The IRS has challenged family limited partnerships on a number of grounds, without much success, in recent years.
Recent
cases against FLPs rely on violations under Sec. 2036(a), where the IRS
disputed the unchanging relationship between the donor and the assets
transferred to the FLP.
But a recent ruling in Bongard v. Commissioner,
(124 TC No. 8), provides an analysis of the Tax Court’s interpretation
of Sec. 2036(a) and its applicability in establishing an FLP.
Many
early FLP challenges focused on the applicability of restrictions on
control and transfer of interests within the partnership agreement.
These restrictions are what appraisers rely on to support valuation
discounts.
Most notable
was the IRS use of Sec. 2704(b) and Reg. 25.2704-2(a) in challenging
the validity of FLPs. The 5th Circuit Court’s decision in Kerr v. Commissioner, (292 F.3d 490, 89 AFTR 2d 2002-2838), helped dissuade the IRS from continuing on this path.
Another
avenue the IRS has tried with some success focused on the annual gift
tax exclusion under Sec. 2503(a) and whether a gift of a partnership
interest is itself entitled to the benefit of the annual gift tax
exclusion.
In Hackel v. Commissioner,
[118 TC 279 (2002)], the IRS argued that a gift of a partnership
interest is not really a transfer of (present) value since it is
subject to restrictions on transferability and is reliant on the
general partner for income distributions.
The
IRS was successful, but the win did not hinder the will of advisers.
While the case is being appealed, planners must consider its
implications and structure partnership agreements accordingly.
In
certain instances, where a taxpayer retains the right to the assets
subsequent to the transfer, the IRS has argued that their full value
should be included in the donor’s estate. Early cases where the IRS had
success using Sec. 2036(a) include Reichardt v. Commissioner, [114 TC 144 (2000)], and Strangi v. Commissioner [115 TC 478 (2000)].
Cases subsequent to Reichardt and Strangi
have gone one step further. Recent rulings describe the need for a
legitimate (non-tax) business purpose for the partnership, such as
management expertise, security and preservation of assets, and
avoidance of personal liability.
Wayne
C. Bongard, a successful business owner, died in 1998. His estate’s
706, filed Feb. 15, 2000, reported that the federal estate tax owed was
$17,004,363. A notice of deficiency totalling $52,878,785 was issued
Feb. 4, 2003.
In 1980, Bongard
started Empak, a Minnesota corporation. Bongard was the company’s sole
shareholder until a few years later, when he transferred a number of
shares to an irrevocable trust for the benefit of his children.
The
business flourished and Bongard’s advisers began preparing the company
for a potential liquidity event, either through a public or private
offering. In 1996, Bongard and his children’s trust exchanged their
stock in Empak for Class A (voting) and Class B (non-voting) member
interest in WCB Holdings, a Minnesota LLC. After the exchange, Bongard
and the trust owned the same proportionate interest in WCB as they did
in Empak (86.39 percent and 13.61 percent).
In Bongard,
the IRS argued that this was not an arm’s-length transaction since one
could not occur between related parties. Upon analysis, the Tax Court
ruled against the IRS in its contention that the transfer to WCB was
not a bona fide sale for adequate and full consideration.
Later
in 1996, the Bongard Family Limited Partnership was formed, whereby
Bongard and the children’s trust transferred their Class B member
interest in WCB to the FLP in exchange for partnership interests. The
exchange left Bongard with a 99 percent LP interest and the trust with
a 1 percent GP interest. In a letter to his children, Bongard expressed
his reasons for forming the FLP, including concern for asset protection
and tax benefits.
A year
later, Bongard gifted his wife a 7.72 percent LP interest. The court
noted, “This was the sole transfer of the FLP during its existence and
that the FLP never diversified its assets during the decedent’s life,
never had an investment plan, and never functioned as a business
enterprise or otherwise engaged in any meaningful economic activity.
Additionally, the FLP did not perform a management function for the
assets it received and never engaged in any businesslike transactions.”
The Tax Court concluded that
the record did not support any non-tax reasons for the FLP’s existence.
The court disregarded the formation of the FLP and the value of its
underlying assets (the WCB Class B member interest) was included in the
gross estate of the decedent under Sec. 2036(a). Also, any value
apportioned in the gift to his wife was brought back into the estate
using the three-year rule under Sec. 2035(a).
FLPs
continue to be legitimate planning devices as long as attention is paid
to recent rulings interpreting how the partnerships should be
structured and managed.
Philip R. Lieberman CPA/ABV, ASAis
a director of valuation services at Long Beach-based Windes &
McClaughry, A/C, and a member of the CalCPA Estate Planning Committee.
You can reach him at plieberman@windes.com. For more information on the Estate Planning Committee, visit www.calcpa.org/estate.
©2005 California Society of Certified Public Accountants. For reprint permission, contact Aldo Maragoni, communications manager.
