The IRS and Section 2036

Demystifying Valuation, Economic Damages + Forensic Accounting

The IRS continues to look at family limited partnerships (FLPs) and whether or not they have been formed for a sufficient business purpose. Section 2036 of the IRS Code provides that the gross estate should include the value of any property to the extent a transfer has been made but the decedent has retained 1) the possession or right to income from the property or 2) the right to designate who shall possess or enjoy the property or income derived from the property. In a recent case, Estate of Perdue v. Commissioner, the IRS argued that the transfer of assets used to form an LLC was a transfer with a retained interest. The IRS argued for the transferred assets to be included in the estate of Mrs. Perdue.

The Estate argued that the transfer was a bona fide sale for full consideration, an exception to Section 2036.

The Tax Court considered the issues of bona fide sale and full consideration as two separate items.

In considering a bona fide sale, the Tax Court looked for whether the LLC was formed for a legitimate and significant non-tax reason. The tax court considered many factors to determine whether or not a bona fide sale occurred.

As for full consideration, the court looked to their position in other cases that full consideration is satisfied if the taxpayers received an interest in the LLC equal to the proportionate value of the LLC.

The Tax Court (T.C. Memo 2015-249) ruled in favor of the estate for both bona fide sale and full consideration. The court noted that the taxpayers were not financially dependent upon distributions from the LLC, there was no commingling of personal and LLC assets, bank accounts were maintained, the operating agreement was followed, assets were timely transferred and the taxpayers were in good health at the time of transfer. The Tax Court also ruled that the “decedent’s desire to have the marketable securities and the building interest held and managed as a family asset constituted a legitimate non-tax motive for transfer of property” to the LLC.

Despite the ruling in favor of the taxpayer, taxpayers need to be aware that the IRS has had Section 2036 issues in its sights for some time now and that is likely not to change. Taxpayers and their trusted advisors need to be aware of the areas which the IRS is prone to concentrate on:

  • Dependence upon income from the entity;
  • Commingling of personal and FLP assets;
  • Establishment of a partnership or operating agreement and adherence thereto;
  • Separate FLP bank accounts;
  • Annual meetings of the FLP;
  • Health and age of the taxpayer at time of transfer;
  • Have the assets been managed differently since formation of the FLP.

Facts and circumstances will always dictate whether or not the formation of the FLP qualifies as a bona fide sale for full consideration. So be sure to get your ducks in a row when forming your FLP.

By Melissa E. Loughlin-Sines, CPA, CFE, CVA, CFF, ABV