“Bad Facts” FLP Case Highlights Impact of Poor Planning

Although significant emphasis is placed on the quantification and underlying support for application of valuation discounts, the following case illustrates that a failure to follow the basic corporate formalities and structure can significantly undermine even the most defensible valuation discounts. – Lynton Kotzin

Lynton Kotzin  

Estate of Liljestrand v. Commissioner, T.C. Memo 2011-259; 2011 Tax Ct. Memo LEXIS 251 (Nov. 2, 2011)

After retiring in 1978, a Hawaii resident, Dr. Paul Liljestrand, exchanged his interest in a local hospital for several real property holdings, including a California shopping center and condominiums, an Oregon warehouse, a Florida strip mall, and an Arizona medical building. In 1984, he formed a revocable trust to hold the real property, naming his eldest son as trustee and paying him to manage the trust’s real estate assets.

In 1996, Dr. Liljestrand decided to create a new estate plan for the benefit of his four children. His planning objectives included ensuring that his eldest son would continue to manage the real estate, a role in which none of the three other children showed an interest. In addition, Dr. Liljestrand was concerned that if the property were gifted while it remained in trust, Hawaii law would allow his other children as beneficiaries to seek judicial partition of the property and oust his son as manager.

To address those issues, Dr. Liljestrand’s estate planning attorney suggested forming a family limited partnership (FLP) funded with the trust-owned properties. In 1997, the FLP was formed, naming Dr. Liljestrand as the 99.8% general partner and giving his manager/son a small Class A limited partnership (LP) interest. Within six months, Dr. Liljestrand transferred to the FLP all of the trust’s real property investments, appraised at roughly $6 million.

Over the next two years, Dr. Liljestrand gifted Class B LP units to four trusts, one for each of his grown children. Since he had contributed all but his personal residence to the FLP, the FLP made disproportionate distributions – larger than those provided by the partnership agreement – to pay his living expenses and debts and to make gifts to his grandchildren.

Dr. Liljestrand passed away in 2004. In 2008, the IRS assessed a $2.6 million deficiency, based on including the entire fair market value of his real estate holdings in his estate pursuant to IRC Section 2036(a). The estate petitioned the court for a determination of liability.

Bad Facts

The court found several “bad facts” indicating that the FLP transfers were not bona fide sales. For example, the FLP failed to follow “even the most basic of partnership formalities,” including keeping regular books and meetings, making proportionate distributions, and refraining from paying personal expenses of Dr. Liljestrand and debts owed by his son. Dr. Liljestrand also stood on “both sides of the transaction” in funding and forming the FLP, without any evidence that he held arm’s-length negotiations with the other partners or created the FLP to fulfill anything but his own objectives. Based on the totality of these facts, the court concluded that Dr. Liljestrand did not have a legitimate tax reason for transferring his assets to the FLP, which thus were not bona fide sales.

The court considered the estate’s claims that Dr. Liljestrand did not retain possession of the FLP assets during his lifetime, but the bad facts of the FLP’s formation, funding and operations undermined those arguments as well. Although Dr. Liljestrand retained some assets outside of the partnership, they were not enough to maintain his lifestyle or satisfy his future obligations, including payment of his estate taxes.

Finally, the court held that the “partnership served primarily as a testamentary device through which [Dr. Liljestrand] would provide for his children at his death.” Taking this feature in light of all the other factors in the case, the court included the full fair-market value of the FLP assets in Dr. Liljestrand’s gross estate, pursuant to Section 2036, and denied the estate’s petition to not pay the $2.6 million in tax deficiencies.

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