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Friday, December 29, 2006


Oftentimes, a taxpayer may transfer assets to a partnership or corporation, and either concurrently or later will gift interests in the entity to family members or trusts for family members. Sometimes, the transferor has no ownership interest in the transferee entity, and the funding transaction is treated as a gift. As part of the overall planning, the transferor will be employed by the transferee entity as a manager or some other function and thus will receive payments from the entity.

For some of these transactions, the IRS may interpret the compensatory income paid to the transferor as a retained income interest under Code Section 2036(a). If that is the case, at the transferor’s death the transferred assets may be subject to estate tax even though the transferor has no (or a reduced) ownership interest in them. The overall concern of the IRS is that the transferor gave away the assets to remove them (and future growth) from estate tax at his or her future death, but in effect retained the economic benefits from such transferred assets by being paid a management or other ongoing fee from the transferred assets or business.

To avoid Code Section 2036(a) inclusion, an effort should be made to establish the bona fides of the compensatory arrangement. As is often the case, some taxpayers do this better than others. A recent family limited partnership case provides instruction on how NOT to handle such arrangements.

In Korby v. Comm., 98 AFTR 2d 2006-8115, (CA8 2006), the taxpayer and his wife transferred assets to a living trust, and then into a limited partnership. The living trust was a 2% general partner, and the 98% limited partnership interests were eventually gifted to family members. Over time, the living trust received distributions from the partnership as ostensible “management fees.” The IRS challenged the arrangement, asserting that the compensatory arrangement was instead a retained Code Section 2036(a) right to income of the transferred assets, and sought to include the assets of the partnership in the estate of the taxpayer when he died.

Both the Tax Court and the appellate court agreed that the compensatory arrangement was not bona fide. The particular items that the courts noted in reaching their decision were:

a. The lack of a written management contract;

b. The lack of records as hours spent on managing the partnership;

c. The haphazard timing and amounts of payments; and

d. The failure of the recipient to report the payments as self-employment income.

Therefore, the case is instructive in reminding us about items that should be addressed in planning for bona fide compensation arrangements - a written agreement, proper record keeping, and reporting of such income as compensatory for employment tax purposes.

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