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Tax Court: What to Avoid with an FLP

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A recent Tax Court decision presents a how-to list of  steps to avoid when using a family limited partnership (FLP). Here is what  happened.

In 1984, Dr. Paul Liljestrand transferred various real estate  assets to a revocable trust, and his son  Robert took over management of the real estate. Dr. Liljestrand was the  sole beneficiary of the trust during his  lifetime. Upon his death, the trust’s assets were to be distributed to  trusts for his four children.

ledger glasses penIn 1997, Dr. Liljestrand formed an FLP by having the  trust transfer the real estate to the FLP in exchange for the initial  partnership interest. At the same time, Robert was granted one unit of class A limited partnership interest.  Robert and the other children later received class B limited partnership  interests through gifts from the trust.

An appraisal firm was engaged to conduct an appraisal of  the partnership interests. Although the appraiser valued the partnership  interests by reference to the value of the real estate contributed, the parties  ignored the appraiser’s valuation and used a  lower value for the gifts to the children. Even at the lower value, each  of the gifts exceeded the annual gift tax exclusion. However, gift tax returns  were not filed until 2005, after Dr. Liljestrand’s death.

Despite having transferred legal title of the real estate  to the FLP, the parties inadvertently continued to treat the real estate as an  asset of the trust. This failure was discovered in 1999. Dr. Liljestrand and  his advisers decided to treat the FLP as having commenced on Jan. 1, 1999, even  though legal title to the real property had been transferred to it by December  1997.

Dr. Liljestrand contributed almost  all of his income-producing assets to the FLP.  His retained assets were insufficient to pay his living expenses. To offset the  shortfall in his income, the partnership  made disproportionate distributions to the trust and directly paid a  number of Dr. Liljestrand’s personal expenses.

Dr. Liljestrand died in 2004. The estate reported a  taxable estate of $5.7 million. The IRS issued a notice of deficiency that  included in the gross estate the value of the real property that Dr.  Liljestrand had transferred to the FLP. As a result, the IRS determined that an additional $2.5 million in  estate tax was due.

The court determined that the FLP  assets should be included in Dr.  Liljestrand’s estate if three conditions were met: (1) Dr. Liljestrand made an inter  vivos transfer of property; (2) the transfer  was not a bona fide sale for adequate and full consideration; and  (3) Dr. Liljestrand retained a beneficial interest in the transferred property  that he did not relinquish before his death.

The estate acknowledged that Dr.  Liljestrand made transfers of property to the FLP,  so the first test was met.

The court observed that whether a sale is bona fide is a question of motive. The court said it had to determine whether Dr.  Liljestrand had a legitimate and significant nontax reason for transferring his  property. Taking into account the totality of the facts and circumstances  surrounding the formation and funding of the FLP, the court concluded that Dr.  Liljestrand did not have a legitimate and significant nontax motive. It found  especially significant that the transactions were not at arm’s length and that  the partnership failed to follow the most basic of partnership formalities.

The court noted that the general test for deciding  whether transfers to a partnership are made for adequate and full consideration  is to measure the value received in the form of a partnership interest to see  if it is approximately equal to the property given up. The court determined  that the interests credited to each partner were not proportionate to the fair  market value of the assets contributed by the partner.

It further found that the assets contributed by each  partner were not properly credited to their respective capital accounts.  Accordingly, it concluded that Dr. Liljestrand did not receive adequate and full consideration for his  contribution to the FLP.

The court also found that there was no significant change  in Dr. Liljestrand’s relationship with the assets before his death. He received  a disproportionate share of the FLP distributions, engineered a guaranteed  payment equal to the FLP’s expected annual income and benefited from the sale  of FLP assets.

The evidence pointed to the fact that he continued to  enjoy the economic benefits associated with the transferred property during his  lifetime.

The Tax Court found that (1) Dr.  Liljestrand transferred assets to the FLP; (2) the transfer was not a bona  fide sale for adequate and full consideration; and (3) he retained  enjoyment of the transferred assets. Therefore, it concluded that the value of  his gross estate included the value of the assets he had transferred to the  FLP.

(Estate of Paul H. Liljestrand v. Commissioner (TC  Memo 2011-259, Nov. 2, 2011)


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