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.
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)