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FLP Fails the “Full and Adequate Consideration” Test

By Joe Aquino, CPA, CVA on October, 9 2012
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Joe Aquino, CPA, CVA

Director | Freed Maxick

Family Limited Partnership Misses the Mark in Tax Court Ruling

Author: Joe Aquino

Although a family limited partnership (FLP) can be a viable method of handling assets in a tax-advantaged way, it must be established and administered correctly. The estate in Estate of Liljestrand v. Commissioner failed to properly set up and manage its FLP, and when the IRS challenged it, the result was a tax deficiency of about $2.6 million.
DIY valuation

Paul Liljestrand owned interests in several pieces of real estate through a revocable trust and 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. Robert received the remaining interest. Liljestrand subsequently gifted FLP interests to trusts established for each of his four children. His estate planning attorney obtained an independent valuation of the interests, but Liljestrand came up with his own value estimates.

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

In or out?

Under Internal Revenue Code Section 2036(a), when assets are transferred by decedents during their lifetime, those assets are considered part of their gross estate if they continued to derive a benefit from the assets or controlled the enjoyment of them. However, if the transfer was a bona fide sale for full and adequate consideration, the assets are excluded from the estate.

The court determined that Liljestrand’s transfers weren’t bona fide sales. It cited several reasons:

Formalities weren’t observed. The FLP existed for two years before a separate bank account was opened for it. Prior to that, its banking was done through the trust’s bank account. As a result, partnership and personal funds were commingled. Only one partnership meeting — at which no minutes were kept — was ever held. What’s more, Liljestrand used FLP assets to pay for personal expenses and was financially dependent on his disproportionate partnership distributions.

Transfers weren’t at arm’s length. Liljestrand formed and fully funded the FLP and received almost 100% of the partnership interests. In other words, he stood on all sides of the transaction.

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

The court ultimately decided that Liljestrand did not contribute the real estate for full and adequate consideration. “Especially significant” in the court’s eyes was the fact 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.

FLP failure

business interruptionThe Liljestrand case is only one of many battles in a larger conflict between FLPs and the IRS. Fortunately, the Tax Court has also upheld FLPs, allowing the exclusion of their assets from estates. To help your clients’ FLPs withstand any challenges, ensure that they’re properly set up and administered to take advantage of the Sec. 2036(a) exclusion.

For any questions regarding this case or other litigation support issues, contact us here or give us a call at 716.847.2651.

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