The wave of litigation over the efficacy of family limited partnerships has not abated. For the first time, the United States Court of Appeals for the Ninth Circuit has considered one of these cases. This is especially significant for many of our clients because tax cases appealed by California taxpayers are heard by the Ninth Circuit. Estate of Bigelow v. Commissioner was another example of what we refer to as a “bad facts” case. After the decedent had suffered a debilitating stroke, her son acted through a durable power of attorney to create a family limited partnership in December, 1994, and transferred the bulk of the decedent’s assets to the partnership. The principal asset transferred was a parcel of income producing real property. The property was encumbered by a mortgage and the decedent retained the liability to pay the mortgage when the property was transferred to the partnership. Nevertheless, the partnership actually made the monthly payments required on the mortgage.
In the two years preceding the decedent’s death in 1997, the partnership also made approximately forty transfers to the decedent to enable her to pay her living expenses. The partnership characterized these transfers as interest free loans in its accounting records. When the decedent’s estate tax return was filed, a discount of 37% for lack of marketability was claimed in valuing the interest in the limited partnership.
This case was typical of the “bad facts” cases in that the decedent, in the last few years of her life, transferred the bulk of her assets to a family limited partnership. The transfer left her unable to pay her living expenses without resort to the assets of the partnership. Thus, when the Tax Court heard the case, it had no trouble concluding that there was an implied agreement between the decedent and the partnership that allowed the decedent to retain for her life the economic benefit of the property she transferred to the partnership. The Tax Court held that all of the assets that the decedent transferred to the partnership were includable in her estate for estate tax purposes under IRC § 2036(a)(1) . On appeal by the taxpayer, the Ninth Circuit agreed with the Tax Court, especially focusing on the fact that although the decedent had retained the obligation on the mortgage encumbering the property that she transferred to the partnership, the partnership nevertheless made the mortgage payments because the decedent did not have the resources to do so.
Even though the courts found that the decedent had retained the right to the income from the property during her lifetime, the transfer would not have been brought back into her estate for estate tax purposes if it could have been demonstrated that the transfer constituted a bona fide sale for adequate and full consideration. Other courts have essentially equated this test to a business purpose test. That is, in order for the transaction to be considered a bona fide sale for adequate consideration, it must be demonstrated that there were non-tax related business purposes involved in the making of the transfer. The Ninth Circuit found that such was not the case here, given that the transfer virtually impoverished the decedent.
The many family limited partnership cases that have reached the courts over the last several years have provided a wealth of information on how these entities should be structured in order the maximize the chances that they will accomplish their primary objective of creating substantial valuation discounts for estate and gift tax purposes. We have recently begun contacting clients for whom we have created these entities over the last several years. We encourage anyone who has created a family limited partnership (or limited liability company) more than a year ago to contact us about updating the form of the agreement to insure that it contains provisions that are helpful and does not contain any provisions that are harmful. It is also important that these entities be operated in a business-like manner. We can provide guidance as to the various factors looked to by the courts in making these evaluations. Probably the single most important consideration in forming a family limited partnership or limited liability company is not to transfer so much of your wealth to the partnership that you are unable to pay your living expenses without resort to the partnership assets. Many of the family limited partnership valuation discount cases that taxpayers have lost had this particularly bad fact.