Retaining control of a family limited partnership or family limited liability may trigger estate tax consequences.

Grantor establishes a family limited partnership or family limited liability company for estate planning purposes. If he or she dies while serving as general partner or chief manager, will the entity be includible in his or her estate for estate tax purposes?

There is no definitive answer, and commentators are divided on the advisability of the grantor serving as general partner or chief manager. Because the IRS raises this issue from time to time (albeit not always successfully), ideally the grantor would not serve in a management capacity.

As background, Section 2036(a) triggers estate inclusion under two scenarios:

  1. Decedent transfers assets (whether in trust or otherwise) and retains the possession or enjoyment of, or the right to the income from, the property.
  2. Decedent transfers assets (whether in trust or otherwise) and retains the right to designate the persons who shall possess or enjoy the property.

However, there will be no inclusion under (1) or (2) if a transfer is a bona fide sale for adequate and full consideration.

Under Section 2036(b), the retention of the right to vote (directly or indirectly) shares of stock is considered retention of the enjoyment of transferred property for purposes of Section 2036(a)(1). This rule, however, only applies to a controlled corporation. Retention of voting rights in other entities apparently is outside the scope of Section 2036(b).

Retention of management rights in a family entity—for example, as chief manager of an LLC or as a general partner of a limited partnership—raises questions about Section 2036(a)(2). After all, a manager typically has the ability to control the timing and amount of entity distributions. As such, this could be viewed as the right to designate the persons who shall possess or enjoy the property.

The IRS issued a series of PLRs and TAMs between 1986 and 1997. Relying on the U.S. Supreme Court’s 1976 decision in U.S. v. Byrum, the IRS ruled that retention of management rights will not cause inclusion under Section 2036 so long as a general partner is subject to a fiduciary duty to the limited partners under state law. See TAM 9131006, PLR 9415007, PLR 9710021, and to a lesser degree TAM 8611004.

On October 20, 2006, the National Office of the Internal Revenue Service issued Appeals Coordinated Issues Settlement Guidelines. The Guidelines indicate that IRS Appeals focuses on four basic issues: (1) validity of the partnership or LLC under Sections 2036 and 2038; (2) valuation; (3) indirect gifts; and (4) penalties.

With respect to Sections 2036 and 2038, the Guidelines review various cases, including some won by the Government and some lost by the Government. Negative factors highlighted included:

  • commingling of partnership and personal funds;
  • property being used by the senior family member without the payment of fair rental;
  • disproportionate distributions; and
  • failure to transfer assets to the partnership that were intended to be contributed.

The Guidelines also suggest that partnership distributions for the purpose of enabling a partner to maintain his or her lifestyle, including the making of annual exclusion gifts, is a basis for Section 2036 inclusion. In addition, contribution of substantially all of a decedent‘s assets to a partnership was cited as a red flag under Section 2036.

Moreover, there have been numerous Section 2036 cases involving family limited partnerships since 1997. In the vast majority of these cases, the IRS prevailed under Section 2036(a)(1), rather than 2036(a)(2). The courts found that the grantor retained possession or enjoyment of transferred assets under two theories. Under the implied agreement theory, courts assumed that a grantor who commingled assets and ignored corporate formalities never really intended to part with the benefits of transferred property. Under the testamentary device theory, transfers in close proximity to death were presumed to be motivated by death tax planning, rather than valid non-tax business concerns.

Regardless, Section 2036(a)(2) remains an issue. As one commentator put it:

While section 2036(a)(2) is less litigated than section 2036(a)(1), it is still important and has formed the basis for successful Service claims of deficiency. It is most likely to be an issue when the client wants to retain as much power over the assets as possible, primarily as a trustee, general partner, or managing member. The safest course is not to let the client accept one of these positions. If, however, the client is insistent on managing the entity, it is crucial to make sure there is a legally enforceable, ascertainable standard in the governing instrument for all important events such as profit sharing, distributions, liquidation, dissolution, amendments, etc.1

Posted by Joel D. Roettger, JD, LLM, EPLS

Levy, Section 2036 of the Internal Revenue Code: A Practitioner’s Guide, 51 Real Property, Trust and Estate Law Journal 75, 90 (Spring 2016)