Tax Court Affirms Application of Section 2036(a) to Family Limited Partnerships
Estate of Abraham 1 was first discussed in the July 2004 issue of this column, 2 after the Tax Court held that the full undiscounted value of real estate transferred by an individual to family limited partnerships was included in her estate under Section 2036(a)(1) because the transfers to the partnerships were subject to an implied agreement that the transferor would be entitled to income and principal from the real estate if needed for her support. 3 The First Circuit has now affirmed the decision of the Tax Court.
Ida Abraham was a widow with four adult children. The property that Mrs. Abraham received from her husband's estate included three parcels of commercial real estate. Mrs. Abraham developed Alzheimer's disease, and one of her daughters became her court-appointed guardian. Litigation arose among three of her children regarding the amount of property that was needed for her support. The litigation was consuming Mrs. Abraham's assets. In order to end this litigation, the three children, each of their respective counsel, and Mrs. Abraham's guardian ad litem entered into a court decree to establish an estate plan for Mrs. Abraham.
The decree directed that three FLPs be created—one for each of Mrs. Abraham's children who participated in the litigation (one son declined any interest in his mother's estate and did not participate in the litigation) and that the three pieces of real estate be placed in the FLPs. The decree also granted authority to the guardian ad litem to gift some of Mrs. Abraham's interests in the FLPs to her three children in order to reduce the estate taxes that would be incurred upon her death. With regard to each of the three FLPs, Mrs. Abraham owned all the stock in the corporate general partner and was a limited partner, and each of the three children received limited partner interests in their respective FLP. The decree also appointed an attorney as limited guardian ad litem with respect to Mrs. Abraham's interest in the FLPs. The decree provided that each child would be entitled to receive income from the FLPs either as a management fee or as a gift from Mrs. Abraham after deducting from the income of the FLPs certain items, including amounts needed in the discretion of the guardian ad litem for Mrs. Abraham's support. The decree provided that support for Mrs. Abraham was to come from the FLPs and that each FLP was to share equally in the amounts needed for Mrs. Abraham's support if the income generated by her separate assets was insufficient for her support.
The decree also authorized annual exclusion gifts of limited partner interests to the three children and their families. According to the decree, the three children would have the right to purchase limited partner interests from Mrs. Abraham. The decree provided that the proceeds from the sale would be held in a revocable trust to be used for Mrs. Abraham's support only if her other assets were insufficient, and the remaining proceeds were to be distributed to “such child or his or her family” upon Mrs. Abraham's death.
The estate plan that was actually established for Mrs. Abraham essentially followed the estate plan agreed to by the parties and set forth in the decree. Unlike the decree, the FLP agreements did not specifically mention any obligation for the support of Mrs. Abraham. After the FLPs were formed, Mrs. Abraham's two daughters on several occasions purchased limited partner interests in their respective FLPs from Mrs. Abraham. The purchase price was deposited not into Mrs. Abraham's account but rather into the account of the FLPs. Also, after the FLPs were formed, the guardian ad litem made gifts to each of the three children and members of their families.
Following the creation of the FLPs and until Mrs. Abraham's death, one of Mrs. Abraham's daughters, as guardian of the person, sent to the guardian ad litem a letter each month setting forth the extent to which Mrs. Abraham's personal income from sources such as Social Security and an annuity could not cover her expenses and demanding that the thee FLPs make up the shortfall. The guardian ad litem paid these shortfalls out of Mrs. Abraham's share of the income of the FLPs. Each month, the guardian ad litem also paid out to the three children their share of the FLP income.
The daughter who was the court-appointed guardian of the person of Mrs. Abraham testified at trial that it was her understanding that all the FLP income from the FLPs would be available to pay Mrs. Abraham's expenses regardless of the children's ownership interests in the FLP, and that the guardian ad litem was obliged to use the overall funds of the FLPs for Mrs. Abraham's support if her personal assets were not sufficient.
The guardian ad litem testified at trial that had Mrs. Abraham's needs increased beyond her share of the FLP income, he would have used for Mrs. Abraham's support the FLP income that was allocated to the other partners. The guardian ad litem also testified at trial that if one of the FLPs had insufficient income, he would have used the income from the other FLPs to make up the shortfall. According to the guardian ad litem, it was his understanding—and that of the three children—that all FLP funds, including FLP funds from the purchase of Mrs. Abraham's limited partner interests, were available for Mrs. Abraham's support.
Following the death of Mrs. Abraham on June 9, 1997, the estate filed an estate tax return and valued her interests in the FLPs by applying a discount to the value of the underlying property for lack of marketability and minority interest. The IRS audited the estate tax return and set aside the value of each FLP as reported by the estate, and included the underlying value of the real estate held by the FLPs as part of Mrs. Abraham's gross estate. The estate filed a petition in the Tax Court and the Tax Court ruled in favor of the IRS. The estate appealed to the First Circuit.
Section 2036(a)(1) provides that a decedent's gross estate includes property transferred by the decedent during his or her life if he or she retained the possession or enjoyment of, or the right to the income from, the transferred property. However, inclusion is not required under Section 2036 if the transfer was pursuant to a bona fide sale for full and adequate consideration.
The First Circuit began its analysis by determining whether the sales to Mrs. Abraham's daughters were bona fide sales for adequate and full consideration. The estate argued that Mrs. Abraham's two daughters purchased their interests in the FLPs in bona fide sales for adequate and full consideration, and therefore those non-gifted interests should not be included in Mrs. Abraham's estate. The court held that the estate failed to produce any admissible evidence regarding the adequacy of the value of the FLP interests.
In the alternative, the estate relied on a series of cases 4 involving the sale of a remainder interest where the decedent retained a life estate in the property. In those cases, the courts held that for purposes of Section 2036, adequate and full consideration is measured by the value of the remainder interest—not the value of the fee simple interest in the property. The Abraham court held that the cases relied upon by the estate were not applicable to the facts of the present case because no evidence in the record suggested that the parties ever contemplated that the transfers were sales by Mrs. Abraham of remainder interests in the FLPs.
The court noted that the evidence in the record did not substantiate the estate's position since the documents memorializing the transfers of FLP interests from Mrs. Abraham to her daughters did not speak of remainder interests. Moreover, the parties computed the amount of money to be paid by Mrs. Abraham's daughters for the FLP interests based on minority and lack of marketability discounts, not on the actuarial value of the remainder interests in the FLPs. Also, the two daughters received monthly payments from the FLPs during Mrs. Abraham's lifetime and did not have to wait until Mrs. Abraham's death for possession or enjoyment of the property.
Next, the estate argued that the Tax Court was incorrect in holding that Mrs. Abraham retained the right to the income from the FLPs. The court of appeals stated that in order for Section 2036 to apply, it is not necessary that the decedent retain a legally enforceable interest in the property. Rather, the court held that to come within the purview of Section 2036, it is sufficient that an interest be retained pursuant to an understanding or arrangement. 5
The court found that the documentary evidence, including the stipulated decree of the probate court, and the understanding of decedent's children and legal representatives, demonstrated that Mrs. Abraham was entitled to any and all funds generated from the FLPs for her support. The court determined that the motivation for forming the FLPs was to prevent her estate from being drained by litigation. In addition, the court noted that the probate court decree explicitly stated that FLP funds needed for Mrs. Abraham's support were an obligation of the FLPs which had to be met before any FLP income could be disbursed to the partners.
According to the appellate court, it was not dispositive that the FLPs' payments for Mrs. Abraham's support never exceeded her proportionate share of the FLPs' income. The court stated that the fact that it was unnecessary to use all FLP income for Mrs. Abraham's needs could not support the conclusion that the option never existed.
The First Circuit, having found that Section 2036(a)(1) was applicable to the transfers by Mrs. Abraham, concluded by affirming the Tax Court. Therefore, the full undiscounted value of the three parcels of real estate transferred on behalf of Mrs. Abraham to the FLPs were included in her estate at an undiscounted value.
The Abraham case first illustrates the importance of obtaining qualified professional appraisals. The estate did not prevail on the issue of the applicability of the exception to Section 2036 for bona fide sales for full and adequate consideration because the estate failed to provide admissible evidence regarding the fair market value of the FLP interests purchased by Mrs. Abraham's daughters. All too frequently, taxpayers fail to prevail in court on issues of valuation because either the evidence submitted at trial is not admissible or the methodology used is so flawed as to lack credibility.
Abraham also illustrates the danger of taxpayers establishing an FLP and retaining either directly or implicitly through an agreement with the other partners the right to the income from the assets transferred to the partnership. The facts of this case are similar to those presented in Estate of Reichardt, 6 Estate of Harper, 7 Estate of Thompson, 8 and Estate of Strangi, 9 where the Tax Court also applied Section 2036(a)(1) after finding that there was an implied agreement that the decedent had the use of assets after they were contributed to an FLP. As the authors have noted many times, the Service has found Section 2036(a) to be an effective weapon against FLPs — especially where the transferor one way or another retains the right to all the income from the transferred property or where the formalities of administering the FLP were ignored. Abraham represents the former sin.
1 95 AFTR 2d 2005-2591, 408 F3d 26 (CA-1, 2005).
2 See Madden and Hayes, “Current Tax Developments: Section 2036 Applied Again,” 31 ETPL 340 (July 2004).
3 See Estate of Abraham, TC Memo 2004-39, RIA TC Memo ¶2004-039, 87 CCH TCM 975 .
4 Estate of Magnin, 84 AFTR 2d 99-5227, 184 F3d 1074 (CA-9, 1999); Wheeler, 80 AFTR 2d 97-5075, 116 F3d 749, 97-2 USTC ¶60278 (CA-5, 1997); Estate of D'Ambrosio, 78 AFTR 2d 96-7347, 101 F3d 309, 96-2 USTC ¶60252 (CA-3, 1996).
5 Estate of Maxwell, 72 AFTR 2d 93-6733, 3 F3d 591, 93-2 USTC ¶60145 (CA-2, 1993); Guynn, 27 AFTR 2d 71-1653, 437 F2d 1148, 71-1 USTC ¶12742 (CA-4, 1971).
6 114 TC 144 (2000).
7 TC Memo 2002-121, RIA TC Memo ¶2002-121, 83 CCH TCM 1641.
8 TC Memo 2002-246, RIA TC Memo ¶2002-246, 84 CCH TCM 374.
9 TC Memo 2003-145, RIA TC Memo ¶2003-145, 85 CCH TCM 1331 , aff'd 96, AFTR2d 2005 (CA-5, 7/15/05).
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.