Importing a Trade or Business Limitation into (Section) 2036: Toward a Regulatory Solution to FLP-Driven Transfer Tax Avoidance

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INTRODUCTION

The federal gift and estate taxes serve important policy goals, among them raising revenue, (1) increasing the overall progressivity of federal taxation, (2) and counteracting the increasing concentration of wealth in the hands of the few. (3) In recent decades, however, many wealthy U.S. taxpayers have managed to avoid the gift and estate taxes by transferring their assets to family limited partnerships (FLPs) in exchange for ownership interests, thereby availing themselves of the valuation discounts the federal transfer tax system has traditionally accorded to equity in closely held businesses. (4) The resulting revenue loss has been significant. (5)

Despite myriad proposals for legislative solutions to FLP abuse, Congress has consistently failed to act. (6) However, this congressional inertia has not prevented the Internal Revenue Service from aggressively challenging FLP transactions in the courts, leaving a litigation trail that spans several decades. In Estate of Strangi v. Commissioner, (7) the Service appeared to win a significant victory, convincing the Tax Court to disregard an FLP transaction under an ostensibly broad reading of Internal Revenue Code [section] 2036. (8) Unfortunately, the victory was short lived, as the Tax Court subsequently clarified that it will respect FLPs under [section] 2036 so long as they serve a "legitimate and significant nontax purpose." (9) In practice, this "nontax purpose" test permits all but the most poorly planned FLP transactions to pass muster.

This Note argues that the Department of the Treasury has the authority to curb FLP abuse by imposing a "trade or business" limitation on valuation discounts for business interests -- a limitation modeled on the "trade or business" eligibility requirement for I.R.C. [section] 6166 estate tax deferral on business interests. Specifically, this Note proposes that Treasury amend its regulations under [section] 2036 to replace the Tax Court's "nontax purpose" motive inquiry with an objective economic test: a person who transfers property to a business entity may only discount the value of transferred assets that the entity actually "use[s] in carrying on a trade or business." (10)

The Note proceeds in five Parts. Part I briefly summarizes the mechanics of the gift and estate taxes and explains how FLPs permit wealthy taxpayers to avoid those taxes. Part II describes the evolution of the "nontax purpose" test that the Tax Court currently applies to scrutinize FLP transactions. Part III explains why [section] 6166's "trade or business" limitation provides the basis for an elegant and administrable solution to FLP abuse, a solution Treasury has authority to implement under [section] 2036. Part IV addresses possible concerns with this Note's reform proposal, and Part V concludes.

I. TURNING GOLD INTO STRAW: THE REVERSE ALCHEMY OF FLP TRANSACTIONS

To grasp the mechanics of FLP-driven transfer tax avoidance, it is first necessary to have a cursory understanding of the federal gift and estate taxes. The goal of those taxes (collectively, transfer taxes) is to tax the value of all gratuitous transfers made by the taxpayer, during her life or at her death, (11) at the applicable tax rate (currently 40%). (12) The transfer taxes accomplish this goal in two steps: First, the gift tax applies to any value the taxpayer transfers out of her estate during her life, (13) less applicable deductions and exclusions. (14) (However, if the lifetime transfer is a sale, only the gratuitous portion of the transfer -- that is, the excess of the value of the transferred property over the value of the sale proceeds -- is subject to gift taxation. (15)) Second, the estate tax applies to the value of the taxpayer's gross estate upon her death, (16) less applicable deductions and exclusions. (17) Notably, under the current unified lifetime exemption, a tax-payer can gratuitously transfer up to $5,250,000 either during her life or at death without incurring any gift or estate tax. …