More On Tax Planningfrom The Advisor's Professional Library
- Selected Provisions of the American Taxpayer Relief Act of 2012 The experts of Tax Facts have produced this comprehensive analysis of selected provisions of the American Taxpayer Relief Act of 2012 (the Act) to provide the most up-to-date information to our subscribers. This supplement analyzes important changes to the tax code with emphasis on how these developments impact Tax Facts’ major areas of focus: Employee Benefits, Insurance, and Investments.
- IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.
When an estate is facing a liquidity crisis, why not tap the family limited partnership (FLP) for cash? After all, the decedent was a partner in the partnership and the partnership can make distributions to the estate, which is now a partner in the FLP.
No so fast. Although an FLP may look like a prime source of cash for paying an estate tax bill, the move can come back to bite the estate in a big way. Done the wrong way, it could jeopardize the valuation discounts and estate planning objectives your clients and their estate planning professionals worked so hard to secure.
The IRS is perpetually on the lookout for new weapons to use against FLPs, but Section 2036 of the Internal Revenue Code has been the IRS’ weapon of choice against FLPs over the past decade.
IRC Section 2036
Section 2036 includes in the gross estate the value of all property which the decedent has transferred away but over which he or she has retained: (1) the “possession or enjoyment of, or the right to income from, the property,” or (2) the right to say who can enjoy the property or its income. In other words, a person can’t give away title to property, but keep the right to use the property as owner and then expect the property to be excluded from his estate.
This loophole had to be closed because the general inclusion section, Section 2033, brings property into the gross estate only if the decedent had an interest in the property at the time of his death. If the decedent had given the property away, even though he or she retained powers over the property for life, the decedent would not have any interest in such property at death that would bring the property into the estate.
Section 2036 and the Estate Tax Bill
The problem for an estate that uses FLP funds to pay the estate tax bill is that payment of estate taxes has been construed by the IRS and the courts as evidence that the decedent had an implied agreement that he would transfer assets to the FLP, but that the FLP would pay the decedent’s estate taxes on his death.
It would be similar to a case where a person gifted her vacation home to her children and then, when finances got tight, sold her primary home and moved into the vacation home, living there until her death.
In that case, the IRS would likely argue that the “gift” to the children came with strings attached—an agreement to allow her to move into the home if necessary. In that case, the woman gave up title to the property, but kept many of the same rights she had before the gift. Those strings bring the vacation home back into her estate on her death, despite the gift.
In the same way, a court can use Section 2036 to unwind the creation of the FLP and include its assets in the decedent’s gross estate when FLP assets are used to pay the estate’s tax bill. Although the assets were transferred to the FLP, the IRS often claims that the assets were transferred with the implicit understanding that they would remain available to the transferor should he or she need them.
Avoiding the Section 2036 Trap
Where a person has already died and liquidity is an issue for his or her estate, there are few good options for avoiding the Section 2036 trap. A recent article in the American Bar Association’s Probate and Property magazine offers a number of helpful—although not foolproof—methods for avoiding Section 2036 when meeting an estate’s liquidity needs.
The best method for ensuring estate liquidity is planning for the estate’s liquidity needs before your client dies. Life insurance can be a great way to ensure there’s enough liquidity to pay estate taxes. But if proper planning wasn’t done and an estate is facing a liquidity crisis, the best option is to borrow funds from an unrelated person or even from one of the estate’s beneficiaries.
Other options include redemption of the partnership interests or sale of the partnership interest to a third party. If necessary, a distribution can be made from the FLP to the decedent’s estate, but it is essential that the distribution be made pro rata—to all the partners in proportion to their ownership interest in the partnership.
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See also The Law Professor's blog at AdvisorFYI.