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An Achilles' Heel For FLPs?
By Robert L. Moshman
re family limited partnerships (FLPs) too good to be true? How is it possible for an individual to transform a $100-million asset into a $60-million asset only a few days prior to death? How can an owner retain a 99.7% interest in an asset and yet claim a 30% or 40% discount on those same assets?
What is this logic-defying magic that can shrink assets so effectively and walk with impunity past the scrutiny of the Internal Revenue Service? Are FLPs a bona fide safe harbor? Notwithstanding the grumblings of the IRS, and the misgivings of analysts, there has been a series of Tax Court victories for FLPs over the past two years. This has been so encouraging to estate planners that suddenly, FLPs are turning up as a primary option in estate plans of every description. Is this such a good idea?
What Can Go Wrong?
The best laid plans can go awry and the changing variables in the worlds of finance and taxation bear that out constantly. After the events of September 11, 2001, nothing in this world will be the same. Nothing can be taken for granted. And though they are limited in impact, there are already a number of known pitfalls to be aware of in utilizing FLPs.
Inappropriate Funding: One of the most recent FLP cases involved the unfortunate case of an individual who won a $17-million lottery but died after receiving only the first of 20 scheduled payments. The remaining 19 payments were held by a family limited trust. The issue was whether their value should be discounted because of their inclusion in the trust. Citing the case of Gribauscas v. U.S., 116 T.C. 142 (2001), it was found that the 19 payments were capable of being valued as an annuity using the tables in Reg. §2031-7. Cook Estate Tax Court (2001).
Too Small: A smaller estate may have relatively small estate tax savings yet the efforts to establish an FLP can involve costly drafting for clients. It should be established that the estate will be sizable enough to be taxable and that the savings involved from the FLP discount have a reasonable chance of being significant. Of course, there may still be non-tax reasons that contribute to the decision to utilize an FLP arrangement.
Design Defects: In, Estate of Jones, 116 T.C. 121 (2001), for example, an FLP allowed the plaintiff to liquidate the FLP interest. This design defect reduced the available discount to 8%.
Operational Defects: Even a properly drafted FLP may be operated in a manner that undermines the existence of a bona fide FLP. For example, after an FLP is established and funded, the partners may make the mistake of commingling personal and FLP assets.
Plaintiffs who wish to prevail should be documenting their respect for the partnership as a separate entity.
Loss Of Stepped-Up Basis: Beneficiaries receiving FLP interests will take a carryover basis and lose out on a stepped-up basis for assets transferred at death. Transfer of certain appreciated assets to a partnership will cause the immediate recognition of gain.
State Law Trip-Ups: State law issues may control the outcome of cases as well, and great care must be taken in complying with state requirements.
State Law Tax Burdens: With the departure of the state death tax credit (it will be eliminated by 2005), states will become more protective of any death taxes they choose to impose. There is no certainty how state laws will treat FLP valuations, and one state is reportedly considering a challenge already.
No More Estate Tax: Obviously, a strategy designed to reduce the value of an estate for estate tax purposes may be diminished if there is no more estate tax to be saved. However, FLPs remain useful until the estate tax is repealed and will remain useful for state death tax purposes, liability issues, organizational benefits, and income tax purposes, depending on the circumstances.
An Endless Struggle
These isolated caveats and exceptions aside, there is a more general, long-term concern that is based on the ongoing struggle between taxpayers and the law in this area. Consider the FLP in historical context.
Originally, in the case of Harrison v. Commissioner, 52 TCM 1306 (1987), an incompetent testator's family used powers of attorney to set up an FLP for a $57-million estate. With the FLP discount, $24 million of value was vaporized. In response came the Revenue Reconciliation Act of 1990, in which Congress attempted to regulate the broad category of estate-freezing transactions. It therefore replaced the flawed estate-freezing approach that preceded it (i.e., §2036(c)) and enacted Chapter 14, §§2701-2704. But over time, monies find their way around tax obstacles and this legislation was also proven to be a porous defense. By the late 1990s, remedial legislation was sought by the Clinton Administration for three successive years. In the absence of any such reform, the task of applying the existing statutes has fallen upon the courts. Thus far, the validity of FLP discounts has been upheld.
Moreover, any threat of the IRS making inroads in this area may have been extinguished with the arrival of the Bush Administration. The passage of the estate tax repeal may discourage the IRS from dedicating its limited resources to an estate tax issue when the estate tax itself is being phased out. Nevertheless, the vanishing surplus adds uncertainty as to whether the estate tax will ever be repealed entirely.
Pushing FLPs to the Limit Resulted in a Winning Streak
To the casual observer, and to the IRS, there would seem to be a vast difference between a business owner who established an FLP as a genuine long-term business plan and a wealthy individual who set up an FLP simply for tax purposes. Compare two circumstances.
Owner #1 set up an FLP 20 years ago and transferred limited shares of 20% of the business to each of his four children while retaining a 20% share for himself. Owner #2 set up an FLP two months before his death and retained 99% of the limited shares. Although the differences between the two circumstances are entirely apparent, the Tax Court has so far upheld the validity of enforceable partnership agreements.
The latter circumstances closely match those of Strangi Estate, 115 T.C. __, No. 35, which was decided late last year. Shortly before his death, Decedent transferred about $10 million of assets, consisting mostly of cash and marketable securities, to an FLP. Decedent held a 99% limited partnership interest and a corporation held the 1% general partnership interest. Decedent also owned a 47% share of the corporation that held the general partnership interest. After Decedent's death, the FLP made distributions to the estate for various taxes, to Decedent's children, and to Decedent's home-healthcare worker.
Despite IRS arguments that the FLP lacked any business purpose, a majority of the Tax Court placed great emphasis on the fact that the FLP was valid under state law (Texas), and therefore was enforceable with respect to the relationships between heirs and potential creditors. Nor did §2703(a) apply. An 8% minority interest and a 25% marketability discount were applied so that Decedent's interests were valued at about $6.5 million.
Taxpayers also prevailed in a gift tax case involving an FLP that kept no records and had no activities. A 1% general partnership interest was held by a management trust. Partnership assets were used for personal purposes both before and after the FLP was formed. Cash, marketable securities, and three parcels of real estate (including the family homes) were transferred to an FLP.
Then, 22.3% interests were transferred by each of the taxpayers to each of two trusts for the benefit of their children. The Tax Court again rejected IRS arguments about the lack of economic substance and found that the transfers were of partnership interests and not of the underlying assets. Knight v. Comm'r, 115 T.C. ___, No. 36 (2000).
The bottom line: FLPs still get the job done From a transfer tax perspective, the FLP is valuable on several levels. First, a family business that is really starting to take off can divide the business among several family members while the business is still growing. Although this may result in a taxable transfer up front, it can remove those assets from the owner's estate before they appreciate in value. Those assets will not be exposed to transfer taxation at the owner's death.
Example: Sam Walton, the founder of Wal-Mart, established an FLP in 1953 when his business was just getting started. The FLP included Sam, his wife, and their four children. Walton Enterprises acquired real estate, banks, a newspaper, and various other businesses. All of these assets were included in the partnership. In time, the partnership financed a variety of businesses that the Walton children launched.
Although the family business was worth approximately $25 billion at Sam Walton's death in 1992, much of the business had either been placed in the hands of heirs to begin with, or transferred there by gift or sale over time. As a result, Walton was left with a 10% share of the business at his death and this was transferred to his wife free of tax, thanks to the unlimited marital deduction.
At his wife's death, Walton's assets will pass to family-run charities, once again avoiding estate taxation. As for the remaining 90% of the business assets that had been transferred out of Sam Walton's estate prior to his death, there were no transfer taxes that applied as a result of Sam Walton's death.
Note, however, that illusory transfers will not successfully remove assets from an estate. Decedent transferred 30.4% limited partnership interests to each of his two children without a bona fide sale and with the "understanding" that he would be able to continue using property that had been transferred to the limited partnership. The FLP assets were included in Decedent's gross estate. Reichardt v. Comm'r, 114 TC 144 (2000).
A second advantage of a partnership is the ability to divide up beneficial interests in one way while dividing up control over the assets in another. Certain heirs can hold limited partnership or non-voting shares while others maintain control over the general partnership shares or voting shares. When the interests transferred to heirs are limited, control of the business will remain in the hands of the owner or whoever else owns or controls the majority of the general partnership interests.
In the effort to secure tax savings, some of the non-tax advantages of FLPs can go overlooked. A business can be exposed to liabilities but those holding only limited partnership shares will generally be shielded from such liability. A limited partner
is much like the shareholder of a corporation-little control, little liability. General partners have control over day-to-day actions of the partnership and therefore may be held liable for those actions as well. Sometimes corporations are used to hold the general partnership interests to place a firewall around the liability those shares entail.
Other advantages pertain to family relationships. For example, the way assets of a family business are divided among siblings or heirs can be a very troublesome issue that tears families apart and causes businesses that are caught in the middle to fail. It is often critical to find a fair way to divide assets among, on the one hand, those who have only a passive interest in the business, and on the other hand, those who are employed in the business or manage its day-to-day affairs. Siblings or heirs who are not involved in the business can still receive income and retain a portion of the business through limited partnership shares.
At the same time, distributing shares of a business and encouraging heirs to become active participants is another valuable byproduct of the limited family partnership. Too often, a family business fails after the death of the owner because no succession plan has been formulated.
Valuation Issues
Another important advantage that has been the focus of several cases within the last year or two has to do with the way partnership assets are valued at death. We are referring to partnership assets that a business owner has retained and which will be included in the owner's taxable estate at death. Because these are partnership interests, each partner's share of any given asset is entitled to discounts for lack of control and lack of marketability.
For example, in a recent Tax Court case, Father transferred land and bank stock to a family partnership in which he held a 50% interest and each of his two sons held a 25% interest. Under Treasury Reg. §25.2511-1(a), these transfers represented indirect gifts to the two sons. But each son could not be said to have gained 25% of the land or the bank stock. The land, being indivisible, was entitled to a marketability discount of 15% (though several judges dissented since fractional shares of land had not been transferred to the sons individually). The bank stock, being subject to the control of the Father's 50% share, was entitled to a minority interest discount of 15% as well. Shepherd v. Comm'r, 115 T.C. ___, No. 30 (Oct., 2000).
It should be noted at this juncture that, notwithstanding the result in Shepherd, a transfer of assets to a limited partnership for the benefit of certain heirs where such assets would otherwise have been inherited by such heirs could be construed as one direct gift under the step-transaction doctrine. To avoid this, it is preferable to clearly delineate the separate steps of the transaction. The FLP can be established and funded with a transfer of assets as a first step. The assets can then be appraised before the second step, which would be the transfer of partnership interests to heirs.
Additional valuation discounts may be obtained by transferring FLP interests to a grantor-retained annuity trust (GRAT). Assets transferred to the GRAT are valued using the §7520 tables.
The Next Challenge
Cases such as Knight, Church, and, most significantly, Strangi (an IRS test case) all upheld the large valuation discounts that reduce estate and gift taxation on assets which are transferred to a partnership. On July 18, 2001, the Court of Appeals affirmed Church in an unpublished three-paragraph opinion. That development has some observers feeling confident that final victory is at hand for FLPs. Strangi now faces an appeal and both taxpayers and the IRS have a lot riding on the outcome. There are thousands of FLPs in the pipeline and billions of dollars will escape transfer taxation unless the IRS finds a winning argument.
But while taxpayers have had a flurry of victories on FLPs of late, the war may be far from over, regardless of the outcome in the Strangi appeal. There were varying degrees of dissent on many issues in Strangi, for example, and the IRS may prevail on appeal in future cases. Several of the dissenting judges believe that a "deemed gift" takes place to the extent that the value of property transferred to an FLP exceeds the value of property received in return.
The IRS also raised an untimely "implied agreement" argument based on §2036 in Strangi. This may prove decisive in future cases. And if need be, and the timing is right to attempt a repair of the estate tax net, the IRS may push for legislative restrictions.
Therefore, FLPs Rule for Now
Despite the drawbacks and potential obstacles ahead, the family limited partnership is an arrangement that has worked beautifully for many estates and appears to have a bright future. Barring further legislative or judicial developments, FLPs remain a highly valuable and attractive technique that should not be overlooked.
© 2001 R. Moshman
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