Abstract:   A family limited partnership (FLP) can be a viable tax-advantaged method of handling assets — but only if it’s established and administered correctly. This article looks at an FLP that the IRS successfully challenged. It explains some of the specific factors that led the Tax Court to conclude that the decedent’s asset transfers were not the bona fide sales that would have qualified the FLP for favorable tax treatment.

Another one bites the dust

Tax court rules against FLP

A family limited partnership (FLP) can be a viable tax-advantaged method of handling assets — but only if it’s established and administered correctly. That wasn’t the case with an FLP the IRS successfully challenged in Estate of Liljestrand v. Commissioner, and the result was a tax deficiency of about $2.6 million.

Asset transfer

Paul Liljestrand owned interests in several pieces of real estate through a revocable trust. His son Robert managed the real estate.

Liljestrand formed an FLP and transferred the real estate to it in exchange for a 99.98% interest, with Robert receiving the remaining interest. Liljestrand subsequently gifted FLP interests to trusts established for each of his four children. Although his estate planning attorney obtained an independent valuation of the interests, Liljestrand came up with his own estimates.

After Liljestrand died, the estate paid his taxes. However, the IRS issued a notice of tax deficiency. In its notice, the IRS included the value of the real estate transferred to the FLP in the gross estate. The estate turned to the Tax Court for relief.

Bona fide or not?

Under Internal Revenue Code Section 2036(a), assets that are transferred by a decedent during his or her lifetime are considered part of the gross estate if the decedent continued to derive a benefit from the assets or control the enjoyment of the assets. An exception excludes assets from the estate, though, if the transfer was a bona fide sale for full and adequate consideration.

The court determined that Liljestrand’s transfers weren’t bona fide sales, identifying several reasons:

Partnership formalities weren’t observed. The FLP was in existence for two years before a separate bank account was opened for it. Prior to that, all of its banking was done through the trust’s bank account, resulting in a commingling of partnership and personal funds. Only one partnership meeting was ever held, and no minutes were kept. Moreover, Liljestrand used FLP assets to pay for personal expenses and was financially dependent on his disproportionate partnership distributions.

The transfers weren’t at arm’s length. Liljestrand stood on all sides of the transaction. He formed and fully funded the FLP and received almost 100% of the partnership interests.

Contributions lacked full and adequate consideration. Interests credited to each of the partners weren’t proportionate to the fair market value of the assets that each contributed to the partnership, because Robert made no contributions. Also, the assets contributed by Liljestrand weren’t properly credited to his capital account.

The court found it “especially significant” that the FLP failed to even maintain capital accounts when it was first formed and used neither the values established in the independent valuation nor the fair market value of the real estate to establish the value of each partner’s FLP interest. It ultimately concluded that Liljestrand did not contribute the real estate for full and adequate consideration.

FLP failure

The Liljestrand case might seem discouraging, but the Tax Court has also upheld FLPs, allowing the exclusion of their assets from estates. It’s imperative that your clients’ FLPs be properly set up and administered to take advantage of the Sec. 2036(a) exclusion.