December 14, 2011
By: Frank S. Baldino
Estate Planning Journal December 2011
Turner, TC Memo 2011-209 , RIA TC Memo ¶2011-209 , 102 CCH TCM 214
In Turner1, the IRS successfully applied Section 2036 to a family limited partnership (FLP) to include in the decedent's gross estate the value of the assets transferred by the decedent to the FLP.
Mr. and Mrs. Turner had four children. One of their children died survived by two children of her own. In April 2002, Mr. and Mrs. Turner formed Turner & Co., a Georgia limited partnership. Mr. and Mrs. Turner each owned a 0.5% general partner interest and 49.5% limited partner interest. The assets contributed to the partnership included cash, certificates of deposit, stock in various banks, and bonds. Mr. and Mrs. Turner retained more than $2 million of assets that were not contributed to the partnership. These assets included their personal residence, investment real estate, cash, certificates of deposit, and stock in various banks. The retained assets, together with Social Security payments, generated more than enough income to pay the couple's living expenses.
On 12/31/2002 and 1/1/2003, Mr. and Mrs. Turner made gifts of limited partner interests in the partnership to their three surviving children and the two children of their deceased daughter. Because of concerns regarding the drug addiction and legal problems of one of their grandsons (Rory), the gift to him was made to an irrevocable trust for his benefit. Mr. Turner died in February 2004. Gift tax returns were filed in October 2004. The IRS audited the estate tax return of Mr. Turner and issued a notice of deficiency in which it determined that the value of the assets transferred by Mr. Turner to the partnership were includable in his gross estate under Section 2036 .
Section 2036 applies if three requirements are satisfied:
- The decedent makes a transfer of property during his or her lifetime.
- The transfer was not a bona fide sale for full and adequate consideration.
- The decedent retained possession or enjoyment of the transferred property or retained the right either alone or in conjunction with any other person to designate the persons who would possess or enjoy the property or the income therefrom.
If the three requirements of Section 2036 are met, the full value of the transferred property is included in the value of the decedent's gross estate.
The court concluded, without discussion, that the first requirement of Section 2036 was satisfied because Mr. Turner made a transfer when he transferred assets to the partnership in exchange for general and limited partner interests.
The court next examined whether the second requirement of 2036 was satisfied, i.e., whether the transfer of property to the partnership was a bona fide sale for full and adequate consideration. In the context of an FLP, the bona fide sale exception is satisfied when the record establishes the existence of a legitimate and significant nontax reason for creation of the partnership and the transferor received partnership interests proportionate to the value of the property transferred. The objective evidence must establish that the nontax reason was a significant factor that motivated the creation of the partnership, and the nontax reason must have been an actual motivation—not a theoretical justification.
The estate argued that Mr. and Mrs. Turner created the partnership for three legitimate and significant nontax reasons. The first reason put forward for the formation of the partnership was that the partnership facilitated the consolidation of the assets for management purposes and allowed someone other than Mr. and Mrs. Turner or their children to maintain and manage the family's assets for future growth. The court stated that most of the cases in which consolidated asset management has been held to be a legitimate nontax purpose have involved assets requiring active management or special protection. However, in this case, Mr. Turner contributed marketable securities, fixed income investments, cash, and certificates of deposit. The court concluded that these assets required no active management or special protection. In reaching this conclusion, the court stated that it relied on the fact that the portfolio of marketable securities did not change in a meaningful way while they were owned by the partnership.
The second reason put forward by the estate for the formation of the partnership was that the partnership facilitated resolution of family disputes through equal sharing of information. The court recognized that the resolution of family disputes or promotion of family harmony may be a legitimate and significant nontax purpose for the creation of an FLP. The court found, however, that there was no evidence in the record to suggest that the ill will among the Turner children was the result of financial disagreements, but rather was the result of personality conflicts.
The third reason put forward by the estate for the formation of the partnership was to protect the family assets and Mrs. Turner from her grandson, Rory, and to protect Rory from himself. The court recognized that asset protection may be a legitimate and significant nontax reason for the formation of a partnership. While the record did show that Mrs. Turner had made gifts to Rory from time to time, there was no evidence that Mrs. Turner's gifts to Rory were not voluntary, nor was there any credible evidence in the record to show that Mrs. Turner wanted or needed protection from Rory. In the absence of such evidence, the court could not perceive any reason that Mrs. Turner needed to be protected from spending her own money however she saw fit. In addition, the court stated that the estate failed to explain how placing the assets in a partnership, as opposed to transferring the underlying assets to a trust for the benefit of Rory, provided any meaningful additional protection.
The court noted that several additional factors indicated that the transfers to the partnership were not bona fide sales:
- Mr. Turner stood on both sides of the transaction, and he created the partnership without any meaningful bargaining or negotiation with Mrs. Turner or with any of the other anticipated limited partners (i.e., his children and grandchildren).
- Mr. Turner commingled personal and partnership funds when he used partnership funds to make personal gifts to two of his grandsons to pay premiums on life insurance policies for the benefit of his children and grandchildren, and to pay legal fees relating to his and Mrs. Turner's estate planning.
- Mr. and Mrs. Turner did not complete the transfer of assets to the partnership for at least eight months after formation of the partnership.
Having concluded that the transfer to the partnership was not a bona fide sale for adequate and full consideration, the court next considered whether Section 2036(a)(1) applied and whether Mr. Turner retained, by express or implied agreement, possession, enjoyment, or the right to income from the property transferred to the partnership. The court stated that factors indicating that a decedent retained an interest in the assets transferred include the following:
- A transfer of most of the decedent's assets.
- Continued use of the transferred property.
- Commingling of personal and partnership assets.
- Disproportionate distributions to the transferor.
- Use of entity funds for personal expenses.
- Testamentary characteristics of the arrangement.
The court began its analysis by examining the partnership agreement. The partnership agreement provided that Mr. and Mrs. Turner, as general partners, were entitled to a reasonable management fee. Mr. and Mrs. Turner chose to receive a management fee of $2,000 a month. The record did not disclose the basis for the calculation or determination of the amount of the management fee. In fact, the record indicated that Mr. and Mrs. Turner did not manage the partnership at all.
The court believed that this arrangement was not indicative of a business or investment activity conducted for profit, but rather of an investment account from which withdrawals could be made at will. The court stated that this conclusion was reinforced by the fact that the partnership agreement gave Mr. Turner the right to amend the partnership agreement at any time without the consent of the limited partners.
In addition, the court found that Mr. Turner commingled personal and partnership funds when he used partnership funds to make personal gifts to two of his grandsons, to pay premiums on life insurance policies for the benefit of his children and grandchildren, and to pay legal fees relating to his and Mrs. Turner's estate planning.
Furthermore, the court found that that the purpose of the partnership was primarily testamentary. Many of the specific purposes Mr. Turner discussed with his estate planning attorney at the initial meeting regarding the formation of the partnership were testamentary in nature—such as providing for Mrs. Turner after his death, providing income for future generations, and protecting his children and grandchildren from creditors. The court was particularly struck by the implausibility of the estate's assertion that the tax savings resulting from the partnership were never discussed. The court did not find testimony to that effect to be credible, and the court stated that this lack of credibility infected all of the testimony the estate offered about what Mr. Turner allegedly said or intended about the purpose of the partnership.
The court stated that it based its findings partially on a letter from Mr. Turner's estate planning attorney in which he wrote: “A key element to a gifting plan is the need of a sound appraisal of the partnership for tax purposes.” The court, therefore, concluded that the formation of the partnership had testamentary characteristics and that Mr. Turner did not curtail his enjoyment of the transferred assets after formation of the partnership.
The court next considered whether Section 2036(a)(2) applied and whether Mr. Turner retained the right, either alone or in conjunction with any person, to designate the persons who would possess or enjoy the property or the income from the property transferred to the partnership. The court stated that a transferor's retention of the right to manage transferred assets does not necessarily require inclusion.
The court stated that for all intents and purposes, Mr. Turner was the sole general partner of the partnership and the partnership agreement gave him broad authority not only to manage partnership property, but also to amend the partnership agreement at any time without the consent of the limited partners.
As a general partner, Mr. Turner had the sole and absolute discretion to make pro rata distributions of partnership income (in addition to distributions to pay federal and state tax liabilities) and to make distributions in kind. Moreover, Mr. Turner had the authority to amend the partnership agreement at any time without the consent of the limited partners. Finally, even after the gifts of limited partnership interests to the children and grandchildren, Mr. and Mrs. Turner owned more than 50% of the limited partnership interests in the partnership and could make any decision requiring a majority vote of the limited partners.
In conclusion, the court determined that Mr. Turner made an inter vivos transfer of property to the partnership, the transfer was not a bona fide sale for adequate and full consideration because it was not motivated by a legitimate and significant nontax purpose, and that Mr. Turner retained by both express and implied agreement the right to possess and enjoy the transferred property, as well as the right to designate which person or persons would enjoy the transferred property. Consequently, Section 2036 applied to include the value of the transferred property in Mr. Turner's gross estate.
The opinion in this case is well written and contains a very good analysis of Section 2036 as it applies to FLPs. In order to successfully avoid the application of Section 2036 in the context of FLPs, this case reminds us that the existence of a significant nontax purpose for the formation of the partnership is essential—particularly when the entity holds only marketable securities. Because the court found that a significant nontax purpose did not exist, the court concluded that the bona fide sale exception to Section 2036 did not apply. The court, therefore, applied Sections 2036(a)(1) and 2036(a)(2) based on the manner in which the partnership was operated for the benefit of Mr. Turner.
1 TC Memo 2011-209 , RIA TC Memo ¶2011-209 , 102 CCH TCM 214