FLPs and I.R.C. § 2036(a)

The winning entry in the Second Annual Mary Moers Wenig Student Writing Contest sponsored by the American College of Trust and Estate Counsel has just been published — Layne T. Smith, FLPs and the 2036(a) Bona Fide Sale Exception: The Vital Role of the Presumption of Adequate and Full Consideration, 31 ACTEC J. 138 (2005).

Mr. Smith graduated from the J. Reuben Clark Law School at Brigham Young University and is now working for Wood Crapo LLC in Salt Lake City, Utah.

Here is the conclusion of Mr. Smith’s article:

The FLP potentially offers taxpayers substantial transfer tax savings in the form of valuation discounts for lack of control and lack of marketability. Under the fair market value standard, these discounts are entirely appropriate and justifiable. However, when taxpayers use FLPs as testamentary vehicles with little accompanying business purpose, the availability of tax savings resulting from these discounts should be curtailed. Recognizing this, courts have been quite willing over the past few years, when appropriate, to bring property transferred to an FLP back into the decedent’s gross estate using Section 2036(a). But courts should be wary of an overly liberal application of the bona fide sale exception that could negate the effectiveness of Section 2036(a).

The general failure to recognize the proper justification for applying the bona fide sale prong has led to confusion among courts concerning the correct standard for evaluating transfers of property to an FLP. The bona fide sale exception cannot be applied to a transfer to an FLP on the grounds that the discounted partnership interest received in return replenishes the estate dollar for dollar. Instead, the exception should only be applied to discounted interests received in exchange for a transfer to an FLP in the ordinary course of business. When a transaction is entered into in the ordinary course of business—that is when the transfer is both bona fide, at arm’s length, and free from donative intent—courts may presume that the transferor received adequate and full consideration in money or money’s worth. Because this presumption is the only proper justification for holding that the bona fide sale exception applies to transfers to an FLP, only transactions entered into in the ordinary course of business should be excepted from the reach of Section 2036(a) as bona fide transfers for adequate and full consideration.