Estate of Korby v. Commissioner—Eighth Circuit Court of Appeals Upholds Including Partnership Assets Under §2036
(1) Basic Facts. Estate of Edna Korby v. Comm’r, T.C. Memo. 2005-102 and Estate of Austin Korby v. Comm’r, T.C. Memo. 2005-103 (May 10, 2005) are related cases (with substantially similar opinions) involving the estates of the wife (who died in July 1998) and the husband (who died several months later in December 1998). The Eighth Circuit Court of Appeals has affirmed the Tax Court’s application of §2036. Cause Nos. 06-1201 and 06-1203, (8 th Cir. December 8, 2006).
Husband and wife funded an FLP with marketable securities worth about $1,850,000 in return for a 98% limited partnership interest, which they gave equally to irrevocable trusts for their four sons (24.5% to the trust for each son). These assets represented almost all of their assets, other than their residence and their right to receive social security checks (and a few other assets) which they retained in a living trust. Soon afterward, the FLP purchased an annuity, showing the FLP as the owner, but entitling the husband to receive annuity payments (and the sons as irrevocable beneficiaries if husband died during the payout period.) The FLP made substantial distributions to the living trust, which it used in turn to pay “many of the Korbys’ household expenses.” The expenses paid by the living trust and the FLP directly included payments to a nursing home, medical care providers, drug stores, utility and heating bills, property taxes, and insurance payments for the residence. The estate later claimed that these payments to the living trust (ranging from roughly $19,000 to $39,000; and ranging from 27% to 50% of the FLP income) were for management fees rather than distributions, although the Korbys did not report any self employment income for the first three years of the FLP and although the distributions were not based on a percentage of assets under management as is normal for determining management fees.
(2) Tax Court Basic Holding. The Tax Court (Judge Goeke), in both related cases, held that §2036(a)(1) applies because of an implied agreement that the partnership income would be available to the Korbys, and held that the bona fide sale for full consideration exception to §2036 does not apply.
(3) Eighth Circuit Basic Holding. The Eighth Circuit affirmed the Tax Court in an opinion filed on December 8, 2006. The court upheld under a “clearly erroneous” standard the factual findings of an implied agreement and of the lack of a bona fide sale.
(4) Retained Interest. The Tax Court concluded that there was an implied agreement between husband (on his own behalf and on behalf of his wife) with the four sons that the income from the assets would continue to be available to the parents as long as they needed income. Despite their increasing expenses, which were not covered by their social security income, the spouses retained only the residence and relatively few other assets. The FLP paid some of the living expenses directly and made significant payments to the living trust, which paid the balance of the living expenses. The court did not believe that the payments to the living trust were management fees. The court cited various reasons, including that the payments were used only for husband and wife, and not for the other co-trustee (one of their sons).
The Eighth Circuit affirmed this factual finding, pointing out that substantial distributions had been made to the Korbys and that the distributions could not be justified as management fees. The court pointed out that “the Korbys retained less than $10,000 in assets in the living trust (their only source of income) following the funding of KPLP—despite the fact both of the Korbys were in poor health and could expect to incur living expenses beyond amounts their Social Security benefits would cover.” The Eighth Circuit went on to cite cases from the First ( Abraham), Third ( Thompson) and Fifth ( Strangi) Circuits that also upheld Tax Court findings on this issue under a clearly erroneous standard.
(5) Bona Fide Sale Exception Not Satisfied. The Tax Court held that there was no legitimate and significant nontax reason for creating the FLP, so the bona fide sale for full consideration exception to § 2036 did not apply. Factors emphasized by the court include: (1) Taxpayer “standing on both sides of the transaction” and no involvement of decedent’s sons in creation of the partnerships; (2) Financial dependence on distributions; and (3) Creditor planning was not a significant factor.
The Eighth Circuit viewed the Tax Court’s ruling on the bona fide sale exception as a factual finding that the circuit court reviewed under a clearly erroneous standard. [Observation: It would seem that this is a mixed question of law and fact—a question of law as to what standard applies for determining if a bona fide sale exists.] The circuit court mentioned in particular two legal standards to determine if a bona fide sale exists. (1) “A transfer is typically not considered a bona fide sale when the taxpayer stands on both sides of the transaction.” (The court went on to explain that the husband with the help of his estate planning lawyer made all decisions about creating and funding the partnership without negotiation or input from limited partners.) (2) “The transaction must ‘be made in good faith’ which requires an examination as to whether there was ‘some potential for benefit other than the potential estate tax advantages that might result from holding assets in the partnership form.’ Thompson, 382 F.3d at 383.” The court also quoted the “ no discernable purpose or benefit” standard in Thompson and cited Strangi and noted in a parenthetical in that citation its “substantial business [or] other non-tax purpose” standard. The court found no clear error in the Tax Court’s finding that the partnership was not created for creditor protection but that it was formed to make a testamentary transfer of assets to their sons at a discounted value.
The two standards mentioned by the Eighth Circuit are interesting. On the one hand, the first standard (standing on both sides of the transaction, no negotiation) is a throw back to the “arms length” standard originally used by the Tax Court but that was rejected in subsequent circuit court of appeals cases. Other cases have mentioned this as an element of discerning whether a “bona fide sale” exists ( e.g., Rosen), but the Eighth Circuit only mentioned two elements, and this was one of them. In that respect, if having an arms length transaction with other parties is necessary to be a bona fide sale, this is more restrictive than any other circuit level case. On the other hand, the “discernable purpose or benefit” standard seems to be an easier standard to satisfy than the “legitimate and significant non-tax reason” standard announced in Bongard or the “substantial business [or] non-tax purpose” standard announced in Strangi (although the court did quote that standard in a parenthetical to a citation to Strangi). The court did not suggest in applying the standard to the facts that it is a more relaxed standard than used in other cases, but just from a linguistic standpoint, finding a “discernable” purpose seems much less stringent than finding a “legitimate and significant” purpose.
Because there was no bona fide sale, the Eighth Circuit did not have to address what standard is required to meet the “full consideration” requirement, which is the second leg of the “bona fide sale for full consideration” exception to §2036.
(6) Retained Interest Despite Transfers of Limited Partnership Interests. Section 2036(a)(1) should not apply at all with respect to a transferred limited partnership interest (even if the bona fide sale for full consideration exception does not apply) if there are no indications that the decedent has retained (even by implied agreement) the right to enjoy the transferred limited partnership interest or the FLP assets attributable to that interest. (However, if the decedent died within three years of relinquishing a retained right, §2035 would cause §2036 to apply.) The court did not state in the facts when the limited partnership interests were given to the sons in 1995. Even though the gifts may have been made more than three years before death (the Korbys died in July and December, respectively, of 1998), that apparently was irrelevant because the court found the existence of an implied agreement to retain enjoyment of all of the income of the partnership even after the limited partnership interests had been given away. (A similar result occurred in Rosen, T.C. Memo 2006-115.)
(7) Marital Deduction Mismatch. If §2036 applies, at the first spouse’s death there may be assets in the gross estate that do not qualify for the marital deduction because the partnership assets would be included without a discount, but the first decedent spouse does not own those assets to leave to the surviving spouse. In Bongard, the Tax Court raised that the possibility that the discounted limited partnership interests may not completely offset inclusion of the partnership assets under §2036. (A footnote in Bongard suggests that a marital deduction “may” be allowed for the full value of underlying assets, not just the limited partnership interest itself: “We note that decedent’s estate may be entitled to a deduction under sec. 2056 for his inter vivos gift of [the LLC] class B membership units to Cynthia Bongard that was pulled back unto his gross estate under sec. 2035(a).” (Footnote 13, emphasis added). In Korby, the wife did not own any limited partnership interests to leave to her surviving husband, because all of the limited partnership interests had been given away before her death. The parties stipulated that if only 32% of the partnership assets were included in the wife’s estate, the marital deduction would not offset those assets in her estate.
Copyright © 2006 by Bessemer Trust Company, N.A. All rights reserved. Reprinted with permission.