In deciding whether Section 2036 was applicable, the Tax Court in both cases pointed out a number of factors that caused them to rule in favor of the IRS. One major factor related to the FLP's failure to conduct activities in a business-like manner after its formation. In both cases, the Tax Court found that the FLP(s) did not conduct their activities like a normal business enterprise, and as a result, an implied agreement was inferred that the decedent would retain the benefits of the transferred assets.

Pool Together Assets of the FLP Immediately After Formation - In Estate of Thompson, the decedent's son contributed a Colorado ranch, among other things, to one of the FLPs in question. As previously mentioned, in connection with the ranch, income generated from the sale of mules went directly to the son; however, the FLP reported losses on the operation of the ranch.7 In forming the FLPs, the Tax Court found that the decedent's children did not pool their assets with those of the decedent because arrangements were made to have income generated by the assets that they specifically contributed go directly to them. This similar type of activity was also found in Gulig.8 In Gulig, the FLP divided its Merrill Lynch account into four separate accounts in each of the decedent's children's names, giving them control over a proportionate share of the partnership assets. Based on these activities, the Tax Court concluded that the parties involved in the FLPs did not have the intent to pool their resources together in an effort to form a bona fide business enterprise. Furthermore, the Tax Court did not believe that the conduct of the FLP was like that of a typical trade or business.

As such, in setting up FLPs, it is always advisable for taxpayers to pool together the contributed assets in a timely fashion. Taxpayers must avoid separating out the transferred assets and allowing each transferor to manage his or her contributed assets. The FLP should control the assets after formation. In addition, taxpayers should refrain from allocating and distributing the income from each contributed assets directly to the transferor. By avoiding such practices, taxpayers will minimize the risk that the IRS will view the formation of the FLP as merely a recycling of the contributed assets through the FLP form for purposes of Section 2036.

Avoid Commingling of FLP and Personal Funds by Establishing Separate Accounts for FLP Accounts - Another example in which the Tax Court found that the FLPs did not conduct matters in a business-like fashion was when the decedent and his children in Estate of Harper failed to set up separate bank accounts for the FLP immediately after formation. As a result of this failure, the decedent was found to have commingled personal funds with FLP funds, which created the inference that there was an implied agreement to retain the enjoyment of the transferred property. The Tax Court also noted that there was a delay in transferring the title of the decedent's assets (through his trust) to the FLP's brokerage account. According to the Tax Court, this delay created an issue for the decedent because his trust continued to receive the dividend and interest payments after the FLP?s formation. Consequently, the Tax Court found that there was a commingling of funds with respect to the FLP and the decedent.

To avoid such issues, taxpayers must establish separate bank accounts (and other accounts to hold other assets) for their FLPs in a timely manner to avoid commingling personal and FLP funds. It is highly recommended that upon creation of the FLP, a separate account in the name of the FLP be immediately established. Furthermore, title to the assets to be included in the FLP, such as marketable securities and real estate, should be transferred and recorded as quickly as possible so that the FLP will be the proper titleholder when income is received from these assets. Certain measures should be taken to avoid the mistakes made by the taxpayers in Estate of Harper - i.e., not creating a taxpayer identification number for the FLP in advance to create a separate bank account and not quickly executing a title transfer of the decedent's assets to the FLP. These steps should help minimize the risk that the IRS will disregard the FLP structure for purposes of Section 2036.

Other Business Activities that FLP Should Conduct "Other factors considered by the Tax Court in finding that the FLPs" activities had no resemblance of a normal operating business were (i) using the same investment adviser and brokerage account to handle the contributed assets (ii) not changing investment strategies for the marketable securities held by the FLP, and (iii) engaging in transactions only with related parties.

In both Estate of Thompson and Estate of Harper, the same investment advisers used by the decedents were also used for the FLPs to handle the marketable securities.10 Moreover, in Estate of Thompson, the Tax Court noted that the make-up of the securities held by the decedent's trust did not change significantly after transferring them to the FLP. Based on the Tax Court's rationale, it is advisable for taxpayers to change service providers (e.g., bankers, brokers, property managers, etc.) after transferring the assets to the FLP. Moreover, to avoid the appearance that the transferred assets are being merely recycled through the FLP for purposes of Section 2036, taxpayers should change the investment strategy of the securities holding. For example, if prior to the transfer, most of the investment holdings were in fixed-income securities, the FLP's manager or general partner might want to consider reinvesting the assets in large-cap stocks with high dividend yields to maintain the flow of income.

Practical considerations such as a long-standing successful relationship with a specific broker can complicate matters. However, it might be advisable for a newly established FLP, through the proper partnership channels, to send a letter or otherwise contact the brokerage company or investment advisor for the FLP and detail the investment strategy and goals of the partnership. These goals and objectives should be consistent with those recited in the partnership agreement.

In addition to switching service providers and investment strategies, taxpayers should have the FLP conduct transactions with third parties instead of having the FLP only deal with family members or other related parties. In Estate of Thompson, the Tax Court pointed out that the FLP did not engage in transactions with anyone outside the family - i.e., loans and gifts were made to family members only. By conducting some, if not all, business transactions with third parties, taxpayers would be able to lower the risk that the FLP will be viewed as a tax avoidance vehicle than a valid business enterprise.

Avoid Contributing the Bulk of the Taxpayer's Assets to the FLP
In ruling that Section 2036 was applicable, the Tax Court considered the value and amount of the contributed assets relative to the taxpayer?s total wealth. In both Estate of Thompson and Estate of Harper, the decedent's contribution to the FLP(s) represented the vast majority of his wealth.11 In Estate of Harper, part of the Tax Court's rationale for holding that the FLP assets were includable in the decedent's gross estate was the fact that the decedent transferred the bulk of his assets to the FLP. By contributing the vast majority of his assets, the Tax Court found that the decedent deprived himself of the assets needed for his own support and, consequently, concluded that the only reasonable explanation for contributing the bulk of his wealth, necessary to cover living expenses, was the existence of an implied agreement that his children (the other partners) would agree to his requests for money from the assets he contributed to the FLPs, until his death. This implied agreement that he would retain enjoyment and economic benefit of the property transferred triggered the application of Section 2036.

Interestingly, the IRS has publicly addressed this issue. Mary Lou Edelstein, national family limited partnership coordinator for IRS Appeals, recently spoke at a session on transfer tax audit issues at the University of Miami Heckerling Institute on Estate Planning. Ms. Edelstein said that the IRS will actively seek to determine whether the partnership property can be included in the estate under Section 2036 without valuation discounts. If the taxpayer hopes to obtain a discount, she mentioned that it is critical that the partnership meet all technical formalities in its creation and operation and that the decedent did not fund the FLP with an excessive amount of his assets or with personal assets such as his residence and vehicles. Finally, she went on to state that it is important that the decedent retain sufficient assets outside the partnership to maintain a reasonable standard of living without needing to use the partnership assets.

Consequently, when setting up FLPs, taxpayers should avoid contributing the majority of their assets. Under this situation, taxpayers should retain more assets than is needed to cover living expenses so that there will be enough funds to pay for unanticipated costs (e.g., gifts, medical expenses, etc.). As an exercise, it might be helpful for taxpayers to list out all assets prior to the formation of the FLP and determine the projected income stream that would be generated from each asset. In addition, it might be useful to determine the living expenses that would need to be paid to maintain a normal standard of living. Such careful planning could help taxpayers avoid the mistake of contributing the bulk of their assets to the FLP.

Make Pro Rata Distributions as Stipulated in the Operating Agreement
Another major factor considered by the Tax Court in determining whether the taxpayers in Estate of Thompson and Estate of Harper retained the enjoyment and economic benefit of the property transferred was the FLP's practice in making disproportionate distributions to the decedent. In Estate of Thompson, it was customary for the FLPs to make disproportionate distributions to the decedent in order that he could continue giving gifts to family members. In Estate of Harper, the FLP made disproportionate distributions to the decedent in many occasions and were characterized as a "return of capital." Furthermore, the FLP obtained the necessary cash to distribute to the decedent's estate to pay the decedent's estate tax liability. The Tax Court stated that such disproportionate distributions supported the inference that the decedents had the ability to access the FLP's cash account when needed. Consequently, such disproportionate distributions helped verify that the decedents retained the enjoyment of the assets contributed to the FLP.

To lower the risk that the IRS will disregard the FLP for estate tax purposes under Section 2036, taxpayers should follow the distribution requirements in the FLP's operating agreement. In particular, the general partner(s) of the FLP should ensure that distributions are made in accordance to the partners' ownership interests. If taxpayers are considering making gifts to their loved ones, taxpayers should consider making gifts of ownership interests in the FLP instead of using cash or other assets. If structured properly, taxpayers would be eligible for valuation discounts on the gifted interests for lack of control and marketability. Furthermore, after the death of the taxpayer, it is advisable for the general partner of the FLP to avoid making distributions too soon to the taxpayer's estate and the family members. Both before and after the taxpayer's death, it is important for the FLP to function like a normal business enterprise to avoid a Section 2036 problem.

Ensure that Arm's Length Standard is Met for Related-Party Transactions
To minimize the possibility that the IRS will reject the use of an FLP as an estate-planning vehicle, taxpayers should ensure that all related-party transactions are structured according to arm's length standards. In Estate of Thompson, the FLP lent various sums of money to the decedent's family members. Although it is uncertain whether the loans were subject to arm's length interest rates, the interest payments were often either late or not paid at all. The FLPs never took action against the family members who failed to make payments on the loans. As previously mentioned, only the decedent's relatives received loans from the FLPs.

There were other instances in Estate of Thompson that reflected questionable related-party dealings. For example, the decedent's son lived on the 312-acre Colorado ranch before and after it was contributed to the FLP. After the transfer, he entered into a lease with the FLP. The lease agreement required the son to pay $12,000 per year to the FLP for use of the 312-acre ranch. It is unclear from the record as to whether the $12,000 represented a fair market rent for the ranch. However, it is very important in intra-family transactions involving FLPs that rent amounts between family members be established at arm's length rates. Once again, it might be helpful to document the estate planning files with research and analyses that show the family performed prudent due diligence prior to setting rent levels.13 Not only should taxpayers make sure that arm's length standards are met when conducting related-party transactions with the FLP, but also it is advisable to include proper documentation for the transactions. For example, when structuring leases between a partner and the FLP, make sure a valid lease agreement is in place.

Conclusion
Overall, these practical suggestions for setting up and maintaining an FLP should help taxpayers dodge the presumption that there was retained control over the contributed assets of an FLP. Interestingly, in both Gulig and Estate of Thompson, the Tax Court did not question the validity of the FLPs for Federal estate and gift tax purposes because, in their opinion, the families took the necessary legal steps to form the FLPs properly under their state laws. The Tax Court further stated that a properly formed FLP changes the relationship of the partners and the assets so that a potential buyer of the decedent's assets would not disregard the FLP. Estate tax practitioners should find comfort from the Tax Court's opinion because it suggests that the use of FLPs, if formed and maintained properly, continues to be an effective estate tax planning vehicle. The use of FLPs also provides the opportunity to qualify for valuation discounts for gift and estate tax purposes. Although it is not entirely certain whether Section 2036 will be used to attack FLPs in which the decedent holds both general and limited partnership interests, estate tax practitioners should, nonetheless, be wary of the fact that the IRS will continue to look at the actions of the taxpayers after formation of the FLP to determine whether an implied retention of an economic benefit existed. Perhaps one lesson to be learned from these cases is that it might be helpful for estate tax practitioners and related professionals to periodically follow-up on their clients after the formation of an FLP to make certain that the manner in which they operate their FLP does not undermine the overall estate plan.

NOTE: This article does not constitute legal, valuation, tax, or any other type of consulting advice. It is offered as an information service to our clients and friends. For specific legal and accounting issues, it is advisable to seek professional advice. We welcome the opportunity to discuss any specific valuation issues that you may have.