In Stone, a recent Tax Court case, the Court determined that the transfer of undeveloped woodlands to a family limited partnership (an "FLP") was a bona fide sale, since the record established that the FLP was created for legitimate non-tax reasons. As a result, since the taxpayer had gifted during her lifetime her 49% limited partnership interest in the FLP to other family members, the woodlands were only includable in her estate for federal estate tax purposes to the extent of the 1% general partnership interest she retained as of her death.
The land at issue was 740 acres of woodlands in Tennessee, which includes a lake created by a dam constructed by the local water utility. However, the resulting lakefront property is of limited value for sale as home sites, since the water level of the lake falls considerably each summer when the utility draws water to supply drinking water for the local community.
Under § 2036 of the Code, property gifted by a decedent will be included in his or her gross estate when three conditions are met: (1) the decedent transferred the property during his or her lifetime, (2) the transfer was not a bona fide sale for adequate and full consideration and (3) the decedent retained certain interests or rights in the property which he or she had not relinquished prior to his or her death.
At issue in Stone was the second prong of this three-part test. The IRS argued that the only purpose of the partnership was to simplify the gifting process (i.e., so that deeds would not have to be executed each time a portion of the woodlands was gifted to a particular family member), and that this was not a sufficient nontax motive to support the conclusion that the transfer was a bona fide sale.
The court concluded, however, that the FLP was created for two additional purposes as well, namely (1) to create a family asset that could eventually be developed and sold by the family in the event that the utility someday ceases drawing water from the lake and (2) to protect the property from division (and attendant loss of value) as a result of partition actions, which family members would be able to bring if they were granted outright interest in the woodlands rather than non-controlling interests in the FLP. The existence of these nontax purposes meant that the transfer to the FLP failed the second prong of § 2036, and thus the property would not be included in the decedent’s gross estate.
The IRS then argued the family members had not respected the formalities of the FLP, since the decedent and her husband had paid all FLP taxes out of their personal funds and because there was inadequate documentation relating to the initial gifts and to certain quitclaims of interests in the FLP made by the divorcing spouses of various family members.
The court agreed that certain formalities had not been respected, but concluded that the FLP was not illusory because the woodlands were formally transferred to the FLP, there was no commingling of funds between the FLP and its partners and no distributions were ever made from the FLP. In addition, the court noted that the gifts of FLP interests to the decedent's family had not involved any valuation discounts (such as for lack of marketability or lack of control).
It is difficult to extract useful lessons from cases involving FLPs, since each case is so fact-specific. This is particularly true in Stone due to the (uncommon) absence of valuation discounts. At a minimum, Stone highlights the importance of formulating and documenting the non-tax purposes of the FLP upon its creation and ensuring that all partnership formalities are respected.