Presented By Thomas J. Murphy
October 22, 2008
Murphy Law Firm, Inc.
PART I –Four reasons to create an FLP:
#1. Asset protection
Creditor is limited to charging order
#2. Retention of control
Person creating FLP controls management of assets within the FLP.
#3. Discounted interests
#4. Income tax advantages
#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. 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”.
With the enactment of Arizona’s Limited Liability Partnership Act, ARS 29-1101 et seq, a general partner is not personally liable for any liabilities arising from FLP activities. ARS 29-367 & -1026.
#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 over the past ten or twelve years. Discounts, based on the lack of marketability and minority interest, can be usually be obtained in the range of 25% to 40% or higher. The various cases discussed below are not always easy to reconcile and the IRS has had considerable success in contesting discounts, but they are often available.
#4. Income tax advantages over a trust
If assets are income-generating, an FLP offers significant income tax advantages over a trust, especially if the desire is to create a dynasty-type trust that will hold the income rather than distribute it. This is due to huge difference in the income tax brackets. For an individual, the highest 35% rate is not reached until $357,700 of taxable income. Due to the compressed tax brackets for trusts, the 35% bracket hits at only $10,700. A trust will pay these high rates if the income is not distributed to the beneficiaries. If the objective is to hold the income rather than make distributions, an FLP is very attractive since all income will be allocated to the partners and not the partnership. If the children/partners are in a lower bracket than the parents, this could result in significant tax savings.
And the income can be allocated among the partners in ways not strictly tied to their capital accounts.
Note that the Kiddie Tax does apply to income derived from an FLP. With the enactment of recent legislation, the Kiddie Tax applies to all children under the age of 19 and to dependent college students under the age of 24 who have unearned income over $1,800.
Because the partners are owners of their FLP interests (and hence are completed gifts), annual Crummey notices are not needed.
PART II – 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.
PART III – Litigation in the court regarding he IRS arguments against discounting FLP interests
A review of the FLP case lae 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.
This is also an area that is still in flux. It is difficult to reconcile many of these cases and the courts deciding these cases are very divided. Cases such as the McCord (120 TC 13, (2003)) and Shepherd case (115 TC 30 (2000)) each generated five opinions in the Tax Court’s decision. 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.
IRS argument #1 – 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.
Another very similar argument is the “indirect gift” argument, whereby the IRS claims that the FLP can be ignored and the gifts of the FLP shares can be treated as a gift directly to the children or other donees. The IRS has seemed to have given up on this argument but, in several recent cases such as Holman, it has again been raised. Since this argument continues to go nowhere, it is not known if the IRS will continue with this.
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.
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.
- Estate of Dailey, TC Memo 2001-263
- Estate of Strangi, 115 TC 478 (2000 – on appeal)
- 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 #2 – 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 (5th Cir, 2002)
IRS argument #3 – IRC sec 2036 and implied agreements
This is the newest and most potent weapon in the IRS arsenal. 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 first notable successes for the IRS were in the Strangi case (293 F3d 279 5th Cir 2002) and Knight case (115 TC 506, 2000).
But this argument is not without its limits. First, while the IRS successfully used this argument in Reichart and Schauerhammer, those cases centered on the commingling and personal use of FLP assets. The IRS has never prevailed nor is likely to prevail in cases where the formalities of the FLP are respected.
Secondly, the courts have never adequately squared these cases with the Byrum case that emphasizes the fiduciary duties of a general partner owed to limited partners. 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.
In this regard, Stacy Eastland, the prominent Houston attorney, notes that this IRS argument flies in the face of 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 addressed 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.
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. Bad facts for the taxpayer and the timing of the opinion is even worse since this will only serve to encourage the IRS to use this argument.
PART IV — 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”.
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 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, 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 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
PART V: 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). There are many others – 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 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. 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. Be cognizant of IRC 2704 and avoid the Jones mistake of making it easier to liquidate or force a distribution than state law would normally allow.
#8. Respect the entity and play by the rules. File the 1065 each year. Make sure the partners are paying taxes on the K-1 income. File annual reports with the Secretary of State (FLPs) or Corporation Commission (LLCs). Hold annual meetings and keep minutes. Make sure the capital accounts are accurate and continually adjusted to reflect gifting or additional contributions.
#9. Always emphasize the fiduciary duties of the general partner. A key battleground in the 2036 fight. In the partnership agreement, be very hesitant to lessen any statutory duty that the GP may owe to the other partners. Be familiar with United States v. Byrum, 408 US 125 (1972) and Rev Rul 81-15. Be particularly diligent if using an LLC since the Arizona LLC statutes are silent as to fiduciary duties as between members.
#10. Be careful with removal powers. When drafting the partnership agreement, try to structure the agreement so that the parents do not, by themselves, have a large enough percentage interest to remove the GP. Or, if this cannot initially be done, then keep this in mind when gifting LP interests so that, over time, the children will have a large enough combined share to preclude the GP’s removal without their consent.
#11. If at all possible, avoid deathbed planning. IRS considers “deathbed” to mean formation of FLP within six months of death. But do not overlook the cause of death – even if terminal was the onset of death much sooner than expected? And concede the obvious – there is nothing wrong with having tax savings as a primary motivating force.
#12. Consider bringing in third parties as partners. Gift a small percentage interest to charities. Use an irrevocable trust as a limited partner to hold the children’s interest and have a private or corporate fiduciary as trustee. This makes it harder to the IRS to claim that all partners/family members are acting in collusion or as part of an implied agreement. Very helpful on the Byrum issue.
#13. Consider having children contribute for their LP interests. The children then have more of a monetary stake in the entity and make it harder for the IRS to claim that Dad as GP could do whatever he pleased. A large enough contribution may also bring it within the “bona fide sale” safe harbor of IRC 2036(a).
#14. Get a first rate appraisal. A few suggestions:
Make sure the appraiser is using current data and not 10 year old studies. The annual May/June edition of Partnership Spectrum (1-800-634-4614, $160.00 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.
For some recent cases in the valuation area, see Adams v. Commissioner, 218 F3d 383 (5th Cir, 2000) and Estate of True, TC Memo 2001-167.
A synopsis of recent FLP cases
Estate of Anna Mirowski v. Commissioner, T.C. Memo. 2008-74(3/26/08)
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.
Rector v. Commissioner, T.C. Memo. 2007-367 (December 13, 2007)
IRC 2036 strikes again in a typical less-than-ideal fact pattern. A more typical case and outcome than in Mirowski.
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.
Holman v. Commissioner, 130 T.C. No. 12(5/27/08)
In a Tax Court case before the full court (although not a fully reviewed case), 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 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.
Gross v. Commissioner, T.C. Memo. 2008-221(9/29/08).
A taxpayer win — 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.
Astleford v. Commissioner, T.C. Memo. 2008-128
Ms Astleford created an FLP in 1996 with her children that held many parcels of real estate and interests in another partnership that also held real estate. The Tax Court rules against the discount sought by taxpayer but still grants a 33.97% and 35.63% for the two years in question.
The most significant aspect of this case involves the treatment of the Pine Bend partnership interest that was transferred to the FLP. The Court granted a “layered” discount. In other words, a 30% discount was granted to the interest held by the FLP, which in turn took a discount for the interest it held.
However, it is important to note that the Pine Bend partnership was a genuine business entity that had been in existence since 1970 that held title to 3,000 acres of farmland, most of which was rented out and actively farmed. And it was only one of 15 real estate investments held by the FLP.
Bigelow v. Commissioner, 503 F3d 955 (9th Cir 2007)
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.
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.
Estate of Gore, TC Memo 2007-169
In December 1997, Ms Gore’s two children executed an FLP agreement together with the daughter acting as POA agent for mother. The two children each had 1% GP interest. The credit shelter trust created through Mr Gore’s will held the remaining 98% interest. In January 1998, the daughter, as successor trustee of the CST, executed an assignment that assigned all assets in the CST ($4.5M) to the FLP but no accounts or other CST assets were retitled into the name of the FLP. In February 1998, the FLP enters into an agency agreement with the bank managing the CST assets. In March 1997, $250,000 was contributed by the CST to the FLP. Within the next month, $134,000 was transferred to the son and $95,000 to the daughter. Ms Gore dies in June 1997.
In September 1997, a small portion of the CST’s stocks are re-registered in the name of the FLP. In October 1997, a series of journal entries are made indicating the various stocks and accounts are owned by the FLP. Re-registering the securities continues and is not completed until mid-2000.
In March 1998, a gift tax return is filed indicating that, in January 1997, Ms Gore gifted a 66% interest in the FLP to her children. A 55% discount was asserted so that the gift was reported to be valued at $1.074M.
Judge Marvel begins by noting the “remarkable and persistent pattern of informality and inaction” by the FLP and the children. Court does not dispute the initial validity of the assignment but finds that the transfer was never completed so there is full inclusion of the FLP in the decedent’s gross estate. Court also states that IRC 2036 would also have required inclusion since Mrs Gore had maintained possession and control of the assets in question.
The Court adds insult to injury by including the CST in Mrs Gore’s estate because the poor drafting of the CST combined with the actions funding the trust constituted a general power of appointment.
Estate of Upchurch, TC Memo 2007-181
This case involved the validity of a notice of deficiency on a gift tax return. What caught my eye was that the 30-day letter allowed a 15% discount on a $1.5M gift. Taxpayer had sought a 62.5% discount.
McCord v. Commissioner, 461 F3d 614 (5th Cir, 2006)
A much-anticipated opinion in which the Tax Court is skewered by the 5th Circuit, the appeals court that has seen more FLP cases than any other. A clear TP victory
McCord involved a rather elaborate structure in which the McCords created and then transferred their LP interests to their four sons and two charities. The two unique aspects of the case involved the use of a defined valuation clause and the discount created when the sons agreed to pay any gift taxes and any estate taxes incurred IAW IRC sec. 2035 due to inclusion of the gift taxes paid within three years of death.
The 5th Circuit holds that the IRS failed to meet its burden of proof regarding valuation since the IRS’ expert’s valuation was $1.7 million less than the deficiency. It repeatedly emphasized the Tax Court’s mistake in looking to a transaction in which the sons bought back the interests given to the charity. It occurred several months after the initial transfers and the parents had no involvement in it.
The Court then went on to uphold the defined valuation clauses that was couched in terms of dollar value rather than numbers of shares although the Court never addressed the public policy argument put forth by the IRS in the trial court
Finally, the Court approved the use of a discount for the potential liability assumed by the sons by agreeing to pay taxes by virtue of a death within three years of the initial gift.
Senda v. Commissioner, 433 F3d 1044 (8th Cir, 2006).
A TP loss on a bad facts case, very reminiscent of an 11th Circuit case, Shepherd v. Commissioner, 283 F3d 1258 (11th Cir, 2002) in which a DIY’er gets slammed.
Mr Senda formed an FLP in which he gave his wife a 1% interest and three 0.01% interests for his children that were held by Mr Senda in an oral trust. Senda did things backwards. He formed the FLP and transferred the interests before funding the FLP. Both courts made short work of this, treating the transfers as an indirect transfer of the stock to the children thereby ignoring the FLP for tax purposes. Tax returns had been filed by the oral trusts but the court was very skeptical of anything said by the Sendas since they had no verification for their assertions that this was all done contemporaneously and not months apart as alleged by the IRS.
Estate of Rosen v. Commissioner, TC Memo 2006-115 (June 1, 2006)
Another IRS victory using the IRC sec. 2036 argument of continued possession and enjoyment of FLP property by Ms Rosen through implied agreements with the other family members.
Judge Laro discusses all of the factors to examine in determining whether possession or enjoyment of the assets continues to exist. No surprises here. They are:
- No books of account
- No capital contribution by partners that was simultaneous with the FLP’s formation
- No annual meetings
- Same family members on both sides of the transaction – acting as agent under POA as well as for acting in own interests
- Nearly all assets transferred into the FLP – FLP funds regularly needed to pay customary living expenses
- No meaningful change in the management of the assets
- FLP assets consisted solely of cash and marketable securities with little activity
- Age and health of parent. Mother was 88 years old suffering from advanced dementia and had 24 hour caretaker
- No significant litigation threat that would justify asset protection planning
- No profit generated by the FLP
Temple v. United States, 423 F Supp 2d 605 (ED Tex, 2006)
Mr & Mrs Temple created and funded four FLPs with $34 million of assets. One owned a ranch, one owned a California winery and two owned publicly traded stock. As to the ranch FLP, TP sought a 58% discount. The court adopts IRS’ contention that a 38% discount is appropriate. As to the winery FLP, TP sought a 25% discount for lack of control and 45% for lack of marketability. The court gave the more than they asked for – a combined 60% discount, apparently due to problems with limitations on how the land could be used. The entities owning interests in the two FLPs holding stock were given a 6% minority discount and a 12.5% marketability discount.
Since the court agreed with the IRS on three of the four entities, conventional wisdom views this as a victory for the IRS. Yet, the discounts were sizable, warranting the effort that went into planning.
Anderson v. United States, 2006 WL 435562 (WD La, 2006) unpublished opinion
A TP victory. TP created four LLC that held oil and gas interests. The case was a battle of experts. The IRS had one, the TP had two. One of the two was Shannon Pratt, who the court called “perhaps the most credentialed of all experts in the field of business valuation”. Mr Pratt “seemed to tread the middle road” between the two other experts and the court chose to adopt his position. Court finds a marketability discount of 40%, a 10% discount for costs of liquidation and a 10% minority discount. Court orders a refund of $1,959,850 of the $14,203,850 of estate taxes initially paid.