The Ninth Circuit now joins the Third, Fifth, and Eighth Circuits in weighing in on the application of §2036 to family limited partnerships. Bigelow v. Commissioner, 100 AFTR2d 2007-xxxx (9th Cir. September 14, 2007), affg, T.C. Memo 2005-65. The Ninth Circuit upheld the Tax Court finding that §2036 caused the inclusion of all partnership assets in the decedent’s gross estate without a discount. The Ninth Circuit decision is not surprising and generally does not plow new ground. The facts of an implied agreement for retained enjoyment of the assets contributed to the partnership are strong. The court focused on the lack of purported non-tax benefits to find that the bona fide sale for full consideration exception did not apply. The court seemed to be looking for actual particular claims or risks to support a liability protection purpose, an actual threat of a partition action to support avoiding partition as a purpose, and particular assets or a business requiring active management to support a management purpose. The court said that a heightened scrutiny analysis would apply, and the court said to consider whether the terms of the transaction differed from those of two unrelated parties negotiating at arm’s length (in effect, suggesting a “comparability” test to determine if unrelated parties would have contributed assets to the partnership in the same situation as the decedent.)
The opinion contains a startling “requirement” for the full consideration exception to §2036. The opinion literally says that there must be more than just transfers to the partnership for a proportional number of units of the partnership, and that there “must” be a “genuine pooling” of assets — which would seem to require significant contributions by other partners. However, the reasoning in the next several pages of the opinion refers to other factors (primarily the absence of non-tax benefits) in addressing the bona fide transfer for full consideration exception to §2036. In fact, there were no significant contributions by other partners in that case, but the court made no mention of that as a reason to refuse application of the full consideration exception. Planners probably will not drastically change their planning for family limited partnerships to urge strongly that clients have other family members make substantial contributions to the partnership in light of this troublesome statement in the opinion —which the court itself did not seem to apply.
1. Key Facts.
Decedent created a revocable trust in 1991 and transferred her interest in her residence to the trust. The trust exchanged the residence for other rental property, and borrowed $350,000 and $100,000 under separate loans secured by the rental property. In December 1994, the revocable trust contributed the investment property to an FLP (but not the $450,000 of liabilities secured by the property, which remained as liabilities of the revocable trust). (The decedent’s children each contributed $100 for very small limited partnership interests.) After contributing the property to the partnership, the decedent had a monthly cash flow shortfall of $1,200 (and three years later the shortfall grew to $2,700 per month.) The partnership made payments on the $350,000 loan (which were owed by the revocable trust) and paid some of the decedent’s living expenses. The son (as agent) made 40 transfers between the partnership and the revocable trust during a period of a little over two years.
In December of 1994 and 1995, the son (as agent under the power of attorney) withdrew some of the trust’s units in the FLP and made gifts to himself and his sisters and to the decedent’s grandchildren. (No gift tax returns were filed until after the decedent’s death.)
Decedent died in August 1997 (when the revocable trust owned the 1% general partnership interest and a 45% limited partnership interest), and the FLP was terminated a little over one year later.
The estate claimed a 31% marketability discount on the gifts of the limited partnership interests and claimed a 37% marketability discount on the value of the limited partnership interests for estate tax purposes.
2. Section 2036(a)(1) Retained Enjoyment
The Ninth Circuit upheld the Tax Court’s finding “that decedent and the Bigelow children impliedly agreed that decedent would have access to income from the transferred property and that decedent continued to enjoy the economic benefit that the property secured her personal debt.” (Because § 2036(a)(1) applies, the Tax Court did not consider § 2036(a)(2) or §2038(a)(1).) The court’s holding supporting the finding of an implied agreement of retained enjoyment is not surprising. The combination of substantial disproportionate distributions to the decedent, the inability of decedent to meet her living expenses, and the use of the partnership property to secure the decedent’s liabilities evidence the implied agreement to retain income from and enjoyment of the rental property that was transferred to the partnership.
The Ninth Circuit pointed to various factors suggesting an implied agreement that decedent could access partnership funds as needed, including the following:
· The contribution of the rental property to the FLP impoverished the decedent and left her vulnerable to monthly shortfalls.
· The children knew that decedent’s long-term coverage was expiring soon after the contribution to the FLP (one policy in 9 months and another policy in 17 months).
· There were 40 transfers between the partnership and the revocable trust. The transfers were characterized as interest free loans (unaccompanied by a promissory note). Eventually a distribution was made from the partnership to the revocable trust to repay the earlier advances and later to pay decedent’s expenses.
· The FLP made substantial payments on the $350,000 debt owed by decedent’s revocable trust, but did not reflect those as distributions on the partnership accountings.
· The children considered having the partnership sell the rental property to have funds available to cover the decedent’s living expenses.
· One child testified that she would not pay decedent’s expenses out of her own pocket, but the children were committed to maintaining their mother in the manner to which she was accustomed.
· Partnership formalities were not observed. (1) Capital accounts were adjusted annually to reflect gifts made to the children, but not to reflect payments on the revocable trust’s debt; (2) No other partner benefited from such informal access to partnership funds; (3) A post-mortem accounting (to reflect the payments on the $350,000 debt owed by the revocable trust) indicated an implied agreement that decedent could access income from the transferred asset.
The implied agreement facts were bad, and the court’s decision is not surprising.
3. Section 2036(a) Bona Fide Sale for Full Consideration Exception
a. Not Two Distinct Requirements. Unlike other courts, the Ninth Circuit refused to break down the analysis into two discrete requirements, “bona fide sale” and “adequate and full consideration.” Instead, the Ninth Circuit said “we consider the ‘bona fide sale’ and ‘adequate and full consideration’ elements as interrelated criteria.” “The validity of the adequate and full consideration prong cannot be gauged independently of the non-tax-related business purposes involved in making the bona fide transfer inquiry.”
b. No Per Se Disqualification for Exception. The IRS argued that a transfer of assets to a partnership in return for interests that are worth less than the value transferred, even though proportional to other contributions, means that the transfer cannot meet the exception. The Ninth Circuit responds that a transfer of real property to a partnership, which reduces the value of the decedent’s interests, “does not per se disqualify the transfer from falling under §2036(a)’s exception.” (The Ninth Circuit said that it was agreeing with the Third and Fifth Circuits in that regard.) In effect, the Ninth Circuit seems to reject the IRS argument that a contribution of assets in return for partnership interests that are proportional but that have a lesser value than the contributed assets necessarily means that the full consideration element is not satisfied.
c. More Than Proportionality Required; Pooling of Assets as a Factor. Proportionality of interests compared to contributions is not enough to satisfy the exception; the estate must also show (a) the “genuine” pooling of assets, AND (b) “a potential [for] intangibles stemming from pooling for joint enterprise.” However, the court’s subsequent analysis does not emphasize these two purported requirements, but instead focuses on supporting the Tax Court’s finding of a lack of “good faith” (and specifically, the absence of non-tax benefits) as a reason to find that the exception does not apply.
Observation: This would be a very significant planning feature if we were to believe that the court is absolutely requiring a genuine pooling of assets. The court opinion literally says that an estate must do more than show a proportional exchange of assets contributed to the partnership in return for the units received, and the estate “MUST” also show a “genuine” pooling of assets, AND a potential for intangibles stemming from the pooling. Despite this very strong language, the court never mentions it again, but instead focuses primarily on the absence of non-tax benefits. This genuine pooling requirement would be particularly ironic in this case in which there was practically NO pooling of assets from various partners. The decedent’s children just contributed $100 each for their miniscule partnership interests before the decedent made gifts of partnership interests to them in later years, and the court made absolutely no mention of the almost complete absence of “pooling” of assets under the facts of this case. Having significant contributions by others to create a genuine pooling of assets may be a helpful factor, but it does not yet appear to be a requirement to satisfy the exception. Still, the court’s literal language is troubling. Having a legitimate non-tax purpose, avoiding causing the impoverishment of the client, and following partnership formalities appear to be more important factors in the court’s discussion, as discussed immediately below.
d. Good Faith; (a) Impoverishment, (b) Formalities, and (c) Non-Tax Benefit. The Tax Court found that the transfer to the partnership was not in good faith because (a) the transfer resulted in the impoverishment of the decedent, (b) the partnership did not follow formalities, and (c) the transfer did not create a potential non-tax benefit. The Ninth Circuit found evidence to support each of these findings, focusing particularly on the absence of non-tax benefits.
(1) Non-Tax Benefit: Avoiding Potential Liability. The taxpayer argued that the partnership shielded family members from personal liability for injuries occurring on the property. The court responded that the decedent was not shielded from liability because her revocable trust was both general partner and limited partner. Also, there was no evidence that the family member-partners “reasonably faced any genuine exposure to liability.” The court later pointed to the absence of “some concrete incident or circumstance,” the absence of any “particular incident,” and “no general conditions of the business venture that posed inherent risks of litigation.” The court noted that in Strangi, the court was not persuaded the possible claims by a housekeeper was a reason for liability protection planning when “no evidence was presented that the maid ever threatened to take such action.”
(2) Non-Tax Benefit; Avoiding Partition. Similarly, the court rejected the proferred non-tax rationale that the formation of the partnership would protect the property from a partition sale where there was no evidence that other family member-partners contemplated a partition or had creditors that might resort to a forced sale.
(3) Non-Tax Benefit; Facilitating Management. Efficient management might count as a credible non-tax business purpose “only if the business of the FLP required some kind of active management.” Here, the court said that the decedent’s son managed the property as trustee of her revocable trust, and nothing changed after the property was contributed to the FLP. The court distinguished the situation in Kimbell where working interests in oil and gas properties were contributed to a partnership.
(4) Non-Tax Benefit; Facilitate Gift Giving. The court agreed with other courts that “gift giving is considered a testamentary purpose and cannot be justified as a legitimate, non-tax business justification.”
e. Heightened Scrutiny; Comparability Analysis. The court evaluated these arrangements “through the heightened scrutiny of intra-family transactions.” In particular, the court considered whether “the terms of the transaction differed from those of two unrelated parties negotiating at arm’s length” (citing Bongard). In effect, the court applies a “comparability” test, to determine if unrelated parties would have contributed assets to the partnership in the same situation as the decedent.
4. Court Did Not Address Reason For Including Partnership Assets Attributable to Gifts of Partnership
Interests to Family Members.
All of the rental property that was contributed to the partnership was included in the gross estate even though the decedent made gifts of about 54% of the limited partnership interests and only owned a 45% interest at her death. Perhaps this issue was not raised by the taxpayers, because neither the Tax Court nor the Ninth Circuit addressed the reasoning for this conclusion. One possible explanation is that § 2036 applied to the transfer of assets to the partnership, so those assets must be included in the estate regardless of any subsequent transfers or when they occur. That would seem troublesome as a general proposition — assuming that the decedent does not retain a § 2036(a)(1) right to income from or enjoyment of all of the partnership property or a § 2036(a)(2) right to designate who can enjoy all of the partnership property — and contrary to the purpose of having a three-year rule under §2035. Another possible explanation is that the court found an implied agreement that all of the FLP assets would be made available to the decedent. Apparently, distributions were only made to or for the benefit of the decedent, even though the decedent only owned a 45% interest in the FLP at her death. Another explanation is that §2035 applies because all of the gifts were made within three years of the decedent’s death so the assets contributed to the partnership that are attributable to those transfers must also be included in the gross estate. (This was the reasoning of the full Tax Court in Bongard.) It would not seem appropriate to include the value of the underlying partnership assets attributable to transfers of partnership interests that are made more than three years before the decedent’s death — if the decedent does not retain “(a)(1) or (a)(2)” rights with respect to the partnership property attributable to the transferred interests.
5. Observations Regarding Full Consideration Requirement.
Cases have previously analyzed two separate prongs to the “bona fide sale for full consideration” exception to §2036: “bona fide transfer” and “adequate and full consideration.” (The Ninth Circuit in Bigelow refused to analyze these as two independent elements, but viewed them as “interrelated criteria.”)
As to the “full consideration” requirement, the Bongard [124 T.C. 95 (2005)] and Kimbell [371 F.3d 257 (5th Cir. 2004)] cases said that the full consideration requirement is met by having proportionate transfers to a partnership that maintains capital accounts and allocates distributions among the partners pursuant to the capital accounts.
The Third Circuit in Thompson said that a dissipation in value from contributing assets to an FLP “will not automatically constitute inadequate consideration for purposes of §2036(a)” (but later suggested that a transfer resulting in a depletion in value does reflect a failure to establish a transfer for consideration when there is no legitimate business or when the sole benefit is a valuation discount).
Similarly, the Ninth Circuit in Bigelow stated that a transfer to an FLP that inherently reduces the value “does not per se disqualify the transfer from falling under § 2036(a)’s exception” but stated that the estate must demonstrate more than just a proportional exchange, observing that the full consideration prong cannot be gauged independently of the non-tax-related business purposes involved in the bona fide transfer inquiry.
However, the IRS is still arguing that the “full consideration” test requires more proportional transfers. The IRS’s brief in the Korby case to the Eighth Circuit, argued:
· The partnership must respect formalities (proportionate transfers reflected in capital accounts, which is the test in Tax Court and Fifth Circuit).
· ALSO, the transaction must not deplete the estate (before and after the transfer to the FLP).
· The IRS recognizes that some immediate depletion in value occurs whenever there is a transfer to any entity, but “the diminution in value from the partnership restrictions must be offset by some other advantage to holding assets in partnership form.”
Conclusion: We cannot assume the “full consideration” issue is resolved. The Third Circuit in Thompson said there is “heightened scrutiny” if there is a dissipation in value, and a concurring opinion, joined by 2 of the 3 judges, explained that the depletion rule would not apply in “routine commercial transactions” — intimating that it would apply in other transactions. The Ninth Circuit in Bigelow was not that restrictive as that, but agreed that the full consideration prong cannot be gauged independently of the non-tax-related business purposes involved in the bona fide transfer inquiry.
6. Planning Implications From This Case.
(1) Do not transfer so many assets to the partnership that it is apparent that the decedent must receive distributions from the partnership to maintain his or her lifestyle. Arguments could be made that individuals often make investments with the expectation of receiving an investment return without having the transaction recast as a § 2036 transfer. However, the cases that have found an implied agreement of retained rights to income or enjoyment of property transferred to an FLP often involve situations where the decedent is likely to need distributions from the partnership.
(2) Do not transfer assets that are subject to liens without also having the partnership assume the liability. (Of course doing so can have significant income tax implications, which might then suggest not distributing that particular encumbered asset to the partnership.)
(3) Do not have the client (or client’s revocable trust) serve as the sole general partner (at least without letting the client know that doing significantly weakens the response to various attacks that the IRS might make.) Among other problems, having the decedent or a revocable trust serve as general partner removes the possible nontax reasons of liability protection and providing for management.
(4) Maintain proper capital accounts and make appropriate adjustments to the capital accounts to reflect the fair market values of all contributions and to reflect all distributions and gifts of partnership interests.
(5) If possible provide for some change in the management of the assets after they are transferred to the partnership.
(6) If possible, provide for some pooling of assets by having other partners make significant contributions (but the court did not emphasize that factor, despite its literal statement that genuine pooling of assets is a requirement to apply the §2036 ona fide transfer for full consideration exception).
(7) When distributions are made, make proportionate distributions to all partners.
(8) Do not have numerous continuous transactions between the client and the partnership. The court pointed several times to the fact that there were transfers between the trust and the partnership 40 different times over about a two-year period.
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