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George F. Bearup, J.D. Senior Legal Trust Advisor

7-Oct-20

String Provisions and the Bona Fide Sale Exception

Take-Away: The Tax Code’s string provisions often create unexpected federal estate tax exposure, cause assets that were transferred during the transferor’s lifetime to be included in the transferor’s taxable estate for federal estate tax calculation purposes. Fortunately, if the lifetime transfer was a bona fide sale, then none of the string provisions will apply to cause unexpected estate taxation.

Background: Each of the deadly string provisions of the Tax Code, i.e. IRC 2036, 2038 and 2035 provides an exception to its application, if the transfer, or release of a prohibited interest or power, was the subject of a bona fide sale. For example, if a parent’s initial capital contribution to an FLP is considered to be a bona fide sale for adequate and full consideration, then neither IRC 2036 nor 2038 will apply. If this statutory exception is satisfied, then the ‘implied understanding’ of use and enjoyment arguments under IRC 2036(a)(1) or the ‘control’ over who can use or enjoy the transferred property under IRC 2036(a)(2) or IRC 2038(a) will be irrelevant, as those sections will not apply. However, it is not easy to satisfy this exception. Through multiple court cases, primarily in the Tax Court, the phrase has been clarified.

Bona Fide Sale Exception: In order to satisfy the bona fide sale exception, the decedent’s estate must establish that the transfer of assets, say to an FLP, satisfies the requirement that it be: (i) a bona fide sale; and (ii) for full and adequate consideration.

  • Non-Tax Reason: The courts have articulated the standard that satisfies the bona fide sale component requires a showing that the creation of the FLP was in furtherance of a legitimate and significant non-tax reason.
  • Family Transactions Subject to Higher Scrutiny: While it is not impossible for the bona fide sale exception to be satisfied in a family transaction context, such transactions will be subject to a greater level of scrutiny.
  • Practical Limitations: The practical challenge is that this exception is not a simple ‘yes or no’ test. It depends on a facts and circumstances based determination. Consequently, there is no way to determine with certainty if this statutory exception has been satisfied until after the transferor has dies and his or her estate is under tax audit. As a result, many of the cases that have focused upon the bona fide sale exception often sound much like after-the-fact rationalizations for the creation of the FLP or FLLC.

What Courts Look For: Some common themes or points appear when a taxpayer’s estate has successfully thwarted claims under IRC 2036, 2038 or 2035 using the bona fide sale exception.

  • Partnership formalities are followed;
  • No personal assets, like homes or boats, are transferred to the FLP;
  • Assets assigned and contributed to the FLP were in fact assigned and re-registered in the name of the FLP;
  • Assets transferred to the FLP require active management, so management efficient is a legitimate non-tax reason for establishing the FLP;
  • Fractionalized assets, e.g. tenant-in-common interests, are consolidated in the FLP, to provide more efficient management and to avoid a tenant’s right of partition;
  • A pooling of assets from multiple partners, to enable their centralized management, is  legitimate non-tax purpose;
  • A pooling of the partners’ stock so it could be voted as a block, thus giving the family the swing vote in the event of a disagreement among the two major shareholders;
  • The character of the assets transferred to the FLP changed dramatically, i.e. the FLP was more than just a wrapper around the same assets;
  • The interest received in the FLP was proportionate in value to the assets that were contributed to the FLP;
  • The decedent’s partnership account was properly credited with the assets contributed to the FLP;
  • Distributions from the FLP required a negative adjustment to the distributee/partner’s capital account;
  • If marketable securities are transferred to the FLP, the FLP may still provide a substantial business or other non-tax purpose if the philosophy of the transferor, and thus FLP, was ‘buy and hold;’
  • On termination and liquidation of the FLP, the partnership agreement requires a distribution to be made to the partners according to their capital account balances;
  • The transferor retains sufficient assets outside the FLP for his/her own financial support (which avoids the IRS argument that there was a tacit understanding of the transferor’s access to the assets);
  • There was no commingling of FLP assets and the transferor’s personal assets.

Some reasons provided by decedent’s estates that did not get any respect in the Tax Court, or facts that cause the Tax Court to be highly suspicious of the motives for the FLP’ creation  include:

  • The FLP shields assets from a partner’s creditor claims (when the asset transferred to the FLP was corporate stock which already provided a layer or liability protection);
  • The FLP shields assets from the potential of divorce claims against family members (when there were no divorces in the family to the time that the FLP was created);
  • Generalized speculation about fears of litigation or a ‘litigious society’ (but without any actual history of expensive or protracted litigation to justify the fear);
  • Facilitating estate planning by the ability to make gifts of FLP units to family members; and
  • The use of FLP assets without paying any rent for the use of the asset.

Conclusion: While IRC 2036 and 2038 create significant transfer tax traps, the bona fide sale for adequate consideration in money or money’s worth exception is something of a comfort. The problem is that the individual who creates and funds the FLP will never really know if the exception was available until after their death, when arguably it is ‘too late.’ The IRS refuses to give advance rulings on the bona fide sale exception. While FLPs are not maybe as popular as they were in the 1990s with the incentive of creating dramatic valuation discounts to reduce exposure to federal estate taxes, if we soon find the transfer tax exemptions dropping back from $11.58 million to $3.5 million, there may be renewed interest in creating and funding FLPs. While clients may come into the office wanting an FLP for the valuation discounts normally associated with them, it is critically important to remind them that it is more than a ‘wrapper’ and that aside from the cost and administrative complexity of setting up an FLP, the consequences of a failed FLP can be worse than never having created it from both a tax and non-tax viewpoint.