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.