Mr. Abraham has graciously allowed Henry & Associates to post his article on family limited partnerships

New Decisions Bring New Life For Family Limited Partnerships

and a

New Meaning to Taxpayers and Their Advisors

 

by Mel H. Abraham, CPA, CVA, ABV, ASA

 

Family Limited Partnerships - What Are They?

 

Family Limited Partnerships (FLPs) are traditional limited partnerships formed under the laws of a specific state.  Typically, the entity is formed to hold various types of assets, including real estate, other tangible assets, marketable securities and/or other securities.  Further, they are used as a means for families to achieve many goals, including:

 

·         A means to provide a resolution of any disputes which may arise among the family in order to preserve harmony and avoid the expense and problems of litigation;

 

·         A means to maintain control of the family assets;

 

·         A means to promote the efficient and economic management of the assets and properties under one entity;

 

·         A means to consolidate fractional interests in family assets;

 

·         A means to increase family wealth;

 

·         A means whereby annual gifts can be made without fractionalizing the underlying family assets;

 

·         A means to restrict the right of non-family members to acquire interests in the family assets;

 

·         A means to provide protection of the family assets from claims of future creditors;

 

·         A means of preventing the transfer of a family member’s interests as a result of a failed marriage;

 

·         A means to provide flexibility in business planning not available through trusts, corporations or other business entities;

 

·         A means to facilitate the administration and reduce the cost associated with the disability or probate of the estate of family members; and/or

 

·         A means to promote the family’s knowledge of and communication about the family assets;

 

The above goals can be achieved as a result of the FLP’s ability to:

 

·         Engage generally in the real estate business and to acquire, own, hold, develop and operate real estate enterprises;

 

·         Invest funds and to raise funds to be invested in furtherance of the underlying purposes; and/or

 

·         Invest, manage and operate various investments including but not limited to marketable securities, stocks, bonds, gold, silver, grain, cotton, other commodities and debt instruments.

 

This type of entity structure also provides a vehicle to maximize the profits and yield to the investors due to the following factors:

 

·         A partnership structure eliminates the possibility of double taxation, that is taxation at the entity and the individual level. Accordingly, this will provide for higher returns to the investors, by reducing their tax burden.  Additionally, unlike outright gifts, this structure minimizes the possibility that any new partners could impair the value of the assets.

 

·         Internal Revenue Code Section 754 permits a partnership to file an election upon the death of a partner to adjust the basis of the property under IRC Section 743(b). Again this provides additional value to the investors.

 

·         Internal Revenue Code Section 2036(b) provides that the retention of the right to vote (directly or indirectly) shares of stock of a controlled corporation is a retention of the enjoyment of transferred property.  Accordingly, the value of such stock is still includable in the estate of the transferor.  However, IRC Section 2036(b) does not apply to partnership interests.

 

How Are They Formed?

 

The partnership is usually formed by the senior generation by transferring assets in return for general and limited partnership interests.  These interests carry certain rights as to distributions, cash flows and/or access to assets based upon the state law provisions specific to the state of governance.

 

Assets are generally investment real estate, marketable securities, bonds or other assets, which are expected to appreciate. General partner interests usually range from one to five percent (1% - 5%). Alternatively, limited partner interests usually range from ninety-five to ninety-nine percent (95% - 99%).  Further, general partner interests are usually held by the senior generation or by a separate entity, whereby the senior generation retains control of the entity and the underlying assets.

 

Subsequently, gifts are generally made to the junior generation of limited partnership interests as a means of transferring value and assets out of the estate of the senior generation. An additional benefit to utilizing a FLP is in the way it allows taxpayers to more efficiently utilize the estate and gift tax structure in transferring assets. This is a direct result of the fact that an ownership interest in limited partnership is substantially different than a direct ownership interest in the assets held by the limited partnership. 

 

For example, assume that Husband (H) and Wife (W) own various marketable securities worth $1,000,000.  H and W transfer these assets to a FLP (HWFLP).  Later, H and W transfer a ten percent (10%) interest to their Child (C). This transfer will typically be taxed for gift tax purposes based upon the value transferred.  If a ten percent (10%) interest in the underlying assets were directly transferred, the taxable value would be $100,000 ($1,000,000 x 10%).  However, through the use of a FLP a taxpayer can leverage the amount of the gift.  The taxable value, due to the nature of the interest transferred would not be a prorata interest in the underlying assets.  Rather, it would be the amount for which a “hypothetical buyer” would pay for a ten percent (10%) interest in a limited partnership.  This interest would consider the fact that a limited partners interest (or an assignee’s interest) cannot and does not have access to the assets, cannot force any distribution or effectively control the ability to receive a return on his investment.

 

As a result, The transferred interest would be discounted for these ownership and marketability issues.  Accordingly, a transfer of a ten percent (10%) interest in the FLP may be valued as follows:

 

Value of underlying assets

 

 $      1,000,000

 

 

 

 

 

Interest transferred

 

 

10%

 

 

 

 

 

Prorata value of interest

 

 

            100,000

 

 

 

 

 

Discount for lack of control

25%

              25,000

 

 

 

 

 

 

 

 

 

              75,000

 

 

 

 

 

Discount for lack of marketability

30%

              22,500

 

 

 

 

 

Value of interest transferred

 

 $           52,500

 

 

By utilizing this type of transfer structure the taxpayers have effectively reduced their exposure to estate and/or gift taxes by $26,125 ($100,000 prorata value - $52,500 discounted value = $47,500 x 55% marginal estate/gift tax rate = $26,125) or twenty-six percent (26.0%).

 

Other characteristics of FLPs include:

 

·         FLPs require at least two different partners (one general partner and one limited partner);

 

·         The general partner(s) has(have) full control over the management, decisions and day to day operations of the partnership affairs;

 

·         The general partner(s) is(are) responsible for all obligations of the partnership;

 

·         The limited partner(s) is(are) viewed as silent investors with no voice in the partnership operations or management; and

 

·         The limited partner(s) is(are) not responsible for any un-guaranteed obligations in excess of their investment.

 

As such this type of  “wealth preservation planning” technique can accomplish multiple goals with respect to an individual’s assets, wealth and estate.  However, these benefits do not come without their share of issues.

 

What Are The Issues and Considerations?

 

FLPs have been riddled with controversy and lack of definitive guidance from the Courts as to the issues at hand.  Accordingly, advisors and taxpayers have been leery of their use in fear that the Internal Revenue Service would disallow the transactions. In that regard, the Internal Revenue Service has openly attacked the FLP structures at various levels including:

 

·         Substance versus form doctrine;

·         Step transaction doctrine;

·         Sham transaction doctrine;

·         Gift on formation;

·         Internal Revenue Code Section 2701;

·         Internal Revenue Code Section 2703; and

·         Internal Revenue Code Section 2704.

 

In fact the IRS has issued almost a dozen related Private Letter Rulings regarding the use of FLPs since 1996.

 

Fortunately for taxpayers and their advisors, there has been effectively four recent decisions that have come down from the tax courts with respect to FLP matters that can provide guidance on the structuring, operating and documenting of FLPs. This guidance should allow taxpayers to put their “best foot forward” in an effort to create an effective “wealth preservation planning” structure for their assets and estate.  This article will present the various issues and finding from these cases for your consideration as well as the author’s opinion as to how to more effectively structure these transactions.

 

 

The taxpayers’ initial attempts at having some of these issues specifically dealt with, came in the Schauerhamer vs. Commissioner - May 28, 1997, T.C. Memo 1997-242 and White vs. Commissioner -  Docket 14412-97 cases.  Unfortunately, in the Schauerhamer case the taxpayer lost on an issue unrelated to the key arguments associated with the IRS’s FLP attacks. In this case, three specific FLPs were established to hold various real estate and other assets. In late November of 1990, the decedent was diagnosed with colon cancer. On December 31, 1990 three family partnerships were set up one for each of three children. However, certificates of limited partnership were not filed until May 13, 1991.

 

All of the partnerships established entity bank accounts.  However, the matriarch of the family continued to receive and pay all income and expenses from her personal accounts.  As such it was deemed that the gifted interests in the FLPs were not completed gifts under IRC Section 2036. The issue was related to the fact that retained enjoyment may have existed between the donor and donees. The court stated, “Retained enjoyment may exist where there is an express or implied understanding at the time of the transfer that the transferor will retain the economic benefits of the property. Where a decedent's relationship to transferred assets remains the same after as it was before the transfer, IRC Section 2036(a)(1) requires that the value of the assets be included in the decedent's gross estate.”

 

In the White case, Judge Foley was well informed about the application of the various issues, especially the congressional intent of IRC Sections 2703 and 2704 due to his involvement in the development of the associated Regulations.  The White case was a well-put together case (by Stacy Eastland and John Porter), which had all of the appropriate issues to be resolved.  Each of the issues would have provided the taxpayers and advisors with some definitive guidance regarding the applicability of the various IRS’s FLP attacks.  Unfortunately, the IRS conceded the case prior to trial and once again the taxpayers and advisors were left to their own devices as to the interpretation of the various provisions of the IRS’s FLP attacks and the applicability of the complex provisions of Chapter 14 of the Internal Revenue Code (primarily IRC Sections 2701, 2703 and 2704). 

 

The second guiding case was Adams v. United States, No. 3-96-CV-3181 –D, N.D. Tex. (3/17/99). Although this case involved a general partnership, it provides some insight into carefully structuring a partnership agreement as well as the need to be mindful of the underlying state law in which the entity is formed.  The taxpayer and three siblings formed a general partnership to hold and manage family property, including ranch land, marketable securities, and oil and gas interests. The net value of the partnership's assets was $33,081,400.

 

Due to the partnership agreement and the terms of the Revised Partnership Act in the state in which the partnership was formed the death of a partner caused the dissolution of the partnership.  As a result of the death of the taxpayer in 1992, the partnership's heirs became assignees of her 25% interest in the partnership. The remaining partners chose to continue the partnership's business.

 

The court acknowledged that the partners had the option to continue the partnership (which they, in fact, did). However, the court also took the position that a “hypothetical buyer” of this interest would not voluntarily reenter into a partnership with these other individuals of which (under the tax standard of fair market value) they had no relationship with (due to the requirement for the value to be based upon a hypothetical buyer).  The court believed that a hypothetical buyer with the opportunity to choose between entering into a partnership and thereby restricting his access to the assets, or receiving the fair value of the underlying assets would have taken the economic “high-road” and asked for the prorata distribution of the fair value of the assets.

 

Accordingly, the court determined that the value of an assignee interest in the partnership was 25% of the value of the partnership's assets, or $8,270,350, discounted by 5.4% for costs of selling the assets, for a total value of $7,821,000.  The court effectively eliminated all discounts typically available to taxpayers to leverage the wealth transfers.

 

The third guiding case was issued by the Tax Court on December 23, 1999, in the gift tax case of Kerr vs. Commissioner (113 T.C. No. 30 – December 23, 1999).  This case was an initial and substantial victory for the taxpayers and FLPs in general. It should also be noted that this opinion is a full Tax Court Opinion not a Memoranda Opinion.

 

The case dealt with a number of relevant issues including:

 

·         Tiered entity discounts;

·         The transfer of a limited partnership interest or assignee interest;

·         The definition of an “applicable restriction” under IRC Section 2704(b)(3)(B); and

·         The applicability of IRC Section 2704, in general, to the terms of a FLP agreement.

 

The taxpayer tried to take the position that interests transferred to the GRATs were assignee interests.  If this were found to be the case, the lack of rights associated with this type of interest would have allowed for larger leveraging of discounts for gift tax purposes. The Court held the Kerrs transferred limited partnership interests to the GRATs in both form and substance. Pursuant to IRC Section 25.2512-1, the value of the limited partnership interests is equal to the price that a hypothetical willing buyer would pay to a willing seller for the limited partnership interests and the restrictions on liquidation do not constitute “applicable restrictions” within the meaning of IRC Section 2704(b) and should not be disregarded.

 

The Court also stated that even if the interests were classified as assignee interests there are very few differences between the two types of interests.  However the author’s opinion, the mere fact that a limited partner has a right of withdrawal but an assignee interest does not, can make significant impact on the application of valuation theory to the interests.

 

This is an important case because it demonstrates that the broad interpretation by the IRS of an “applicable restriction” under IRC Section 2704(b) cannot be applied to a withdrawal provision of a partnership agreement.  These withdrawal provisions were of concern to certain advisors and have caused many partnerships to be formed in states that had no right of withdrawal in their Revised Partnership Acts.  The case was one where the IRS acknowledged that if the interests are classified as assignee interests then the interests could not be subject to the provisions of IRC Section 2704(b).  It also demonstrates the importance of taxpayers complying strictly with terms and conditions set forth in various agreements and documents.  As such, if we expect the provisions to be respected then we must respect them also. Additionally, it is also important to be selective in the wording and execution of various transfers and transfer documents to ensure that the taxpayers are taking consistent positions relating to these transactions.  Lastly, although not dealt with in this case, it is clear that these partnerships considered and took tiered discounts from one entity to another. 

 

The last case, Church vs. United States – USDC, TX, is the most recent and the most dramatic decision with respect to reducing the controversy in utilizing a FLP structure to leverage wealth planning
strategies and, thereby, substantially reducing related estate and gift taxes.

 

Mrs. Church formed a limited partnership two days prior to her death to provide for centralized management of and consolidate undivided interests in various ranch properties as well as to hold a portfolio of marketable securities.  Additionally, the entity was to protect the assets from creditor claims as well as others.  Further, the certificate of limited partnership was not filed until a few days after Mrs. Church’s death.

 

The IRS took the position that the partnership was formed solely to avoid estate taxes and the transaction had no substance.  Accordingly, the IRS attacked this partnership under the provisions of IRC Section 2703 in an effort to eliminate the partnership and the related discounts taken.  As such, the IRS suggested that (as it has in numerous Private Letter Rulings) that the assets to be valued for estate tax purposes was the prorata interest in the underlying partnership property instead of the partnership interest.  The IRS also alleged that Mrs. Church continued to use, enjoy and possess the partnership property within the meaning of IRC Section 2036 - the same argument successfully made under the Schauerhamer case.  If the 2036 argument was successful all prior gifts would have been brought back to the estate and nullifying the wealth planning transactions undertaken by Mrs. Church.  Lastly, the IRS contended that there was a gift on formation of the partnership based upon the perspective that Mrs. Church contributed $1,467,748 in assets to the partnership yet received a partnership interest in return valued at only $617,591.

 

The arguments presented above may appear to be (and in fact are) technical issues beyond the scope of which many taxpayers and some advisors want to deal with.  However, the arguments are representative of the historical arguments made by the IRS in an effort to eliminate these wealth planning vehicles as well as the benefits of being able to leverage the gift tax and estate tax values from the taxpayer’s perspective.  Until the Church case, these arguments created an environment whereby certain taxpayers and advisors were reluctant to “take the chance” that the IRS would attack the structure.  If the IRS were to be able to successfully make these arguments the result would be to eliminate the ability to use these structures to leverage the US tax structure.

 

Judge Orlando Garcia reviewed each of these arguments and issued the following findings:

 

1.        The formation of the partnership was a valid Texas limited partnership, and all transfers must be taxed accordingly.

 

2.        The IRS contention of gift on formation confuses the market value of the assignee interest passing at Mrs. Church’s death with the interest received in return for her contribution to the partnership.  Judge Garcia stated that in order for this contention to hold true there must have been a gratuitous transfer of value to others, which was not the case.

 

3.        At the time of formation Mrs. Church was terminally ill with cancer.  However, she was living a normal life and not under the direct care of a care facility.  Her death two days after formation was from cardiopulmonary collapse, not cancer.  This case was not viewed as a “deathbed” transfer in the eyes of the court.

 

4.        There was a substantial change in the economics of the interests held and there was no implied or written agreement between the parties.  Accordingly, Mrs. Church did not continue to use, enjoy and possess the partnership property within the meaning of IRC Section 2036.

 

5.        There is no statutory basis for the contentions made by the IRS under IRC Section 2703.  In other words, the assets transferred and/or held at death were not the underlying assets of partnership rather a partnership interest which owned the assets.  The IRS cannot try to interpret this section without Congressional authorization that would make it unique to the estate tax provisions of the IRC.

 

6.        The other contention made by the IRS is to disregard the term and transferability restrictions (those that have the affect of reducing the value of the interest) in the agreement.  Judge Garcia found that there was no case or legislative history to support this position.  In fact he specifically stated;

 

“…a partnership is a voluntary association of those who wish to engage in business together, and upon whom the law imposes fiduciary duties. Term restrictions, or those on the sale or assignment of a partnership interest that preclude partnership status for a buyer, are part and parcel of the property interest created by state law.  These agreements are not the agreements or restrictions Congress intended to reach in passing IRC Section 2703. Reviewing the legislative history, and construing IRC Section 2703 with its companion statute, IRC Section 2704, it is clear that the former was intended to deal with below-market buy-sell agreements and options that artificially depress the fair market value of property subject to tax and not are not inherent components of the property interest itself.”

 

The Result

 

As a result of the findings in the Church case, Mrs. Church’s estate was subject to tax on the value of the partnership interest ($617,591) rather than the prorata value of the underlying assets ($1,467,748) as contended by the IRS.  This resulted in an estate tax saving of approximately $460,000.  This a direct result of the proper structuring and operating of the partnership as well as the ability to leverage the valuations in this case.

 

These cases clearly demonstrate elements and requirements of a proper wealth preservation plan, including:

 

1.        The proper structuring of the entity, complying with requirements under state law that governs the entity;

 

2.        The need to properly document the entity formation, its purpose, transfer of the assets and terms and conditions by competent legal counsel;

 

3.        The need to properly document all transfers in a consistent manner with the partnership agreement and state law by competent legal counsel;

 

4.        The need to understand the underlying state law and how there may be differing interpretations for an interest under a gift situation and an estate situation;

 

5.        The need to appropriately respect the entity structure and operations of the separate and distinct legal entity formed; and

 

6.        The need to have contemporaneously prepared valuations that comply with the finalized adequate disclosure regulations for all transfers and transactions.  These valuations need to be prepared by a  competent valuation professional who has a substantial background and understanding of the specific issues as well as the how IRS will attack the discounts under Chapter 14 as well as other provisions of the Internal Revenue Code.

 

The case also demonstrates the need for a strong team approach to the plan in the early stages of the plan such that all elements of the plan are considered.  This is the only way that the taxpayers can put their best foot forward in the wealth-planning arena.  It is this concept that has been promoted by my friend and colleague, Owen G. Fiore, Esq. Without the proper players on the team as well as well-documented valuation and valuation report, taxpayers will continue to run the risk of losing on valuation issues in the future.  Further, with the finalizing of the “adequate disclosure” regulations in December 1999 we have now been put on notice as to the substantial documentation requirements in wealth planning.  It is imperative that we take these cases and new regulations and act accordingly and in the best interest of our clients.

 

 

 

Mel Abraham is a frequent and award-winning lecturer on valuation matters.  He has addressed conferences on a local, state and national level and has provided guidance regarding valuation issues around the country.  Mel is consulted regularly and responsible for a variety of valuation engagements around the country such as family limited partnerships, co-tenant interest valuations, operating businesses as well as various entities including corporations (S and C), partnerships, ESOPs and limited liability companies.  These projects have ranged from small family owned businesses to large $100.0 million holding companies.  These valuations are in the context of gift, estate and income tax issues, S-corporation conversions, reorganizations, mergers and acquisitions, dissenting shareholder actions, economic loss issues and marital dissolution.  Mel is considered an expert in various areas and has authored and presented various types of presentations such as Valuing Preferred Stock in Closely Held Companies and The Chapter 14 Puzzle? – Complex Valuation Concepts Under Chapter 14 of the Internal Revenue Code.  He has authored a number of articles as well as his book entitled, Valuation Issues and Case Law Update – A Reference Guide.  Mr. Abraham can be reached at 805-578-1515.

Mel H. Abraham, CPA, CVA, ABV, ASA
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805-578-1515
805-578-0090 fax

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