Doc 2005-21173 (4 pgs)
By J. Joseph Korpics
J. Joseph Korpics is an attorney with Jones Day,
Cleveland. The views set forth herein are the personal
views of the author and do not necessarily reflect
those of Jones Day or its clients. These materials do not
constitute legal advice and the author assumes no
responsibility for any reliance on them. All original
sources should be verified and facts and other issues
should be considered independently by the reader.
A lingering question for family limited partnership
(FLP) practitioners and taxpayers has been whether the
bona fide sale exception to section 2036(a) includibility
can be met by a primarily marketable securities FLP
formed for a generic nontax reason such as asset protection, training the next generation, investment considerations, litigation avoidance through arbitration provisions, and so on. While it has been relatively clear that a
particularly noteworthy nontax purpose should suffice —
such as the initial public offering rationale in Bongard,1 or
the Kimbell2 creditor protection rationale to protect
against potential environmental liability, or the litigation
context of Stone3 — there has been less certainty regarding generic purposes. Nevertheless, the law in that regard
rightfully has evolved over the past year or so from the
Tax Court’s ‘‘mere recycling’’ emphasis on pooling of
assets and the presence of a business component, to a
uniform, practical acceptance of the ‘‘any nontax reason’’
approach.4
Evolution of the Bona Fide Sale Exception
Early on, the Tax Court fashioned and followed a bona
fide sale exception test for FLPs that required, in relevant
part, something other than a ‘‘mere recycling’’ of assets.5
As described by the Tax Court, moreover, it appeared
that ‘‘mere recycling’’ could be avoided only through a
legitimate pooling of assets or the presence of a material
business component. The decisions thus seemed to leave
little room for taxpayers to rely on plain nontax reasons
for forming FLPs — unless those reasons somehow
satisfied the pooling/business rationale.
The move toward approving standard nontax reasons
for forming FLPs began in earnest with the 2004 Kimbell
decision. In Kimbell, the Fifth Circuit rejected ‘‘mere
recycling’’ and became the first court to openly imply
that any nontax reason should suffice. In its bona fide
sale analysis, the court underscored that the Kimbell FLP
was formed for ‘‘substantial business and other nontax
reasons,’’ and favorably considered plain nontax reasons
such as creditor protection, economies of scale, litigation
avoidance, and continuity of management. (The court
also explained that an FLP should be something other
than ‘‘a sham transaction motivated solely by tax avoidance’’ (based on objective evidence)). Nevertheless, despite that favorable sentiment toward standard nontax
reasons for forming an FLP, and despite the fact that the
court ruled in favor of the estate, many taxpayers remained wary for several reasons. First, the Kimbell court
singled out the FLP’s 11 percent business component as a
primary consideration in its pro-taxpayer decision. Second, the Fifth Circuit not only emphasized the 11 percent
business component, but the court also appeared to
superimpose it onto the FLP’s generic nontax reasons:
‘‘[m]ore to the point, the stated reasons for the formation
of the Partnership are confirmed by objective facts, many
of which relate to the rights and responsibilities associated with investments in oil and gas investments’’ (that
is, the business component); and ‘‘[those generic nontax]
reasons were strongly supported by the nature of the
business assets (divided working interests in oil and gas
properties).’’ Third, the IRS failed to challenge the generic
factors offered by the estate — a tactic that seemed
unlikely to be repeated. Thus, while Kimbell started the
ball rolling, taxpayers generally were left waiting for
more.
The Third Circuit’s Thompson6 decision followed literally on the heels of Kimbell, and more clearly trumpeted
the notion that any nontax reason would be acceptable.7
1
Estate of Bongard v. Comm’r, 124 T.C. No. 8, Doc 2005-5359,
2005 TNT 50-11 (Mar. 15, 2005).
2
Kimbell v. U.S., 371 F.3d 257, Doc 2004-10976, 2004 TNT 100-9
(5th Cir. 2004).
3
Estate of Stone v. Comm’r, T.C. Memo. 2003-309, Doc 200324235, 2003 TNT 217-26.
4
The bona fide sale exception also requires adherence to
formation and operational considerations that are not discussed
in this article but are detailed in Korpics, ‘‘Qualifying New FLPs
for the Bona Fide Sale Exception: Managing Thompson, Kimbell,
Harper, and Stone,’’ 102 J. Tax’n 111 (February 2005).
5
See, e.g., Estate of Stone, T.C. Memo. 2003-309; Strangi v.
Comm’r, T.C. Memo. 2003-145, Doc 2003-12584, 2003 TNT 98-16,
aff’d on other grounds, 417 F.3d 468, Doc 2005-15234, 2005 TNT
137-12 (5th Cir. 2005); Estate of Thompson v. Comm’r, T.C. Memo.
2002-246, Doc 2002-22023, 2002 TNT 188-7, aff’d, 382 F.3d 367,
Doc 2004-17577, 2004 TNT 171-8 (3d Cir. 2004); Estate of Harper v.
Comm’r, T.C. Memo. 2002-121, Doc 2002-11394, 2002 TNT 95-11.
6
Estate of Thompson v. Comm’r, 382 F.3d 367 (3d Cir. 2004), aff’g
T.C. Memo. 2002-246.
7
Although Thompson blessed the ‘‘mere recycling’’ approach,
this is not inconsistent with its commensurate approval of the
(Footnote continued in next column.)
(Footnote continued on next page.)
TAX NOTES, October 31, 2005
663
(C) Tax Analysts 2004.
2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
FLPs: With Careful Planning, Any
Nontax Reason Should Suffice
Doc 2005-21173 (4 pgs)
COMMENTARY / VIEWPOINTS
Because Bongard was a reviewed decision — the most
authoritative opinion the Tax Court can render — it was
clear that the Tax Court had fundamentally aligned itself
with the ‘‘any nontax reason’’ approach.
Further, having adopted that test, the Bongard court
then considered the plain vanilla reasons that were offered
by the taxpayer as the sole reasons for forming the Bongard FLP — for example, creditor protection and ease of
gifting. Although the court rejected the standard reasons
on the facts, the court’s decision to consider the rationales
absent any type of pooling or business component suggested rather forcibly that the Tax Court would be willing
to accept plain reasons if the facts supported them.
That mindset was demonstrated twice more in the
later Bigelow8 and Korby9 Tax Court decisions. In Bigelow,
‘‘any nontax reason’’ approach. In other words, a pooling of
assets, business component, or other nontax reason could
qualify for the bona fide sale exception. See, e.g., Bongard, 124
T.C. No. 8. See also infra note 15.
8
Estate of Bigelow v. Comm’r, T.C. Memo. 2005-65, Doc 20056581, 2005 TNT 61-9.
9
Estate of Korby v. Comm’r, T.C. Memos. 2005-102, Doc 200510206, 2005 TNT 90-14, and 2005-103, Doc 2005-10180, 2005 TNT
90-13.
664
the estate contended that its FLP was formed and operated for three standard nontax reasons (that is, creditor
protection, continuity of management, and efficient gifting). The court struck down the first two on the facts (the
decedent was general partner and thus had no creditor
protection, and the partnership’s termination provision
trumped the continuity argument), but rejected the gifting argument apparently as a matter of law (thereby
casting some doubt on the Bongard court’s determination
in that regard). In Korby, the estate argued that the FLP
was formed for asset protection purposes; however, the
Tax Court (once again) ruled against the estate on the
facts.
Thus, up to that point there had not been a taxpayer
victory involving a marketable securities FLP that was
formed solely for one or more plain vanilla reasons,
despite the judicial sentiment in favor of those rationales.
In the subsequent Schutt10 decision, however, the Tax
Court considered two marketable securities business
trusts that were formed for the primary nontax purpose
of investment management, and ruled in favor of the
taxpayer. More specifically, the business entities were
formed by the decedent and several irrevocable family
trusts for the express purpose of imposing the decedent’s
personal buy-and-hold investment strategy on the irrevocable trusts.11 In its analysis, the Tax Court focused
initially on ‘‘whether perpetuation of a buy and hold
investment strategy qualified as a ‘legitimate and significant nontax reason’ within the meaning of [Bongard].’’
The court determined that it did,12 based on the following
considerations:13
10
Estate of Schutt v. Comm’r, T.C. Memo. 2005-126, Doc
2005-11675, 2005 TNT 102-12.
11
The decedent and irrevocable trusts contributed $42 million and $50 million (estimated) respectively in publicly traded
securities. The court further noted that the decedent’s own
assets had to be included in the entities to ‘‘serve essentially as
leverage in the form of a carrot,’’ without which the trustees
would not have agreed to place the trust assets into the entities.
12
Regarding the passive investment strategy, the court specifically and repeatedly emphasized the ‘‘unique’’ facts of the
case. In that respect, the court cautioned that ‘‘the mere holding of
an untraded portfolio of marketable securities weighs negatively in the
assessment of potential nontax benefits available as a result of a
transfer to a family entity’’ (emphasis added). The court further
intimated that this aspect of the holding should not be applied
too broadly:
The Court is able to conclude in this case that [the entities]
were formed for a legitimate and significant nontax
purpose without probing the parties’ disagreement as to
whether, in theory, an investment strategy premised on
buy and hold should offer just as much justification for an
entity premised thereon as a philosophy that focuses on
active trading.
Thus, taxpayers who desire to pursue a passive investment
approach should use material caution to the extent their nontax
reason for forming the FLP is investment management.
13
The findings of the court were, by its own observation,
supported by extensive correspondence, testimony, and record
evidence.
TAX NOTES, October 31, 2005
(C) Tax Analysts 2004.
2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
To that end, consider these statements by the court: (a)
‘‘[the partnership agreements were structured in a fashion that] denied decedent any non-tax benefit potentially
derived from the assets collected in the partnership’’; (b)
‘‘if there is no discernable purpose or benefit for the
transfer other than estate tax savings, the sale is not bona
fide within the meaning of section 2036’’; and (c) ‘‘[a]
‘good faith’ transfer to a family limited partnership must
provide the transferor some potential for benefit other
than the potential estate tax advantages that might result
from holding assets in the partnership form.’’ (Similar to
Kimbell, the court also considered motivation and ‘‘good
faith,’’ based on objective evidence.) Nevertheless, the
court did not have occasion to actually consider and rule
on standard nontax reasons, and thus the decision fell
short in that regard.
Despite the principles laid down in Kimbell and Thompson, practitioners still had to contend with the Tax Court’s
‘‘mere recycling’’ test, which at that point seemed to favor
a pooling or business component approach (as mentioned
above). In March 2005, however, the Tax Court issued its
reviewed Bongard decision, which effectively replaced the
‘‘mere recycling’’ criterion with an ‘‘any legitimate and
significant nontax reason’’ approach:
In the context of family limited partnerships, the
bona fide sale for adequate and full consideration
exception is met where the record establishes the
existence of a legitimate and significant nontax
reason for creating the family limited partnership,
and the transferors received partnership interests
proportionate to the value of the property
transferred. . . . The objective evidence must indicate that the nontax reason was a significant factor
that motivated the partnership’s creation. [Citations omitted.]
Doc 2005-21173 (4 pgs)
COMMENTARY / VIEWPOINTS
formed for a plain nontax reason. Schutt, however, was
not the final word on the bona fide sale exception.
Two months later, in May 2005, the Fifth Circuit issued
the Strangi II opinion, which ruled in favor of the IRS but
nevertheless cemented and advanced Kimbell and Schutt
in several ways. First, the Fifth Circuit once again (as it
did in Kimbell) considered the plain reasons offered by
the taxpayer as to the largely marketable securities FLP;
importantly, however, it did so absent the compelling
business component found in Kimbell. Second, although
the court ruled in favor of the IRS, the court did more
than tacitly indicate that such nontax reasons could
theoretically suffice under different circumstances.16 The
court instead repeatedly noted that it was constrained by
the ‘‘clearly erroneous’’ standard of review17 and seemed
to distance itself more than once from the Tax Court’s
conclusions: (a) ‘‘although a finder of fact might infer
[that the proffered purpose was genuine], there is nothing clearly erroneous in the Tax Court’s refusal to do so’’;
and (b) ‘‘although reasonable minds might differ on this
point [that is, whether the proffered reason was genuine],
the Tax Court’s factual conclusion . . . is not clearly erroneous.’’ Third, the Fifth Circuit had every opportunity to
distinguish Schutt or comment negatively on the result of
that case, but it chose not to do so. Fourth, the Fifth
Circuit clarified its position that nonbusiness, nontax
reasons would alone qualify for the bona fide sale
exception, when it purposely reformulated Kimbell’s observation that the Kimbell FLP was formed for ‘‘substantial business and other non-tax reasons’’ (emphasis
added). More specifically, the Strangi II court explained
that ‘‘the proper approach was set forth in Kimbell, in
which we held that a sale is bona fide if, as an objective
matter, it serves a substantial business [or] other non-tax
purpose’’ (emphasis added). Thus, the Fifth Circuit purposely changed ‘‘and’’ to ‘‘or’’ to emphasize that any
nontax purpose, standing apart from a business purpose
or pooling, should suffice. In light of those considerations, Strangi II further entrenches in FLP case law the
‘‘any nontax reason’’ approach and the Schutt result.
At this point, therefore, the Third Circuit, Fifth Circuit,
and Tax Court clearly espouse the ‘‘any nontax reason’’
approach (and take into account the taxpayer’s motivations and the legitimacy of the FLP, based on objective
evidence). As importantly, the approach has been applied
favorably to a marketable securities FLP formed for a
plain nontax reason. The practical implications of those
developments are discussed below.
14
As indicated in the text and notes, supra, the Kimbell,
Thompson, and Bongard courts likewise considered legitimacy
and motivation.
15
To the extent a court sees fit to apply a ‘‘mere recycling’’
standard in spite of the cases discussed herein, Schutt indicates
that that standard should be satisfied by any nontax reason. See
also supra note 7.
16
This point has been adapted from insights provided by
David Kearns, an attorney with Perry & Associates, Cleveland.
17
In this regard, for example, the court teed up its review as
follows: ‘‘[i]n reviewing for clear error, we ask only whether the
Tax Court’s findings are supported by evidence in the record as
a whole, not whether we would necessarily reach the same
conclusions.’’
TAX NOTES, October 31, 2005
Practical Considerations
Although those developments bode well for FLPs,
taxpayers should not become cavalier in their FLP endeavors. A key lesson to be gained from the foregoing
case law is that a generic nontax rationale for forming an
665
(C) Tax Analysts 2004.
2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
(1) the nontax purpose was real and a significant
motivating factor14 as demonstrated by the objective
evidence (for example, the decedent’s longestablished, historic pattern of buy-and-hold investing, some beneficiaries’ rejection of that strategy, the fact that the beneficiaries otherwise could
have received the trust assets outright during the
decedent’s lifetime (either by trust termination or
distribution), and the principal focus of the FLP
planning);
(2) the entities ‘‘appreciably advanced’’ the decedent’s
nontax purpose; and
(3) the investment management purpose was unrelated to the tax ramifications of the entities.
Notably, although the Schutt decedent’s desire to
impose his investment strategy on the irrevocable trusts
necessarily involved pooling as a matter of course (see
supra note 11), the court did not hold or imply that
pooling or a business component is either required or
recommended in order to qualify for the bona fide sale
exception. (That, of course, is entirely consistent with the
Bongard test, which was adopted and applied by the
Schutt court.) The court determined, based solely on the
three factors set forth above, that it was ‘‘thus able to
conclude in this case that [the Schutt entities] were
formed for a legitimate and significant nontax purpose’’
(emphasis added). In other words, pooling was not even
mentioned in the legitimate nontax purpose context.
Admittedly, the court did allude to pooling in its
rejection of the IRS’s ‘‘mere recycling’’ argument: ‘‘Looking in isolation at the relationship of a decedent to his or
her assets may be sufficient where the decedent’s contributions make up the bulk of the property held by the
relevant entity and no suggestion of any benefit beyond
change in form is evident.’’ The court was simply pointing out, however, that if there is no pooling, there had
better be another nontax benefit for the bona fide sale
exception to apply. Indeed, consistent with that statement
(and the court’s holding as set forth in the preceding
paragraph), the court ultimately relied on its ‘‘any nontax
reason’’ principle in its final response to the IRS’s ‘‘mere
recycling’’ claim: ‘‘[i]n that decedent employed his capital to
achieve a legitimate nontax purpose, the Court cannot conclude that he merely recycled his shareholdings’’ (emphasis added).15 Thus, in full agreement with the reviewed Bongard opinion, the Schutt decision does not
require or otherwise advocate pooling of assets or the
presence of a material business component to qualify for
the bona fide sale exception.
In light of those considerations, the Schutt decision in
many ways provided the culminating decision in the
courts’ inexorable advance toward approving the bona
fide sale exception as to a marketable securities FLP
Doc 2005-21173 (4 pgs)
COMMENTARY / VIEWPOINTS
18
See supra note 4.
This final criterion should not pose a material problem for
two reasons: Most plain nontax reasons for forming FLPs (for
example, investment management, training the next generation,
continuity of management, and asset protection) are, by their
very nature, free from estate tax motivations; and in any event,
a taxpayer is not precluded from having secondary tax motivations in forming an FLP. See, e.g., Kimbell (FLP should not be
motivated ‘‘solely’’ by tax planning) (’’tax planning motives do
not prevent a sale from being ‘bona fide’ if the transaction is
otherwise, real, actual or genuine’’); Schutt (‘‘proffered evidence
is insufficient to establish that estate tax savings were decedent’s
predominant reason for forming [the entities]’’).
20
By contrast, a family should not offhandedly assume that a
court will grant the bona fide sale exception regarding an FLP
that is deliberately designed to take generic advantage of the
numerous broad purposes for which FLPs legitimately may be
formed. That is not to suggest that a court inevitably would rule
against that FLP, but rather to suggest that the strategy should
not be undertaken lightly.
21
The Schutt estate received a favorable ruling despite the
fact that early planning emphasized the estate tax advantages of
FLPs. After that initial emphasis, the Schutt family and advisers
focused on the nontax aspect of the FLPs that ultimately drove
the FLP transactions. Notably, the Schutt court was not put off
by the advisers’ initial emphasis on taxes:
While it is clear that estate tax implications were recognized and considered in the initial stages of the planning
process, the record fails to reflect that such issues predominated in decedent’s thinking and desires. What may
have originally been approached as a relatively routine
estate planning transaction rapidly developed into an
opportunity and vehicle for addressing more fundamental concerns of decedent.
Thus, if the estate planning professional who first broaches FLP
planning with a particular client unduly stresses the tax benefits, the parties may avoid future unpleasantness by legitimately refocusing on specific, genuine nontax considerations
that would favor the client’s use of an FLP. Those considerations
should reflect the client’s specific circumstances and goals.
19
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the FLP’s purpose is genuine. By way of illustration,
those activities, discussions, and decisions might involve
asset selection and other funding considerations, management concerns (including the division of labor for
training purposes), investment strategies, distribution
rules, transfer restrictions (including rights of first refusal
and call options), withdrawal/termination provisions,
arbitration parameters, and so on. Relevant meetings and
discussions should be properly documented. Finally,
after formation the FLP should be operated carefully, in
accordance with the partnership agreement, and in pursuit of the goals for which it was formed. That, too, will
underscore the legitimacy and significance of the nontax
rationale. With that type of focused planning and purposeful operation, therefore, a ‘‘plain’’ marketable securities FLP should qualify for the bona fide sale exception
under current law.22
Summary
Over the course of 2004 and 2005, the courts’ interpretation of the bona fide sale exception as applied to FLPs
evolved from emphasizing pooling of assets and business
components, to recognizing and accepting the fact that
any nontax reason should suffice. Thus, a generic nontax
rationale should qualify for the bona fide sale exception
if, for example, care is taken to ensure (based on objective
evidence) that the rationale is genuine and material, a
significant motivation to the taxpayer, and unrelated to
tax considerations, and that the FLP is properly operated
to advance that rationale.23
22
For an excellent and more detailed consideration of the
practical aspects of planning for a plain nontax reason, see
Hatcher and Manigault, ‘‘The Tax Court’s ‘Practical Control’
Test in Bongard: More Than FLPs Are in the Balance,’’ 102 J. Tax’n
261 (May 2005).
23
See supra note 4.
TAX NOTES, October 31, 2005
(C) Tax Analysts 2004.
2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
FLP should suffice when, based on objective evidence:18
(a) the chosen rationale is genuine and material, (b) the
rationale is a significant motivating factor for the taxpayer, (c) the FLP is purposefully operated to advance
that rationale, and (d) the rationale is unrelated to tax
considerations.19 In other words, to execute a generic
nontax reason approach, the taxpayer preferably should
endeavor to transform a ‘‘plain’’ rationale into a notable
purpose as to his particular FLP.20 That may require a fair
amount of attention to detail regarding both planning
and operating an FLP.
For example, at the outset of the planning process21 a
family might seek to identify one or more material
nontax purposes that genuinely fit the family’s particular
situation and goals. That effort, in turn, presumably will
yield a nontax rationale that is significant to (and embraced by) the family. (That particular nuance should not
be overlooked because it is the taxpayer’s motivation that
ultimately will be scrutinized based on the objective
evidence.) Also, the expectation is that once a purpose is
selected in this fashion (or by some other thoughtful
approach), the specific planning activities, discussions,
and decisions that subsequently cultivate and advance
that purpose will further demonstrate and confirm that