Tax Court includes FLP property in gross estate

The Tax Court recently held that a decedent’s transfer of real estate to a family limited partnership (FLP) was not a bona fide sale. As a result, the value of the property transferred to the FLP was included in the decedent’s estate. The decision reflects a commonly occurring dispute between the IRS and taxpayers that have tried to use the FLP to transfer assets to surviving family members with limited tax liability. Rather than signal that FLPs should be avoided, this case should indicate that the tax benefits within FLPs have their limits. Overreaching in structuring an FLP can result in an outcome that may put into harm’s way those tax benefits still clearly available within the legitimate FLP structure.

The FLP, in brief

A family limited partnership (FLP) is simply a business or investment vehicle, formed pursuant to a limited partnership agreement among family members, which enables the family unit to effectively and efficiently control, distribute and protect the family's contributed assets. Although the concept of the FLP is this basic, the actual formation, maintenance and operation of the entity can be quite complex and expensive. But, if all of the assorted obstacles are overcome, significant family goals, of both a personal and financial nature, are readily available.

The proper structuring of an FLP involves the balancing of numerous business, tax and personal objectives. A primary objective, as in this case, is to transfer a family’s business and investment interests from an older generation to a younger generation with limited estate and gift taxation.

Factual background

The facts of the Tax Court case are that the decedent during his lifetime had transferred more than $5 million in real estate to the FLP in exchange for a 98.8 percent limited partner interest. No other parties contributed to the FLP apart from the decedent. Starting two years later, the FLP began paying the decedent’s personal expenses along with gifts to his grandchildren. The FLP sold some of its real estate holdings to pay these personal expenses.

After the decedent’s death in 2004, the IRS issued a notice of deficiency to the decedent’s gross estate in the amount of $2.5 million. The IRS included the value of the real estate transferred to the FLP in the decedent’s gross estate. The estate challenged the IRS’s determination in the Tax Court.

Court’s analysis

The court rejected the estate’s arguments in favor of exclusion of the transferred property, holding that it met all the three conditions under which the value of the transferred property must be included in the gross estate under Code Sec. 2036(a): (1) The decedent made an inter vivos transfer of property; (2) the decedent's transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest in the transferred property, which he did not relinquish before his death.

The court further found the decedent did not have a legitimate nontax reason for creating the FLP. The transaction lacked any arm's length bargaining before the formation of the partnership. Rather, the decedent "stood on all sides of the transaction," the court found. The FLP also failed to follow the most basic of partnership formalities, the court noted. The court was also not persuaded that the decedent had created the FLP to protect the real estate from potential creditors.

Liljestrand Est., TC Memo. 2011-259