Bad facts to avoid in FLP planning

By Jeffrey J. Radowich, Esq.,
and Sarah Barr Kahl, Esq., CPA

Several of the most recent cases attacking family limited partnerships (FLPs) on the basis of Section 2036(a) of the Internal Revenue Code – Bongard, Bigelow and Korby – provide further illustrations on what not to do in FLP planning.

This article, the second in a series of three to review recent developments in estate planning, will highlight a few of the key “bad facts” as found in the recent cases, thereby reminding planners what to avoid in the future.

Section 2036(a): The IRS’s favorite argument

The IRS has settled into a method of attacking FLPs when the valuation discount being sought is for federal estate tax purposes. The IRS’s method of choice is Section 2036(a) of the Internal Revenue Code. If a decedent transferred property to an FLP and there was an express or implied agreement that the decedent would retain enjoyment from the property, the property will be included in the decedent’s gross estate. Taxpayers avoid this rule if the transaction qualifies as a bona fide sale (the “bona fide sale exception”).

Mr. Bongard, Mrs. Bigelow and the Korbys crashed into Section 2036(a). You can escape the same hazard by being careful to avoid the following “bad facts.”

Don’t paralyze the FLP by controlling the sale of the underlying assets. Mr. Bongard was the CEO and sole board member of a closely held corporation. He transferred his stock to an LLC in exchange for membership units. He then transferred his non-voting interest in the LLC to a newly formed FLP. The first transfer to the LLC fell within the bona fide sale exception, but the second transfer to the FLP did not. The transfer to the FLP was thus open to the argument of an implied agreement that Mr. Bongard would retain enjoyment.

As the CEO and sole board member of the underlying corporation, Mr. Bongard could determine when the stock belonging to the LLC was sold. This control, even at a different level of ownership, implied an agreement that Mr. Bongard would retain enjoyment from the property. The estate argued that the general partner of the FLP had fiduciary duties that would trump any implied agreement, but Mr. Bongard’s FLP had too little activity to be taken seriously as a separate entity with separate fiduciary duties.

To avoid Mr. Bongard’s mistake without giving up leadership in the underlying company, allow other decision-makers to determine when stock may be redeemed. If the company actually redeems some of the stock owned by the FLP or any layers in between, all the better.

Giving away more limited partnership interests may also help. If a substantial amount of non-management equity is given away, there is a stronger argument that the general partner’s fiduciary obligation to other owners trumps the implied agreement. Strengthen the argument by stating in the partnership agreement that the general partner is a fiduciary and accountable to the owners with no indemnification or exculpation for breach of fiduciary obligations.
Don’t forget about your business purpose when operating the FLP. Mr. Bongard’s stated purposes in forming the FLP included creditor protection, diversification and the facilitation of gifts. In reality, the FLP never diversified its one investment and had no written investment plan. Mr. Bongard made only one gift with a limited partnership interest, and he was already insulated from creditors through the underlying LLC.

These facts left Mr. Bongard’s FLP out of the bona fide sale exception. To fall within the exception, the formation and transfer must have a non-tax purpose. The Bongard court requires this purpose to be legitimate and significant. The key in forming your client’s FLP is not simply finding a legitimate and significant purpose; rather, the FLP must be operated in line with the stated business purpose. The more activity the FLP has correlating to its business purpose, the more evidence that the FLP was created for legitimate and significant non-tax purposes.
Don’t transfer too many assets. Don’t try to replace the income you were getting. Don’t have the partnership pay personal expenses. Mrs. Bigelow transferred real property to an FLP, and after the transfer she did not have sufficient income to meet her living expenses or to satisfy payments for her line of credit secured by the property. Mrs. Bigelow received income payments from the partnership, which were used for her general support and to make loan payments. The court held that there was an implied agreement that Mrs. Bigelow would retain the enjoyment of the real property.

Mr. and Mrs. Korby were also financially dependent on distributions from the partnership. The court used this fact, among others, to conclude that the bona fide sale exception did not apply. Avoid these arguments by keeping enough assets to meet the transferor’s expenses, and actually use the retained assets to pay for those expenses.
Don’t make distributions only to the transferor or do anything contrary to partnership agreement. Treat the FLP like any other business. It would almost go without saying that the partnership agreement must be respected in reality to be respected by the courts. Mrs. Bigelow, however, did not follow the formalities of the partnership. She was the only partner to benefit from distributions during her lifetime. The Korbys, too, were the only partners to receive distributions from the partnership. This bad fact is evidence that there was an implied agreement of beneficial enjoyment and no bona fide sale.

Treat the partnership as the business that it is, and follow the terms of the agreement. Make distributions to other partners, and meet at times other than during the traditional holiday season. And document, document, document.

Footnotes

1. Estate of Bongard v. Comm’r, 124 T. C. 95 (2005); Estate of Bigelow v. Comm’r, T. C. Memo 2005-65 (March 30, 2005); Estate of Korby v. Comm’r, T. C. Memo 2005-102 and 2005-103 (May 10, 2005).

2. Section 2036(a) provides that the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death – (1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right either alone or in conjunction with any other person, to designate the persons who shall possess or enjoy the property or the income therefrom.

Jeff Radowich is a partner in Venable LLP, where he practices estate planning and business continuity planning as a member of the Tax and Wealth Management Group. He has been listed continuously on the list of "The Best Lawyers in America" since 1993.

Sarah Kahl is a CPA and an associate in the group. She graduated cum laude from Georgetown Law School, and Phi Beta Kappa and magna cum laude from Franklin and Marshall College.

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