By Trisha J. English, Esq.
Winstead PC, Houston, TX
In Stone Est. v. Comr.,1 Mr. and Mrs. Stone jointly owned approximately 740 acres of undeveloped woodlands near a man-made lake in Cumberland County, Tennessee. After the lake was formed, the Stones desired for the woodlands to become a family asset in hopes that the family would one day be able to develop and sell homes near the lake. The Stones sought legal counsel as to the best way to facilitate gifts of real property to family members and were advised that creating a family limited partnership would (1) simplify the gift giving process by not requiring frequent execution and recording of deeds, and (2) help guard against partition suits.
A limited partnership was formed on December 29, 1997, naming Mr. and Mrs. Stone as each having a 1% general partner interest and a 48% limited partner interest. The next day, the Stones deeded the woodlands to the partnership. The day after that, the Stones gifted 26.628% of their limited partnership interests to their children, children's spouses, and grandchildren. The Stones continued to gift limited partnership interests over the next three years and, by the end of 2000, Mr. and Mrs. Stone each owned only a 1% general partnership interest - with the children, children's spouses, and grandchildren owning the remaining 98% limited partnership interests. The gifts of limited partnership interests were reported on gift tax returns and the value of the gifts were based on undiscounted real estate appraisals of the woodlands.
The woodlands were the partnership's only asset. The partnership had no income and made no distributions. The partnership's only expense consisted of property taxes that Mr. and Mrs. Stone paid from their personal account. The woodlands remained undeveloped and the Stones only use of the woodlands were for fishing to and visit one of their children who lived on an adjacent property.
Mrs. Stone died in 2005 - more than three years after her final gifts of limited partnership interests - and the IRS argued that the value of Mrs. Stone's share of the woodlands that were transferred to the partnership were includible in her estate under §2036(a).
Creation of family-managed asset was a legitimate and significant nontax purpose for the transfer. The court's analysis focused on whether the exception to §2036(a) applied; namely whether the transfer of assets to the partnership was a bona fide sale for adequate and full consideration. In the context of family limited partnerships, the bona fide sale exception is met where the record establishes the existence of a legitimate and significant nontax reason for creating the partnership and the transferors received partnership interests proportional to the value of the property transferred.2
The court dismissed the IRS's argument that the primary purpose of the partnership created by the Stones was to facilitate gift giving: "While we agree with respondent that gift giving alone is not an acceptable nontax motive, we disagree that gift giving was decedent's only motive in transferring the woodland parcels to [the partnership]." The court then concluded that the "significant purpose" of the transfer of the woodlands to the partnership was to create a family-managed asset, and that this was a legitimate nontax motive for purposes of qualifying for the exception to §2036.
Arm's-length transaction. The IRS argued that §2036 should apply because the Stones were "on both sides of the transaction" as both transferor of the woodlands and as general manager of the partnership. The court appeared to dismiss this factor as a consideration when there is a legitimate and nontax reason for the transaction. The court stated, "[w]e have already found the existence of a legitimate nontax motive for the transaction…we also believe decedent received interests in [the partnership] proportional to the property she contributed. Therefore, this factor does not weigh against the estate."
Failure to respect partnership formalities not determinative. The IRS also argued that no bona fide sale occurred because the Stones failed to respect certain partnership formalities by: (1) paying for the woodlands' property taxes out of their personal account, (2) using the wrong form of documentation for some of the gift transactions,3 and (3) requiring, during two divorce proceedings, the ex-spouses of their children to quitclaim interests in the woodlands as opposed to transferring their partnership interests.4
The court acknowledged that the Stones failed to respect some partnership formalities, but concluded that the following additional factors support the conclusion that a bona fide sale occurred: (1) the Stones did not rely on distributions from the partnership for living expenses (as no distributions were made); (2) the Stones made a complete transfer of the woodlands to the partnership; (3) there was no commingling of partners' personal and partnership funds; (4) the Stones did not take a discount on the value of the gifted partnership interests; and (5) the Stones were in good health at the time of the transfer. On balance, the court concluded that the factors were in favor of finding that there was a bona fide sale, thus §2036(a) did not apply to cause inclusion of the value of the woodlands in Mrs. Stone's estate.
Comment. It is interesting that the IRS chose to pursue this case even though no discount was taken on either the 1% general partnership interest on the estate tax return, or on the gifts of limited partnership interests reported on prior gift tax returns. Also, the facts of this case favored the taxpayer. Although there were some partnership formalities that were not followed, on balance they were minimal. Furthermore, if the court had actually reached an analysis of retained enjoyment under §2036(a)(1), it would have been in the taxpayer's favor that the decedent did not live on the partnership property, rarely used the property, and did not rely on partnership distributions.
For more information, in the Tax Management Portfolios, see Lischer, 52 T.M., Incomeplete Lifetime Transfers: Retained Beneficial Interests Under Sections 2036(a)(1) and 2037, and in Tax Practice Series, see ¶6200, Pre-Death Transfers - Sections 2035, 2036, 2037, and 2038.
1 T.C. Memo 2012-48.
2 Bongard Est. v. Comr., 124 T.C. 95, 118 (2005).
3 The Stones mistakenly used bills of sale to make gifts of partnership interests. The bills of sale had a recitation of a nominal consideration for the transfer even though no consideration was actually paid.
4 Two of the Stones' children went through divorces and, instead of a buy-out of the non-family spouse's partnership interest, the non-family spouses quitclaimed interests in the woodland parcels (apparently attributable to their partnership interests) to the spouses who were children of the Stones. Technically this was incorrect, as the asset owned was a partnership interest, and not a direct ownership of the land.