Kimbell v. US, 93 AFTR 2d 2004-2400 (5th Cir. 2004)

By

Louis A. Mezzullo, Esquire

Presented by National Law Foundation, LLC

P.O. Box 218 Montchanin, DE 19710

Tel (302) 656-4757 Fax (302) 655-6363

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This article has no CLE.

Written Materials © 2004 by National Law Foundation, LLC All rights reserved

IMPORTANT NOTICE

These seminar materials and the seminar presentations are intended to provide the

participants with guidance in the topics covered. The materials and the comments of the speakers

do not constitute, and should not be treated as, legal advice. Although every effort has been

made to assure the accuracy of these materials and comments, the speakers and National Law

Foundation do not assume responsibility for any individual’s reliance on the written or oral

information disseminated. You should independently verify all statements made in the materials

and at the seminar before applying them to a particular fact situation, and should independently

determine the consequences of using any theory before recommending it to a client or

implementing it on a client’s or your own behalf.

© 2004, NATIONAL LAW FOUNDATION, LLC. ALL RIGHTS RESERVED.

Kimbell v. US, 93 AFTR 2d 2004-2400 (5th Cir. 2004)*

Louis A. Mezzullo, Esq.

Presented by National Law Foundation, LLC

P.O. Box 218 Montchanin, DE 19710

Tel (302) 656-4757 Fax (302) 655-6363

www.nlfcle.com

This article has no CLE value

© 2004 by Louis A. Mezzullo, Esq. All rights reserved

* This article will be published in the July 2004 issue of The Journal of Taxation.

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DISCLAIMER

This article does not constitute, and should not be treated as, legal advice

regarding the use of any particular estate planning technique or the tax consequences

associated with any such technique. The author and the National Law Foundation do not

assume responsibility for any individual’s reliance on this information. You should

independently verify all information before applying it to a particular fact situation and

should independently determine both the tax and nontax consequences of using any

particular estate planning technique before recommending that technique to a client or

implementing it on a client’s or your own behalf.

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Louis A. Mezzullo

Louis A. Mezzullo graduated from the University of Maryland (B.A., with high honors, 1967, M.A., 1976) and the University of Richmond (J.D., 1976) Phi Beta Kappa, Omicron Delta Kappa, Phi Alpha Delta. He was admitted to the Virginia Bar in 1976. Mr. Mezzullo currently serves as an Adjunct Professor of Law at the T.C. Williams School of Law, University of Richmond, in Richmond, VA, where he teaches classes on estate and gift taxation, estate planning and fiduciary administration. He also serves as a lecturer for Continuing Legal Education Committee of the Virginia Bar Foundation. Mr. Mezzullo is a partner in the Richmond, VA, firm of McGuireWoods, LLP, practicing in the areas of tax, estate planning, employee benefits, and business planning.

Author: An Estate Planner's Guide to Qualified Retirement Plan Benefits (Third Edition, 2002), An Estate Planner’s Guide to Buy-Sell Agreements For Closely Held Businesses (2001), An Estate Planner’s Guide to Life Insurance (2000), An Estate Planner's Guide to Family Business Entities (1998), and Valuation Rules Under Chapter 14 (1995), all published by the American Bar Association Section of Real Property, Probate and Trust Law; co-authored Advising the Elderly Client, published by Clark Boardman Callaghan (September 1992); authored Estate Planning for Owners of Closely Held Businesses, (2002) 809 Tax Management Portfolio Series, Family Limited Partnerships and Limited Liability Companies, (1998) 812 Tax Management Portfolio Series, and Estate and Gift Tax Issues for Employee Benefit Plans, (2002) 378 Tax Management Portfolio Series, all published by the Bureau of National Affairs, Inc.; editor and co-author of Limited Liability Companies in Virginia, published by the Virginia Law Foundation (December 1995); and numerous articles on the subjects of Taxation, Estate Planning and Employee Benefits for the Journal of Taxation, the University of Richmond Law Review, the Virginia Bar Association Journal, Estate Planning, ACTEC Notes, Probate & Property, Taxation for Accountants, Taxation for Lawyers, Taxation of Employee Benefits, Journal of Passthrough Entities, and Trusts & Estates.

Member: Richmond, Virginia; Virginia Bar Association (former chair of its Section on Taxation); Virginia State Bar; and American Bar Association, former member of Council and current chair of the Business Planning Subcommittee of the Estate and Gift Taxes Committee of the ABA Section of Taxation, and Past Chair of the ABA Section of Real Property, Probate and Trust Law; member and former chair of the University of Richmond Estate Planning Advisory Council; member and former President of the Trust Administrator's Council of Richmond; former co-director of the William and Mary Tax Conference Advisory Council; former member of the Editorial Boards of Trusts & Estates magazine and the Journal of Passthrough Entities; former editor of the American College of Trust and Estate Counsel Journal and Vice Chair of the American College of Trust and Estates Counsel; a Fellow of the American Bar Foundation; a Fellow of the Virginia Law Foundation; a Fellow and former Regent of the American College of Trust and Estate Counsel, former chair of its Employee Benefits in Estate Planning and Elder Law Committees and incoming chair of its business planning committee; an Academician and Vice President of the International Academy of Estate and Trust Law.

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Table Of Contents Introduction....................................................................................................................5

The Kimbell Case...........................................................................................................6

Facts In Kimbell .............................................................................................................8

Court’s Opinion ...........................................................................................................11

The Wheeler Case ........................................................................................................12

Wheeler Holding Applied to Kimbell ..........................................................................14

Analysis of the Court’s Opinion ..................................................................................19

What Does the Decision Stand For? ............................................................................22

What to Tell Clients .....................................................................................................24

Conclusion ...................................................................................................................26

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Kimbell v. US, 93 AFTR 2d 2004-2400 (5th Cir. 2004)†

Louis A. Mezzullo

McGuireWoods LLP Richmond, VA

lmezzullo@mcguirewoods.com June 15, 2004

Introduction. Ever since the issuance of Rev. Rul. 93-12 (1993-1 C.B. 202), family limited partnerships

(FLPs) and limited liability companies (FLLCs) have been touted as vehicles to transfer

assets to younger family members at a substantially reduced value for federal transfer tax

purposes. In Rev. Rul. 93-12, the IRS acknowledged that lack of control discounts were

not inappropriate when valuing a transferred interest in a family-controlled business

entity. Although estate planners have been advising the use of business entities for

transferring family owned businesses and other assets to younger family members in an

orderly manner both before and after Rev. Rul. 93-12 was issued, the primary motivation

in many cases is not the reduction of transfer taxes, but the accomplishment of non-tax

objectives, such as protecting assets from the younger family members’ creditors and

spouses, reducing administration and management expenses, and facilitating transfers of

undivided interests in family assets. Beginning in 1997 with the issuance of a number of

Technical Advice Memoranda (TAMs)1, the Internal Revenue Service (IRS) invoked a

number of theories to attack the significant discounts that the taxpayers were taking in

connection with transfers of interests in FLPs and FLLCs during lifetime and at death.

The IRS was unsuccessful in challenging these transactions based on a sham-transaction

† This article will be published in the July 2004 issue of The Journal of Taxation.

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or step-transaction theory or by applying I.R.C. § 2703 or § 2704(b) to disregard either

the entity itself or restrictions in the partnership or operating agreement.2 However,

beginning with the Schauerhamer3 case, the IRS was successful in having the underlying

assets in the entity included in a decedent’s estate under I.R.C. § 2036(a) because of an

implied right to continue to enjoy the income from the transferred property or because of

a retained right to designate the persons entitled to enjoy the income from the transferred

property. The most troublesome of these cases for many practitioners was the decision in

Strangi II4, in which the Tax Court held that (1) the bona fide sale exception to I.R.C. §

2036(a) did not apply; (2) I.R.C. § 2036(a)(1) applied because the decedent retained an

implied right to continue to enjoy the income from the transferred assets; and (3) I.R.C. §

2036(a)(2) applied because the decedent retained the right, in conjunction with others, to

designate the persons entitled to enjoy the income from the transferred assets.

However, in the Stone5 case, the taxpayer successfully avoided the application of

I.R.C. § 2036(a) because of the bona fide sale exception. Specifically, the Tax Court in

Stone held that the creation of a pro rata partnership, where the contributing partner

received partnership interests in proportion to the value of the assets each partner

contributed, was a bona fide sale for an adequate and full consideration, as long as the

transaction was not a sham. Although subsequent to Stone, the IRS successfully invoked

I.R.C. § 2036(a) in Abraham6 and Hillgren7, the facts in those cases were not particularly

conducive to a taxpayer victory.

The Kimbell Case

The Texas federal District Court’s decision in Kimbell8, that the bona fide sale exception

to I.R.C. § 2036(a) did not apply, and that the decedent retained both the right to enjoy

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the income from the transferred property and the right to designate the persons entitled to

receive the income from the transferred property, was not viewed by many practitioners

as particularly troublesome because of the facts in the case as stated in the District

Court’s opinion. The partnership agreement provided that the general partner owed no

fiduciary duty to the other partners or to the partnership and 70% of the limited partners

had the right to remove the general partner. The decedent owned 99% of the limited

partnership interest and 50% of the membership interest in the LLC that was the general

partner of the partnership. Although the District Court, probably incorrectly, stated that

the Byrum9 case had been overruled by the adoption of I.R.C. § 2036(b), most

practitioners thought that a properly structured FLP or FLLC would pass muster even if

the Kimbell decision was correct.

The Kimbell decision was appealed by the taxpayer. The American College of

Trust and Estate Counsel filed an amicus curiae brief arguing that the Appellate Court

should, in applying I.R.C. § 2036(a), including the bona fide sale exception, adopt bright

line standards based on objective factors that taxpayers could rely on in structuring

legitimate family entities. The Fifth Circuit’s opinion was filed on May 20, 2004, finding

in favor of the taxpayer. While the opinion concerning the application of the bona fide

sale exception provides much needed clarity, the decision should not be viewed by

practitioners as a blank check for achieving significant reductions in value for transfer tax

purposes through FLPs and FLLCs when the only reason for forming the entity is to save

taxes. As will be discussed, the Fifth Circuit’s emphasis on non-tax reasons for forming

the limited partnership and on the active management of the oil and gas working

interests, which comprised 11% of the limited partnership assets, should serve as a

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warning that there must be more to the transaction than tax savings to achieve the desired

discounts for transfer tax purposes.

Facts in Kimbell.

The facts in the Kimbell case as set out in the Fifth Circuit’s opinion certainly are in

contrast with the facts that were set out in the District Court’s opinion. Perhaps this is

one reason why the Fifth Circuit’s decision in Kimbell is initially surprising. When

viewing the facts as stated in the District Court’s opinion alone, its opinion seems

reasonable. However, once the additional facts set out in the Fifth Circuit’s opinion are

considered, the Fifth Circuit’s decision becomes the more reasonable decision.

Mrs. Kimbell died on March 25, 1998 at the age of 96. In January of 1998, Mrs.

Kimbell’s revocable living trust that owned most of her assets, her son, and her son’s

wife formed an LLC. Mrs. Kimbell’s trust received a 50% interest in exchange for

$20,000 and her son and daughter-in-law each received a 25% interest in exchange for

$10,000 each. Her son was the sole manager of the LLC. Later in the same month, the

trust and the LLC formed a limited partnership. The trust received a 99% pro rata limited

partnership interest in exchange for approximately $2,500,000 in cash, oil and gas

working interests and royalty interests, securities, notes and other assets. Notably, the oil

and gas interests were a continuation of an oil and gas business that Mrs. Kimbell’s

deceased husband had founded in the 1920s and represented approximately 15% of the

partnership assets. 11% of the partnership assets were oil and gas working interests. The

LLC contributed $25,000 for a 1% pro rata general partnership interest. Mrs. Kimbell’s

son, David, managed Mrs. Kimbell’s business interests before and after the creation of

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the LLC and the partnership. Mrs. Kimbell retained over $450,000 in assets outside of

the partnership.

The stated purposes of the partnership were to:

increase Family wealth; establish a method by which annual gifts can be made without fractionalizing Family Assets; continue the ownership and collective operation of Family Assets and restrict the right of non-Family members to acquire interests in Family Assets; provide protection to Family Assets from claims of future creditors against Family members; prevent transfer of a Family member’s interest in the Partnership as a result of a failed marriage; provide flexibility and continuity in business planning for the Family not available through trusts, corporations or other business entities; facilitate the administration and reduce the cost associated with the disability or probate of the estate of Family members; promote the Family’s knowledge of and communication about Family Assets; provide resolution of any disputes which may arise among the Family in order to preserve Family harmony and avoid the expense and problems of litigation; and consolidate fractional interests in Family Assets.

The purposes were supported by deposition testimony of Mrs. Kimbell’s son and

Michael Elyea, Mrs. Kimbell’s business advisor. Elyea testified that Mrs. Kimbell

sought legal protection from creditors as a result of her investment as a working interest

owner in oil and gas properties. She also wanted the oil and gas operation to continue

after her death and by putting the assets in the limited partnership she could keep a pool

of capital together in one entity. Keeping the assets in one entity would also reduce

administration expenses, avoid costs of recording transfers as the oil and gas properties

passed from generation to generation and preserve the property as the separate property

of the descendants. The family had already faced the divorce of Mrs. Kimbell’s

grandson. The partnership also provided for the management of the assets if something

happened to her son who had experienced heart problems and undergone a serious

surgery. Disputes among family members would be avoided because the agreement

10

provided for mediation and arbitration of disputes. In addition to the recitation of the

purposes in the partnership agreement and the deposition testimony of Mrs. Kimbell’s

son and her business advisor, the Court found that the stated reasons for the formation of

the partnership were confirmed by objective facts, many of which related to rights and

responsibilities associated with the oil and gas investments.

The LLC, as general partner, managed the partnership and had exclusive authority

to make distributions. Although the agreement provided that the general partners owed

no fiduciary duty to the partnership or any partner, it did owe a duty of loyalty and a duty

of care to the partnership. Note that the District Court’s opinion, in stating that the

partnership agreement provided that the general partner owed no fiduciary duty to the

partnership or any partner, did not mention that it did owe a duty of loyalty and a duty of

care to the partnership. It is difficult to distinguish between the combination of a duty of

loyalty and a duty of care and a fiduciary duty. The trust, as a limited partner, had no

right to withdraw from the partnership or to receive a return of contributions until the

termination of the partnership, which could occur only by the unanimous consent of the

partners. The partnership agreement provided that 70% in interest of the limited partners

had the right to remove the general partner and the majority in interest of the partners had

the right to elect a new partner.

The estate reported the value of Mrs. Kimbell’s limited partnership interest at

approximately $1,200,000 and her LLC interest at $17,000 on the estate’s federal estate

tax return. These values represented a 49% discount for lack of control and lack of

marketability from the net asset value of the limited partnership of approximately

$2,400,000. The IRS included the assets, rather than Mrs. Kimbell’s interests in the

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entities, in her federal gross estate under I.R.C. § 2036(a) and increased the tax due

accordingly. The estate paid the tax and filed a claim for refund.

As mentioned earlier, the District Court found in favor of the IRS on cross

motions for summary judgment. Specifically, the District Court held that the assets were

included in Mrs. Kimbell’s estate under I.R.C. § 2036(a) because the transfer was not a

bona fide sale for full and adequate consideration and she retained the right to enjoy the

income and to designate who was entitled to enjoy the income. The Fifth Circuit, in its

opinion, concluded that the District Court erred in finding as a matter of law that (1)

family members cannot enter into a bona fide transaction and (2) a transfer of assets in

return for a pro rata partnership interest is not a transfer for full and adequate

consideration. It also found that the District Court erred in failing to consider

uncontroverted record evidence to support the taxpayer’s position that the transfer was a

bona fide sale. Consequently, the District Court’s grant of summary judgment in favor of

the government and denial of the taxpayer’s motion for summary judgment were vacated

and the case was remanded to the District Court to determine whether the interest Mrs.

Kimbell owned was a limited partnership interest or an assignee interest for valuing the

interest for estate tax purposes.

Court’s Opinion.

Because the District Court granted summary judgment, under the Fifth Circuit’s case law,

its review was de novo. Consequently, the Court was free to revisit the facts in the record

and was not bound to give deference to the lower court’s interpretation of those facts. As

will become apparent, the Fifth Circuit’s opinion rests, to a large extent, on facts that

were not even discussed by the District Court in its opinion.

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The Court recognized two exceptions to the application of I.R.C. § 2036(a), the

bona fide sale exception and the lack of the retention of the enjoyment of the income

from the transferred property or a right to designate the persons who would possess or

enjoy the transferred property. The Court adopted that the District Court’s two-part test

in determining whether the bona fide exception applied, the same test used in Harper,

Thompson and Strangi II. First, was the transaction a bona fide sale, meaning an arm’s

length transaction? Second, was there adequate and full consideration? The District

Court defined an arm’s length transaction as one involving “two parties who are not

related or not on close terms,” citing Black’s Law Dictionary. Consequently, because

Mrs. Kimbell, or at least family members, were present on both sides of the transfer to

the partnership, the District Court found that the transfer was not arm’s length and

therefore not a bona fide sale. Furthermore, the District Court held that the pro rata

interest in the partnership received by Mrs. Kimbell was not adequate consideration

because it was a mere recycling of value.

The Wheeler case.

The Court noted that Wheeler v. United States10 was the only case in the Fifth Circuit

dealing with the bona fide sale exception, and the only appellate level case dealing with

the exception that had been cited by the parties. Wheeler involved the sale of a remainder

interest in a ranch for its actuarial value. The IRS argued that the sale did not satisfy the

bona fide sale exception because the amount received did not equal the value of the ranch

itself. In Wheeler, the Court adopted the depletion theory, i.e., that the adequate and full

consideration requires only that the sale not deplete the gross estate, i.e., the estate

receives roughly equivalent value for the asset it gives up. The Wheeler case also made it

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clear that the test is objective, distinguishing the subjective test under the contemplation

of death standard under former I.R.C. § 2035 that was found to be unworkable. Hence, at

least in the Fifth Circuit, a taxpayer’s testamentary or tax saving motives for a transfer

alone does not trigger I.R.C. § 2036(a) recapture if objective facts demonstrate that the

transfer was made for full and adequate consideration. Wheeler also stands for the

proposition that the bona fide sale requirement is based on whether the transferor actually

parted with the interest and the transferee actually parted with the requisite adequate and

full consideration.

The Court noted that while Wheeler may require heightened scrutiny for intra

family transfers, the heightened scrutiny does not impose an additional requirement not

contained in I.R.C. § 2036 to establish that a transaction is bona fide. Consequently, a

transaction that is bona fide between strangers must also be bona fide between members

of the same family. Furthermore, the absence of negotiations among family members as

to price and terms is not a compelling factor, especially when the exchange value is set

by objective factors.

In addressing what constitutes a bona fide transaction, the Court noted that the

Treasury Regulations treat a transaction as bona fide if it is made in good faith and

Black’s Law Dictionary defines bona fide as “real, actual, genuine, and not feigned.”

The Court again refers to objective factors in determining whether a transaction is bona

fide. Although “a transaction motivated solely by tax planning with no business purpose

or corporate purpose [whatever corporate purpose means in this context] is nothing more

than a contrivance without substance that is rightly ignored for purposes of the tax

computation,” tax planning motives do not prevent a sale from being “bona fide” if the

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transaction is otherwise real, actual, or genuine. The Court went on to cite Church v.

United States11, and Estate of Stone v. Commissioner, for the proposition that because in

each case there were non-tax, and especially business, reasons for creating the

partnership, the Court held that transfers to the partnerships were bona fide sales. In

addition, in Stone, the Court noted that the decedents retained enough assets to maintain

their standards of living.

On the other hand, the Court found as a common element in cases where the

Court held the bona fide sale exception did not apply, such as Thompson, Harper and

Strangi II, the lack of any non-tax purposes or conduct of an active business. However,

even these cases recognize that a family partnership could qualify for the bona fide sale

exception if the transaction included elements that indicated that the exchange was more

than a sham or disguised sale.

The Court concluded that to qualify as a bona fide sale under Wheeler, Mrs.

Kimbell must have actually parted with her interest in the transferred assets and the

partnership actually parted with the interest issued in exchange. To qualify as adequate

and full consideration, the exchange must be roughly equivalent so that the transfer does

not deplete the estate. Although transactions among family members are subject to

heightened scrutiny to ensure the sale is not a shame transaction or disguised gift, the

scrutiny is limited to the examination of objective facts that confirm or deny the

taxpayer’s assertion that the transaction is bona fide.

Wheeler Holding Applied to Kimbell.

The Court, citing the Stone case, dismissed the District Court’s argument that the

exchange in Kimbell was not for adequate and full consideration because the

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partnership’s interests were worth less than the assets transferred as a result of lack of

control and lack of marketability discounts. In Stone, the Tax Court held that this

argument

in effect reads out of section 2036(a) the exception for a ‘bona fide sale for an adequate and a full consideration in money or money’s worth’ in any case where there is a bona fide, arm’s length transfer of property to a business entity (e.g., a partnership or a corporation) for which the transferor receives an interest in such entity (e.g., a partnership interest or stock) that is proportionate to the fair market value of the property transferred to such entity and the determination of the value of such interest takes into account appropriate discounts.

The Court also added that the government’s argument was “a classic mixing of

apples and oranges: the government is attempting to equate the venerable ‘willing buyer-

willing seller’ test of fair market value (which applies when calculating gift or estate tax)

with the proper test for adequate and full consideration under § 2036(a).” Because

investors acquire non-assignable, non-managerial interests in a limited partnership with

the expectation of realizing benefits, such as management expertise, security and

preservation of assets, capital appreciation, and avoidance of personal liability, there is

nothing inconsistent in the investors acquiring a partnership interest at arm’s length for

adequate and full consideration although the interest acquired has a present fair market

value less than the dollars just paid. The Court refers to this as “a classic informed trade

off.” Because this principle applies to unrelated buyers and sellers, it should also apply

to related parties, unless the evidence demonstrates the absence of good faith, i.e., a sham

transaction motivated solely by tax avoidance or Congress or the courts are ready to

change long-held positions and establish a per se rule that related parties can never enter

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into arm’s length transactions for adequate and full consideration – a position that,

according to the Court, none has shown any inclination to assume.

The Court sets forth the following three factors in determining whether a transfer

to a partnership is for adequate and full consideration:

(1) Whether the interests credited to each of the partners was proportionate to

the fair market value of the assets each partner contributed to the

partnership;

(2) Whether the assets contributed by each partner to the partnership were

properly credited to the respective capital accounts of the partners; and

(3) Whether on termination or dissolution of the partnership the partners were

entitled to distributions from the partnership in amounts equal to their

respective capital accounts.

The Court determined that Mrs. Kimbell’s transfer to the partnership satisfied all three

factors. Therefore, her transfer was for adequate and full consideration.

As for the “recycling of value” argument adopted in Harper, Thompson, and

Strangi II, the Court felt that this was better addressed under the “bona fide sale” prong

of the bona fide sale exception. In determining whether the transfer satisfied this prong,

the Court noted that the District Court ignored record evidence in support of the estate’s

position that the transaction was entered into for substantial business and other non-tax

reasons. The Court cited the following objective facts that supported the taxpayer’s

position:

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(1) Mrs. Kimbell retained sufficient assets outside the partnership for her own

support and there was no commingling of partnership and her personal

assets.

(2) Partnership formalities were satisfied and the assets contributed to the

partnership were actually assigned to the partnership.

(3) The assets contributed to the partnership included working interests in oil

and gas properties which did require active management. The Court went

to some length to describe why such interests required active management.

(4) Mrs. Kimbell’s son and her business advisor provided credible and

unchallenged non-tax business reasons for the formation of the partnership

that could not be accomplished by Mrs. Kimbell’s revocable trust. These

reasons are discussed earlier in this article.

The Court rejected the conclusion that, because Mrs. Kimbell’s son and daughter-

in-law contributed only $20,000 of the $2.4 million in assets to the partnership, the

transaction was a sham. Equating this to a restatement of the government’s recycling of

value argument, the Court pointed out that it knew of no principle of partnership law that

would require a minority partner to own a minimum percentage interest in the partnership

for the partnership to be legitimate and its transfers bona fide. The Court also believed

that the fact that Mrs. Kimbell’s son performed the same services for the assets in the

partnership as he had before the creation of the partnership was irrelevant because of the

business reasons established for changing the form of entity. The important fact was that

he contributed his management expertise to the partnership after its formation.

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In reaching its conclusion that Mrs. Kimbell’s transfer to the partnership was a

bona fide sale for full and adequate consideration, the Court again held that the pro rata

partnership interest she received was adequate and full consideration for the assets she

transferred and there was no contention that the transfer did not actually take place.

Importantly, the Court noted that the government had raised no material issues of fact to

counter the taxpayer’s evidence that the partnership was entered into for substantial

business reasons, which were strongly supported by the nature of the business assets

(divided working interests in oil and gas properties) conveyed and the deposition

testimony of Michael Elyea and David Kimbell.

After dealing with the transfers to the partnership, the Court turned to Mrs.

Kimbell’s transfer to the LLC. For some unarticulated reason, the Court assumed that the

bona fide sale exception did not apply to the transfers to the LLC. Consequently, the

Court had to address whether Mrs. Kimbell retained the right to enjoy the income from

the transferred assets or the right to designate who would enjoy the income from the

transferred assets. The Court found that, because Mrs. Kimbell retained only 50% of the

membership interest in the LLC, she did not have sufficient control of the assets to make

her transfer subject to I.R.C. § 2036(a)(1) or (2). In addition, her son was the sole

manager of the LLC. The Court may be correct that the failure to retain control was a

factor indicating that she did not have an implied agreement to retain the enjoyment of

the income. However, the Court ignores that I.R.C. § 2036(a)(2) applies if the transferor

retained, alone or in conjunction with any person, the right to designate the persons who

would enjoy the income from the transferred assets. Control by the transferor alone is not

the proper test. The Court remanded the case to the District Court to determine whether

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Mrs. Kimbell’s interest in the partnership was an assignee interest or a limited partnership

interest for placing a value on the interest for estate tax purposes.

Analysis of the Court’s Opinion.

As discussed earlier, once one considers the additional facts set out in the Fifth Circuit’s

opinion, the result is not surprising. While some may view the decision as being very

favorable to the taxpayer, the opinion should not be read as a blank check for all FLPs

and FLLCs, however structured and funded. The existence of oil and gas working

interests in the partnership was heavily relied on by the Court in reaching its decision that

the transfer was bona fide. Granted, the decisions in Kimbell and Stone could give

comfort that the adequate and full consideration for money or money’s worth prong of

the bona fide sale exception is satisfied as long as the transferor takes back a pro rata

interest in the entity proportionate to the value of the assets contributed by all the owners

and that interest entitles him or her to a pro rata share of distributions from the entity.

However, the bona fide sale prong may be more difficult to satisfy when the only assets

in the entity are passive investments requiring no active management. Nonetheless, even

in the case of passive investments, if it can be shown that there were benefits to be

derived by having the assets held in an entity, such as a partnership or LLC, the bona fide

sale test may be satisfied. For example, if more than one family member is able to

transfer significant assets to the entity, the family members may have achieved a

reduction in expenses and gained additional investment opportunities as a result of

combining their investments.

Note that the discussion concerning the bona fide sale exception in Kimbell

focuses only on the transfer to the partnership. Because Mrs. Kimbell did not make gifts

20

of partnership interests before she died, there was no issue as to whether such gifts would

have caused a portion of the underlying assets to be included in her estate. In Abraham,

the Tax Court held that gifts of partnership interests were not transfers for adequate and

full consideration and therefore, because it held that the decedent retained an implied

right to the income from the transferred assets, I.R.C. § 2036(a)(1) applied. Because the

gift of an interest in a business entity would not fall under the bona fide sale exception,

I.R.C. § 2036(a)(1) or (2) or both could apply to gifts of entity interests.

In determining whether I.R.C. § 2036(a) applied, would the inquiry be whether

the donor retained a right to enjoy the income from the transferred interest or the right to

control the enjoyment of the income from the transferred interest, or would the inquiry be

whether the donor retained such a right with regard to the underlying assets of the entity

that he or she had earlier transferred in a bona fide sale transaction? In addition, it is

unclear what would be included in the donor’s estate, i.e., the discounted value of the

gifted interests in the entity or the undiscounted value of the underlying assets.

For example, if the donor gives a limited partnership interest to a trust over which

the donor has a discretionary power to make distributions, clearly I.R.C. § 2036(a)(2)

would apply. On the other hand, if the donor made an outright gift of the limited

partnership interest to the donor’s adult child, but was the general partner of the limited

partnership and under the partnership agreement the general partner had no fiduciary duty

to the partnership or other partners (assuming it would be possible under state law to

eliminate such a duty), would I.R.C. § 2036 (a)(2) apply?

In discussing the application of I.R.C. § 2036 (a) to Mrs. Kimbell’s transfer to the

LLC general partner, the Court does not mention the Byrum case at all, presumably

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because the Court found that she did not retain sufficient control to invoke that section.

Its conclusion was based on two facts. Mrs. Kimbell only held 50% of the membership

interest and her son was the sole manager. While these factors may be relevant to

whether she had an implied right to enjoy the income from the transferred assets, as

mentioned earlier, I.R.C. § 2036 (a)(2) refers to a right held alone or in conjunction with

any other person. The Court also ignores Mrs. Kimbell’s ability under the agreement to

remove the general partner and to appoint herself as the general partner.

Because in the Court’s eyes it was not necessary to invoke Bryum, we are forced

to wait until another day to learn whether the Tax Court’s expansive reading of I.R.C. §

2036(a)(2) in Strangi II is correct. Although Strangi II is on appeal to the Fifth Circuit, it

is unlikely that we will get any clarification of the I.R.C. § 2036(a)(2) issue when the

Fifth Circuit renders it decision. The Fifth Circuit cited Strangi II favorably five times in

discussing the bona fide sale exception, including the following quote: “[the partnership]

patently fails to qualify as the sort of business enterprise that could potentially inject

intangibles that would lift the situation beyond mere recycling.” Consequently, it is

possible that the Fifth Circuit, albeit a different panel of judges, would hold that the bona

fide sale exception does not apply to Mr. Strangi’s transfer of assets to the limited

partnership and the corporate general partner. If it finds that the bona fide sale exception

applies, then it will not have to consider I.R.C. § 2036(a)(1) or (2). Keep in mind that the

Fifth Circuit’s review in Strangi II will not be de novo. It is also possible that it would

find that Mr. Strangi retained an implied right to enjoy the transferred property,

particularly considering he transferred 98% of his assets, including his residence, to the

corporate general partner. As a result, the Fifth Circuit may find that it unnecessary to

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deal with the I.R.C. § 2036(a)(2) issue. Although Thompson, also involving I.R.C. §

2036(a), is on appeal to the Third Circuit, because it does not involve the I.R.C. §

2036(a)(2) issue, no additional guidance will come out of that decision with regard to the

retained control issue.

What Does the Decision Stand For?

The following are specific holdings that can be gleaned from the Fifth Circuit’s decision;

(1) The bona fide sale exception is based on objective, not subjective, facts.

This was the position argued in the amicus curiae brief filed by the

American College of Trust and Estate Counsel.

(2) The recycling argument applies to the bona fide transaction prong of the

bona fide sale exception, rather than the adequate and full consideration

prong.

(3) Although closer scrutiny of intra family transactions may be appropriate,

what constitutes a bona fide sale among unrelated parties is also a bona

fide sale among related parties. There are no additional requirements that

intra family transactions must satisfy.

(4) Some non-tax reason must exist for the arrangement to satisfy the bona

fide sale prong. Mere tax avoidance is not sufficient.

(5) Active management of at least some of the assets after the transfer to the

entity demonstrates a non-tax reason for the arrangement. Whether active

management of at least some of the transferred assets must exist to avoid

I.R.C. § 2036(a) is not clear.

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(6) The fact that the same person or persons continue to manage the

transferred assets after the transfer is not relevant as long as there are

business reasons for forming the entity.

(7) There is no requirement that minority owners own any particular

minimum amount of interest in the entity to create a legitimate entity and

to have its transfers treated as bona fide.

(8) A transfer of assets to an entity is an exchange for adequate and full

consideration if the transferor takes back an interest in the entity that is in

proportion to the fair market value of the assets transferred in relation to

the interests received by the other contributors to the entity. The fact that

immediately after the transfer the value of the transferor’s interest in the

entity is not equal to the value of the transferred assets because of

appropriate discounts for lack of control and lack of marketability is not

relevant.

(9) The lack of negotiations between family members over price or terms is

not a compelling factor if the value is set by objective standards. In the

typical FLP or FLLC, the value of the transferred assets, except with

regard to marketable securities, will be determined by an appraiser. As

long as the same methodology is used for valuing all the assets transferred

to the entity in exchange for interests in the entity, the value should be

considered to be set by objective standards.

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(10) A taxpayer’s testamentary or tax savings motive alone does not trigger

I.R.C. § 2036(a) if objective facts demonstrate the transfer was made for a

full and adequate consideration.

The following are issues that are not dealt with or are dealt with inadequately in the Fifth

Circuit’s decision:

(1) The decision does not deal with gifts of interests in the entity.

(2) The decision does not provide any detailed analysis of either I.R.C. §

2036(a)(1) or (2) and perhaps incorrectly applies I.R.C. § 2036(a)(2) by

ignoring the “either alone or in conjunction with any persons” language.

(3) The decision does not give guidance on whether the lack of active

management of any of the transferred assets would cause the transaction to

flunk the bona fide sale prong of the bona fide sale exception.

What to Tell Clients.

As a result of Kimbell and Stone, and the lessons learned from other cases that the IRS won,

FLPs and FLLCs that are properly structured and operated should continue to provide an

efficient means of transferring wealth to younger generations. The implied agreement argument

under I.R.C. § 2036(a)(1) can be avoided by:

(1) refraining from making non-pro rata distributions to the owners, especially the

transferor;

(2) refraining from commingling the entity’s funds with personal funds;

(3) keeping accurate books reflecting the operative agreement and the entity’s

operations, beginning as soon as possible after the entity is formed;

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(4) encouraging the general partners or managing members to actively manage the

assets in the entity;

(5) complying with all of the formalities imposed by state law;

(6) complying with the operative agreement in every respect or amending the agreement

to reflect changes in circumstances;

(7) ensuring that assets transferred to the entity are retitled to reflect the new owner;

(8) not transferring assets that the transferor will continue to use personally, such as his

or her residence; and

(9) not transferring so much of the older family member’s assets that he or she cannot

continue to live in his or her accustomed manner without distributions from the

entity in excess of distributions that would be considered normal for the type of

assets held by the entity.

The transferor should not be treated as possessing a legally enforceable and

ascertainable right under I.R.C. § 2036(a)(2) if either of the following facts exist:

(1) The transferor never had the right, either alone or in conjunction with any other

person, to designate the persons who will receive the income from the transferred

property; or

(2) Other owners have more than a de minimis interest in the entity and the fiduciary

duty of the transferor as the general partner or managing member has not been

waived.

Based on Stone and Kimbell, the bona fide sale exception may apply if:

(1) Capital accounts reflect the fair market value of the contributed property and all

distributions are based on capital accounts;

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(2) Other owners have more than a de minimis interest;

(3) There is active management of the assets after the creation and funding of the

entity; and

(4) There are non-tax reasons for the creation and funding of the entity.

Conclusion.

As stated above, the Fifth Circuit’s decision in Kimbell has given us some much needed

guidance with regard to the bona fide sale exception to the application of I.R.C. § 2036

(a), especially when it can be demonstrated that there were non-tax reasons for creating

the business entity and those reasons that are supported by the facts in the case.

However, the guidance may be of no avail to those clients who wish to make gifts of

interests in the entity or to clients who intend to transfer only passive investments to the

entity and cannot demonstrate that there is some non-tax benefit achieved by the creation

of the entity. Avoiding the implied retention of enjoyment and the retained control

arguments, as discussed above, will still be necessary to preclude the application of I.R.C.

§ 2036 (a).

\\TAX\208144.1 1 TAM 9842003 (July 2, 1998); TAM 9736004 (June 6, 1997); TAM 9735003 (May 8, 1997); TAM 9730004 (Apr. 3, 1997); TAM 9725002 (Mar. 3, 1997); TAM 9723009 (Feb. 24, 1997); TAM 9719006 (Jan. 14, 1997). 2 Church v. U.S., 2000-1 U.S.T.C. 160,369 (W.D. Tex. 2000), aff’d without published opinion, 268 F.3d 1063 (5th Cir. 2001); Estate of Strangi v. Commissioner, 115 T.C. 478, aff’d in part and rev’d and remanded in part, 293 F.3d 279 (5th Cir. 2002); Knight v. Commissioner, 115 T.C. 506 (2000); W.W. Jones, II v. Commissioner, 116 T.C. No. 11 (2001); Estate of Thompson v. Commissioner, T.C. Memo 2002-246; Kerr v. Commissioner, 292 F.3d 490 (5th Cir. 2002), aff’g 113 T.C. 449 (1999); and Estate of Harper v. Commissioner, 116 T.C. No. 11 (2001). 3 Estate of Schauerhamer v. Commissioner, T.C. Memo. 1997-242; Estate of Reichardt v. Commissioner, 114 TC 144 (2000); Estate of Thompson v. Commissioner, T.C. Memo. 2002-246; Estate of Harper v. Commissioner, T.C. Memo. 2002-121; Kimble v. U.S., 2003-1 USTC ¶ 60,455 (N.D. Tex. 2002); Estate of Strangi v. Commissioner, 2003-145 (Strange II); Estate of Ida Abraham, T.C. Memo. 2004-39; and Estate of Lea K. Hillgren, T.C. Memo. 2004-46 4 Estate of Strangi v. Commissioner, 2003-145 (Strangi II)

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5 Estate of Stone, T.C. Memo. 2003-309 6 Estate of Ida Abraham, T.C. Memo. 2004-39 7 Estate of Lea K. Hillgren, T.C. Memo. 2004-46 8 Kimbell v. U.S., 2003-1 USTC ¶ 60,455 (N.D. Tex. 2002) 9 U.S. v. Byrum, 408 U.S. 125 (1972) 10 Wheeler v. United States10, 116 F.3d 749 (5th Cir. 1997) 11 268 F.3d 1063 (5th Cir. 2001) confirming the District Court’s decision in favor of the taxpayer , 85 A.F.T.R. 2d (RIA) 804 (W.D. Tex. 2000)