Presented to the National Business Institute
“Protecting Personal Assets and Minimizing Estate Taxes At Death”
April 28, 2009
By Thomas J. Murphy
Murphy Law Firm, Inc.
Nature of a family limited partnership
An FLP functions much like a trust. Documents are drafted to create the entity, much like a how a trust is created. Funding for an FLP is the same as that for a trust – assets are retitled in the name of the general partner of FLP, just as trust assets are titled in the name of the trustee. But there are a number of differences that must be considered:
Income tax aspects are more involved.
Beware of Subchapter K. A straightforward formation will not cause any problems but proceed at your peril with any creative or unusual situations
Tax ID number for FLP must be obtained. Grantor trusts use SSN
Separate tax return – form 1065 with forms K-1 issues – must be prepared for FLPS. No separate return for grantor trusts. Single member LLCs can file a schedule C on the form 1040.
Pass-through treatment means income will be taxed at partners’ individual rate, even if funds accumulate within the FLP. Compressed tax rates for non-grantor trusts result in very high tax rates if income accumulates – for 2007, the 25% rate hits at $2,150 of income and the top 35% rate hits at $10,450. But this is not a problem if the non-grantor trust is holding property (such as undeveloped land) that may be appreciating in value but is not generating income.
No Crummey notices required for gifts from FLPs.
FLPs can be amended as set forth in the partnership agreement. Irrevocable trusts will usually require action by a trust protector, if the trust has one, or by reformation through a court.
Profit and losses can be allocated. Income, gain, loss, deduction and credit items can be specially allocated but be wary.
While these are important considerations, the additional four factors set forth below usually get most or all of the client’s attention:
- Asset protection
- Creditor is limited to charging order
- Retention of control
- Person creating FLP controls management of assets within the FLP
- Easy mechanism for non-cash gifting
- Discounted valuations of FLP interests
#1. Asset protection.
A charging order is the “exclusive remedy” available to the creditor of a partner. ARS 29-341 (See ARS 29-655 for similar provision for LLCs.) A charging order is obtained by a judgment creditor (ie, the creditor must have first sued the partner and prevailed). It, in essence, states that any distributions from the FLP must be directed to the creditor and not the partner. But, the creditor has no management rights so he cannot force a distribution from the FLP to the debtor/partner nor can he reach the assets held within the FLP or force liquidation of the FLP. ARS 29-227 & -1043.
Furthermore, a charging order has some very detrimental tax consequences since a creditor holding a charging order is treated as an assignee of the debtor/partner, thereby attributing taxable income to the creditor despite the fact that the creditor never received an actual distribution from the FLP. This “phantom income” concept is based on Rev. Rul. 77-137 and Evans v. Commissioner, 447 F2d 547 (7th Cir., 1971). One commentator has referred to this as “getting KO’d by the K-1”.
Arizona is one of only several states (Nevada, Alaska, Oklahoma and Connecticut) that have this protection. Recently, there has been controversy among commentators has to exactly how bullet-proof the “exclusive remedy” language actually provides. Schurig & Jetel, “A Charging Order Is The Exclusive Remedy Against a Partnership Interest: Fact or Fiction?”, Probate and Property, Nov/Dec 2003 and Kleinberger, Bishop & Geu, “Dispelling Rumors of Disaster: Charging Orders and the New Uniform Limited Partnership Act, Probate and Property, July/Aug 2004; Nguyen, “Perception – v. – Case Law: Just How Protective For Assets of the Entity is the Charging Order Limitation?”, www.assetprotectionbook.com.
There is no reported Arizona case on the “exclusive remedy” language but it appears that an Arizona court would likely take a limited and strict interpretation of the statute. This is due to a case dealing with the predecessor statute that did not contain the “exclusive remedy” and that had broader language that permitted a charging order “and make all other orders, directions, accounts and inquiries which the debtor partner might have made, or which the circumstances of the case may require”. The Arizona Supreme Court reversed the trial court that had authorized the liquidation of a limited partnership by a creditor of a limited partner. Bohonus v. Amerco, 124 Ariz 88 (1979)It also appears that creating a funding an FLP when there is trouble or litigation on the horizon may be permissible and may not be considered a fraudulent conveyance as set forth in ARS 44-1001 since the FLP interest will have “reasonably equivalent value in exchange for the transfer”. While, again, there is no reported Arizona case, the Ninth Circuit has approved the transfer of non-exempt assets to exempt status for pre-petition bankruptcy planning. In Re Stern, 317 F3d 1111 (CA9, 2003). The same reasoning would seem to apply in a scenario in which an FLP is being created and funded. Compare this with recent developments in trust law. Both the Restatement Third and the Uniform Trust Code significantly lessen the creditor protection afforded trust beneficiaries. Section 501 of the UTC provides that a creditor may attach “present or future distributions to or for the benefit of the beneficiary”. Section 60 of the Restatement Third goes further, stating that “the trustee is personally liable to the creditor for any amount paid to or applied for the benefit of the beneficiary in disregard of the rights of a creditor”. Comment c, illustration 4.
#2. Retained control.
Occasionally, parents are reluctant to part with property. Either they fear that they will impoverish themselves or they don’t trust the child or child’s spouse. By gifting limited partnership interests, FLPs are a marvelous tool to gift to the child while the parents, as the general partner, retain control over the assets. But, as discussed later, this control must be exercised in a manner that will not run afoul of IRC sec. 2036.
Still, the FLP can be a very useful tool by limiting the outlay of cash to a child. It is less likely to diminish the child’s initiative or productivity. It may eliminate the need for a child to present to a spouse a distasteful pre- or post-nuptial agreement. The potential commingling of separate assets such a bank or brokerage account during marriage is eliminated. And never overlook the fact that a properly structured FLP can avoid probate proceedings due to a partner’s death or incapacity.
#3. Discounted valuations of FLP interests.
This is where all the action is taking place in the courts. Discounts, based on the lack of marketability and minority interest, can be usually be obtained in the range of 25% to 40% or higher.
A review of the recent FLP cases is largely an exercise in learning from the mistakes of other taxpayers. The IRS has been very careful in which cases have ended up in court. Nearly all of them have had bad facts for the taxpayer yet the results have overall been favorable to the taxpayer.
And the courts deciding these cases are very divided. The Shepherd case (115 TC 30 (2000)) generated five opinions in the Tax Court’s decision. The McCord case generated seven concurring or dissenting opinions. The federal circuits are split — the 5th and 9th circuits are reliably pro-taxpayer in their FLP cases but it is anything goes in other circuits.
For a summary of the various theories put forth by the IRS, see FSA 200049003 and the very recent settlement guidelines issued in October 2006 by Mary Lou Edelstein, the IRS’s National Coordinator for FLPs, discussed below.
However, be on the lookout for new legislation from Congress that will lessen or eliminate the discounting of minority interests in FLPs and similar entities. On January 9, 2009, HR 436 was introduced that would amend section 2031 of the IRC by requiring the IRS to ignore, for valuation purposes, all transactions involving any “non-business” assets held by a non-publicly trade entity. It also flatly prohibits any minority discount. It will apply to all transfers occurring after the bill’s enactment.
The sources I am reading indicate there is wide-ranging Congressional support for this concept.
IRS argument #1 – IRC sec 2036 and implied agreements
This is the most potent weapon in the IRS arsenal and has been raised in all post-Strangi cases.
Sec 2036 provides that all property transferred by a decedent in which the decedent retained possession, enjoyment or control will be includable in the decedent’s gross estate. Simply put, if you maintain all the control and receive all the income, then the IRS will treat the entire entity as yours. The question is — has anything really changed? If the decedent is the general partner, the IRS will maintain that the decedent’s control of the FLP’s assets is sufficient to trigger inclusion under sec. 2036.
The Strangi case has been a turning point in the litigation regarding discounts. It has a long procedural history – two Tax Court decisions and two Fifth Circuit opinions: 115 TC 478 (2000); 293 F3d 468 (5th Cir, 2002); TCM 2003-145 & 417 F3d 468. While many, many articles with differing interpretations have been written on Strangi and its consequences, it is the first case in which the IRS’s position centered on section 2036.
The courts in Strangi essentially held that nothing had changed after the FLP was formed and that there was an implied agreement to this effect among the family members.
But this argument is not without its limits. First, while the IRS successfully used this argument early on in the Reichart and Schauerhammer cases and more recently in the Senda case, those cases centered on the commingling and personal use of FLP assets and sloppy recordkeeping. The taxpayers have been much more successful where the formalities have been followed and respected.
Secondly, the courts have been reluctant to address the impact of the existence of fiduciary duties that a general partner owes to the limited partners. These duties and obligations loomed large in Kerr and Strangi but those cases dealt with the sec 2703 and lack of economic substance issues. The importance of those duties would seem to be equally compelling to preclude a successful sec 2036 argument by the Service.
The Church case touched on this but not quite in these terms. In ruling that there was no sec 2036 inclusion, the District Court stressed Ms Church’s limitations as a partner precluded her from doing as she pleased with the ranch land that was owned by the FLP. Note that the District Court’s decision was upheld in July 2001 by the Fifth Circuit in a terse three paragraph, unpublished opinion.
The argument concerns the United States Supreme Court’s decision in United States v. Byrum, 408 US 125 (1972) holding that a trust settlor’s retention of broad management powers did not make the trust’s assets includible in the deceased settlor’s gross estate since the settlor, who had retained nearly all of the voting rights, had fiduciary duties to minority shareholders. See also TAM 9131006 and Rev Rul 81-15.
This needs to be emphasized in the partnership agreement which should state some sort of standard or limitation on the GP’s discretion in administering the FLP. Make it clear – no unfettered discretion or lessening of fiduciary obligations.
To no one’s surprise, Strangi was followed in October 2001 with the Trotter case in which the Tax Court found an implied agreement among family members existed. In Trotter, the decedent created an irrevocable trust and deeded her residence into the trust. Ms Trotter continued to occupy the residence, paid all expenses and never paid any rent to the FLP. It is now conventional wisdom to never title the residence in the name of the FLP. See, most recently, Estate of Disbrow, TC Memo 2006-34.
While the Tax Court has been quick to find implied agreements, the Circuit courts have been much more reluctant to do so. See the strong language in McCord criticizing the Tax Court. Practitioners were delighted to see a recent Tax Court case where no implied agreement was found in Estate of Anna Mirowski v. Commissioner, T.C. Memo. 2008-74, that was a resounding taxpayer victory in which the IRS fails in its IRC 2036 argument.
Ms Mirowski, through the estate of her deceased husband, held patent rights to a defibrillator that annually generated millions of dollars. In August 27, 2001, she signed documents creating an LLC. Those documents were filed with the state on August 30th. Transfers were made on September 1, 5, 6 & 7 of the patent rights and $62M of cash and marketable securities. On September 7th, Ms Mirowski gifted 16% interests in the LLC to each of her three children. On September 11th, she died unexpectedly.
The IRS first asserted the now-customary IRC 2036 argument. The estate countered that there were non-tax reasons for the creation of the LLC in that Ms Mirowski strongly encouraged joint management by the children. This was proven to the Court’s satisfaction by a long-established practice of having annual family retreat where lawyers, accountants and financial advisors were invited. An important point was that the Court refused to adopt the argument put forth by the IRS, citing the Bongard case, 124 T.C. 95 (2005), that this family involvement reason was never, as a matter of law, a sufficient non-tax reason.
The Mirowski’s avoided many of the issues that have tripped up families in the past. For instance, Ms Mirowski had $7.5M outside of the LLC, to include $3M in marketable securities. This negated any implied agreement argument. Ms Mirowski was also the sole managing member of the LLC but the court chose to emphasize that the manager was required under the LLC agreement to distribute all income each year and that the manager has fiduciary duties to the other members. The IRS also emphasized that $36M of LLC assets were later used to pay Ms Mirowski’s estate tax bill but the Court noted that, given the unexpectedness of her death, this was never an issue while Ms Mirowski was alive. The Court also seemed to be swayed by the fact that the children kept the LLC functioning even when the case went to trial in October 2006.
The case seemed to center on the Court’s favorable opinion of the family stating, in a footnote, that “we found Ginat Mirowski and Ariella Rosengard (two of the three daughters of decedent) to be completely candid, sincere, and credible and accorded controlling weight to their respective testimonies.” This is one of the few times that a “good facts” case has made its way to the Tax Court although, given cases such as Rector, the IRS cannot be faulted for thinking it had a good chance of prevailing. Nevertheless, many commentators have emphasized that this case, taken together with another good facts case, Stone v. Commissioner, T.C. Memo. 2003-309, gives taxpayers some hope.
Unfortunately, a more typical result where the taxpayer lost recently occurred in Rector v. Commissioner, T.C. Memo. 2007-367. Ms Rector created the FLP in 1998 at the age of 92. (She lived another 3 years.) Initial funding was $8.8M in cash and marketable securities.
In ruling against the taxpayer, Judge Laro emphasized these factors:
- No independent counsel for the limited partners
- No negotiations over the terms of the partnership agreement
- The son was the primary mover of the planning
- Virtually all of Ms rector’s assets were transferred into the FLP – non-FLP assets only covered about 1/3 of her living expenses – resulting in non-pro-rata distributions
- Gifting was done at the same time as funding
- $665,000 in cash gifts, outside the FLP, were not reported
- Ms Rector was the sole general partner
- No financial statements were generated
In view of this, the Court determined that an implied agreement existed that Ms Rector never relinquished control of the assets and were therefore included n her gross estate for estate tax purposes. The estate was also hit with a Code section 6662(a) and (b)(1) accuracy related penalty because of the unreported non-FLP gifts.
More of a mixed bag was Bigelow v. Commissioner, 503 F3d 955 (9th Cir, 2007) where the 9th Circuit upholds findings of Tax Court that IRC 2036 applied to bring all assets held by FLP into decedent’s gross estate for estate tax purposes.
Decedent had a debilitating stroke in 1992 and moves into a nursing home. Her son, acting through power of attorney, takes over her finances to include the creation of an FLP in 1994 that held title to decedent’s residence valued at $1.45M. FLP rents out house. In 1997, decedent dies. In 1998, gift tax returns are filed for the years 1994 through 1997 indicating that, as of date of death, decedent held a 44% interest in the FLP.
The 9th Circuit dealt with two issues: whether there was an implied agreement and whether the exception for bona fide sale for full and adequate consideration applied.
The court rules that there was an implied agreement in which decedent continued to enjoy the use and benefit of the residence owned by the FLP. The court focused on the note that remained on the property. There were two notes for a combined $450,000 that remained in decedent’s name even though title was in the name of the FLP. And the monthly $2,000 loan payments were made by the FLP, not the decedent. The estate claimed that the FLP had “practical liability” for the note by paying it but the court focused on the fact that the FLP was under no obligation to do so.
There were 40 distributions made to decedent and none to any other partner. The estate claimed that there were adjustments to her capital account to reflect these distributions but apparently these were only done post mortem. The court disregards this. The court also emphasized that these distributions were made because the decedent had insufficient funds to pay her living expenses.
Finding an implied agreement, the court then addressed if the bona fide sale exception set forth in IRC 2036(a) applied. This was the argument used in the much-discussed Bongard case, 124 TC 95 (2005). The court upheld the Tax Court’s finding that there was no non-tax reason for the transfer that, it said, Bongard required. The estate asserted that there were liability protections issues because the property had been rented out but it was not able to point to any specific liability threats. The estate also maintained that centralized management and a pooling of assets were non-tax reasons. But the court noted that there was minimal management involved and that there was only one asset so there was nothing to be pooled. The court noted that there was no real change in the management of the property before and after the transfer of the property to the FLP.
The court also held that there was no bona fide sale because the FLP took the property subject to the two notes, which would not normally occur in an arm’s-length transaction.
Bona fide sale
There has been a recent development regarding an exception to sec 2036 inclusion – the bona fide sale (“BFS”) for adequate and full consideration. While the case results are roughly evenly split between taxpayer and the IRS, the trend seems to be in the taxpayer’s favor. The courts seem to be looking for a nontax purpose to justify the transaction. While there is no language in the statute to this effect, a number of the recent cases seemed to require this and the Bongard case expressly held such a requirement does exist. It has been immensely helpful if there was a pooling of assets by the family member (ie, that the children contributed money to the FLP and were not simply gifted interests) together with the implementation of a new investment strategy. Having an interest in an active business is also very helpful, as demonstrated in the Kimbell case.
The Kimbell case has been seized upon by taxpayers’ counsel. It had some good facts. It held interests in an oil and gas business. The court agreed that this business carried with it serious liability issues, which constituted a valid non-tax reason for the formation of the FLP. The son, not the parent, was the general partner and had paid for his 1% GP interest. And the parent had kept $450,000 outside of the FLP to pay for living expenses. The Fifth Circuit ruled that the BFS exception applied.
The case law has required an arms-length transaction in creating the FLPs. A taxpayer will be helped immensely if parent and children each have their own counsel, as was the case in Stone. The IRS has made the argument that family members can never conduct an arms-length transaction but Kimbell expressly held to the contrary, holding that family members can take part in an arms-length transaction although a higher level of scrutiny can be employed.
A typical recent case is Estate of Erickson, TC Memo 2007-107. In 1999, Ms Erickson was diagnosed with Alzheimer ’s disease and was admitted to a care facility as she became progressively disoriented. A daughter undertook management of her financial affairs at that time. In May 2001, Mrs Erickson’s two daughters decided to enter into an FLP agreement. Mrs Erickson, through her daughter acting as power of attorney, contributed marketable securities worth $2.1M for an 86% limited partnership interest. Both daughters and a son-in-law contributed interests in several Colorado condo’s for a 5.6% interest and the credit shelter trust created upon Dr Erickson’s death contributed an interest in a Florida condo for an 8.2% interest. Bother daughters were the general partners.
However, the FLP was not funded until September 2001 when Mrs Erickson’s health began to fail and she died shortly thereafter. Just prior to the death, gifts were made by Mrs Erickson, acting through her daughter, from the FLP to three trusts created for her grandchildren that left her with a 24.18% interest.
After Mrs Erickson’s death, the assets remained in the trust but unsecured loans were made to one of the daughters for $140,000 and to a son-in-law for $70,000. A disbursement of $104,000 was made to the estate to pay estate taxes.
The Tax Court rules that there was an implied agreement that Mrs Erickson could continue to use her funds for her possession and enjoyment, rendering the FLP interests includible in her estate IAW section 2036. The Court stated a number of reasons:
- The delay in funding the FLP
- The payment of estate taxes with money from the FLP
- The creation of the FLP had “little practical effect”, largely due to the late funding
- The passive nature of the assets, to include the fact that management of the securities and real estate had not changed before and after the FLP funding
- The unsecured loans to family members
- The same law firm represented all of the parties.
- Mrs Erickson was 88 years old and in poor health when the FLP was created.
The Court also ruled that the exception to IRC 2036 discussed in the Bongard case, 124 TC 8 (2005) did not apply – there was no bona fide sale for full and adequate consideration in that there was no nontax reason for creating the FLP. The benefits of centralized management were minimal and the use of the FLP to facilitate a gifting program were not sufficient nontax reasons.
The cases on the BFS exception to sec 2036:
Estate of Bongard, 124 TC 8 (2005) – the court seemed to go both ways.
BFS exception found:
- Estate of Schutt, TC Memo 2005-126
- Estate of Kimbell, 371 F3d 257 (5th Cir, 2004)
- Estate of Stone, TC Memo 2003-309
No BFS found:
- Estate of Hillgren, TC Memo 2004-46
- Estate of Bongard, 124 TC 8 (2005)
- Estate of Thompson, 382 F3d 367 (3rd Cir, 2004)
- Estate of Bigelow, TC Memo 2005-65
- Estate of Harper, TC Memo 2002-121
- Estate of Korby, TC Memo 2005 -102 & -103
Defined valuation clauses
For reasons that have never been entirely clear to me, the IRS will vigorously contest defined valuation clauses. The courts have agreed with the IRS, dating back to the Proctor case, 142 F2d 824 (5th Cir, 1944). However, the recent reversal of the Tax Court by the Fifth Circuit in McCord v. Commissioner, 461 F3d 614 (5th Cir, 2006), has been widely sited as authority that courts may be re-examining the appropriateness of the Proctor line of cases.
In McCord, the gifts to children were made in terms of dollar-equivalent amounts rather than in a number of shares or membership units. For instance, the four children were to receive the number of shares that would have a FMV of $6.9 million. The court never specifically held that this was permissible but the court could not have reached its holding without authorizing the valuation clause.
Edlestein’s Settlement Guidelines.
On October 20, 2006, Mary Lou Edelstein, the National Coordinator for Family Limited Partnerships at IRS Appeals, issued the “Appeals Coordinated Issue Settlement Guidelines” regarding discounts for FLPs. The redacted version is a recitation of case law relating to IRC sec. 2036, valuation discounts, indirect gifts and accuracy-related penalties. But there are several glimpses into IRS thinking on this matter that can be gleaned from this.
First, as to discounts, the memo emphasizes three cases – two 2003 Tax Court memorandum decisions, Lappo, TC Memo 2003-258 & Peracchio, TC Memo 2003-280 and the 2003 McCord decision. The more recent 6th Circuit decision on McCord apparently had not been issued when Edelstein’s memo was written. The important point is that the combined discounts in those cases of 27%, 29% & 32% seemed to be cited with approval. Edelstein also strongly criticizes the Tax Court’s 2005 decision in Estate of Kelley, TC Memo 2005-235.
Second, the memo emphasizes the indirect gift theory set forth in Senda and 2002 Shepherd case from the 11th circuit
Third, the memo discusses when accuracy-related penalties do not apply under the reasonable cause exception. This usually occurs when a taxpayer has relied, reasonably and in good faith, on an advisor’s advice. The memo states that this is satisfied if the taxpayer used a competent advisor and made full disclosure of all relevant facts to the advisor.
LESSONS TO BE LEARNED
#1. Make sure you have valid non-tax reasons for creating an FLP. The creditor protection reason alone should be sufficient , Bramblett v. Commissioner, 960 F2d 526 (5th Cir, 1992); Kimbell, Stone. There are many other reasons – the need to avoid gifting cash that can lead to spoiled children or broken marriages, the ability to keep the property within the family, the need to avoid fractionalizing interests in real estate and other property and obtaining economies of scale through the consolidation of assets.
#2. Set forth these reasons in the partnership agreement or other contemporaneous documentation so that you are creating a record for any subsequent IRS attack. This is particularly important if the parents are elderly or in ill health who may be dead or incapacitated when the audit occurs.
#3. Be careful what you put into the FLP. Leave out dangerous assets that could subject the FLP to liability. (For such assets, consider forming an LLC with the FLP owning the membership interest in the LLC.) Leave the residence out – this is a red flag to the IRS as we have seen in Reichart and Trotter. It makes it more difficult to claim a profit motive with a home as a significant asset. If you must deed in the residence, then it is imperative that rent at the prevailing rate be paid to the FLP.
#4. Don’t use the FLP as your personal checking account. Commingling of assets is a time honored IRS (and creditor) tactic to ignore the existence of an FLP. Distribute funds from the FLP for appropriate purposes (see #5 below) into the parents’ personal checking account and have the check written out of that account.
#5. Watch out for non-pro-rata distributions. Another red flag as seen in Thompson & Strangi. If you are going to do so, treat it as a loan (with proper documentation and collateral) or as a management fee (with a W-2 generated)
#6. Document, document, document. Remember, your primary witnesses may be deceased or incapacitated when the auditor comes knocking. Consider recording certain transfers, especially gifting, so there is no question when it occurred. This prevents IRS from claiming documents were backdated. This could also be useful to contradict any assertions of implied agreements. Loans need to be in writing with reasonable amortization schedules and collateral. The essential point – it’s not over until it’s over. Even if you correctly create the entity, you must respect the FLP by properly maintaining the entity.
#7. Prompt and timely funding. Bad things, like the client dying, can happen if the funding of the FLP is not done immediately. See Senda, Hillgren & Shepherd
#8. As mentioned above, keep the residence out of the FLP. If you must deed the home into the FLP, have a rental agreement with arms-length terms and require regularly payments of rent. Disbrow
#9. Make sure the parents have ample funds outside the FLP to pay all foreseeable living expenses. This was an easy way for the courts to find an implied agreement as in Harper and Bigelow but having ample funds saved the taxpayer in Stone, Schutt & Kimbell.
#10. Consider having the children or someone other than the parents serve as general partner. The involvement and independence of a corporate fiduciary was very important in Schutt where there was “considered negotiations and not blind accommodation” to the parents.
#11. Be prepared to address the implied agreement allegation from the IRS. Show that there were no side deals, understandings or expectations and that the parents were relinquishing all interest in the gifted property, especially in light of Bongard.
#12. Do not make it too easy for parents to remove or control the GP. Otherwise, this may trigger subparagraph (2) of section 2036(a) that allows for estate inclusion if the decedent had the right, in conjunction with others, to designate who shall have possession or enjoyment of the property. Strangi, Jones, Bongard
#13. Try to show some change of investment strategy or at least some benefit by the pooling of assets. Thompson. Yet, the converse strategy carried the day in Schutt, where the patriarch insisted on a buy-and-hold strategy that he feared his descendants would not follow and he believed that only through an FLP could this strategy be kept in force.
#14. Beware of any comments you make regarding FLPs that may appear on your website or in seminar materials. The IRS may check on documented statements you and your associates have made in promoting planning with FLPs, looking for inconsistencies between those statements and positions taken on the 706. Strangi.
#15. Get a first rate appraisal for the discount. Watch out for using a discount that was obtained during the litigation and is higher than the discount alleged in the form 706. The IRS has had success pointing out the inconsistency. Estate of Leichter, TC Memo 2003-66. A few suggestions:
Make sure the appraiser is using current data and not 10 year old studies. The Minority Interest Discount Database of Partnership Spectrum (1-800-634-4614, $375.00 annually), while not favored by the IRS, is a good place to start.
Avoid simply applying a discount from a study to your case. Always explain in depth why the facts in your case are similar those in the study.
Watch out for a change in the appraiser’s discount – consistency throughout the course of litigation is key. The Tax Court has had great fun lambasting appraisers who have changed their discounts when it suits their purpose.
Make sure assumptions are consistent. For instance, don’t assume an orderly sale for purposes of NAV methodology while using a forced sale approach to justify lack of marketability.
Try to minimize inconsistent values over a period of time. Avoid the Jameson situation where two 706s done a year apart with large differences in the share price with a family agreement two years later with a third share price.
If you are appraising a controlling interest, don’t be using restricted or pre-IPO stock sales since these involve minority interests.
Be careful if you are factoring in a potential capital gain. It won’t be allowed if an IRC 754 election is available. And be on solid ground as to when you expect the gain will be realized since the longer it takes for a sale to occur, the smaller the discount will be because of the time value of money with the tax not being paid until later.
Don’t rely too heavily on buy-sell agreements – you need to have a valid formula that can be periodically reviewed and revised,
And always remember that you are using hypothetical buyers and hypothetical sellers and not the actual parties –this is particularly important if there is a swing vote issue.
If possible, avoid deathbed formations. The IRS will consider “deathbed” as formation within 6 months of death.
The sec 2036 cases:
- Estate of Harper, TC Memo 2002-121
- Estate of Rosen, TC Memo 2006-115
- Estate of Thompson, 382 F3d 367 (CA3, 2004)
- Estate of Stone, TC Memo 2003-309
- Estate of Hillgren, TC Memo 2004-46
- Estate of Bongard, 124 TC 8 (2005)
- Estate of Kimbell, 371 F3d 257 (CA5, 2004)
- Estate of Bigelow, TC Memo 2005-65
- Estate of Korby, CV 2006-1201, 8th Cir (Dec 8, 2006)
- Estate of Abraham, 408 F3d 26 (CA1, 2005)
- Estate of Senda, 433 F3d 1044 (CA8, 2006)
- Estate of Shepherd, 283 F3d 1258 (CA11, 2002)
- Estate of Strangi, 417 F3d 468 (CA5, 2005)
IRS argument #2 – IRC 2703 & lack of economic substance
The first contention of the IRS will be that no discount of any amount should be allowed. This is, in essence, a “sham transaction” or “lack of economic substance” argument. In other words, the IRS alleges that creating the FLP is simply rank tax avoidance and that there is no other reason for the formation of the FLP.
The IRS will zero in on three factors: a) marketable securities that make up virtually all of the FLP assets, b) an incapacitated parent who formed the FLP or an agent acting under a power of attorney and c) a deathbed formation, defined by the IRS as death within 6 months of formation.
The IRS dresses up this argument under the guise of IRC sec. 2703. That section states, in part, that “the value of any property shall be determined without regard to ….any restriction on the right to sell or use the property”. Subparagraph (b) of sec 2703 provides a safe harbor exception, stating that the restrictions can be considered if a) it is a “bona fide business arrangement”, b) it is not a device to transfer property to family members for less than full and adequate consideration and c) the terms are comparable to an arm’s-length transaction.
The good news is that the IRS has been soundly defeated in applying sec 2703 in that context. See Kerr and Knight. The IRS’s position has been that the FLP agreement is a restriction on the right to sell and use the assets held within the FLP. In other words, it is as if the FLP did not exist and that “the property” for purposes of sec 2703 is the underlying assets.
The courts have not agreed. As long as the FLP was properly formed and maintained under the applicable state law, it must be recognized. “The property” is the limited partnership interest and not the assets owned by the FLP. The courts have pointed out that the creation of the FLP agreement does change the legal relationships of the parties. For instance, there are now fiduciary obligations among the partners that would not have existed without the FLP agreement.
There seems to be a recent trend where the IRS has used an “indirect gift” theory that ignores the existence of the FLP. In Holman v. Commissioner, 130 T.C. No. 12 (2008), the Tax Court case before the full court (although not a fully reviewed case) ruled that the IRS failed in its indirect gift argument but prevailed on its section 2703 argument. Court granted taxpayers a 22.41% discount.
Mr and Ms Holman created an FLP that held Mr Holman’s Dell stock, his employer with both as general partners. The four children’s trust and UTMA account were limited partners together with the parents.
The indirect argument failed, in which the IRS alleged that the gifts should be treated a gifts of the underlying shares of stock, and not a percentage interest in the FLP. The Court rejected this, noting that six days had passed between formation of the FLP and the gifts. The Court emphasized that the value of Dell stock was very volatile at that point, so that the six day period was significant. Likewise, there was no step transaction.
The IRS has better luck on the section 2703 argument, in which the IRS seeks to disregard any transfer restrictions of FLP interests that are more restrictive than applicable state law. The fight here was over a repurchase agreement dealing with the acquisition of a partnership interest in the event of a non-permitted assignment that provided that the partnership had the option to acquire the interest of the assignee in a non-permitted transfer based on an appraisal-determined value of the assignee’s right to share in partnership distributions. The agreement also prohibited transfers absolutely without consent of the other partners, rather than just requiring consent of the partners to recognize a successor owner as a full partner rather than just as an assignee.
The Court failed to find any “bona fid business arrangement” that would qualify for the safe harbor of 2703(b), so that the terms of the repurchase agreement could be ignored for valuation purposes.
This then left the valuation issue. Taxpayers sought a 42.5% discount but the Court largely agreed with the IRS expert in granting a (still substantial) discount of 22.41%. Both experts relied on publicly traded, closed-end funds in their analysis.
The conventional wisdom from Holman and Gross (discussed below)is that, to avoid the indirect gift argument, a period of time should elapse between the creation and funding of the FLP and any gifting of FLP interest. But these cases also demonstrate that the IRS has had little success with the indirect gift argument.
Other commentators have noted that it probably was not a good idea for the FLP to hold Dell stock and nothing else.
In Gross v. Commissioner, T.C. Memo. 2008-221, the taxpayer won when the Tax Court finds there was no indirect gift of stock and would not use a step transaction approach to the case.
Ms Gross and her two daughters formed a partnership Agreement when they filed and published a Certificate of Limited Partnership in July 1998 but the limited partnership agreement was not signed until December 1998. During October through December, $2M in marketable securities were transferred into the FLP by Ms Gross. On the same day that the agreement was signed in December, Ms Gross gifted 22.5% interests to both daughters. Ms Gross was the sole general partner.
A 709 was filed, claiming a 35% discount (which was stipulated to at trial).
The IRS made a section 2511 “indirect gift” argument, claiming that the daughters had the 22.5% interest first and then received the securities later.
The court rejects this, finding that a partnership existed in July even though the agreement was not reduced to writing until December. The court struggled with whether the partnership was general or limited but ultimately determined that, for valuation purposes, it would not make a difference.
The IRS then claimed a step transaction but the court found that the 11 days that elapsed between the last contribution of securities in December and the gifts of partnership interests.
This case is yet another reminder of the importance of getting the documentation done correctly and in a timely fashion.
It should also be noted that this was a gift tax case (as was Holman), so the IRS did not trot out section 2036. Nor was there any mention of section 2703, as in Holman. And since the 35% discount was stipulated to, that was never an issue.
The IRS is also not succeeding with the “lack of economic substance” approach, as put forth in the seminal case of Gregory v. Helvering, 293 US 465 (1935) and which has been successfully used by the IRS in cases such as ACM Partnership v. Commissioner, 157 F3d 231 (3rd Cir., 1998) . Yet, for FLPs, the courts have made short shrift of this approach, claiming that this is a concept recognized in income tax law but not in estate or other transfer tax matter.
A related IRS approach is the “piercing the corporate veil” argument. The IRS prevailed – and deservedly so – using this approach in the Reichart and Schauerhammer cases. Even though the FLP was validly formed, it was not properly maintained. Mr Reichart had deeded his home into the FLP and then lived rent-free in the home. He also used the FLP’s bank account to pay many of his personal obligations. In Schauerhammer, there was no partnership checking account and all partnership income went to the parents. In short, the FLP was not treated as a separate entity and the Tax Court had no problem in disregarding the FLP for valuation purposes.
For a recent case that painfully recites the mistakes made by the estate’s attorney regarding formation and maintenance of an FLP, see Hurford v. Commissioner, TC Memo 2008-26124.
- Estate of Dailey, TC Memo 2001-263
- Estate of Strangi, 417 F3d 468 (CA5, 2005)
- Estate of Knight, 115 TC 506 (2000)
- Estate of Church, unpublished 5th Cir opinion, decided 7-18-01
- Estate of Trotter, TC Memo 2001-250
- Estate of Reichart, 114 TC 9 (2000)
- Estate of Schauerhammer, TC Memo 1997-242
IRS argument #3 – IRC 2704(b)
Anyone advising on FLPs must be intimately familiar with the workings of IRC sec 2704. It is of paramount importance in determining a discount.
The concept is rather simple but the confusing terminology makes this concept more difficult to understand than need be. In the viewpoint of the IRS, the taxpayer has taken a viable asset and has deflated the value of that asset through means of an onerous FLP agreement that greatly restricts the rights of the partners. While the IRS cannot stop anyone from entering into such a partnership, the IRS maintains that it should not be bound by unreasonable or unrealistic restrictions imposed by the FLP agreement.
So what are reasonable and realistic restrictions that deserve to be considered? According to IRC sec 2704(b), it is the applicable state law that would govern the partnership if there was no FLP agreement in the first place. In other words, lets pretend that no written FLP agreement ever existed – what restrictions would state law place on the partners? This is the key concept of sec 2704(b) – any terms that are more restrictive than state law will be disregarded.
It would be nice if the IRS called these “disregarded restrictions”. But that would be too simple. Instead, they are called “applicable restrictions”. Not “inapplicable” restrictions but “applicable” restrictions. The reasoning for this is that these are restrictions to which sec 2704 will apply which means that they will be disregarded.
Simply put, when one hears the term “applicable” restriction, think “disregarded” restriction.
So, again, the upshot of sec 2704(b) is that any terms of the FLP agreement pertaining to liquidation that are stricter than state law will be disregarded. This means that the appraiser must first look to state law rather than the terms of the FLP agreement.
But neither the appraiser nor the attorney advising the partnership can ignore the terms of the FLP agreement because, in this scenario, the IRS gets to have it both ways. As just stated, the IRS can disregard the stricter terms. Yet, on the other hand, the IRS can consider any terms that are more lenient than state law. This can be a trap for the unwary and it happened in the Jones case.
For instance, it has already been pointed out that, under Arizona law, unanimous consent by the partners is required to voluntarily dissolve a partnership. But the partnership agreement could provide that, say, only a majority of the partners need consent to dissolution. The IRS will want to use a majority consent, rather than a unanimous one, since that makes it easier to dissolve the partnership. And the easier it is to dissolve, the easier it is for a partner to get his or her money which will result in a smaller discount. This oversight needs to be avoided at all costs.
This sort of problem occurred in the Jones case. A son had been gifted an 83% limited partnership interest. The problem was that, under the FLP agreement, a general partner could be removed by a member or members holding a 75% partnership interest. (It was unclear in the opinion as to what percentage was required to remove under applicable Texas law but it appeared to more than 75%.) If the general partner was removed and never replaced, the partnership would dissolve under state law. This ability to remove and replace the general partner could ultimately constitute control of the FLP or lead to its liquidation after dissolution. As a result, the Jones court held that there was no minority discount.
The crux of all of this is that, for valuation purposes, state law and not the partnership agreement controls. I do not recommend having more onerous or stricter terms in a partnership agreement unless there are good reasons to do so. The reason for this is that if the terms of the agreement are too restrictive, some commentators are concerned that the IRS could claim that no present interest has been gifted so that there is no completed gift. The IRS will have a hard time making this argument if the partnership agreement corresponds to state law.
There is a comical aspect to the 2704 approach. The IRS got hoisted on its own petard. At the impetus of the local tax bars, many state legislatures including Arizona changed their state partnership laws so that, in many instances, the state laws became stricter what would customarily be in partnership agreements. This turned the sec 2704 argument on its head. Since the laws were stricter, fewer terms in the FLP agreement could be ignored for valuation purposes.
There is no question that the courts will allow the IRS to use the sec 2704 “applicable restrictions” approach. The fight is usually over what is or is not required under the applicable state law and comparing that to the FLP agreement.
Also be mindful of IRC sec 2704(a) (rather than (b)) that deals with lapsed voting and liquidation rights. The applicability of 2704(a) can be avoided by simply not allowing any partner to unilaterally exercise liquidation rights.
- Jones v. Commissioner, 116 TC 121 (2001)
- Estate of Strangi, supra
- Estate of Knight, supra
- Estate of Harper, TC Memo 2000-202
- Kerr v. Commissioner, 292 F3d 490 (CA5, 2002)
BURDEN OF PROOF
One issue that is looming increasingly large over all of this is the new IRC sec 7491 which shifts the burden of proof to the IRS once the taxpayer “introduces credible evidence with respect to any factual issue”. But before this occurs, a taxpayer must have substantiation for the items in question and must have “cooperated with all reasonable requests by the Secretary for witnesses, information, documents, meetings and interviews”. It is not entirely clear what constitutes “cooperation” but the House Conference report states that a taxpayer “is not required to agree to extend the statute of limitations to be considered to have fully cooperated”.
The new statute may be the driving force behind the infamous FLP questionnaire that requests privileged information and asks for items like seminar materials that the attorney or advisor have used in public presentations. The concern id that the refusal – an entirely proper one – to provide all this information may be used by the IRS to constitute insufficient cooperation for the taxpayer to avail themselves of the new statute.
This new rule is in effect for all “examinations” commencing after July 22, 1998. Note that the term “examination” is not defined but that the Conference Agreement indicates that the term is not limited to audits.
This change in the burden of proof will likely have its biggest impact on valuation disputes. The Dailey case is an excellent example that was decided in favor of the taxpayer due to the burden having shifted to the IRS. It will also loom large when the IRS is alleging – and now having to prove – the lack of any non-tax motives by the taxpayer in establishing an FLP as well as the existence of implied agreements. In fact, the Trotter court seemed to suggest that the result (ie existence of the implied agreement) might have been different had the new sec 7491 been applicable.
For a recent Tax Court case (tried here in Phoenix) applying sec 7491 where the taxpayer failed to present credible evidence of certain deductions for income tax purposes, see Higbee v. Commissioner, 116 TC 28, decided June 6, 2001.
It has been my experience as a trial attorney that the side that has the burden of proof usually loses. One need look no further than the recent 9th Circuit trilogy of Morrissey, Simplot and Mitchell where all three cases were reversed because the Tax Court had improperly failed to place the burden of proof on the IRS. Note that all three were valuation cases (and that Arizona is in the 9th Circuit).
- Estate of Dailey, TC Memo 2001-263
- Morrissey v. Comm. 243 F3d 1145 (9th Cir, 2001)
- Estate of Simplot, 249 F3d 1191 (9th Cir, 2001)
- Estate of Mitchell, 250 F3d 696 (9th Cir, 2001)
- Estate of Trotter, TC Memo 2001-250
How Aggressive Will the IRS Be?
The IRS has recently eliminated 157 of its 345 estate tax attorneys, symptomatic of the continuing overall decline in IRS employment. In 1995, 114.6 million tax returns were filed. By 2003, that number was 130.3 million. Yet during that period, the number of revenue officers declined from 8,139 to 5,004 and the number of revenue agents declined from 16,078 to 11,513.
Yet, at the same time, the number of estates subject to the federal estate tax has plummeted. According to the Statistics of Income Division of the IRS, the figures are as follows:
Year # of FET returns # of FET returns from AZ FET returns as % of persons dyin
2005 45,070 615 unavail
2004 65,039 1,262 unavail
2003 73,128 1,014 unavail
2002 99,603 1,417 1.17
2001 108,071 1,706 2.11
2000 108,322 1,660 2.18
1999 103,979 1,965 2.30
1998 97,856 1,628 2.19
1997 90,006 1,309 2.12
1996 79,321 1,252 1.80
1995 69,755 1,180 1.63
FLP or LLC?
For most legal, non-tax purposes (ie, governance, creditor protection, etc), there is no longer a significant difference between partnerships and limited liability companies. This is particularly so given the enactment of ARS 29-1101 et seq that permits the creation of limited liability limited partnerships that shield all partners, including general partners, from personal liability.
However, there remains a very significant distinction between them for purposes of discount valuation because it is easier to liquidate and dissolve an LLC, which translates into a smaller discount for membership interests in an LLC.
As subsequently discussed in more detail, the name of the game in discounting is determining how difficult it is for a partner/member to get a distribution from the FLP/LLC. Usually, this entails analyzing the applicable statutes governing the liquidation and dissolution rights of a partner/member.
In Arizona, there is a significant difference in these statutes. A partnership will require unanimous consent for dissolution. ARS 29-344. (This has been called the “Hotel California” problem – “you can check out any time you like but you can never leave”.) By contrast, an LLC only requires the consent of one-half of the members who collectively must hold liquidation rights to more than one-half of the value of the LLC’s assets. ARS 29-781. As an example, assume there are three equal (ie, 33%) members in an LLC. A vote by two of the three members can dissolve the LLC. But a partnership would require all three partners to consent.
It can be easy to obtain an administrative dissolution with an LLC. Among the grounds for an administrative dissolution are: 1) failure to make required amendments to the articles of organization, 2) failure to make required publications, 3) no statutory agent or registered office for a period of 60 days and 4) failure to notify the corporation commission of a change is statutory agent or registered office within 60 days of the change. ARS 29-786. Partnerships have no corresponding statute.
As for distributions, a majority of the LLC members can require a distribution. ARS 29-681. With a partnership, there is no right to a distribution until winding up. ARS 29-331 & -334.
For these reasons and in this setting, an FLP (or, more precisely, an FLLP) is the better choice.
Income Tax Issues
Estate planning attorneys tend to focus on the estate tax and asset protection issues relating to FLPs but they ignore the income tax consequences at their peril. This, most definitely, is an area where keeping it simple is the overriding concept. There is probably no more dangerous and complex area of income tax law than what is lurking in Subchapter K of the IRC. It is very easy to run into all sorts of unexpected problems if a practitioner gets too creative.
Traps for the unwary
Be careful if the debt on the contributed property exceeds the partner’s basis. IRC 752 may require that gain may be recognized on the difference. A solution is to pay the debt down or off prior to contribution.
The allocation of the proceeds of the sale of appreciated property by the FLP must take into account the property’s built-in gain at the time of the contribution of the property, with the contributing partner being allocated the built-in gain if the property has been held by the FLP for less than seven years. Any excess can be allocated as the partners may agree. IRC 704(c).
Loss of cash method of accounting
A “tax shelter” cannot use the cash method. IRC 448 defines a tax shelter as any entity with it has a “significant purpose” that is “the avoidance or evasion of Federal income tax”. This can be triggered if the FLP is consistently generating losses.
An FLP can allocate income, gain, loss, deduction or credit items in any manner it deems appropriate. However, IRC 704 allows the IRS to reallocate or ignore the allocations if there is no “substantial economic effect” to the allocations.
If a partner’s interest was a gifted to him or donated funds were used to contribute to the FLP, then any allocation must be limited to that partner’s interest in the partnership. In other words, if Junior was gifted a 5 percent interest in the FLP, he cannot be allocated more than 5 percent of the income. IRC 704(e)(2)
IRC 754 election
This illustrates the important difference between a partner’s inside basis and the outside basis. When a partner dies, his basis is stepped up to the fair market value as of the date of death less any IRD attributable to the partnership interest. IRC 1014(a)(1) & Treas Reg 1.742-1. But this only affects the outside basis.
In other words, if the FLP sells an asset that has appreciated, the partner’s estate report the gain as if there had never been a step-up in basis. This is due to the inside basis – the asset was held inside the FLP. The estate’s interest in the FLP can immediately be sold with little or no gain. But if assets within the FLP are sold, the estate’s share of the gain will be fully taxed.
To eliminate this inconsistency, an election can be made by the FLP that will step up the decedent’s (but not the other partners’) inside basis. Treas Reg 1.743-1(j)(1)
Investment company rules.
You want to avoid the application of the investment company rules set forth in IRC 721 and 351. Generally, there is nonrecognition of gain or loss when property is contributed in exchange for an interest in an FLP unless the investment company rules apply. If so, the unrealized appreciation in the contributed property will be recognized and taxed. These rules will come into play of 80 per cent of the FLP assets consist of securities, cash, notes, REITs or entities holding such assets. The question becomes has the parents’ holdings been diversified by reason of the creation of the FLP?
Fortunately, there are several ways around this problem. One is the contribute other forms of assets, such as real estate. However, watch out if securities, cash or other 721 assets are later distributed to any partner who did not contribute the real estate.
Or the partners can contribute an already diversified portfolio of assets. A contributing partner will be sufficiently diversified if no more than 25 percent in any one stock and if no more than half of the portfolio assets are invested in five or fewer companies.
Another solution is to have the partners contribute identical or nearly identical assets to the FLP, so that the combined asset mix does not change. Jointly titled property held in the parents and children’s name works nicely here.
Married couples can avoid all of this by contributing community property or, before contribution, retitle and transmute the assets so the each spouse has a one-half interest in the property that is then contributed. Such transfers between spouses are not taxable events. IRC 1041 & 2523
Good materials on FLPs are hard to find. Here are some suggestions:
- A Drafting Guide to the Family Limited Partnership
- By Thomas C. Baird
- Baird, Crews, Schiller & Whitaker PC
- 401 North 3rd Street, 2nd floor
- Temple, TX 76501
This is the best one-volume source I know of on FLPs. Availability of materials not confirmed as of this writing.
- BNA Tax Management Portfolio #722
- By Louis A. Mezullo
The usual thorough and useful explanation typical of this great series
- The Birth and Life After Death of the Family Limited Partnership
- The Florida Bar
- 650 Apalachee Parkway
- Tallahassee, FL 32399
These materials with audiotapes are from an April 2001 seminar where several high ranking IRS officials spoke on IRS policies and practices regarding FLPs. It also featured Norm Lofgren, the taxpayer’s attorney in the Strangi case. Much of Mr Lofgren’s materials and the appellate briefs in Strangi are available from his website, www.LRMlaw.com/news.asp
- FLPs and LLCs: Their Use in Family Wealth Transfers
- Continuing Education of the Bar – California
- 300 Frank H. Ogawa Plaza, #410
- Oakland, CA 94612-2001
Excellent materials and audiotapes. Not too California-specific.
- Comprehensive Guide for the Valuation of Family Limited Partnerships
- By Bruce A. Johnson and Spencer J. Jefferies
- Partnership Profiles, Inc.
- P O Box 7938
- Dallas, TX 75209
From the publishers of Partnership Spectrum, this is a good introductory guide to the concepts used in FLP valuations.
- Business Valuation Review
- American Society of Appraisers
- 555 Herndon Parkway, #125
- Herndon, VA 20170
Excellent quarterly journal dealing with current issues in valuations.
- Introducing The Family Limited Partnership
- Charles S. Stoll & Ronald C. White
- Stoll Financial Corp.
- 129 NW 13th Street, #D-26
- Boca Raton, FL 33432
A book geared more for our clients who are interested in learning more about FLPs