Family Limited Partnership Didn't Achieve Desired Estate Planning Benefits

September 4, 2007 | Roger McEowen


The U.S. Court of Appeals for the Ninth Circuit has ruled that a family limited partnership (FLP) failed to achieve the desired estate tax valuation discounts.  The decedent established a revocable trust to which she transferred her residence.  When she moved to a nursing home, the trust exchanged the residence for an investment property.  To pay off the existing mortgages on the residence, the trust obtained a $350,000 loan and a $100,000 line of credit, both of which were secured by the investment property.  Later the decedent and her children created an FLP and transferred the investment property (then worth $1.4 million) to it in exchange for partnership interests.  The decedent remained personally liable on the loan and line of credit.  The FLP made the $2,000 monthly loan payments for the decedent.  But, most of the net rental income was used to pay the decedent’s living expenses, which increased after her insurance coverage ended.  Upon her death, the estate took a 37 percent minority interest and marketability discount to her remaining FLP interest, but IRS said the FMV of the investment property rather than the discounted FLP interest was included in the estate under I.R.C. §2036(a)(1), and the Tax Court agreed. 

On appeal, the Ninth Circuit affirmed.  The court found an implied agreement between the decedent and her children that she would continue to retain income and economic benefit from the transferred property.  In addition, the transfer was not a bona fide sale for full consideration.  The main problem, the court determined, was that the loan and line of credit were not transferred to the FLP with the investment property.  It didn’t matter that the estate was liable to make the loan payments on the decedent’s behalf.  Also, a transfer of the investment property would have impoverished the decedent if there had not been an implied agreement that the FLP would supplement her income.  The FLP also failed to follow partnership formalities.  But, the court rejected the IRS contention that inter-vivos transfers of real property to an FLP are can never satisfy the bona fide sale exception to I.R.C. §2036(a).  Ultimately, the court said that there must be a significant and legitimate non-tax purpose for the transfer.  

With the opinion, the Ninth Circuit has followed several significant FLP cases in recent months concerning the application of I.R.C. §2036(a) to FLPs and the need for a non-tax purpose for the entity’s creation.  Bigelow v. Comr., No. 05-75957, 2007 U.S. App. LEXIS 22030 (9th Cir. Sept. 14, 2007), aff’g, T.C. Memo. 2005-65).