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FAMILY LIMITED PARTNERSHIPS:
MAJOR TAXPAYER VICTORY IN KIMBELL
By
Thomas J. Murphy
Murphy Law Firm, Inc.
Ahwatukee Station
P O Box 51244
Phoenix, AZ 85076
480-838-4838
www.murphylawaz.com
On May 20, 2004, the Fifth Circuit Court of Appeals issued a
major taxpayer victory regarding the applicability of IRC 2036 to interests in a
family limited partnership in Estate of Kimbell. This case has drawn
considerable attention because it is the same court that will rule on the appeal
of the Strangi case.
FACTS:
In January 1998, Ruth Kimbell, 96 years old, created a
limited liability company with her son. Each contributed $20,000 to the LLC and
took back a 50% membership interest with the son as the managing member.
Later that same month, a limited partnership was created. Mrs Kimbell
contributed $2.5 million in cash and shares of the family owned oil and gas
business. She took back a 99% limited partnership interest. The LLC contributed
$25,000 for a 1% general partnership interest.
Mrs Kimbell retained $450,000 in liquid assets outside of the FLP/LLC. She died
in March 1998. In December 1998, Mrs Kimbell’s estate tax return was filed,
claiming a 49% discount.
TRIAL COURT
The trial court, a federal district court in Texas rather
than the Tax Court, slammed the estate. The trial court ruled that a transfer
among related parties could never qualify as a bona fide sale. As a result, IRC
2036 applied and the value of the assets transferred to the entities, rather
than Mrs Kimbell’s interest in those entities, was included in her gross estate
for estate tax purposes, thereby disallowing any discount.
APPELLATE COURT
The only issue before the 5th Circuit was whether Mrs
Kimbell’s contributions to the LLC and FLP constituted a bona fide sale for full
and adequate consideration. If so, IRC 2036 expressly provides for an exception.
The issue was whether this bona fide sale exception applied to these facts. The
5th Circuit ruled that it did apply.
Prong #1 – full and adequate consideration
The 5th Circuit adopted a two-prong test in determining
whether the bona fide sale exception applied. The first prong centers around
whether full and adequate consideration was received by Mrs Kimbell. In other
words, was the asset received of roughly equivalent value to the asset given up?
The IRS argued that the estate’s position was wildly inconsistent in that it
claimed full and adequate consideration when the FLP was formed and then claimed
a 49% discount two months later. Fortunately for the taxpayer, the Court saw
through this in a very well-stated portion of its opinion that has been widely
quoted by commentators:
“The business decision to exchange cash or other assets for a
transfer-restricted, non-managerial interest in a limited partnership involves
financial considerations other than the purchaser’s ability to turn right around
and sell the newly acquired limited partnership interest for 100 cents on the
dollar. Investors who acquire such interests do so with the expectation of
realizing benefits such as managerial expertise, security and preservation of
assets, capital appreciation and avoidance of personal liability. Thus, there is
nothing inconsistent in acknowledging, on the one hand, that the investor’s
dollars have acquired a limited partnership interest at arm’s length for
adequate and full consideration and, on the other hand, that the asset thus
acquired has a present fair market value, i.e. immediate sale potential, of
substantially less than the dollars just paid – a classic informed trade-off.”
This hits the nail on the head. Something of considerable
value to the partner may be of no value to someone else or the general investing
public. These non-monetary benefits are real and the Court was convinced that
they did exist. For instance, the court acknowledged the need to avoid
fractionalizing of interests as the interests pass through generations or the
need to avoid family squabbles by requiring partners to use mediation and
arbitration.
In other words, are there non-tax reasons for the creation of the entity? Two
particular issues that the Court accepted and emphasized leapt out at me. One
concerned the need for creditor and lawsuit protection. The Kimbell FLP was
heavily invested in oil and gas working interests that created significant
exposure to environmental issues. I have been preaching this for years – the
creditor protection afforded an Arizona limited partnership by virtue of ARS 29-
341 is a unique and extremely important feature in the estate planning realm.
This alone is ample reason for many of my clients to establish an FLP and the
Kimbell case solidly adopts this as a justifiable rationale for creating one.
The second issue that caught my attention was when the Court
pointed out the need to keep property characterized as separate property in the
event of a grandchild’s divorce, which had already happened in the Kimbell
family.
These types of considerations are hard to put a price tag on but Kimbell
emphasizes that they are real and must be recognized as a valid non-tax reason
for creating an FLP.
The IRS put forth a couple other theories that indicated there was no bona fide
sale. One theory was that the son only had a 1% interest that could be
disregarded for estate inclusion purposes. The Court flatly rejected this,
stating that there was no minimum percentage interest. Surprisingly, the IRS
apparently did not stress an argument that the trial court found convincing: the
partnership agreement allowed for the removal of the general partner if 70% of
the partners agreed. This was fatal to the taxpayer in Strangi but was
apparently never raised with the 5th Circuit.
The second theory was that the son had complete managerial
control both before and after the FLP’s formation. The IRS maintained that this
showed that there was no change in how the family ran its operation so that the
entity could be ignored for estate tax purposes. But this too was swiftly
rejected the Court, going so far as to label it “irrelevant”. It only mattered
that the son was the sole manager after the FLP’s formation. What may have
happened before formation was of little importance.
The Court tried to come up with a workable standard in
determining what will be considered full and adequate consideration. It cited
three factors: 1) pro-rata interests, 2) properly maintaining capital accounts
and 3) rights to a pro-rata distribution upon termination or dissolution.
Prong #2 – Relinquishing possession and control
If the first prong is met (full and adequate consideration),
the second issue is whether the transferor, Mrs Kimbell, actually parted with
the property. For an FLP, this really means whether the partnership was properly
funded with pro-rata capital accounts and with following the requisite
formalities (filing of tax returns, separate bank account, etc.).
One aspect that seemed very important to the Court was that
Mrs Kimbell had retained a sizeable portion of her assets, approximately
$450,000.00, and kept them outside of the FLP. This meant that she had ample
resources on which to live so that she did not have to rely on the FLP for
income and hence did not have to involve herself in partnership activities.
SO WHERE DOES THIS LEAVE US?
The Tax Court litigation in the FLP area has been one “bad
facts” case after another. However, other than the deathbed planning, Kimbell
had fairly strong facts. The Court was able to point to a variety of non-tax
reasons for the creation of the FLP that have often been given short shrift by
the courts. But a trend may be developing. Kimbell follows, and indeed
repeatedly cites, the recent Tax Court case of Estate of Stone, TC Memo
2003-309, in which the court ruled there was a bona fide sale among family
members so that IRC 2036 did not apply. Both cases involve ongoing family
businesses with significant participation by the children. Some commentators see
this as an important distinguishing feature from those cases where the FLP
primarily holds marketable securities.
It must also be kept in mind that these cases did not involve gifting that, by
definition, could never be a transfer for full and adequate consideration.
Coming down the pike are the appeals on the Strangi and
Thompson cases. Strangi will be decided by the same 5th Circuit court that
decided Kimbell but a different panel of judges has been assigned to the case.
Opening briefs are due in late June. Thompson is a 3rd Circuit case has already
been briefed and argued to the court that has indicated that they would probably
wait for an opinion in Kimbell before reaching a decision. Stay tuned.
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