Section 2036 Ambush Leaves Dr. Liljestrand’s Estate in Need of a Medic

Liljestrand v. Comm’r, TC Memo 2011-259 is another bad facts case that propelled the IRS in a Section 2036 attack, and resulted in an approximate $2.6 million federal estate tax deficiency for the taxpayer. 

Background

Dr. Paul H. Liljestrand accumulated his wealth as a general practitioner and surgeon for a medical practice that he established in Hawaii and operated on hospital real property that he owned.  Dr. Liljestrand retired from the practice of medicine in 1978, sold the medical building one year later, and reinvested the proceeds in 14 properties within four states.  By 1984, Robert Liljestrand, one of Dr. Liljestrand’s four children, became the manager of the real estate business.  In May 1997, Paul H. Liljestrand Limited Partnership (“PLP”) was formed, and the subject properties were transferred from a revocable trust in exchange for the initial partnership interests in December 1997¹.   Each of the four children received their PLP interests through a series of gifts in 1998 and 1999².  Despite having transferred legal title of the real estate to PLP, the parties continued to treat the real estate as an asset of the trust, ignoring certain formalities of the partnership.  At issue was whether the value of the assets transferred by Dr. Liljestrand to a family limited partnership should be included in the value of his gross estate under Section 2036 (a).

Court Discussion

As further explained below, under the bona-fide sale test of Section 2036, the estate’s three primary arguments for the nontax purpose of PLP were all rejected by the Court.

1. Central management of real estate, and long-term employment of Robert Liljestrand as manager.  The Court argued that PLP did not enhance centralized management, since Robert was already extensively involved as manager via his management agreement, and role as cotrustee of the trust.  Additionally, given that Robert’s personal interest in the property and his role as trustee presented a continuing conflict of interest (before and after the formation of PLP), the creation of PLP did not enhance his prospects for long-term employment.
2. Avoidance of partition or division.  The Court noted that Dr. Liljestrand’s legal counsel relied on Hawaii partition-action statutes as the primary basis for the added protection, but failed to engage in basic legal research for the partition action statutes applicable to the properties held in other states (most of PLP’s holdings), thereby undermining the significance of partition in the decision to form PLP.  In addition, upon Dr. Liljestrand’s death, the real estate held in the trust would have been distributed to the residuary trust and the children’s trust, and neither trust would terminate until the death of Dr. Liljestrand’s last living child. Accordingly, the beneficiaries (Dr. Liljestrand's children) would not hold real estate as joint tenants or tenants-in-common and could never be joint tenants or tenants-in common. Lastly, the Court cited that there is no evidence that any of Dr. Liljestrand’s children had any interest in seeking a partition.
3. Creditor protection. The Court cited that there is no evidence that Dr. Liljestrand or any of the other PLP partners were concerned with creditor claims, as the estate failed to name a single creditor or even establish an activity or pattern of activity by the partners which could open them up to potential liability.

In addition, the Court emphasized the failure to respect partnership formalities as evidence that the transfers were not bona fide sales.  Some of the missteps included co-mingling of partnership and personal funds (partnership bank account was opened 2 years after its formation; partnership assets were used to pay personal expenses), infrequent partnership meetings (one meeting since its formation with no minutes), disproportionate distributions, and Dr. Liljestrand’s strong financial dependency upon partnership distributions to maintain his lifestyle.

The Court also concluded that the transfers were not for adequate and full consideration, given that the interests credited to each partner were not proportionate to the fair market value of the assets contributed by each partner (original appraisal of the various classes of interests as of December 1997 was ignored in the capitalization of the partnership, and a small GP interest was assigned to Robert at formation for no consideration).

Lastly, the Court noted that the taxpayer retained the possession or enjoyment of, or the right to the income from, the property transferred to PLP. The Court emphasized triggers that included co-mingling of funds, disproportionate distributions that were heavily favored in Dr. Liljestrand’s favor, and that Dr. Liljestrand lacked sufficient funds outside of PLP to maintain his lifestyle and satisfy his future obligations.

FINAL COMMENTARY

In summary, the IRS was provided with strong ammunition to argue in favor of Section 2036, given the taxpayer’s missteps that included commingling of funds, disproportionate distributions, infrequent partnership meetings, Dr. Liljestrand’s heavy reliance on PLP distributions, and lack of strong support for PLP’s nontax business purpose.

¹The agreement called for a general partner, and two classes of limited partners (Class A and Class B). The Class A limited partner was granted a preferred return. The amount of this preferred return along with a number of other important terms was left blank in the agreement when signed by the parties. 
²In 1998, 172 Class B limited partner units (a 3.1 percent interest) were valued at $60,092. In 1999, 33 Class B limited partner units were valued at $11,913. Each respective gift required a gift tax return (exceeded annual exclusion of $10,000), and such gift tax returns were not filed until 2005.