More On Tax Planningfrom The Advisor's Professional Library
- ETF Taxation The use of ETFs may be attractive to certain investors. The tax advantages may make them even more attractive.
- Charitable Giving Charitable giving can reduce your clients’ tax liabilities. However, the general and verification rules for the deduction of charitable gifts must be understood in order to take full tax advantage of such gifts.
Forming a foolproof family limited partnership is as easy as calling the most prestigious law firm in town and handing over the reins to them, right? The Turner family found out the hard way that even the best firms are prone to pulling an FLP off the shelf and using it with little modification. That approach may work for a simple will, but a strong FLP must be custom-built from the ground up or you risk having the IRS or a court set it aside. [Estate of Turner v. Commissioner, T.C. Memo. 2011-209 (2011)]
Clyde Turner Sr. and his wife, Jewell, acquired 170,000 shares of regions bank stock throughout their marriage. Because of family associations with the bank and sentimental attachment, they rarely sold shares in the bank.
Despite the Turners’ significant wealth and advancing age, they did not have a solid estate plan or even investment plan. As a result, their son Marc stepped in and tried to help Clyde Sr. get his estate plan in order. As part of that plan, Clyde Sr.’s estate planning attorney drafted a family limited partnership to hold the Turners’ significant stock holdings (and cash). The FLP, Turner & Co., was formed as a Georgia limited liability partnership. Under the partnership agreement, Clyde Sr. and Jewell each owned a 0.5% general partnership interest and a 49.5% limited partnership interest.
About eight months after the FLP was formed, the Turners contributed assets with a total fair market value of $8,667,342 to the FLP. Transfers to the FLP were completed by December 2002.
Most of the value contributed to the partnership was made up of cash and marketable bank stocks, including shares of Regions Bank stock, shares of NBOG Bancorp stock, shares of Friends Bank, shares of Southern Heritage Bancorp stock, 21 CDs at Habersham Bank, and other assorted bank accounts and securities accounts.
The Turners received partnership interests in exchange for the contributions that were proportionate to the fair market value of the contributed assets (which the IRS stipulated to). The assets were properly titled to Turner & Co.
The Partnership Agreement
The partnership agreement, provided that the three general purposes of Turner & Co. were to “(1) To make a profit, (2) to increase the family's wealth, and (3) to provide a means whereby family members can become more knowledgeable about the management and preservation of the family's assets.” Nine specific purposes were also listed.
Because the partnership agreement was modeled on a standard used by the law firm, it included some provisions that did not apply to the Turner’s particular situation. Regardless, the partnership agreement still required that, "The General Partner shall effectuate the purposes of the Partnership and operated in accordance with the purposes of the Partnership and in accordance with the fiduciary duties, and the rights and powers granted it in this Agreement."
In April 2002, Clyde Sr. and Jewell entered into a management fee agreement for the FLP. The Turners allocated $500 per month each to their sons, Mark and Travis, in exchange for daily management services. Payments were made to Mark and Travis, between 2002 and 2004.
Between 2002 and 2004, the FLP sold and bought a small amount of stock and also made two real estate purchases. As part of one of those purchases, the FLP incurred indebtedness to a bank. Shortly thereafter, Clyde Sr. paid the FLP's outstanding debt. With respect to the other property, the FLP was unable to get a loan, so Clyde Sr. wrote a personal check at closing for $363,188.
On Dec. 31, 2002 and Jan. 1, 2003 the Turners gave limited partnership interest in the FLP to their three children and two of Joyce's children. The total fair market value of the partnership interest transferred on Dec. 31, 2002 was $1,652,315 and the value of the partnership interest transferred on Jan. 1, 2003 was $474,315.
Clyde Sr. died on Feb. 4, 2004 and his estate filed a gift tax return on Oct. 13, 2004.
The IRS challenged the estate’s characterization of the FLP assets as being outside the estate. The estate challenged the IRS’ determination in the Tax Court.
The Tax Court’s Decision
A decedent's gross estate includes the value of any interest in property held by the decedent at the time of his or her death. Specifically, Section 2036(a) includes the value of property in a decedent’s gross estate where the decedent had transferred property to another, but retained a life estate in the property. But property will not be included in the gross estate under that section if the property was transferred in a bona fide sale for adequate and full consideration.
A transfer to an FLP may be challenged under Section 2036(a) if the IRS believes that the taxpayer (or decedent) made the transfer but continued to use the property as they had prior to the transfer. When transfers are made to a family limited partnership, the general rule is that the taxpayer must establish a “legitimate and significant nontax reason” for the transfer. The motivation must be "actual motivation, not a theoretical justification."
The court casually dismissed the three general and nine specific purposes for creating the Turner FLP, saying that they were "taken from a form partnership agreement" and did not necessarily reflect the couple’s actual reasons for transferring the assets to the FLP.
Clyde Sr.'s estate countered that the FLP was formed for three legitimate and significant nontax reasons: “(1) to consolidate their assets for management purposes and allow someone other than themselves or their children to maintain and manage the family’s assets for future growth pursuant to more active and formal investment management strategy; (2) to facilitate resolution of family disputes through equal sharing of information; and (3) to protect the family assets and Jewell from Rory” (a drug-addicted grandchild).
Consolidated Asset Management
The court acknowledged that the first reason, consolidated asset management, can be a legitimate nontax purpose for forming an FLP, but said that consolidated asset management is not a significant nontax purpose where an FLP is “a mere asset container.”
In most cases holding that consolidated asset management was a legitimate nontax reason for funding the FLP, the assets held by the FLP required active management. Also, where the FLP owns stock in a closely held corporation, consolidated asset management often is a legitimate justification. For instance, an FLP may legitimately be formed to ensure that family members cannot transfer stock to an outsider or to keep the stock together in a voting block.
Here, the Turners’ FLP held passive investments, including publicly traded bank stocks. Clyde Sr. did not have a personal investing philosophy that he hoped to perpetuate. And the court found that the Tuner’s portfolio didn’t “change in a meaningful way” after creation of the FLP and that giving management authority over the FLP to their sons didn’t have a “material impact on the profit potential of the portfolio.” As a result, the court dismissed consolidated asset management.
Resolution of Family Discord
Similarly, the court dismissed the family’s second claimed reason for funding the FLP. Although resolution of family discord can be a legitimate nontax reason for forming an FLP, the court found that the Turner children didn’t fight over their parent’s assets and never expressed any interest in managing the assets. In fact, creation of the FLP created some discord between the siblings rather than resolving it.
Protection of the Assets from the Drug-Addicted Grandchild
Although asset protection can be a legitimate reason for forming an FLP, the court dismissed that reasoning here because, in its view, Jewell had shown that she was capable of protecting herself from her son; there was no evidence that any gifts she gave her son were other than voluntary. Also, the court found that a trust that had been created for Rory adequately protected him from himself and that the FLP didn’t add any additional protection.
Factors Showing that the Transfers Were Not Bona Fide Sales
The court felt that there were several other factors indicating that the transfers to Turner & Co. were not bona fide sales. First, Clyde Sr. was on both sides of the transaction, and there was no meaningful bargain struck between him and his wife or any of the children and grandchildren who were to become partners in the FLP. Also, Clyde Sr. "co-mingled personal and partnership funds" to make personal gifts, to make life insurance premium payments, and to pay estate planning legal fees.
Because the court found that the transfer to the FLP was not a bona fide sale, it held that the bona fide sale exception did not apply. The court then considered whether Clyde Sr. retained enjoyment of the property that had been transferred to the FLP. According to the court, "a transferor retains the enjoyment of property if there is an express or implied agreement at the time of the transfer that the transferor will retain the present economic benefits of the property."
The court viewed the $2,000 management fee paid to Mr. and Mrs. Turner as unreasonable because they did nothing to manage the partnership. According to the court, that fact showed that the FLP was not a business conducted for profit. They viewed it as more akin to an investment account. Also, the court believes that the FLP was testamentary in nature. As a result, the court held that Clyde Sr. retained a life interest in the transferred property. Because Clyde Sr. had retained an interest in the FLP’s assets during his lifetime, the value of the property was included in his gross estate.
This was not a case where the family and its attorneys could not have formed a bulletproof FLP under any circumstances. There is a very good change that, with proper counsel, the family could have funded its FLP in such a way that the Tax Court, and maybe even the IRS, would have respected the entity.
The focus of the court’s analysis seemed to be on the “off-the-shelf” nature of the FLP. They apparently believed that if the FLP were intended for a business or other nontax purpose, more care would have been put into drafting it. Although the Turners provided a laundry list of nontax reasons for forming and funding the FLP, the structure of the partnership and the Clyde Sr.’s relationship with the FLP did not bear out those purposes.
For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s partner, AdvisorFX, for a free trial.
See also The Law Professor's blog at AdvisorFYI.