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Friday, June 29, 2012
Lessons from Turner to Protect Against IRS Challenge to FLP By Richard P. Breed, III, Esq, and Jennifer A. Civitella Hilario, Esq.

A version of this article appears in the July 2012 issue of Estate Planning, Volume 39, Number 7 © 2012, Thomson Reuters.

Section 2036 – IRS’s Silver Bullet to the FLP?

Lessons Learned from Turner v. Commissioner, T.C. Memo 2011-209

By Richard P. Breed,III, Esq, and Jennifer A. Civitella Hilario, Esq.

Introduction:   Within an estate planner’s bag of tricks, lays the much beloved, yet much feared, family limited partnership (or more recently, the limited liability company).  On its face, FLP planning can provide our clients significant transfer tax savings as wealth is transferred to the next generation, while allowing our clients to retain somecontrol over gifted assets.  However, these tax savings may be illusory if an FLP is implemented for the “wrong”client.  To avoid the looming trap of Section 2036, an important measure of a client’s eligibility for FLP planning is whether sufficient “non tax reasons” exist for the FLP.  The estate planning attorney needs to understand the boundaries (based on both case law and the IRS’s positions in such cases) Section 2036 places on FLP planning.  The practitioner must evaluate each client’s specific circumstances against Section 2036’s limits and grade the client’s candidacy for the FLP.  For the appropriate client, the transfer tax savings may be realized with FLP planning.  However, the definition of the appropriate client is evolving, as recently redefined by Turner[1].

            Turner provides us three “reality checks” as we embark on FLP planning with our clients.  First, Section 2036 is alive and well within the Tax Court and the arsenal of the IRS.  Second, our clients are human and they will bring down the FLP.  Third, if our clients do not sabotage the FLP, the attorney may.  The following article will provide a case study of a common FLP strategy and will test it against the Turner ruling.  Whether or not the Tax Court memorandum decision will be upheld upon appeal, Turner provides us valuable insight into the IRS’s and the Tax Court's perceived limitations on the FLP strategy.  The objective of this article is to provide practitioners guidance with their FLP strategies, love them or hate them, in light of the Turner decision.

Case Study:     Your Clients.  You meet with Mr. and Mrs. Client in early September, 2011.  You’ve worked with them on some basic estate planning; they are now ready “for the good stuff.”  Having sold a business in 2008, Mr. and Mrs. Client are retired and are enjoying a comfortable lifestyle with a net worth comprised of the following:

Asset

Value

Primary Residence

$3,000,000

Vacation Residence

$2,000,000

Marketable Securities

$10,000,000

Retirement Accounts

$2,000,000

Real Estate Investments (owned with business partner in separate LLCs)

$5,000,000

Private Equity Investments

$5,000,000

Cash and Cash Equivalents

$3,000,000

TOTAL:

$30,000,000

Mr. and Mrs. Client are in their early 60s and in good health. They have two adult children, both happily married.  Daughter, a serial entrepreneur, has not yet hit her first homerun and sometimes struggles to support herself and her family, which includes three young children.  Mr. and Mrs. Client provide her assistance through annual gifting.  Son, an IP attorney, has no children and lives on the West Coast to allow his wife to beclose to her family.  Mr. and Mrs. Client do not directly make gifts to Son, but he, along with Daughter, are the sole beneficiaries of an Irrevocable Trust established for the benefit of each child (and their respective children).  Each share of the Irrevocable Trust is worth approximately $1,000,000, funded with marketable securities, in addition to the Trust’s ownership of a $5,000,000 face value survivor life insurance policy on Mr. and Mrs. Client’s lives.  Neither child is particularly involved with Mr. and Mrs. Client’s financial affairs, although they are aware of their parents’ wealth. 

            Your Recommendation.  During the meeting, Mr. and Mrs. Client expressed their goals in the following priority: (i) protect Daughter from herself, but help her succeed; (ii) minimize transfer taxes as property is passed from generation to generation; (iii) hold assets in a protective manner so they are immune, to the fullest extent possible, from creditors (including a divorcing spouse); and (iv) involve Son in the planning to encourage him and his wife to spend more time with Mr. and Mrs. Client.  After having reviewed a number of differentstrategies, Mr. and Mrs. Client liked the FLP planning best.  Your demonstration that the FLP planning may save them approximately $5 million in transfer taxes was an obvious motivating factor.  Your recommendation included the following:

·    Form a multi-member limited liability company (“LLC”) of which Mr. and Mrs. Client would be the initial members, each having a 50% membership interest.  Mr. Client would be the sole manger of the LLC and Mrs. Client would be named as the successor manager.  Mr. Client is considering whether to name Son as a co-manager or not.  While the manager will have authority to handle the daily management of the LLC, including investment of LLC assets, all other decisions, including distributions to members and termination of the entity, require the consent of those persons holding 75% of the membership interests in the LLC. 

·    Following formation, assets comprising $10 million in marketable securities, $5 million in real estate investments and $5 million in private equity investments would be contributed to the LLC. 

·    Following the LLC’s funding, Mr. and Mrs. Client will retain a net worth of $10 million, 50% comprised of residential real estate and the balance comprised of their retirement accounts (upon which they do not currently draw) and cash.  Their income will be substantially less than before, but they believe it will be enough to support themselves. 

·    Early January 2012, four months after the assets were contributed to the LLC, Mr. and Mrs. Client each make an outright gift of 10% of the membership interests in the LLC to each child, and 25% of the membership interests to each child’s share of the Irrevocable Trust, resulting in Mr. and Mrs. Client each retaining a 15% membership interest in the LLC.  Prior to the assignment of the membership interests, Son accepted his appointment as co-manager of the LLC, albeit with some hesitation.

·  A qualified appraisal of the membership interests gifted, reflecting a 33% valuation discount for lack of marketability and lack of control, was obtained and a timely gift tax return will be filed in 2013. 

During your annual review meeting following the formation of the LLC, Mr. and Mrs.Client advise you that the following has occurred:

·    The managers had quarterly meetings to reviewand modify investments; however, Mr. Client handled most of the affairs andinvestment decisions of the LLC. 

·   With the assistance of Mr. and Mrs. Client’s financial advisor, bi-annual reports were provided to the members of the LLC regarding the performance of the entity’s investments.

·   Annual filings with the Secretary of State were made.  The LLC’s records were maintained, including an annual meeting of the managers and the members in December. 

·    From LLC profits, a distribution of $200,000 was made, distributed pro rata among the partners. 

·   By month-six, the following investments occurred: (i) $4 million of the marketable securities were liquidated; (ii) $2 million was contributed to a new real estate investment opportunity that was recently presented to Mr. Client and his business partner; and (iii) $2 million was contributed into Daughter’s most recent start-up in exchange for a minority interest in the entity. 

As memorialized in the partnership agreement and in your written correspondences to the client concerning the planning, the following are intended purposes for the LLC: (i) make a profit to increase the family’s wealth; (ii) establish a means through which family members will gain knowledge and become involved in the management of the family’s wealth; (iii) consolidate family assets to qualify as an “accredited investor” to gain access to riskier funds and other alternative investment opportunities; (iv) provide protection of family wealth from persons outside the family acquiring rights or interests in such assets; and (v) invest in entrepreneurial ventures of family members.  Although you made a note to the file that as of the one-year anniversary, the entity formalities are being followed, including no payment of personal expenses with partnership assets, you did not inquire into whether the stated purposes of the LLC are being fulfilled.  Nonetheless, you check this off as a successful plan and send the file off to storage.  

Turner:  The cases in which the taxpayer was successful tend to grab our attention and are added to our FLP research file.  We learned from the Miller decision that the transferor’s objective to perpetuate his investment strategy, which involved a long practice of charting stocks, was a legitimate non-tax reason for forming his FLP.[2]  From the Mirowski decision, we also learned the importance of the transferor retaining enough personal assets to maintain her living expenses.[3]  On the other hand, a taxpayer loss quickly becomes a caricature of the wrong client, just another “bad facts” case, and an example of “things I’d never let my clients do.”  From some of these cases we learned the following: (i) transferring a personal residence to a partnership and continuing to reside there for less than fair market rent will trigger Section 2036[4]; (ii) transferring certain assets into an existing partnership contemporaneous with a gift of partnership interest is evidence of an indirect gift of the transferred assets[5]; and (iii) formation of partnership and transfer of assets by the attorney-in-fact, because the transferor is incapacitated, is evidence that the transaction was not a bona fide sale.[6]  Disregarding the latter category of cases is a mistake, as evidenced by the valuable information the Tax Court provided us in its memorandum decision in Turner. [7]

Facts of the Case:  With the advice of their estate planning attorney, Mr. and Mrs. Turner formed a Georgia limited partnership, Turner & Co., initially holding for themselves a 1% general partner interest and a 99% limited partner interest.[8]  Over the several months following the formation of the partnership, Mr. and Mrs. Turner transferred approximately 80%of their wealth to Turner & Co., retaining more than $2 million to support themselves.[9]  Assets transferred to the partnership were mostly comprised of securities, cash and cash equivalents; 60% of the assets transferred consisted of stock in Regions Bank, the successor to a bank in which both of their families had held stock for two generations.[10]  Nonetheless, Mr. and Mrs. Turner’s ownership in Regions Bank was less than 1% of its outstanding stock.[11]  Commencing December 31st of that same year, Mr. and Mrs. Turner began to gift limited partnership interests in the FLP to their children, grandchildren and an irrevocable trust for the benefit of a grandson.[12]  They retained for themselves a combined 55.6%limited partner interest and 1% general partner interest in Turner & Co.[13]  Although in good health when Turner & Co.was formed, Mr. Turner became ill and died within the next two years.[14]  The IRS took the position that assets transferred by Mr. Turner to the FLP were included in his taxable estate under Sections 2035, 2036 and 2038, and assessed an estate tax deficiency.[15]

Decision:  The Tax Court’s memorandum decision to include one-half of the assets of Turner & Co. in Mr. Turner’s gross estate was premised on Section 2036.[16]  The Court did not opine on whether the FLP’s assets would also be included under Section 2035 and Section 2038.[17]  Finding that Mr. Turner’s FLP transaction did not meet the requirements of the “bona fide sale for adequate and full consideration” exception to Section 2036 (commonly referred to as the “bona fide sale exception” and for the purposes of this article, the “BOFIS Exception”), the Tax Court held that the assets were included in Mr. Turner’s gross estate under both Section 2036(a)(1) and Section 2036(a)(2).[18]  This result is consistent with other decisions of the Tax Court when it has found that the bona fide sale exception to Section 2036 did not apply.[19]  In the context of a family limited partnership, there is greater scrutiny to determine if the transaction is of the same terms and conditions as a similar transaction between unrelated parties and therefore, truly “arm’s length.”[20]

Bona Fide Sale Exception to Section 2036:   Absent the BOFIS Exception to Section 2036 applying, your client is exposed to estate tax inclusion if she retained an interest described in “(a)(1)”(enjoyment in or right to income from transferred property) or “(a)(2)” (right to designate beneficial enjoyment of the transferred property or its income), which will be a risk if your client retains a general partner interest in the FLP or serves as manager of the LLC.[21]  Under Turner,to fit within the BOFIS Exception, the FLP must pass a two-part test: (i) the facts and circumstances of the FLP transaction must present, as actualmotivation for the planning, a “legitimate and significant nontax reason” to create the FLP; and (ii) the transferor received a partnership interest proportionate to the property transferred to the FLP.[22]  Mr. Turner’s FLP passed the second prong of the test, but flunked the first.[23]  The Court concluded that there was no factual basis for the purported nontax reasons for the FLP, summarized as follows:

Nontax Motives

Purported by Mr. Turner’s Estate

Factual Determination of Tax Court

Consolidation of assets

·  Mr. Turner’s concern for “scattered nature of assets” could have been addressed without FLP[24]

·  Assets, mostly comprising securities and cash or cash equivalents, did not require active management or special protection[25]

Management of assets

·  Assets and investments that existed prior to FLP remained the same after contribution to FLP[26], including minimal trading of securities and no sales of Regions Bank stock[27]

· Mr. Turner did not have a distinctive investment philosophy and no special investment strategy was implemented[28]

More efficient management of assets

·  Grandson who assisted with management of assets prior to FLP continued after contribution to FLP; therefore, FLP provided no greater efficiency than before[29]

Resolve family disputes

· No litigation or threat of litigation among family members which may jeopardize assets transferred to FLP[30]

·  No evidence assets were transferred to FLP to resolve conflict among children and grandchildren [31]

Protect family assets

·  No evidence the Turner’s assets were at risk because of troubled grandson[32]

·  No evidence that assets held for the benefit of troubled grandson were provided any greater asset protection as a result of FLP because they were already held in an irrevocable trust

In addition to finding the Turner estate’s purported nontax business reasons unsubstantiated, the Tax Court also found several additional factors which evidenced there was not a bona fide sale:

Nontax Motives

Additional Factors Indicating
Transfer Not Bona-Fide
Sale


Factual Determination of Tax Court

Transferor on both sides of transaction

· There was no negotiation or meaningful bargaining with other parties involved in the transaction[33]

Comingled personal assets and partnership funds

·  Mr. Turner used partnership assets to make gifts and pay life insurance premiums and attorney fees for personal estate planning[34]

Time between formation and funding

· Transfers occurred over eight month period[35]

Evidence of tax reasons

·  Attorney’s letter discussing FLP planning referenced the need to have an appraisal for gift tax purposes[36]

Section2036(a)(1):  Having concluded that Mr. Turner’s FLP did not fulfill the requirements of the BOFIS Exception, the Tax Court next evaluated whether Mr. Turner retained the powers described in Sections2036(a)(1) and 2036(a)(2).  The Tax Court considered the facts and circumstances concerning Turner & Co. and whether there was an express or implied agreement that Mr. Turner would retain the present economic benefit of the property transferred to the FLP.[37]  The Tax Court concluded that Mr. Turner’s enjoyment of the assets transferred to the FLP did not change and therefore Section 2036(a)(1) did apply.[38]  In its determination, the Tax Court considered the following factors:

Section 2036(a)(1)

Factors that Evidence an
Express or Implied Agreement for
Transferor to Enjoy Property



Factual Determination of Tax Court

Transfer of most of transferor’s assets

·  Mr. Turner transferred approximately 86% of his wealth; however, the court did not expressly opine on whether this was a factor evidencing an agreement[39]

Continued use of transferred property

· Although Mr. Turner and his wife had sufficient assets to support themselves, they still drew a monthly fee from the FLP for management services, although there is no evidence such services were ever performed[40]

Comingling of personal and partnership assets

· In connection with certain real estate investments that were made prior to his death, Mr. Turner made investments and paid off debts of the FLP on its behalf[41]

Disproportionate distributions to transferor

·  During his lifetime, Mr. Turner and his wife were the only partners to receive distributions from the FLP, although 43.4% interest in the partnership was held by other limited partners[42]

Use of entity funds for personal expenses

·  Mr. Turner used entity funds, at will, to make gifts to his grandsons, to pay life insurance premiums and to pay attorneys fees for personal estate planning matters[43]

Purpose was primarily testamentary

· Circumstances surrounding FLP planning were testamentary in nature, pursuant to estate planning primarily focused on testamentary planning and minimizing estate taxes[44]

            Section 2036(a)(2):  The Tax Court also held that Section 2036(a)(2) applied because Mr. Turner retained the right (in conjunction with his wife) to designate who may possess or enjoy the property transferred to the FLP.[45]  Fatal facts under Section 2036(a)(2) included: (i) as general partner, Mr. Turner had the authority to amend the partnership agreement without the consent of the limited partners; (ii) as general partner, Mr. Turner had the sole and absolute discretion to make distributions of partnership income and distributions in kind; and, (iii) owning, along with his wife, a combined 55.6% limited partnership interest, Mr. Turner could make any decision concerning the FLP that required the consent of a majority of the limited partners.[46]

Client Contributions to Inclusion under Section 2036:  There were a number of actions by Mr. Turner that undermined the FLP’s qualification for the BOFIS Exception and contributed to inclusion under Sections 2036(a)(1) and 2036(a)(2).  First, Mr. Turner weakened his purported nontax reason to provide for the consolidation and management of transferred assets when he failed to make any significant changes to the investment strategy of the assets contributed to Turner & Co., and only engaged in minimal trades of securities during the two-year period between the entity’s formation and his death.[47]  There was no purposeful or active management of the assets, which supported the argument that the FLP was a “mere container.”[48]  Second, of the additional factors the Court found indicating that there was not a bona fide sale, Mr. Turner was guilty of comingling his personal assets with partnership assets.[49]  Mr. Turner appeared to disregard the partnership as a separate entity and accessed its funds at will for his personal use – gifts, insurance premiums and legal fees.[50]  Mr. Turner also used personal assets to make real estate investments on behalf of the partnership and pay off its liabilities, only to memorialize such actions after the fact on the entity’s records as loans.[51]  Third, Mr. Turner continued his enjoyment of partnership assets when he and Mrs. Turner withdrew a monthly fee of $2,000 each for management services, although there was no evidence such services were ever provided.[52]  Lastly, in addition to this monthly fee, Mr. Turner made disproportionate distributions from the FLP, only making distributions to Mrs. Turner and to himself.[53]  Following formation of the FLP, Mr. Turner’s actions reflect the fact that he did not change his relationship to, control over and enjoyment of the transferred assets after they were contributed to the FLP.

Attorney Contributions to Inclusion under Section 2036:  Mr. Turner is not alone insubverting the success of the FLP; his estate planning attorney must accept some of the culpability.  First, it wasclear in the Tax Court’s decision that the drafting attorney used a standard form to generate the partnership agreement for Turner & Co.[54]  In particular, many of the purposes of the FLP as set forth in the partnership agreement were not applicable to Mr. and Mrs. Turner and their family’s circumstances.[55]  Second, the Tax Court’s reasoning for inclusion under Section 2036(a)(2) was served on a silver platter by the express terms of the partnership agreement: (i) general partner’s power to amend the agreement without the consent of the limited partners; (ii) general partner’s absolute discretion to make pro rata distributions from the partnership; and (iii) general partner’s absolute discretion to make distributions in kind.[56]  Third, albeit difficult to avoid, the drafting attorney’s communications with Mr. and Mrs. Turner expressed the tax motivations behind the FLP planning.[57]  Fourth, the drafting attorney ignored the fact that Mr. Turner simply may not have been the right client for an FLP.  Mr. Turner’s assets did not require active management or special protection.  The Turner family was, for the most part, not suffering from any disharmony among each other.  The majority of assets transferred to the FLP, Regions Bank stock, was clearly never going to be liquidated; therefore, the attorney knew in advance that there was no particular investment strategy that would be implemented.  Lastly, there is no evidence that the drafting attorney continued to work with Mr. Turner to assist with the operation of the FLP; therefore, the lack of oversight permitted Mr. Turner to comingle assets and to continue his personal use of partnership funds. 

Comparison of Case Study to holding in Turner:  Next, we put our case study to the “Turner-test” to see how we would measure up in the event of Mr. Client’s untimely death. 

Nontax Motives

Purported by Mr. Client’s Estate

Facts

To make a profit and increase family’s wealth

·  Positive - There has been a change in the underlying pool of assets, and therefore, prospect for profit

· Negative – Only 20% of the assets contributed to the LLC have undergone any change, and the real estate investments entered into by the LLC were channeled from Mr. Client to the LLC; Furthermore, assets contributed to LLC are passive in nature and do not require  active management or special protection

To be a means through which family members will gain knowledge and become involved in the management of the family’s wealth

·  Positive – Members were informed about investments made by the LLC through bi-annual statements and an annual meeting

· Negative – Facts suggest that children, including Son who is a co-Manager, do not have any particular interest in their parents’ wealth or the performance of the LLC; Mr. Client remains the sole person handling management investments

To consolidate family assets to qualify as an accredited investor to gain access to riskier funds and other alternative investment opportunities

·   Positive – $20 million was transferred to the LLC, qualifying it is an accredited investor for alternative investments, such as private equity funds

·  Negative – Prior to formation, Mr. and Mrs. Client already qualified as an accredited investor; no assets were contributed by Son or Daughter to pool their funds to attain this status

To provide protection of family wealth from persons outside the family acquiring rights or interests to such assets

·  Positive – Daughter’s unsuccessful business ventures in the past, while not having actually exposed her personal assets to any risk, provide context for Mr. and Mrs. Client’s concerns about her poor judgment regarding finances and investing

· Negative – There is no pending or threatened litigation either between the children or from those outside the family that is jeopardizing the family’s wealth

To invest in entrepreneurial ventures of family members

·  Positive – LLC has invested in Daughter’s start-up venture

· Negative – LLC was not necessary to permit Mr. and Mrs. Client to invest in children’s entrepreneurial endeavors, as they could have made direct investments with their personal assets

The purported nontax motives for Mr. and Mrs. Client’s formation of the LLC are substantiated by facts; however, there are other facts which may mitigate the strength of their argument that there were significant and legitimate nontax reasons for transferring the property to the LLC.  We should also consider whether any of the following factors undermining Mr. Turner’s nontax motives are present with Mr. and Mrs. Client’s LLC:

Nontax Motives

Additional Factors Indicating
Transfer Not Bona-Fide
Sale


Facts

Transferor on both sides of transaction

·  Similar to Turner, there was no negotiation or meaningful bargaining with children or Trustee of the Irrevocable Trust; no one other than Mr. and Mrs. Client was represented by an attorney

Comingled personal assets and partnership funds

·   None

Time between formation and funding

·  Nominal; transfers occurred within the same month as formation

Evidence of tax reasons

· Attorney’s letter discussing LLC planning referenced potential estate tax savings

Mr.Client was careful not to comingle his personal assets with partnership assets, and refrained from making withdrawals for personal expenditures, giving credibility to this being an arm’s length transaction.  Unfortunately, factors within the attorney’s control, such as whether other parties participated in the negotiations for theLLC and the communications set forth in correspondences with the clients, undermine our success with the BOFIS Exception.  If Mr. Client’s LLC fails the BOFIS Exception, then his estate will find itself defending against inclusion under Sections 2036(a)(1) and 2036(a)(2).  Applying the facts of our case study to the factors raised by the Turner decision, we have the following:

Section 2036(a)(1)

Factors that Evidence
an Express or Implied Agreement for
Transferor to Enjoy Property



Facts

Transfer of most of transferor’s assets

·  No, Mr. and Mrs. Client retained 1/3 of their net worth; however, half of it consists of personal real estate which may affect their ability to provide for themselves from income earned from investment assets retained – retirement accounts and cash

Continued use of transferred property

·  Partnership agreement did not provide for any fee to be paid to Mr. Client for his management services

Comingling of personal and partnership assets

·  None occurred; when assets were acquired by the LLC, Mr. Client never used his personal funds to make such acquisitions, using strictly LLC funds

Disproportionate distributions to transferor

·  None; distributions to members were pro rata

Use of entity funds for personal expenses

·  None; Mr. Client made no withdrawals of LLC funds for personal use

Purpose was primarily testamentary

· Conversations with an estate planning attorney concerning testamentary planning occurred prior to discussion regarding LLC; however, transfer of majority of wealth into LLC was testamentary in nature because it provided for the disposition of Mr. Client’s assets upon his death, although, in light of Mr. Client’s relatively young age and good health, it was not a motivating factor in the planning

            On balance, there does not seem to be much weight to the argument that there was an express or implied agreement that Mr. Client would retain the right to enjoy property transferred to the LLC.  Mr. Client was a good record-keeper and did respect the line between his personal assets and the LLC’s assets.  As manager, he operated the LLC as a business, even though the entity’s investments were passive in nature.  However, there remains the fact that Mr.Client, and Mr. Client alone, was on both sides of the transaction.  The fact that the LLC is apparently a one-sided transaction gives strength to the argument that Mr. Client had the power to designate the persons who would enjoy property transferred to the LLC.  Section 2036(a)(2) applies whetheror not the transferor has such power alone or with another person:

Section 2036(a)(2)

Factors that Evidence Power to Designate Possession or Enjoyment of Property


Facts

Power exercisable alone or in conjunction with another

·  Yes, Mr. Client served as manager along with Son

Power to amend partnership agreement

·  No, amendment to the partnership agreement required the consent of 75% of the members of LLC

Discretion to make distributions from partnership

·     Yes, with consent of co-Manager and 75% of members of LLC

Discretion to make distributions in kind

·  Yes, with consent of co-Manager and 75% of members of LLC

Ability, with Mrs. Client, to vote on matters requiring the consent of a majority of the partners

·  No, at Mr. Client’s death, he and Mrs. Client owned a combined interest in the LLC of 30%

Comparing the circumstances of Mr. Client’s LLC to the factors raised in the Turner decision, Mr. Client’s LLC seems to fall short of triggering inclusion under Section 2036; however, this may be a naïve conclusion.  Unless the client’s estate can satisfy the BOFIS Exception, inclusion appears to be inevitable in the event of review by the Tax Court.[58] 

Lesson Learned by Turner - RecommendedModification of Strategy in Case Study:  One of the Tax Court’s strongest arguments indenying the BOFIS Exception was the fact that assets transferred to Turner & Co. did not require active management.[59]  The Tax Court’s decision reflected its bias against FLP planning that involves assets other than those of an active business.  As practitioners, some of us may use this as our litmus test to recommend the FLP strategy or not; however, that test would disqualify a significant portion of our clients from FLP planning and may not be necessary – at least not yet. Whether or not the “active management” factor is a requirement under the BOFIS Exception as set forth in Section 2036, it appears to be an imperative factor for the Tax Court.  Although not an active business, Mr. Client’s management of the LLC’s investments could have been more active, for example: engaging in more alterative investments which require additional research and oversight, investing in more real estate opportunities in addition to those traditionally pursued by Mr. Client prior to the LLC and further trading of investments to develop a specific investment strategy concerning the $6 million in securities remaining in the LLC after its first year.  An increase in the investment activities and a change in the nature of the investments after contribution to the LLC would be evidence that it is engaged in active management of its assets. 

The Turner decision also provided practitioners insight into the level of scrutiny the Tax Court engages in when reviewing purported nontax motives for the FLP.[60]  Not only do these factors need to be present at the time the assets are transferred to the FLP, but also during its operations.  The Tax Court also seemed to evaluate each purported nontax motive by asking, “can this motive be accomplished without the FLP?” and answered in the negative concerning Mr.Turner’s objectives to consolidate and manage family assets and to protect assets from his troubled grandson.[61]  The Tax Court also closely examined the nature of the purported conflict between two of Mr. Turner’s children and concluded that it had nothing to do with their parents’ wealth, and therefore wasn’t a factor motivating the FLP’s formation.[62] 

As mentioned above, changing the nature of the assets contributed by Mr. Client to his LLC and engaging in greater active management of those assets would have substantiated the motivation of making a profit and increasing family wealth.  Furthermore, engaging both children in the management of the LLC would have been preferable, especially if they both participated, as co-managers, in the identification, research and investment of LLC assets.  Also, if a stated motive was to invest in alternative investments, that should have occurred (as it did with investment in Daughter’s start-up), and not an investment into another real estate venture, similar to opportunities previously taken by Mr. Client.  Lastly, although most of our clients have asset protection as one of their estate planning priorities, the Tax Court appears to require a real and present risk to assets as themotivation for transfers to an FLP.[63]  This fact is not present with Mr. Client’s family; nonetheless, asset protection is a legitimate nontax reason for Mr.Client pursuing the LLC and should remain in the planning. 

Another lesson from Turner is to be learned by the attorney.  We rely so heavily on our forms – they maintain the quality of our work and keep our fees competitive.  However, we may have to discipline ourselves to abandon our forms when drafting the motivations for and purposes of our clients’ FLPs.  This self-restraint should force us to reflect on the actual reasons promoting this specific client’s FLP planning.  As evident in the Turner decision, we should not take a cookie-cutter approach with our FLP planning.[64]  If the terms of our partnership agreement do not accurately reflect the client’s reasons for the FLP, it may harm our client’s qualification for the BOFIS Exception. Once identified, the nontax objectives for the FLP should be integrated within all communications concerning the planning, which should be separate and distinct from testamentary and tax planning. Even after we are confident with our customized list of nontax motives, as the client’s advisor, we need to apply the same scrutiny of our client’s facts to these purported motives; otherwise, we may be leading her down a path of inevitable inclusion under Section 2036 without the BOFIS Exception. 

Post-Turner Practice Tips: Planning for your next FLP and evaluating your last FLP:  To add to your pre-existing FLP-checklist, the authors offer the following considerations in light of the Turner decision:

Pre-Formation:  Commencing at the initial meeting with your client, planning should be focused on qualifying for the BOFIS Exception.  As mentioned above, the nontax motives for the FLP should be based on the client’s specific circumstances and vetted by the drafting attorney.  Pre-formation evaluation of the appropriateness of the FLP planning should also consider whether the client would still meet the BOFIS Exception after the FLP is put into place: (i) will she respect the entity as being separate from her own personal asserts; (ii) will she involve her family as discussed (possibly with them represented by separate counsel); and (iii) will she respect the terms of the partnership agreement.  We would neither recommend a GRAT to a client who refuses to pay the annuity, nor would we recommend a QPRT to a client who will not pay rent at the expiration of the term; therefore, why would we recommend an FLP to the client who will obviously ignore the FLP after it has been formed?  Your pre-formation FLP planning must include you asking the tough question to yourself and to your client – “Will you respect the FLP?”  

Formation:  Accepting the fact that our documents will be scrutinized, we need to make sure the FLP’s partnership agreement is appropriate. First, purge the instrument of any powers (assuming our client will serve as manager, in the case of a limited liability company, or own a general partner interest, in the case of a limited partnership) that are a per se violation of Section 2036.  To the extent our client retains some power over the investment of partnership assets and distributions from the FLP, consider whether there are any limitations that we can draft which will balance both Section 2036(a)(2)’s prohibitions and our client’s desire to retain some control over the FLP.  Second, the FLP’s purpose, as described in the partnership agreement, should be consistent with the client’s actual nontax motives for forming the FLP.  You may have some great language from another client addressing consolidation of fractional interests; however, if that is not applicable to the present client, do not add it.  Third, counsel your client to have the anticipated recipients of interests in the FLP obtain their own attorney to participate in the process and, at a minimum, review the partnership agreement.  Fatal to the BOFIS Exception is when the transferor, alone, is on both sides of the transaction.  Understandably, clients will balk at the prospect of additional legal fees; however, in light of the keystone to the BOFIS Exception being an arm’s length transaction, there needs to be someone on the other side to engage in meaningful bargaining with the client.

Funding:  Mr. Turner’s estate was admonished for spreading out the FLP funding process over an 8-month period without a credible explanation for the delay.  This was seenas a red flag by the Tax Court as behavior not typical of an arm’s length transaction.  Although there will always be factors out of the client’s control concerning transferring assets to the FLP, the attorney can provide a valuable service if he actively works with the family to oversee the process.  This assistance should begin in advance of forming the FLP, including identification of each asset to be transferred and the means by which such asset will be transferred.  Communication should be made with each entity holding custody to an asset to gather necessary information and forms required for transfer. If assets to be transferred are comprised of alternative investments, such as private equity funds, the conversation regarding transferring that interest (including, whether it can be transferred and at what time) should begin with the fund’s general counsel as soon as possible.  The objective of this additional work is that preparatory efforts concerning transferring assets made in advance of the FLP should minimize the funding period which will commence immediately after formation of the entity. 

Operations:  Just as important as forming the FLP, attention to detail concerning operation of the FLP is necessary.  We have learned that we cannot trust our clients to send out timely Crummey letters; why do we think they will be able to mange the LLC safely outside the vortex that is Section 2036?  Our engagement with our FLP-clients should continue past formation and consist of us serving as general counsel to the entity itself.  If you do represent both the entity and the transferor (who, presumably, will remain one of the partners), you should obtain a conflict waiver from the other partners, consenting to the mutual representation. The scope of your representation of the entity does not contemplate you being its “babysitter.”  If that isnecessary, the FLP may not be appropriate planning for your client.  However, as general counsel, it would be within your responsibilities to develop procedures for the general partner or manager to execute her duties, communicate with partners and exercise discretion.  You may also assist with record keeping, provide counsel when assets are acquired or disposed, and make recommendations regarding distributions among partners.  You may also provide an annual “audit” of the operations of the FLP to confirm that it is furthering its purpose(s) as set forth in the partnership agreement. 

For those FLPs that are already in existence, an immediate review of operations should be conducted to evaluate whether the entity has been operating consistently with its purported nontax purposes.  Whether the FLPs are recent or not, we should contact our clients to recommend an audit and to engage in a frank conversation about current FLP case law and the realities of their FLPs.  Even if you are having some concern that you would have done a client’s planning differently if you knew then what you know now, do not hesitate to meet with the client and review the operations of the FLP. 

Conclusion:  As you finish this article, hopefully you have resumed loving your FLPs.  We can keep our FLPs, we just need to be disciplined – disciplined in recommending the FLP to appropriate clients, disciplined in determining the legitimate, nontax reasonsfor the FLP, and disciplined in advising our clients concerning operations of the FLP.  Turner provided insight regarding the scrutiny the IRS and the Tax Court will engage in when evaluating an FLP’s qualification under the BOFIS Exception.  We must scrutinize each client’s FLP planning as well.  Before you plan your next FLP, take a step back, roll up your sleeves, and have a candid dialogue with your clients to determine if the FLP is an appropriate strategy for them. 

About the Authors:  Richard P. Breed, III is a founding shareholder of Tarlow, Breed, Hart & Rodgers, P.C., a law firm located in Boston, Massachusetts.  Attorney Breed concentrates in business succession planning for owners of privately-held enterprises.  In addition, Attorney Breed counsels high networth families in the preservation and protection of their children's inheritances from excessive transfer taxes and from possible interference by third parties, including creditors and divorcing spouses. Attorney Breed also counsels fiduciaries and beneficiaries in matters of trust and estate administration,a nd has testified as an expert witness in cases involving fiduciary litigation.  To read more about Attorney Richard P. Breed, III, please click here.

Jennifer A. Civitella Hilario is an associate of Tarlow, Breed, Hart & Rodgers, P.C.  Attorney Civitella Hilario advises high net worth families and individuals in the areas of estate and tax planning.  Attorney Civitella Hilario also counsels her clients on charitable planning strategies and philanthropic giving.  To read more about Attorney Civitella Hilario, please click here.



[1] Estate of Turner v. Comm’r, 2011 Tax Ct. Memo LEXIS 211 (Aug. 30, 2011).

[2] Estate of Miller v. Comm’r, 2009 Tax Ct. Memo LEXIS 117 (May 27, 2009).

[3] Estate of Mirowski v., Comm’r, 2008 Tax Ct. Memo LEXIS 75 (Mar. 26, 2008).

[4] Estate of Disbrow v. Comm'r, 2006 Tax Ct.Memo LEXIS 34 (Feb. 28, 2006).

[5]Heckerman v. United States, 2009 U.S. Dist. LEXIS 65746 (W.D. Wash. July 27, 2009).

[6] Estate of Erickson v. Comm’r, 2007 Tax Ct. Memo LEXIS 108 (Apr. 30, 2007).

[7] In addition to its holding concerning FLPs, the Turner Tax Court decided favorably for the taxpayer, holding, Mr.Turner’s payment of insurance premiums directly to the insurance company were indirect gifts to his irrevocable insurance trust and, nonetheless, qualified as a “present interest” for the purposes of Section 2503. 

[8] Turner, 2011 Tax Ct. Memo LEXIS 211, at*19.

[9] Id. at *11.

[10] Id. at *10.

[11] Id.

[12] Turner, 2011 Tax Ct. Memo LEXIS 211, at*19.

[13] Id.

[14] Turner, 2011 Tax Ct. Memo LEXIS 211, at*30.

[15] Id.

[16] Only one-half of the assets of Turner & Co. were included in Mr. Turner’s gross estate because his surviving wife contributed the other half of the assets to the entity and owned one-half of the entity’s partnership interests. 

[17] Turner, 2011 Tax Ct. Memo LEXIS 211, at*61.

[18] Id. at *60.

[19] Steve R. Akers, Estate Planning Current Developments 105 (Bessemer Trust, N.A. 2011).

[20] Estate of Bongard v. Comm’r, 124 T.C.95, 123 (2005).

[21] See Akers, supra, at 113 (discussing risks under Section 2036(a)(2) relating to having transferor serve as general partner or manger, or merely be a limited partner).

[22] Turner, 2011 Tax Ct. Memo LEXIS 211, at*36.

[23] Id. at *52-53.

[24] Id. at *46.

[25] Id. at *40 (comparing Mr. Turner’s FLP to other decisions in which it was held that consolidation of assets was a legitimate nontax motive, such as Estate of Black v., Comm’r, 133 T.C. 340 (2009), where transferor formed FLP toprevent family members from disposing of stock in order to maintain ability to have a swing vote in family-owned business).

[26] Turner, 2011 Tax Ct.Memo LEXIS 211, at *30 (stating that “consolidated asset management is not a significant nontax business purpose where family limited partnership is ….‘a mere asset container,’” quoting Estate of Erickson v. Comm’r, 2007 Tax Ct.Memo LEXIS 108 (Apr. 30, 2007)).

[27] Turner, 2011 Tax Ct. Memo LEXIS 211, at*44.

[28] Id. at *45-46 (comparing Mr. Turner’s FLP to other decisions in which it was held that management of assets was a legitimate nontax motive, such as Estate of Schutt v. Comm’r, 2005 Tax Ct.Memo LEXIS 126 (May 26, 2005), where transferor had a distinctive buy-hold investment philosophy that he sought to perpetuate).

[29] Turner, 2011 Tax Ct. Memo LEXIS 211, at *46 (comparing Mr. Turner’s FLP to decision in Erickson, supra, in which the Tax Court held that delegating investment responsibility to daughter via FLP was not a legitimate and significant nontax purpose when daughter already had management responsibility over such assets, significantly comprised of passive assets). 

[30] Id. at *47 (comparing Mr. Turner’s family disharmony to its decision in Estate of Stone v. Comm’r, 2003 Tax Ct.Memo LEXIS 312 (Nov. 7, 2003), in which it was held that resolution of familydisputes was a legitimate nontax motive where transferor formed FLP to resolve on-going litigation among children concerning ownership and control of family wealth).

[31] Turner, 2011 Tax Ct. Memo LEXIS 211, at *47.

[32] Turner, 2011 Tax Ct. Memo LEXIS 211, at *49 (comparing Mr. Turner’s purported need for asset protection to its decision in Estate of Schurtz v. Comm’r, 2010 Tax Ct. Memo LEXIS 22 (Feb. 3, 2010), in which it was held that there was a present risk to assets transferred to FLP, interests in a timberland business, because a litigious environment in Mississippi at the time of the formation of the FLP).

[33] Turner, 2011 Tax Ct. Memo LEXIS 211, at *51.

[34] Id.

[35] Turner, 2011 Tax Ct. Memo LEXIS 211, at *52.

[36] Id. at *58.

[37] Id. at *53-54.

[38] Id. at *58.

[39] Id. at *54.

[40] Id. at *56.

[41] See Turner,2011 Tax Ct. Memo LEXIS 211, at *56.

[42] Turner, 2011 Tax Ct. Memo LEXIS 211, at*57.

[43] Id. at *56.

[44] Id. at *57-58.

[45] Id. at *60.

[46] Id. at *59-60.

[47] Id. at *44(determining that transferred assets incurred no meaningful change).

[48] Id. at *36.

[49] Id. at *51.

[50] Id.

[51] Id., at*43-44.

[52] Id. at *55 (comparing Turner & Co. to an investment account from which withdrawals could be made at will because there was no evidence of there being any actual management of FLP assets).

[53] Id. at *57.

[54] Id. at *13.

[55] Id. at *38.

[56] Id. at *59-60.

[57] Id. at *8-9.

[58] See Akers, supra, at 105.

[59] Turner, 2011 Tax Ct. Memo LEXIS 211, at*40, *42

[60] Id. at *36.

[61] Id. at *49.

[62] Id. at *48.

[63] Id. at *49.

[64] Id. at *38 (the Court noting that consolidation of fractional interests, as stated in Turner & Co.’s partnership agreement, was not applicable in light of composition of Mr. Turner’s assets).





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