The attorney for Roy and Joanne Stone was Looney ??" Joe Looney. Joe referred his clients, the eldest members of a prominent Tennessee publishing family, to attorney Harry Sabine for estate planning services. Harry in turn advised the Stones to create a family limited partnership to hold a chunk of the Tennessee countryside that the couple desired remain in Stone family hands for the indefinite future.
Family limited partnerships are quite commonly encountered in tax preparation practices and are thoroughly studied in CPA review courses. Also commonplace are IRS challenges of the use of family limited partnerships as a device for removing valuable property from a decedent’s estate solely for the purpose of reducing the estate tax, and it is commonplace for the IRS to prevail. Unless there are significant non-tax reasons for the use of this device, the Tax Court will generally agree with the IRS that the family limited partnership is nothing more than a method to evade tax. The Stone’s case,
however, turned out to be rock solid.
Roy and Joanne set up the Stone Family Limited Partnership of Cumberland County (“SFLP”) on December 29, 1997, each taking a 1% general partnership interest and a 99% limited partnership interest. As general partners Roy and Joanne held considerable powers, including the rights to: determine whether properties would be sold; manage the day-to-day business of SFLP; and determine the amounts of any distributions.
Two days after SFLP was formed, the Stones each gave portions of their limited partner interests to their 21 children, children's spouses, and grandchildren. Similar gifts were made in 1998 and 1999, and 2000. All the gifts were structured to qualify for the annual exemption from the gift tax that accountants are taught in CPA exam preparation courses. As a result of these gifts, Roy and Joanne were left only with a 1% general partnership each and their children, children's spouses, and grandchildren owned the remaining 98% limited partnership interests.
In some respects, the Stones failed to adhere to partnership formalities. When two of their children divorced, the spouses quitclaimed their interests in the parcels themselves to their former spouses but did not transfer actual SFLP interests. Roy and Joanne used “bills of sale” to document the gifts of SFLP interests rather than gift letters. Also, they paid SFLP property taxes out of their personal funds.
In 2005, while preparing for the Sunday school class she had taught for 60 years, Joanne died. The IRS determined that the Sunday school’s loss was the U.S. Treasury’s gain, and they asserted a deficiency of almost a quarter of a million dollars against the estate, claiming that SFLP was a sham because there were no sufficient non-tax motives for the arrangement.
Background
Internal Revenue Code (“Code”) §2036(a) generally provides that if a decedent makes a lifetime transfer of property other than a bona fide sale for adequate and full consideration and retains certain enumerated rights or interests in the property which are not relinquished until death, the full value of the transferred property will be included in the decedent's gross estate. Retained control is a key ingredient of this subject in CPA exam material.
In the context of family limited partnerships, the bona fide sale for adequate and full consideration exception is met where the record establishes the existence of a legitimate and significant non-tax reason for creating the family limited partnership and the transferors received partnership interests proportional to the value of the property transferred. It is crucial that objective evidence indicate that the non-tax reason was a significant factor that motivated the partnership's creation.
Furthermore, a significant purpose must be an actual motivation, not just a theoretical justification. Among the factors to be considered are: the parties to the transaction; the taxpayer's financial dependence on distributions from the partnership; the partners’ commingling of partnership funds with their own funds; the taxpayer’s actual transfer of the property to the partnership; the discounted value of the partnership interests relative to the value of the property contributed; and the taxpayer’s age and health at the time the partnership was formed.
The Stones’ situation is typical of a sample question from CPA exam prep on the subject of family limited partnerships. They claimed that the non-tax purposes of SFLP were to create a family asset from a disparate group of real estate parcels and to protect those parcels from partition into smaller pieces. The IRS, however, didn’t buy it ??" they asserted that the only reason was to facilitate gifts of the parcels in an effort to reduce estate taxes.
The Tax Court has previously held that a desire to have assets jointly managed by family members, even standing alone, is a sufficient non-tax motive for forming a family limited partnership. Of course the Stones were mindful of the favorable estate tax consequences ??" after all, it was an estate planning attorney that helped them set up SFLP. The Tax Court understands that legitimate non-tax purposes are often inextricably interwoven with testamentary objectives, however, so this dual motive is not fatal.
The IRS also attacked the creation of the partnership more generally, pointing out that the Stones were both the transferors of the parcels to SFLP and the general managers of SFLP, having complete managerial discretion. As such, they stood on both sides of the transaction and there was no arm’s-length bargaining. Thus, argued the IRS, the “bona fide transfer” exception did not apply. The Tax Court, however, has stated that an arm’s-length transaction is deemed to occur when mutual legitimate and significant non-tax reasons exist for the transaction. Having concluded that such reasons existed in the Stones case, the court summarily dismissed the IRS argument in this regard.
The strongest IRS argument involved the Stones’ lack of respect for partnership formalities. In other cases, failure to treat the partnership as such has been the foil that caused the court to side with the IRS. In this case, however, the court found that there were sufficient countervailing facts to overcome these indiscretions. For example, the Stones did not depend on distributions from SFLP. In fact, no distributions were ever made. Also, they actually did transfer the woodland parcels to SFLP. While it was true that they paid the property taxes from personal funds, there could not be said to have been any commingling of partnership funds because there were no SFLP funds. Overall, the SFLP tax return was as uncomplicated as any scenario in CPA exam study about partnerships.
Another common downfall of these arrangements is aggressive discounting in determining the value of the gifts. The Stones applied no discounting of SFLP interests for gift tax purposes. They used the appraised value of the land without adjustment to determine the value of the gifts.
Finally, the Stones were not exactly on their deathbeds at the time of the transfer. Joanne was still teaching Sunday school up to and including the last Sunday before she passed away. Roy, although over age 80 at the time of transfer, was still alive at the time of trial in June 2011. Given all of these facts in the Stones’ favor, their relatively minor administrative snafus were deemed to be inconsequential.
Question:
In the context of a family limited partnership, the bona fide sale exception to inclusion of the transferred property in the decedent’s taxable estate under Code §2036(a) may be overcome by demonstrating what?
a. The same parties were on both sides of the transaction
b. There was a testamentary reason for the transfer
c. There was a significant non-tax reason for the transfer
d. Significant discounts were applied to value subsequent gifts
Answer: c IRS Circular 230 Disclosure Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.
Source: http://fastforwardacademy.blogspot.com/2012/10/family-limited-partnerships.html
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