Mr. Black had gifted stock to his son and to trusts established for his grandchildren. He became concerned that his son might default on a bank loan and that his son’s marriage was heading toward divorce. These factors could cause his son to have to sell some of his Erie stock. He was also concerned that the Erie stock would be distributed to his grandchildren from the trusts and that they might then also sell some of stock. Mr. Black was told that if he established an FLP which included as limited partners his son and his grandchildren’s trusts, he could better keep the Erie stock from being sold without his consent. In 1993 the FLP was formed and Mr. Black was the general partner until 1998, at which time his son became managing general partner of the FLP. Throughout the years, Mr. Black made several gifts of interests in the FLP to his son, to his grandchildren, to the trusts established for the grandchildren, and to a charity. When Mr. Black died in 2001, the FLP still held all of the original Erie stock.
When just five months after he had passed away Mr. Black’s wife died, a secondary public offering was made of the Erie stock wherein the FLP sold three million shares for $98 million, in order to pay estate taxes. The FLP then loaned $71 million to Mrs. Black’s estate to pay estate taxes. The Internal Revenue Service (“IRS”) asserted that the stock in Erie which Mr. Black had transferred to the FLP should be included in his gross estate under Section 2036 of the Internal Revenue Code (“IRC”). It is not clear whether Mr. Black retained any of the proscribed rights under Section 2036; however, the court addressed the bona fide sale exception first. In prior cases, the Tax Court has held that to meet the bona fide sale exception, the decedent must have had a legitimate and significant non‐tax reason for creating the family limited partnership. Under this analysis, the court held for the taxpayer stating that using the partnership to address Mr. Black’s concerns about the Erie stock being sold was such a legitimate non‐tax reason.
In 1996, Mrs. Shurtz and her husband formed a family limited partnership—Doulos L.P. (the “FLP”)—for the apparent reason of protecting family assets from potential creditor claims. It appeared that Mrs. Shurtz believed the state where the timber was located was an especially litigious state. Mrs. Shurtz contributed her interest in C.A. Barge Timberlands, L.P. along with other separate timberland that she owned to Doulos L.P. She initially held a 1% general partnership interest and a 98% limited partnership interest in the FLP, while her husband held a 1% general partnership interest. Before passing away in 2002, over the course of several years she made many gifts of small interests in FLP to her children and to trusts established for her grandchildren.
The court accepted the estate’s argument that FLP was formed to protect family assets from litigation claims and to facilitate management, thereby finding that her transfers fell within the bona fide sale exception to Section 2036 of the IRC. Therefore, the court was not required to consider whether she had retained any of the proscribed 2036 rights.
Estate of Samuel P. Black and Estate of Charlene B. Shurtz are both good examples of why it is important to emphasize the non‐tax reasons for entering into an FLP transaction in which ownership in the entity is being transferred from one generation to the next. Some courts are more lenient than others in what they are willing to except as legitimate nontax reasons, so it is best to have several potential reasons on hand. Also, choosing a non‐tax reason like asset protection may sound great for tax purposes, but could become problematic from an asset protection standpoint if a transfer to an entity is ever challenged and it looks like asset protection was the sole reason for its creation as it may be difficult to argue that said transfer was not made to hinder, delay, or defraud creditors. Alternative suggested non‐tax reasons for transferring ownership of an entity could be: to consolidate control of family owned assets, ease of management and transfer of ownership, facilitation of financing, etc. The bottom line is that each case needs to be addressed separately and legitimate non‐tax reasons specific to a given transaction need to be considered and documented or the client needs to understand the potential exposure he/she faces by not doing so.