Several recent cases have addressed tax issues related to family limited partnerships or limited liability companies. Using these popular forms of entities, if properly structured, assets can be transferred to a partnership or limited liability company and interests in the entity can be given away or sold to other family members at a significant discount from the underlying asset value because of the minority, illiquid, and noncontrolling nature of the interest transferred.

In Estate of Beatrice Kelly (Tax Court, March 19, 2012), the taxpayer created about as good a factual record as seems possible. Following her husband’s death, Mrs. Kelly was diagnosed with Alzheimer’s disease and needed help managing her assets (she owned 27 parcels of real estate, two rock quarries, and a post office). Her children petitioned the court to become her legal guardians. They also learned that her will did not divide her estate equally among them and entered into an agreement to divide her estate equally, excluding specific gifts not involving any of the four of them. For the children as guardians, managing the properties was difficult – they had to petition the court for approval of virtually anything they wanted to do. Holding the properties, especially the rock quarries, in Mrs. Kelly’s name presented liability concerns as well.

To address these problems, Mrs. Kelly and three of her four children (the fourth was largely incapacitated and not involved in the decisions) developed a plan to create a management corporation, KWC Management (KWC), and a limited partnership for each of three of the children. Mrs. Kelly funded each partnership with an equal amount of assets. A fourth limited partnership was created to hold the interests in the quarries. KWC was the general partner of and held a 1 percent interest in each of the partnerships. Mrs. Kelly then made gifts of limited partnership interests in the various partnerships to the children. She retained assets of $1.1 million, and no distributions from the partnerships were used to pay her living expenses. Each of the three children worked for KWC, the general partner entity, in connection with the management of the partnerships’ assets.

When Mrs. Kelly died, she still owned some limited partnership interests and also owned 100 percent of the stock of the general partner, KWC. The IRS took the position that the assets of the partnerships should all be included in Mrs. Kelly’s estate for estate tax purposes under IRC Section 2036. Property transferred by a decedent during life is brought back into the decedent’s estate under IRC Section 2036 if the decedent retains the possession or enjoyment of, or the right to receive the income from the transferred property during his lifetime, or retains the right to designate the persons who possess or enjoy the property or the income therefrom. An exception exists for transfers that are bona fide sales for adequate consideration.

Courts have determined that, in order for transfers to limited partnerships to qualify for the bona fide sale exception, the decedent must have made the transfer in question for significant non-tax reasons and received a partnership interest that is proportional to the assets transferred. In this case, the taxpayer prevailed on all grounds. The court found that the transfer was motivated by non-tax reasons, including insuring that Mrs. Kelly’s assets were shared equally by her children, providing a management structure for the assets in light of her incapacity and providing some liability insulation from the risks of operating the quarries.

The court also found that the decedent did not retain the enjoyment or income from the assets. The IRS argued that there was an implied agreement among the parties that the decedent would continue to receive the income from the partnerships. Even though the decedent continued to own 100 percent of the entity that was the general partner, the court found that her ability to receive management fees through that entity was limited by the terms of the partnership agreement and the fiduciary duty provisions of the applicable state law.

The facts of this case provide an excellent template for the creation of a family partnership. The partnerships were formed well in advance of the decedent’s death; no “death bed transfers” occurred. The limited partners, as employees of the corporate general partner, were also actively involved in the management of the partnerships, a condition made necessary by the incapacity of the decedent. Of course, while this factor will not be present in all cases, involving the limited partners in the business of the partnership to the extent possible is advisable.

The extensive litigation of these issues also indicates some very clear trends – including that taxpayers almost always win when the factual record is good, and they almost always lose when it is not.

In another case, Estate of Clyde Turner, Sr. (Tax Court, August 30, 2011), the U.S. Tax Court addressed a new aspect of family limited partnership cases. The court had held in a prior case that assets the decedent transferred to a family limited partnership would be included in his estate for estate tax purposes because he had retained a prohibited interest in those assets. After losing that case, the decedent’s executors decided that since the estate had been increased by the amount of assets transferred to the partnership, the marital deduction available to the estate should also be increased. The executors’ reasoned that the decedent’s will used a pecuniary formula marital deduction, and under the formula the decedent’s wife was entitled to receive an amount that would reduce the tax on the decedent’s estate to zero. Since the estate was now larger and subject to tax, the executors argued that the marital deduction should be increased by the amount necessary to reduce the tax to zero.

The problem the court had with this argument was that, in order to receive a marital deduction with respect to a particular asset, the asset must be transferred to the decedent’s spouse and that had not occurred. After transferring the assets to the partnership, the decedent had transferred partnership interests to his children – they did not pass to his wife. The decedent’s will did not control the disposition of these interests because he gave them away before he died. Since the assets brought back into his estate by IRC Section 2036 did not pass to his wife, the court did not permit a marital deduction with respect to those assets.

Finally, in Estate of Joanne Harrison Stone (Tax Court, February 22, 2012), the court held that the transfer of real property to a family limited partnership qualified for the bona fide sale exception to IRC Section 2036 upon the death of the transferors. The principal non-tax reason for the transfer was to insure that the property would not be subject to partition actions, as would be the case if the property was transferred to the decedent’s children in undivided interests upon the death of the decedent. This case was unusual in that the decedent did not claim any valuation discounts in connection with her gift of limited partnership interests to her children and other family members. The court pointed to the lack of a claimed discount as a factor in reaching the conclusion that the decedent had significant non-tax reasons for transferring assets to the partnership. With no discount taken on the gifts, the only tax benefit the decedent obtained from the partnership was that any appreciation in the value of the partnership assets between the date of the gifts and the date of her death was not subject to estate tax in her estate. This would have also been the case if she had simply given the real property directly to her children.