Assets Transferred to Family Limited Partnership Included in Decedent's Estate

Scott E. Vincent
Vincent & Fontg LLC
Kansas City
The Eighth Circuit, in Estate of Korby v. Comr., No. 06-1202 (8th Cir., December 8, 2006), recently held that assets transferred to a family limited partnership were included in the estates of a husband and wife because the spouses retained the right to income from assets and did not make a bona fide sale for consideration.

Factual Background

Austin and Edna Korby were married in 1948, and had four sons, Dennis Korby, Gary Alan Korby, Donald Wayne Korby, and Steven Glen Korby. In 1993, Austin was 79 years old and Edna was 69 years old. In February 1993, Edna was diagnosed with severe Alzheimer’s dementia, and she resided in a nursing home from mid-February 1993 until she died in 1998, from progressive dementia. Austin was also in poor health in 1993, and his condition gradually worsened, leading to his death in 1998.

In 1993, Austin and Dennis met with an attorney specializing in estate planning. On June 2, 1993, with the assistance of the attorney, Austin and Edna formed a living trust as co-makers. Austin and Dennis were the only trustees of the living trust from its inception until Austin’s death in 1998. Edna was never a trustee of the living trust. The living trust gave Austin and Edna the authority to control and direct payments, add or remove living trust property, and amend or revoke the living trust.

On March 26, 1994, Korby Properties, a Limited Partnership (“KPLP”) was formed under the Minnesota Limited Partnership Act with the help of the estate attorney who had been involved in the formation of the living trust. Austin, Edna, and each of their sons signed the limited partnership agreement as limited partners. The living trust was the sole general partner of KPLP from its formation until 1999. Austin and Dennis signed the KPLP agreement as co-trustees of the living trust. The KPLP agreement provided for management fees to be paid to the general partner “to be measured by the time required to manage and administer the partnership, by the value of property under the general partner(s) administration, and by the responsibilities the general partner(s) assume in discharging of the duties of office.” The general partner was to decide the amounts of the management fees. The KPLP agreement also required KPLP to reimburse the general partner for “all reasonable and necessary business expenses incurred in managing and administering the partnership.”

Between 1993 and spring 1995, the following assets of the Korbys were transferred to the living trust: (1) money market account; (2) a house in Fergus Falls, Minnesota; (3) a vacant lot in Fergus Falls, Minnesota; (4) a checking account; (5) a savings account; (6) household furnishings and items; (7) a 1% general partnership interest in Crane Properties, A Limited Partnership (Crane Properties); (8) a 2% general partnership interest in KPLP; and (9) the Korbys’ monthly Social Security checks. During 1993, the living trust also opened a checking account.

Austin and Edna also transferred $1,850,863 of stocks and bonds to KPLP in exchange for a 98% limited partnership interest. The living trust transferred a $37,841 savings account to KPLP in exchange for a 2% general partnership interest. In 1995, Austin and Edna gave the 98% limited partnership interest in equal shares to four irrevocable living trusts for their sons. The couple’s gift tax returns for 1995 valued each gift at $260,935, after applying discounts of 43.61%.

Between 1995 and 1998, the year both Austin and Edna died, KPLP made distributions totaling $120,795 to the living trust as general partner and made distributions totaling $34,562 to the sons’ living trusts as limited partners. The payments to the living trust were used to pay Edna’s nursing home costs and to pay the couple’s taxes, medical bills, and other expenses. The distributions to the sons’ living trusts were intended to pay the limited partners’ income taxes.

Estate tax returns for Austin and Edna were filed in September 1999. The return for Edna, who died first, listed a gross estate of $73,398, consisting of joint property and a 1% general partnership interest in KPLP. Austin’s estate tax return then included the entire 2% general partnership interest in KPLP. Neither return included the value of the assets transferred to KPLP in 1995. The IRS issued deficiency notices to both estates in 2002, asserting that the estates should include the full value of the KPLP assets under § 2036 because Austin and Edna retained for life the possession of, enjoyment of, or right to income from those assets.

The Tax Court held that: (1) Austin and Edna had retained a right to the assets transferred to KPLP; (2) KPLP did not satisfy the § 2036(a) exception for bona fide sales for adequate consideration because tax avoidance was the couple’s main reason for forming KPLP; and (3) contrary to the estates’ argument, the IRS had not admitted that Austin and Edna lacked control over KPLP by taking the position that Edna’s estate was not entitled to a § 2056 marital deduction for the assets she transferred to KPLP in exchange for a limited partnership interest. The estates appealed the Tax Court’s decision.

Holding and Analysis

The Eighth Circuit affirmed the Tax Court, holding that Austin and Edna retained for their lives the right to income from the assets transferred to KPLP.

The Eighth Circuit first held that the Tax Court’s determination that Austin and Edna had an implied agreement with their sons to retain the right to income from KPLP after its initial funding was not clear error. The Tax Court had rejected the estates’ claim that the KPLP payments to the living trust were legitimate management fees. The Eighth Circuit agreed, noting that: (1) KPLP made significant payments to the living trust over the remainder of the couple’s lives; (2) there was no management contract; (3) Austin failed to keep track of the hours he spent managing KPLP; (4) KPLP made payments to the living trust whenever Austin requested, with no set payment schedule; and (5) Austin did not report the payments as self-employment income. The court also noted that Austin and Edna, who were in poor health, did not retain sufficient income to cover their expenses after the transfers to KPLP.

The Eighth Circuit also found no clear error in the Tax Court’s conclusion that the transfers did not satisfy the § 2036 exception for bona fide sales. The Eighth Circuit stated that a transfer is not typically a bona fide sale if the transferor participates on both sides of the transaction. The court also stated that a bona fide sale must have a substantial business or other non-tax purpose. In this case, the court concluded that Austin was on all sides of the transaction because he formed KPLP with the help of his estate planning lawyer, did not involve other parties in the formation, and made the determinations regarding which assets would be transferred to KPLP. The court also upheld the Tax Court’s conclusion that Austin and Edna formed KPLP to make a testamentary transfer to their sons at a discounted value, while retaining access to the income from the transferred assets.

Lastly, the Eighth Circuit rejected the estate argument that the IRS had judicially admitted that Austin and Edna did not retain an interest in the KPLP assets when the IRS countered Edna’s estate claim for a marital deduction.

Conclusion

The Eighth Circuit decision in this case emphasizes the recent trend in Tax Court decisions making use of family limited partnerships much more challenging. As an Eighth Circuit decision, it will be binding on all Tax Court cases originating from Missouri.