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Lessons from Turner to Protect Against IRS Challenge to FLP By Richard P. Breed, III, Esq, and Jennifer A. Civitella Hilario, Esq.

Friday, June 29, 2012 - By: Richard P. Breed, III
A version of this article appears in the July 2012 issue of Estate Planning, Volume 39, Number 7 © 2012, Thomson Reuters.

Section 2036 – IRS’s Silver Bullet to the FLP?

Lessons Learned from Turner v. Commissioner, T.C. Memo 2011-209

By Richard P. Breed,III, Esq, and Jennifer A. Civitella Hilario, Esq.

 

Introduction:   Within an estate planner’s bag of tricks, lays the much beloved, yet much feared, family limited partnership (or more recently, the limited liability company).  On its face, FLP planning can provide our clients significant transfer tax savings as wealth is transferred to the next generation, while allowing our clients to retain somecontrol over gifted assets.  However, these tax savings may be illusory if an FLP is implemented for the “wrong”client.  To avoid the looming trap of Section 2036, an important measure of a client’s eligibility for FLP planning is whether sufficient “non tax reasons” exist for the FLP.  The estate planning attorney needs to understand the boundaries (based on both case law and the IRS’s positions in such cases) Section 2036 places on FLP planning.  The practitioner must evaluate each client’s specific circumstances against Section 2036’s limits and grade the client’s candidacy for the FLP.  For the appropriate client, the transfer tax savings may be realized with FLP planning.  However, the definition of the appropriate client is evolving, as recently redefined by Turner[1].

            Turner provides us three “reality checks” as we embark on FLP planning with our clients.  First, Section 2036 is alive and well within the Tax Court and the arsenal of the IRS.  Second, our clients are human and they will bring down the FLP.  Third, if our clients do not sabotage the FLP, the attorney may.  The following article will provide a case study of a common FLP strategy and will test it against the Turner ruling.  Whether or not the Tax Court memorandum decision will be upheld upon appeal, Turner provides us valuable insight into the IRS’s and the Tax Court's perceived limitations on the FLP strategy.  The objective of this article is to provide practitioners guidance with their FLP strategies, love them or hate them, in light of the Turner decision.

Case Study:     Your Clients.  You meet with Mr. and Mrs. Client in early September, 2011.  You’ve worked with them on some basic estate planning; they are now ready “for the good stuff.”  Having sold a business in 2008, Mr. and Mrs. Client are retired and are enjoying a comfortable lifestyle with a net worth comprised of the following:

Asset

Value

Primary Residence

$3,000,000

Vacation Residence

$2,000,000

Marketable Securities

$10,000,000

Retirement Accounts

$2,000,000

Real Estate Investments (owned with business partner in separate LLCs)

$5,000,000

Private Equity Investments

$5,000,000

Cash and Cash Equivalents

$3,000,000

TOTAL:

$30,000,000

Mr. and Mrs. Client are in their early 60s and in good health. They have two adult children, both happily married.  Daughter, a serial entrepreneur, has not yet hit her first homerun and sometimes struggles to support herself and her family, which includes three young children.  Mr. and Mrs. Client provide her assistance through annual gifting.  Son, an IP attorney, has no children and lives on the West Coast to allow his wife to beclose to her family.  Mr. and Mrs. Client do not directly make gifts to Son, but he, along with Daughter, are the sole beneficiaries of an Irrevocable Trust established for the benefit of each child (and their respective children).  Each share of the Irrevocable Trust is worth approximately $1,000,000, funded with marketable securities, in addition to the Trust’s ownership of a $5,000,000 face value survivor life insurance policy on Mr. and Mrs. Client’s lives.  Neither child is particularly involved with Mr. and Mrs. Client’s financial affairs, although they are aware of their parents’ wealth. 

            Your Recommendation.  During the meeting, Mr. and Mrs. Client expressed their goals in the following priority: (i) protect Daughter from herself, but help her succeed; (ii) minimize transfer taxes as property is passed from generation to generation; (iii) hold assets in a protective manner so they are immune, to the fullest extent possible, from creditors (including a divorcing spouse); and (iv) involve Son in the planning to encourage him and his wife to spend more time with Mr. and Mrs. Client.  After having reviewed a number of differentstrategies, Mr. and Mrs. Client liked the FLP planning best.  Your demonstration that the FLP planning may save them approximately $5 million in transfer taxes was an obvious motivating factor.  Your recommendation included the following:

·    Form a multi-member limited liability company (“LLC”) of which Mr. and Mrs. Client would be the initial members, each having a 50% membership interest.  Mr. Client would be the sole manger of the LLC and Mrs. Client would be named as the successor manager.  Mr. Client is considering whether to name Son as a co-manager or not.  While the manager will have authority to handle the daily management of the LLC, including investment of LLC assets, all other decisions, including distributions to members and termination of the entity, require the consent of those persons holding 75% of the membership interests in the LLC. 

·    Following formation, assets comprising $10 million in marketable securities, $5 million in real estate investments and $5 million in private equity investments would be contributed to the LLC. 

·    Following the LLC’s funding, Mr. and Mrs. Client will retain a net worth of $10 million, 50% comprised of residential real estate and the balance comprised of their retirement accounts (upon which they do not currently draw) and cash.  Their income will be substantially less than before, but they believe it will be enough to support themselves. 

·    Early January 2012, four months after the assets were contributed to the LLC, Mr. and Mrs. Client each make an outright gift of 10% of the membership interests in the LLC to each child, and 25% of the membership interests to each child’s share of the Irrevocable Trust, resulting in Mr. and Mrs. Client each retaining a 15% membership interest in the LLC.  Prior to the assignment of the membership interests, Son accepted his appointment as co-manager of the LLC, albeit with some hesitation.

·  A qualified appraisal of the membership interests gifted, reflecting a 33% valuation discount for lack of marketability and lack of control, was obtained and a timely gift tax return will be filed in 2013. 

During your annual review meeting following the formation of the LLC, Mr. and Mrs.Client advise you that the following has occurred:

·    The managers had quarterly meetings to reviewand modify investments; however, Mr. Client handled most of the affairs andinvestment decisions of the LLC. 

·   With the assistance of Mr. and Mrs. Client’s financial advisor, bi-annual reports were provided to the members of the LLC regarding the performance of the entity’s investments.

·   Annual filings with the Secretary of State were made.  The LLC’s records were maintained, including an annual meeting of the managers and the members in December. 

·    From LLC profits, a distribution of $200,000 was made, distributed pro rata among the partners. 

·   By month-six, the following investments occurred: (i) $4 million of the marketable securities were liquidated; (ii) $2 million was contributed to a new real estate investment opportunity that was recently presented to Mr. Client and his business partner; and (iii) $2 million was contributed into Daughter’s most recent start-up in exchange for a minority interest in the entity. 

As memorialized in the partnership agreement and in your written correspondences to the client concerning the planning, the following are intended purposes for the LLC: (i) make a profit to increase the family’s wealth; (ii) establish a means through which family members will gain knowledge and become involved in the management of the family’s wealth; (iii) consolidate family assets to qualify as an “accredited investor” to gain access to riskier funds and other alternative investment opportunities; (iv) provide protection of family wealth from persons outside the family acquiring rights or interests in such assets; and (v) invest in entrepreneurial ventures of family members.  Although you made a note to the file that as of the one-year anniversary, the entity formalities are being followed, including no payment of personal expenses with partnership assets, you did not inquire into whether the stated purposes of the LLC are being fulfilled.  Nonetheless, you check this off as a successful plan and send the file off to storage.  

Turner:  The cases in which the taxpayer was successful tend to grab our attention and are added to our FLP research file.  We learned from the Miller decision that the transferor’s objective to perpetuate his investment strategy, which involved a long practice of charting stocks, was a legitimate non-tax reason for forming his FLP.[2]  From the Mirowski decision, we also learned the importance of the transferor retaining enough personal assets to maintain her living expenses.[3]  On the other hand, a taxpayer loss quickly becomes a caricature of the wrong client, just another “bad facts” case, and an example of “things I’d never let my clients do.”  From some of these cases we learned the following: (i) transferring a personal residence to a partnership and continuing to reside there for less than fair market rent will trigger Section 2036[4]; (ii) transferring certain assets into an existing partnership contemporaneous with a gift of partnership interest is evidence of an indirect gift of the transferred assets[5]; and (iii) formation of partnership and transfer of assets by the attorney-in-fact, because the transferor is incapacitated, is evidence that the transaction was not a bona fide sale.[6]  Disregarding the latter category of cases is a mistake, as evidenced by the valuable information the Tax Court provided us in its memorandum decision in Turner. [7]

Facts of the Case:  With the advice of their estate planning attorney, Mr. and Mrs. Turner formed a Georgia limited partnership, Turner & Co., initially holding for themselves a 1% general partner interest and a 99% limited partner interest.[8]  Over the several months following the formation of the partnership, Mr. and Mrs. Turner transferred approximately 80%of their wealth to Turner & Co., retaining more than $2 million to support themselves.[9]  Assets transferred to the partnership were mostly comprised of securities, cash and cash equivalents; 60% of the assets transferred consisted of stock in Regions Bank, the successor to a bank in which both of their families had held stock for two generations.[10]  Nonetheless, Mr. and Mrs. Turner’s ownership in Regions Bank was less than 1% of its outstanding stock.[11]  Commencing December 31st of that same year, Mr. and Mrs. Turner began to gift limited partnership interests in the FLP to their children, grandchildren and an irrevocable trust for the benefit of a grandson.[12]  They retained for themselves a combined 55.6%limited partner interest and 1% general partner interest in Turner & Co.[13]  Although in good health when Turner & Co.was formed, Mr. Turner became ill and died within the next two years.[14]  The IRS took the position that assets transferred by Mr. Turner to the FLP were included in his taxable estate under Sections 2035, 2036 and 2038, and assessed an estate tax deficiency.[15]

Decision:  The Tax Court’s memorandum decision to include one-half of the assets of Turner & Co. in Mr. Turner’s gross estate was premised on Section 2036.[16]  The Court did not opine on whether the FLP’s assets would also be included under Section 2035 and Section 2038.[17]  Finding that Mr. Turner’s FLP transaction did not meet the requirements of the “bona fide sale for adequate and full consideration” exception to Section 2036 (commonly referred to as the “bona fide sale exception” and for the purposes of this article, the “BOFIS Exception”), the Tax Court held that the assets were included in Mr. Turner’s gross estate under both Section 2036(a)(1) and Section 2036(a)(2).[18]  This result is consistent with other decisions of the Tax Court when it has found that the bona fide sale exception to Section 2036 did not apply.[19]  In the context of a family limited partnership, there is greater scrutiny to determine if the transaction is of the same terms and conditions as a similar transaction between unrelated parties and therefore, truly “arm’s length.”[20]

Bona Fide Sale Exception to Section 2036:   Absent the BOFIS Exception to Section 2036 applying, your client is exposed to estate tax inclusion if she retained an interest described in “(a)(1)”(enjoyment in or right to income from transferred property) or “(a)(2)” (right to designate beneficial enjoyment of the transferred property or its income), which will be a risk if your client retains a general partner interest in the FLP or serves as manager of the LLC.[21]  Under Turner,to fit within the BOFIS Exception, the FLP must pass a two-part test: (i) the facts and circumstances of the FLP transaction must present, as actualmotivation for the planning, a “legitimate and significant nontax reason” to create the FLP; and (ii) the transferor received a partnership interest proportionate to the property transferred to the FLP.[22]  Mr. Turner’s FLP passed the second prong of the test, but flunked the first.[23]  The Court concluded that there was no factual basis for the purported nontax reasons for the FLP, summarized as follows:

Nontax Motives

Purported by Mr. Turner’s Estate

Factual Determination of Tax Court

Consolidation of assets

·  Mr. Turner’s concern for “scattered nature of assets” could have been addressed without FLP[24]

·  Assets, mostly comprising securities and cash or cash equivalents, did not require active management or special protection[25]

Management of assets

·  Assets and investments that existed prior to FLP remained the same after contribution to FLP[26], including minimal trading of securities and no sales of Regions Bank stock[27]

· Mr. Turner did not have a distinctive investment philosophy and no special investment strategy was implemented[28]

More efficient management of assets

·  Grandson who assisted with management of assets prior to FLP continued after contribution to FLP; therefore, FLP provided no greater efficiency than before[29]

Resolve family disputes

· No litigation or threat of litigation among family members which may jeopardize assets transferred to FLP[30]

·  No evidence assets were transferred to FLP to resolve conflict among children and grandchildren [31]

Protect family assets

·  No evidence the Turner’s assets were at risk because of troubled grandson[32]

·  No evidence that assets held for the benefit of troubled grandson were provided any greater asset protection as a result of FLP because they were already held in an irrevocable trust

In addition to finding the Turner estate’s purported nontax business reasons unsubstantiated, the Tax Court also found several additional factors which evidenced there was not a bona fide sale:

Nontax Motives

Additional Factors Indicating
Transfer Not Bona-Fide
Sale


Factual Determination of Tax Court

Transferor on both sides of transaction

· There was no negotiation or meaningful bargaining with other parties involved in the transaction[33]

Comingled personal assets and partnership funds

·  Mr. Turner used partnership assets to make gifts and pay life insurance premiums and attorney fees for personal estate planning[34]

Time between formation and funding

· Transfers occurred over eight month period[35]

Evidence of tax reasons

·  Attorney’s letter discussing FLP planning referenced the need to have an appraisal for gift tax purposes[36]

Section2036(a)(1):  Having concluded that Mr. Turner’s FLP did not fulfill the requirements of the BOFIS Exception, the Tax Court next evaluated whether Mr. Turner retained the powers described in Sections2036(a)(1) and 2036(a)(2).  The Tax Court considered the facts and circumstances concerning Turner & Co. and whether there was an express or implied agreement that Mr. Turner would retain the present economic benefit of the property transferred to the FLP.[37]  The Tax Court concluded that Mr. Turner’s enjoyment of the assets transferred to the FLP did not change and therefore Section 2036(a)(1) did apply.[38]  In its determination, the Tax Court considered the following factors:

Section 2036(a)(1)

Factors that Evidence an
Express or Implied Agreement for
Transferor to Enjoy Property



Factual Determination of Tax Court

Transfer of most of transferor’s assets

·  Mr. Turner transferred approximately 86% of his wealth; however, the court did not expressly opine on whether this was a factor evidencing an agreement[39]

Continued use of transferred property

· Although Mr. Turner and his wife had sufficient assets to support themselves, they still drew a monthly fee from the FLP for management services, although there is no evidence such services were ever performed[40]

Comingling of personal and partnership assets

· In connection with certain real estate investments that were made prior to his death, Mr. Turner made investments and paid off debts of the FLP on its behalf[41]

Disproportionate distributions to transferor

·  During his lifetime, Mr. Turner and his wife were the only partners to receive distributions from the FLP, although 43.4% interest in the partnership was held by other limited partners[42]

Use of entity funds for personal expenses

·  Mr. Turner used entity funds, at will, to make gifts to his grandsons, to pay life insurance premiums and to pay attorneys fees for personal estate planning matters[43]

Purpose was primarily testamentary

· Circumstances surrounding FLP planning were testamentary in nature, pursuant to estate planning primarily focused on testamentary planning and minimizing estate taxes[44]

            Section 2036(a)(2):  The Tax Court also held that Section 2036(a)(2) applied because Mr. Turner retained the right (in conjunction with his wife) to designate who may possess or enjoy the property transferred to the FLP.[45]  Fatal facts under Section 2036(a)(2) included: (i) as general partner, Mr. Turner had the authority to amend the partnership agreement without the consent of the limited partners; (ii) as general partner, Mr. Turner had the sole and absolute discretion to make distributions of partnership income and distributions in kind; and, (iii) owning, along with his wife, a combined 55.6% limited partnership interest, Mr. Turner could make any decision concerning the FLP that required the consent of a majority of the limited partners.[46]

Client Contributions to Inclusion under Section 2036:  There were a number of actions by Mr. Turner that undermined the FLP’s qualification for the BOFIS Exception and contributed to inclusion under Sections 2036(a)(1) and 2036(a)(2).  First, Mr. Turner weakened his purported nontax reason to provide for the consolidation and management of transferred assets when he failed to make any significant changes to the investment strategy of the assets contributed to Turner & Co., and only engaged in minimal trades of securities during the two-year period between the entity’s formation and his death.[47]  There was no purposeful or active management of the assets, which supported the argument that the FLP was a “mere container.”[48]  Second, of the additional factors the Court found indicating that there was not a bona fide sale, Mr. Turner was guilty of comingling his personal assets with partnership assets.[49]  Mr. Turner appeared to disregard the partnership as a separate entity and accessed its funds at will for his personal use – gifts, insurance premiums and legal fees.[50]  Mr. Turner also used personal assets to make real estate investments on behalf of the partnership and pay off its liabilities, only to memorialize such actions after the fact on the entity’s records as loans.[51]  Third, Mr. Turner continued his enjoyment of partnership assets when he and Mrs. Turner withdrew a monthly fee of $2,000 each for management services, although there was no evidence such services were ever provided.[52]  Lastly, in addition to this monthly fee, Mr. Turner made disproportionate distributions from the FLP, only making distributions to Mrs. Turner and to himself.[53]  Following formation of the FLP, Mr. Turner’s actions reflect the fact that he did not change his relationship to, control over and enjoyment of the transferred assets after they were contributed to the FLP.

Attorney Contributions to Inclusion under Section 2036:  Mr. Turner is not alone insubverting the success of the FLP; his estate planning attorney must accept some of the culpability.  First, it wasclear in the Tax Court’s decision that the drafting attorney used a standard form to generate the partnership agreement for Turner & Co.[54]  In particular, many of the purposes of the FLP as set forth in the partnership agreement were not applicable to Mr. and Mrs. Turner and their family’s circumstances.[55]  Second, the Tax Court’s reasoning for inclusion under Section 2036(a)(2) was served on a silver platter by the express terms of the partnership agreement: (i) general partner’s power to amend the agreement without the consent of the limited partners; (ii) general partner’s absolute discretion to make pro rata distributions from the partnership; and (iii) general partner’s absolute discretion to make distributions in kind.[56]  Third, albeit difficult to avoid, the drafting attorney’s communications with Mr. and Mrs. Turner expressed the tax motivations behind the FLP planning.[57]  Fourth, the drafting attorney ignored the fact that Mr. Turner simply may not have been the right client for an FLP.  Mr. Turner’s assets did not require active management or special protection.  The Turner family was, for the most part, not suffering from any disharmony among each other.  The majority of assets transferred to the FLP, Regions Bank stock, was clearly never going to be liquidated; therefore, the attorney knew in advance that there was no particular investment strategy that would be implemented.  Lastly, there is no evidence that the drafting attorney continued to work with Mr. Turner to assist with the operation of the FLP; therefore, the lack of oversight permitted Mr. Turner to comingle assets and to continue his personal use of partnership funds. 

Comparison of Case Study to holding in Turner:  Next, we put our case study to the “Turner-test” to see how we would measure up in the event of Mr. Client’s untimely death. 

Nontax Motives

Purported by Mr. Client’s Estate

Facts

To make a profit and increase family’s wealth

·  Positive - There has been a change in the underlying pool of assets, and therefore, prospect for profit

· Negative – Only 20% of the assets contributed to the LLC have undergone any change, and the real estate investments entered into by the LLC were channeled from Mr. Client to the LLC; Furthermore, assets contributed to LLC are passive in nature and do not require  active management or special protection

To be a means through which family members will gain knowledge and become involved in the management of the family’s wealth

·  Positive – Members were informed about investments made by the LLC through bi-annual statements and an annual meeting

· Negative – Facts suggest that children, including Son who is a co-Manager, do not have any particular interest in their parents’ wealth or the performance of the LLC; Mr. Client remains the sole person handling management investments

To consolidate family assets to qualify as an accredited investor to gain access to riskier funds and other alternative investment opportunities

·   Positive – $20 million was transferred to the LLC, qualifying it is an accredited investor for alternative investments, such as private equity funds

·  Negative – Prior to formation, Mr. and Mrs. Client already qualified as an accredited investor; no assets were contributed by Son or Daughter to pool their funds to attain this status

To provide protection of family wealth from persons outside the family acquiring rights or interests to such assets

·  Positive – Daughter’s unsuccessful business ventures in the past, while not having actually exposed her personal assets to any risk, provide context for Mr. and Mrs. Client’s concerns about her poor judgment regarding finances and investing

· Negative – There is no pending or threatened litigation either between the children or from those outside the family that is jeopardizing the family’s wealth

To invest in entrepreneurial ventures of family members

·  Positive – LLC has invested in Daughter’s start-up venture

· Negative – LLC was not necessary to permit Mr. and Mrs. Client to invest in children’s entrepreneurial endeavors, as they could have made direct investments with their personal assets

The purported nontax motives for Mr. and Mrs. Client’s formation of the LLC are substantiated by facts; however, there are other facts which may mitigate the strength of their argument that there were significant and legitimate nontax reasons for transferring the property to the LLC.  We should also consider whether any of the following factors undermining Mr. Turner’s nontax motives are present with Mr. and Mrs. Client’s LLC:

Nontax Motives

Additional Factors Indicating
Transfer Not Bona-Fide
Sale


Facts

Transferor on both sides of transaction

·  Similar to Turner, there was no negotiation or meaningful bargaining with children or Trustee of the Irrevocable Trust; no one other than Mr. and Mrs. Client was represented by an attorney

Comingled personal assets and partnership funds

·   None

Time between formation and funding

·  Nominal; transfers occurred within the same month as formation

Evidence of tax reasons

· Attorney’s letter discussing LLC planning referenced potential estate tax savings

Mr.Client was careful not to comingle his personal assets with partnership assets, and refrained from making withdrawals for personal expenditures, giving credibility to this being an arm’s length transaction.  Unfortunately, factors within the attorney’s control, such as whether other parties participated in the negotiations for theLLC and the communications set forth in correspondences with the clients, undermine our success with the BOFIS Exception.  If Mr. Client’s LLC fails the BOFIS Exception, then his estate wil