ESTATE PLANNING ADVISOR

ESTATE PLANNING ADVISOR[i]

Vol.2, No. 25 November, 2001

HOW SECTION 2036(b) REALLY WORKS WITH CONTROLLED STOCK IN A FAMILY LIMITED PARTNERSHIP OR LLC

This Advisor provides an explanation of how the rules of Internal Revenue Code (Code) Section 2036 really apply in the practical world of estate planning. The Advisor will use the question and answer format.

1. What is Code section 2036 all about?

Code Section 2036 is referred to as an inclusion section. By that is meant, that if the statutory rules are complied with, or violated, depending on one’s view, the relevant property is included in the decedent’s estate.

2. What types of transactions does 2036 apply to?

Section 2036 applies to certain types of transfers of property by the decedent, prior to death. However, it is important to understand that 2036 never applies to “. . . a bona fide sale for an adequate consideration in money or money’s worth. . .” Note that the excepted transfer does not involve “adequate consideration” alone, only to a “. . .bona fide sale for an adequate consideration. . .”

3. I don’t understand, what other kind of a transfer can there be?

Actually, there are quite a few. Examples would be the transfer of property to a partnership in return for an interest in the partnership, which is tax-free under Section 721. Likewise, a transfer of property to a corporation that is tax-free under Section 351. However, it is important to note that neither of these transfers is “. . .a bona fide sale. . . “ Because the transferor has made a transfer that is not a bona fide sale, the property transferred to the partnership or corporation might be included in the transferor’s estate at the transferor’s death.

4. I think I understand that there are transfers that are not bona fide sales and there are transfers which are bona fide sales. Is it correct that a transfer that is not a bona fide sale must be further analyzed to see if the transfer is subject to Section 2036?

Very well stated. Once we know that the transfer is not a bona fide sale for adequate consideration, we must check the other rules of Section 2036 to see if the transferred property will be included in the estate of the transferor at the transferor’s death.

5. What are the characteristics of a non bona fide sale transfer (Transfer) that will cause the transferred property to be included in the estate of the transferor?

There are several rights, which if retained by the transferor, will cause the property subject to the Transfer to be included in the transferor’s estate at the date of death value. These retained rights are:

1. The right to the possession or enjoyment of, or the right to the income from the property,

2. The right, either alone or in conjunction with any other person, to designate the persons who shall possess or enjoy the property or the income thereon, or

3. The retention of the right to vote (directly or indirectly) the stock of a controlled corporation (20% of the total combined voting power of all classes of stock). [§2036(b)]

Number three is the one we are going to deal with in some detail.

6. I don’t understand the relationship between an FLP or LLC and the transfer of controlled stock to either entity, would you explain it?

As you may know, if I transfer property into an FLP or LLC (FLP), my estate now includes the FLP interests rather than the property I transferred. That is, unless I have run afoul of Section 2036. Standard valuation techniques tell us that the willing buyer, the test for gift and estate tax purposes, will pay less for an interest in the FLP than for the property I transferred. Therefore, the use of FLPs has become a very popular estate planning technique.

7. What does that have to do with a controlled corporation?

Let’s assume that I own 100% of the stock, voting common, of a corporation that has a value of $1,000,000. If I die owning the stock, the stock will be valued at $1,000,000. However, my advisor suggests that I transfer the stock to an FLP so as to obtain a discount in the value of my estate. I transfer all of the stock to the FLP, and now my estate consists of interests in the FLP and not in the corporation, unless I have violated Section 2036(b). As I have made a transfer, what is the first question you need to ask?

8. Was the transfer a bona fide sale for adequate consideration in money or money’s worth?

Good, that is right. We know that the transfer of the stock to the FLP was not a bona fide sale, so what is the next question we need to ask?

9. Did you retain any rights that violate the terms of Section 2036?

I am safe on retained powers listed as numbers one and two above, because I, as the general partner, have a fiduciary duty to the other partners. However, the third item, retention of the right to vote the shares I contributed, specifically states that the status in which I am able to vote the shares “(directly or indirectly)” removes the protection for my ability, as general partner, to vote the shares.

10. Does that mean that the shares held by the FLP, at your death, are included in your estate at the date of death value?

Yes it does. For purposes of an example, assume that when I die, the shares are valued at $5,000,000.

11. Does that mean your estate includes $5,000,000 in controlled corporation stock?

Well, sort of. It doesn’t seem fair to keep the FLP interests in my estate and the date of death value of the stock I transferred to obtain the FLP interests. This is where the concept of “adequate and full consideration in money or money’s worth” enters the picture. Regulations 20.2036-1(a) provide that: “A decedent’s gross estate includes under section 2036 the value of any interest in property transferred by the decedent. . .except to the extent the transfer was for an adequate and full consideration in money or money’s worth (see sec. 20.2043-1). … Note that there is no requirement of a bona fide sale.

12. I’m confused, would you summarize where we are?

Sure. I transferred controlled corporation stock into an FLP. However, the transfer was not a bona fide sale. Because the transfer was not a bona fide sale, the corporate stock might be included in my estate if I retained a forbidden right. I did retain a forbidden right because I can vote the shares of stock as the general partner in the partnership. We are now trying to find out how much of the $5,000,000 in controlled corporation stock is included in my estate under section 2036(b). The regulations under 2036 referred us to section 2043. Section 2043 deals with transfers for less than adequate consideration.

13. So, what does Section 2043 do?

Section 2043 allows me to reduce the value of the $5,000,000 date of death value of the stock by the consideration, the FLP interests, I received for the stock. Let me quote Section 2043(a):

§ 2043 Transfers for insufficient consideration.

(a) In general.

If any one of the transfers, trusts, interests, rights, or powers enumerated and described in sections 2035 to 2038 [2036], inclusive, and section 2041 is made, created, exercised, or relinquished for a consideration in money or money's worth, but is not a bona fide sale for an adequate and full consideration in money or money's worth, there shall be included in the gross estate only the excess of the fair market value at the time of death of the property otherwise to be included on account of such transaction, over the value of the consideration received therefore by the decedent.

As you can see, because the transfer was not a bona fide sale, the stock is included in my estate at its date of death value, $5,000,000, but my estate is allowed to reduce the $5,000,000 by the value [defined as the fair market value in the 2043 regulations] of the consideration, the FLP interests, I received in the original transfer. If we assumed a 50% discount on the original transfer, the value of the consideration I received might be $500,000 (50% of $1,000,000).

14. Assuming that his how the “value” issue under Section 2043 works, what is actually included in your estate?

Value of the Stock at Date of Death	$5,000,000
Less Value of Consideration	(500,000 )
Estate Tax Value	$4,500,000

Even if the “value” of the FLP interests received in consideration for the stock was treated as $1,000,000, the amount included in my estate would be $4,000,000.

15. Wouldn’t that be a planning disaster?

Yes, but if I were to recapitalize my corporation’s stock into 99 nonvoting shares and 1 voting share, only the 1 voting share is included in my estate, because I cannot vote the other 99. This is a very effective method to avoid the disaster we just discussed. See TAM 199938005.