On February 22, 2012, the United States Tax Court issued its memorandum opinion in Estate of Stone v. Commissioner, T.C. Memo 2012-48. At first blush, this case appears to be simply one more case in a string of litigated cases between the taxpayers and the Internal Revenue Service as to when family limited partnerships would be respected for federal estate and gift tax purposes. A closer look, however, may reveal something more.
The facts in this case are fairly straightforward. The decedent and her husband were a prominent family in Cumberland County, Tennessee. The decedent and her husband owned significant undeveloped woodland real estate in the county. One of the decedent's sons, Steve Stone, acquired real estate near the undeveloped land and entered into an agreement with a third party to build a dam that would create a lake which would cause a portion of the property to front the newly-formed lake. The decedent and her husband contacted a local attorney, Harry Sabine, to discuss the planning with respect to the woodland properties. The decedent and her husband informed Mr. Sabine that they wanted to make gifts of real estate to various family members and were seeking the best way to do so. Mr. Sabine, in consultation with the decedent and her husband, decided to form a limited partnership to hold the woodland parcels. The certificate of limited partnership was filed with the Tennessee Secretary of State on December 29, 1997. The decedent and her husband were the general partners of the partnership. They had the sole right to (1) determine whether any properties would be sold, (2) manage the day-to-day business of the limited partnership and (3) determine the amounts of any distributions to partners. The limited partnership agreement also provided that the limited partners had the right to dismiss the general partners upon written agreement of those limited partners owning 67% or more of the ownership interests held by all limited partners. Upon formation of the partnership, the decedent and her husband each obtained a 1% general partnership interest and a 49% limited partnership interest. On December 30, 1997, the decedent and her husband transferred the woodland real estate into the limited partnership and that real estate became the limited partnership's only asset. An appraisal of all woodland parcels was obtained and the appraised value of 1.5756 million was used as the value of the real estate and of the partnership interests. On December 31, 1997, the decedent and her husband gave portions of their limited partnership interest as gifts to their 21 children, spouses of children and grandchildren. Similar gifts were made in 1998, 1999 and 2000. No discounts were claimed on the gifts of partnership interests. By the end of 2000, the decedent and her husband each only owned their 1% general partnership interests as the remaining limited partnership interests had been given away to family members. During 1999 and 2000, two of decedent's children divorced. In each divorce, the nonfamily member executed a quit claim deed conveying any interest that person had in the woodland real estate back to their spouse. The deeds mentioned that the parcels involved were the same ones that had been conveyed to the limited partnership. As of the decedent's date of death in 2005, the limited partnership has not yet developed or improved the woodland real estate. The limited partnership initially had a bank account but the bank account was closed as the limited partnership had no income. The only expenses of the partnership were property taxes of approximately $700 per year which were paid directly by the decedent and her husband from personal funds. Decedent and her husband made no use of the woodland parcels other than to fish and occasionally visit their son.
The court first indicated that § 2036 is applicable when three conditions are met: first, the decedent makes an inter vivos transfer of property, second, the decedent's transfer was not a bona fide sale for adequate and full consideration, and third, the decedent retained an interest or a right enumerated in § 2036 in the transferred property which he or she did not relinquish before death. The taxpayer conceded that the first condition had been met and the case concerned whether the second two conditions had been met.
With respect to family limited partnerships, the bona fide sale for adequate and full consideration exception is met when the record establishes the existence of a legitimate and significant non-tax reason for creating the family limited partnership. The taxpayer argued that the decedent had two non-tax motives for transferring the woodland parcels into the limited partnership. First, to create a family asset which could later be developed and sold by the family and second, to protect the woodland real estate from division as the result of a partition action if undivided interests in the real estate had been conveyed. The Tax Court held that the decedent's desire to have the woodland real estate held and managed as a family asset constitutes a legitimate non-tax motive for the transfer of parcels to the limited partnership.
The government argued that the limited partnership formalities had not been observed because (1) in the divorce proceedings the two children quit claimed their interests in real estate but did not transfer the limited partnership interests, (2) some inadequate documentation was kept for the partnership, (3) and the decedent and her husband paid the property tax from their personal funds. The court agreed with the government that in certain instances the partners failed to respect certain partnership formalities. But the court concluded that a bona fide sale had occurred. First, because no distributions from the limited partnership were ever made, the decedent and her husband did not depend on such distributions. Second, the decedent and her husband had actually transferred the woodland property to the limited partnership. Since the partnership had no funds, there was never a commingling of the funds of the partnership and the partners. Fourth, no discounting of partnership interests occurred for gift tax purposes. Finally, the evidence indicated that at the time of the formation of the partnership while the decedent and her husband were elderly, they were both in good health and the decedent lived for an additional seven years.
Because the court found that the decedent had a legitimate and actual non-tax purpose in transferring the woodland property to the limited partnership, the court found that the transaction was not merely an attempt to change the form in which the decedent held the woodland parcels and therefore the full and adequate consideration requirement had been satisfied. Because the court held that the decedent's transfer was bona fide and for adequate and full consideration § 2036(a) was held inapplicable.
The interesting thing about this case is the fact that the court explicitly held that one of the factors that indicated that a bona fide sale with full consideration had occurred was the lack of a claimed discount in the gifts made by the taxpayer to the family members. The court appears to be saying that transfers that do not involve a discount in the calculation of value of the gifted interests will be subjected to a somewhat lesser standard in determining the applicability of § 2036. This case appears to open a new chapter in the ongoing struggle between taxpayers and the Service as to the applicability of § 2036 to transfers of family limited partnership interests.