Recent Cases on Section 2036 for Family Limited Partnerships and Limited Liability CompaniesLangdon Owen
June 23, 2005 — 1,631 views
IRC § 2036 is not itself a valuation provision. It is a gross estate inclusion provision. However, it is center stage with respect to the conflict over valuation discounts. Under this section, the gross estate of the giver may include the value of property given away if too much enjoyment or control is retained with respect to the property given. The section is triggered where a decedent has retained possession, enjoyment, or right to income, or has retained control over who enjoys the income from the property. The section does not apply to “bona fide sales for an adequate and full consideration in money or money’s worth,” however, a string of cases has held that this exception generally does not apply to the creation of a family LLC or limited partnership. See Harper v. Com’r, T.C. Memo 2002-121; but compare with Stone v. Com’r, T.C. Memo 2003-309.
The recent Fifth Circuit case of Kimbell v. U.S., 371 F3d 257 93 (5th Cir., 2004), may reverse this trend. In that case, the Circuit Court, in reversing the District Court, held that the bona fide sale exception applied to the transfer of assets in exchange for a partnership interest where the interest credited to each partner was proportionate to the fair market value of the assets contributed for it, capital accounts were properly credited, and on dissolution, the partners would be entitled to distributions determined by their capital accounts. In addition, the Court found that sufficient assets were retained outside the partnership to support the decedent, formalities were satisfied on the transfers, the partnership included working interests in oil and gas which required management, and there were nontax business reasons for the use of the partnership.
Although the reasoning of the case is not rock solid, the Stone v. Com’r case cited above also gives some hope that Section 2036(a)(1) can be avoided under the bona fide sale exception where the older generation negotiates the agreement with the younger generation, which puts in some substantial assets itself and exercises management control; there is no gift on the creation of the company because interests are received pro rata to the value of property contributed; and there is a substantial business purpose for the arrangement. In such a case, the applicability of valuation discounts alone should not destroy the bona fide sale exception to Section 2036.
However, the Third Circuit case of Turner v. Com’r, 382 F.3d 367 (3d Cir 2004) upheld the Tax Court in finding that the bona fide sale exception would not apply where there was not an actual business enterprise or business motive. In addition the Court found that sufficient assets to support the decedent were not retained outside the partnerships at issue and that there was an implied agreement to use the assets for decedent’s benefit.
Recent Tax Court cases have narrowly treated the bona-fide sale exclusion from Section 2036 and have not applied the exception where it found no substantial nontax purpose to the contributions to the family company. See Estate of Bongard v. Com’r, 124 T.C. No. 8 (2005); Estate of Korby v. Com’r, T.C. Memo 2005-102. Both of these cases emphasized four factors: (1) the taxpayer standing on both sides of the transaction, (2) the taxpayer’s dependence on distributions from the partnership, (3) the partners’ commingling of partnership funds with their own, and (4) the taxpayer’s failure to actually transfer the property to the partnership. The court in Korby found that creditor protection derived from the partnership was not sufficient to be a significant nontax reason for forming the partnership. Facilitating gift giving has also been found to be an inadequate nontax reason. See also Estate of Bigelow v. Com’r, T.C. Memo. 2005-65. However, maintaining a buy and hold investment philosophy on the stocks of two companies was held to be sufficient business purpose in Schutt v. Comr, T.C. Memo 2005-126.
If an asset is placed in a company, its value typically goes down because it is subject to the rules, restrictions, and similar matters to which a company interest is subject. If the company’s foundational organization documents provide excessive control, beyond the usual business controls typical of similar interests, the company may be a mechanism to institute a disguised retention of enjoyment or control under IRC § 2036 bringing into the gross estate the entire, nondiscounted value of the underlying assets contributed to the company. Generally, validly-created business organizations are not disregarded (see Strangi v. Commissioner, 115 T.C. 478 (2000)) but if excessive controls over the assets are retained, the result will be different. The areas of greatest risk are generally:
- The company is not respected as a truly separate entity, for example, by reason of commingling funds, delay in transferring assets, or making disproportionate distributions to the decedent. These kinds of things can cause trouble even where actual control over the organization resides elsewhere. See Harper v. Com’r, T.C. Memo 2002-121 (children were the only general partners, but these other factors sufficient to cause inclusion under IRC § 2036, even though decedent had only a limited, not a general, interest).
- There is an agreement or understanding, even an implied one, allowing the decedent to continue to enjoy the property, for example, where the decedent gives away most of his or her property and has insufficient funds for living expenses absent disproportionate distributions from the company. See Estate of Thompson, T.C. Memo 2002-246, aff’d by Turner v. Com’r, 382 F.3d 367 (3d Cir 2004). See also Strangi v. Com’r (known as Strangi II), T.C. Memo 2003-145. Abraham v. Com’r, 95AFTR 2d § 2005-1018, 2005 WL 1230774 (1st Cir. 5/25/2005) (implied agreement to use income from transferred property for incapacitated person).
- There is excessive power retained, for example, if a 99% limited partner retains the power to remove the general partner. See Kimbell v. U.S., 244 F. Supp 2d 700 (N.D.Texas 2003) rev’d on other grounds by Kimbell v. U.S., 371 F.3d 257 (5th Cir. 2004).
- There is no third party with an interest in enforcing fiduciary duties which may affect distributions or their timing. The Strangi II case (cited above) raises the possibility of inclusion under IRC § 2036(a)(2), as well as under (a)(1). Under IRC § 2036(a)(2), property is includable if the decedent retains “the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.” This includes the power to control the timing of distributions. (See U.S. v. O’Malley, 383 US 627, 631 (1966).) In the case of Byrum (U.S. v. Byrum, 408 US 125 (1972)) the power to designate was limited by corporate fiduciary duties in the case of an operating business subject to practical business realities and concerns. Strangi II distinguished Byrum and found that in Strangi II there was no operating business and no substantial third-party minority interest to enforce any fiduciary duties.
Some things to take into account in planning to avoid problems under IRC § 2036(a)(1) or (a)(2) include:
- Have, and document, one or more nontax business purposes
- Operate in a business-like way as a joint enterprise for profit
- Maintain good records and accounts
- Convey property to the company as soon as it is created
- Use company assets only for company purposes
- Pay all accrued expenses timely, particularly if to related persons
- Do not commingle company and personal funds or assets
- Do not have numerous transactions between founder and the company
- Do not allow founder to make disproportionate distributions
- Maintain and properly adjust capital accounts
- Continue operations beyond death of the founder
- Do not transfer assets that are subject to liability without also having the company assume the liability (note: there will be income tax issues)
- Do not relieve general partner or managing members of fiduciary duties to other partners or members
- Do not allow person holding power of attorney from founder to be the manager or general partner of the company
- Have a nonfamily member or partner contribute to company and hold a substantial interest
- Have family members contribute to company and hold substantial interests
- Negotiate terms of company with family members who will become partners or members
- Restrict founder’s vote on distributions or liquidations
- Consider having voting and management powers held by a noncontributing spouse or other third person
- Provide for some change in the management of the assets after transfer to the company
Langdon T. Owen, Jr. is a member of the law firm of Parsons Kinghorn Harris, p.c. in Salt Lake City, Utah. Mr. Owen is a transactional lawyer who practices in the areas of estate and tax planning, business and commercial transactions involving both corporate and partnership taxed enterprises (including tax, employment, and benefit issues relating to such transactions), loans and creditors' workouts, pension and profit sharing plans, health care law, probate, and real estate.