Take-Away: Another risk associated with using a family limited partnership (FLP) if the FLP’s assets are included in the transferor’s taxable estate due to IRC 2036 is a potential mismatch between the IRC 2036 inclusion amount and the decedent’s reliance upon the marital deduction.

Background: As previously covered, the IRS often successfully challenges estate planning with the use of an FLP under IRC 2036(a)(1) and IRC 2036 (a)(2). The challenge is typically based on the premise that a founding partner has not actually given up enjoyment or control over the assets that he or she contributed to the partnership so as to enable only the value of his/her partnership interest, as opposed to the value of his or her proportionate share of the underlying assets in the partnership, to be included in his or her estate. In the context of IRS challenges to FLPs, the IRC 2036(a)(1) argument focuses on a partner’s retained ability to use or enjoy the FLP’s assets. The IRC 2036(a)(2) challenge focuses on the partner’s retained ability to control who uses or enjoys the FLP’s assets. Implicit, then, is that there is a transfer in which the transferor retained the use, enjoyment, or control over an asset that is transferred to the FLP. The determination of whether or not a partner has retained a prohibited interest is based on all of the facts and circumstances, and quite often after the transferor has died.

Valuation Downside: In Part I it was noted that the Tax Court’s formula for estate inclusion, if IRC 2036 applies, could lead to ‘double counting’ of the appreciation in the assets (the FLP’s assets under IRC 2036) and the retained FLP interest itself (under IRC 2033.) Technically the assets are not supposed to be counted twice, which is why IRC 2043 was added to the Tax Code, but the way that code section is now interpreted by the Tax Court, the result is that more assets may be included in the transferor’s taxable estate since IRC 2036 snares all appreciation in the transferred FLP assets, while the offset is only the actual value of the assets initially transferred to the FLP.

Marital Deduction Mismatch Downside: A second risk posed by IRC 2036 to an FLP is a mismatch between what is included in the decedent-transferor’s taxable estate and the marital deduction that the decedent’s estate may rely upon to defer any federal estate taxation until the surviving spouse’s subsequent death. Specifically, IRC 2036 applies to cause phantom gross estate inclusion of assets (at full, undiscounted value) transferred by the decedent to an FLP, but the decedent legally owns only FLP units (more likely only limited partnership units) at the time of his or her death which may then pass subject to the unlimited marital deduction.

  • Example: Brian creates and funds an FLP. Harry gifts a 1% general partnership interest to his child. Harry continues to own a 99% limited partnership interest. On Harry’s death, the 99% limited partnership interest then passes into a Qualified Terminable Interest Property trust (QTIP) for the lifetime benefit of Harry’s surviving spouse, Wendy. If IRC 2036 applies to the FLP that Harry created and funded prior to his death, the full inclusion of the underlying assets held in the FLP will be in Harry’s gross taxable estate. However, the FLP units, those actually owned by Harry, which are valued less than the FLP’s assets due to lack of control and lack of marketability of limited partnership interests, will pass to the QTIP trust for Harry’s surviving spouse, Wendy. In short, there is a mismatch between the value that is included in Harry’s gross taxable estate, which creates federal estate tax liability, and the value of assets  i.e. the less valuable (FLP units) that pass to the QTIP trust for Wendy . The valuable controlling general partnership interest is owned by Harry’s child, not Harry, and it will not pass to the QTIP trust.
  • Mismatch: Can the phantom asset value that is added to Harry’s gross estate under IRC 2036 be offset by the value of the LP units (with a lower value) that actually pass from Harry’s estate to the QTIP Trust that is created for his surviving spouse and is intended to qualify for the unlimited marital deduction? The Tax Court specifically addressed this question and said ‘no.’

Estate of Turner v. Commissioner, 102 Tax Court Memo, (2011) supplemented in Turner v. Commissioner, 138 Tax Court 306 (2012)

I will not get into the facts. Suffice it to say that the Tax Court found that both IRC 2036(a)(1) and IRC 2036 (a)(2) applied to an FLP formed by both the husband and his wife. In a Supplemental Decision, the Tax Court considered the husband’s estate’s argument that, in light of the determination of the gross estate inclusion under IRC 2036 of the assets transferred to the FLP, i.e. a phantom asset value, a full offsetting estate tax marital deduction should apply, if the same FLP interest then passed to a trust for the surviving spouse. The Tax Court rejected this argument, noting that it was not possible to obtain the marital deduction with respect to the assets that pass into the marital deduction trust (since the decedent had gifted  the limited partnership (LP) interests during his lifetime.) The Tax Court reasoned that the marital deduction can only be permitted under the Tax Code [IRC 2056] to the extent that the property actually ‘passes’ to or for the benefit of the surviving spouse, which did not occur with regard to the LP interests that the decedent had transferred during his lifetime. Therefore, the phantom asset inclusion in the decedent’s gross estate caused by IRC 2036 was without an offsetting marital deduction of the same amount, which produced a particularly harsh tax result for the husband’s estate, i.e. (i) phantom assets caused an estate tax, and (ii) since those phantom assets did not actually pass to the decedent’s surviving spouse, there was no offsetting marital deduction against the increased federal estate tax.

Conclusion: As was mentioned in Part I, the use of FLPs are not ‘nothing to lose’ estate planning ventures. A failed FLP (under IRC 2036) can have significantly worse estate tax consequences when the first spouse dies than if nothing was done at all, if the FLP worked to the extent that the assets transferred to it continued to appreciate in value, but it did not work because the transferor retained too much enjoyment or control over the transferred assets. If the retained FLP asset then passes to the transferor’s surviving spouse there can be a mismatch in values (phantom FLP assets vs. what actually passes to the surviving spouse) that is yet another reason to periodically diagnose an existing FLP to discern the transferor’s exposure to an IRC 2036 claim and take action to move the retained FLP interest away from the transferor.