tax avoidance. The Court repeatedly stressed the children’s active roles in negotiating for their parents’ former property and then managing it after its contribution to the partnerships. It also noted that immediately after the partnerships were formed, each partner held a partnership interest proportionate to the fair market value of the assets that the partner had transferred.
Kara E. Major graduated cum laude from the Georgetown University Law Center in May 2005. She can be reached at firstname.lastname@example.org.
For More Information About the Section of Taxation
- This article is an abridged and edited version of one that originally appeared on page 947 of The Tax Lawyer, Summer 2004 (57:4).
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