Additional Insights for Using Business Entities to Transfer Assets

A few weeks ago (Protecting Your Assets Even While Getting Rid of Them) I wrote about using business entities to make asset gifts or sales. Something I didn’t mention then, but is critical in this discussion, is the need to keep in mind that the IRS and the courts use something called the “bona fide sale” rule to determine whether a “real, actual, or genuine” sale has taken place.

To illustrate how this works, let me refer to a court case involving the estate of Theodore Thompson, who had been told by his financial advisor that he needed to protect his assets with family limited partnerships (FLPs). The advisor said the primary advantages were: “(1) lowering the taxable value of the estate, (2) maximizing the preservation of assets, (3) reducing income taxes by. . . provid[ing] medical, retirement, and ‘income splitting’ benefits for family members, and (4) facilitating family and charitable giving.” (Thompson, 84 T.C.M. at 376). In essence, the advisor said Theodore could convey his assets to an FLP, realize major tax and asset protection benefits, and still control the assets as before.

Thompson transferred $2.8M to two FLPs in return for partnership interests. His children also received partnership interests. Upon his death, Thompson’s estate tax return applied a 40% lack of control and lack of marketability discount to his FLP interests. The IRS disagreed and pursued over $700,000 in estate taxes.

The court sided with the IRS, noting that Thompson “parted with almost all of his wealth”. This “outright transfer of the vast bulk of [Thompson’s] assets… can only be explained if [Thompson] had at least an implied understanding that his children would agree to his requests for money from the assets he contributed to the partnerships, and . . . [would] do so for as long as he lived.” (Thompson, 84 T.C.M. at 386-87). This “implied understanding” violated Internal Revenue Code §2036(a)(1), concerning estate valuations for estate taxes.

An exception to the §2036 violation would exist if the asset transfer was a “bona fide sale for adequate and full consideration.” (26 U.S.C. §2036(a)). The court felt there were no transfers for consideration because the transactions “were not motivated by . . . legitimate business concerns.” (Thompson, 84 T.C.M. at 388)

Elements of a Bona Fide Sale
Looking at Thompson and other court rulings and IRS positions, you can determine what you must do to successfully sell assets from your estate. Here’s a short list of things to watch out for:

• “Arm’s length” transaction – does the transfer resemble what would happen if two strangers negotiated in a competitive market environment?
• “Good faith” transaction – did the respective parties actually part with the items being exchanged? Did the transferor lose “possession, enjoyment, or rights” to the transferred property? Or was the transaction merely feigned, with the original asset owner retaining overall control of the asset?
• Legitimate business concerns – does the business entity have legitimate business operations providing a substantive non-tax rationale for transferring assets? If not, courts may view the transfer as a mere “contrivance”.
• Full and adequate consideration – did the transfer involve enough of a trade-off in value? The IRS argues that if the value of assets in a business entity is discounted for estate tax purposes, there is no “full and adequate consideration” in the sale. However, the Fifth Circuit identified business benefits that could make up for a dollar value decrease, such as management expertise, security and preservation of assets, and avoidance of personal liability.
• Loss of the right to designate possession or enjoyment – even if an asset transfer is not shown to be for “adequate and full consideration”, it can still avoid I.R.C. § 2036(a) if the person who transfers the asset can be shown to have lost the right to designate the persons who would possess or enjoy the transferred property.

When evaluating an asset transfer, courts look at both the form and the substance of the transaction. “Form” questions usually look at whether a business entity, trust, or transaction was planned, set up, or documented correctly. “Substance” questions tend to look downstream, at whether subsequent operations of the business entity, trust, or transaction are proper. As in sports, follow-through on your asset transfers is essential.

Summary & Conclusion
If you transfer assets correctly, you can achieve significant liability and tax advantages. If you don’t, the penalties can be costly. The IRS has multiple strategies to go after gift and estate taxes. If you claim a sale, they’ll seek to call it a gift and charge gift taxes. If they can’t prove it was a gift, they’ll argue it was not a bona fide sale and try to assess estate taxes. If you follow the rules, you can withstand any challenge the IRS or a private litigant might raise.

Under current tax law, people with significant estates can count on the bulk of their wealth being consumed in taxes unless they address the issue through wealth and estate planning. While the federal estate tax is slated to disappear in 2010, it comes right back in 2011 unless Congress passes new tax laws. Also, more and more states are levying estate taxes at the state level in an effort to increase revenue. Even if the federal estate tax is abolished, you may still be subject to state estate taxes.

Using Bulletproof Veil is the best way to ensure that your asset transfers have substance. We help you maintain proper behaviors on an ongoing basis so your asset gifts or transfers will succeed. Visit BulletproofVeil.com for more information, or call and take advantage of the free 15-minute phone consultation available through their toll free number 1-888-716-3180.