Case — Estate Inclusion of Property Transfers

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TL Case Summ

THE QUESTION

Should the value of real property transferred by a decedent to a family limited partnership be included in the value of the gross estate?

THE DISPUTE

Taxpayer Says: The transaction meets all the requirements of a completed transfer, and the property should not be included in the estate.

Internal Revenue Service Says: The transfer meets the three conditions that require the full value of the transferred property to be included in the estate.

THE LAW

From Internal Revenue Code Section 2036(a): Generally provides that if a decedent makes an inter vivos transfer of property other than a bona fide sale for adequate and full consideration and retains certain enumerated rights or interests in the property which are not relinquished until death, the full value of the transferred property will be included in the decedent’s gross estate. Section 2036(a) is applicable when three conditions are met: (1) the decedent made an inter vivos transfer of property; (2) the decedent’s transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest or right enumerated in section 2036(a)(1) or (2) or (b) in the transferred property which he or she did not relinquish before death.

From Estate of Bongard v. Commissioner, 124 T.C. 95, 118 (2005):  In the context of family limited partnerships, the bona fide sale for adequate and full consideration exception is met where the record establishes the existence of a legitimate and significant nontax reason for creating the family limited partnership and the transferors received partnership interests proportional to the value of the property transferred.

From Estate of Gore v. Commissioner, T.C. Memo. 2007-169: A taxpayer’s receipt of a partnership interest is not part of a bona fide sale for full and adequate consideration where an intra-family transaction merely attempts to change the form in which the decedent holds property. 

THE CAUSE OF THE DISPUTE

In general, your estate consists of assets (and the related liabilities) that you own or have an interest in at the date of your death. In some cases, property you transfer prior to your death may also be part of your estate. For instance, say you give someone property but you keep the right to receive income from the property (or you keep some other significant control over the property) during your lifetime. Since you did not truly give up the property, it can be part of your estate.

One estate planning technique for transferring property is a family limited partnership. These partnerships combine a family’s assets (or selected assets) into a business entity that family members own interests in. The family limited partnership saves estate taxes by removing the assets from the gross estate of the person who transferred the ownership.

Disputes with the IRS arise over family limited partnerships because the partnerships must be formed for a significant non-tax purpose, which means a reason other than merely saving taxes. In addition, the partnerships must be treated as a business – for example, family limited partnerships should be established under applicable state law, with assets legally transferred, and operated with minimal commingling of personal and business funds.

In this case, the taxpayer and her husband owned undeveloped land by a reservoir. In 1997, they formed a family partnership to help simplify the transfer of the property to other family members. The partnership’s stated purpose was to hold and manage the property for the family members for later development, and to make it difficult for the property to be divided and distributed without family consent.

The partnership agreement limited the ability of each partner to transfer individual interests, and granted the taxpayer and her husband the sole rights to determine whether the property would be sold, to manage the day-to-day business of the partnership, and to determine the amounts of distributions to partners.

The taxpayer and her husband transferred the property to the partnership at the appraised value on the date of the transfer. The property was the only asset of the partnership. Since there was no income from the land, the taxpayers continued to pay the real estate taxes from their own funds.

Over the years, the taxpayer and her husband gave away their interests in the partnership to other family members using documents called “bills of sale”. By the end of 2000, the taxpayer owned only a 1% general interest in the partnership.

The taxpayer died in 2005. Her personal representatives believed the transfer of the land to the family limited partnership met all the requirements for excluding the value of the property from her estate.

The IRS says the transfer was not a bona fide sale for full and adequate compensation because the taxpayer’s only motive in transferring the land to the partnership was gift giving, which is not a legitimate, non-tax business justification.

In addition, the taxpayer retained significant control over the property and did not respect partnership formalities by paying partnership bills with personal funds.

The IRS argues these factors show that Section 2036(a) applies and the value of the land should be included in the gross estate, leading to a $2.5 million increase in estate tax.

WHAT WOULD YOU DECIDE?

For the Taxpayer or for the IRS?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 27KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
Sorry, wrong answer :(
For the taxpayer. The taxpayer’s desire to have the property held and managed as a family asset constituted a legitimate nontax motive for the transfer to the family limited partnership, resulting in full and adequate consideration. The transfer of the property was a bona fide transfer. Section 2036(a) is inapplicable and does not operate to include the value of the property in the value of the gross estate.
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