FLIPS: IT'S YOUR CHOICE, UNCLE SAM OR YOUR FAMILY

By Ellen Harrison, CPA, Ross, Anglim, Angelini, Valla & Krawitz LLP

A top transfer tax rate of 55% and the compressed income tax rates applicable to trusts are inspirations to financial planners. The family limited partnership (FLIP) and its alternative, the LLC, have become vehicles of choice for structuring tax-wise planning for family-owned enterprises. Substantial tax savings can be achieved via the effective use of valuation discounts. In valuing closely-held family business interests, combined discounts for lack of marketability and minority ownership can reduce the value of an entity by 30%-50% for transfer tax purpose. The FLIP can be used in estate planning to manage family wealth and to create valuation discounts for marketable securities and other liquid assets not usually thought of as "discountable."

In 1993, the IRS threw in the towel on the transfer tax valuation question, changing the landscape for intra-family gifting programs. Assets which would otherwise be included in an individual's gross estate at full value can be disposed of during life to family members at discounted values of, conservatively, 35%. Rev. Rule 93-12, 1993-1 C.B. 202, illustrates the hypothetical rule that a "willing seller" is related to no one. The discount gives proper weight to the limited market for the interest and the difficulty of the limited partner to influence management, acquire control, or force liquidation. The ruling goes as follows:

Issue. If a donor transfers shares in a corporation to each of the donor's children, is the factor of corporate control in the family to be considered in valuing each transferred interest, for purposes of IRC Sec. 2512?

Facts. P owned all of the single outstanding class of stock of X corporation. P transferred all of P's shares by making simultaneous gifts of 20% of the shares to each of P's five children, A, B, C, D, and E.

Holding. If a donor transfers shares in a corporation to each of the donor's children, the factor of corporate control in the family is not considered in valuing each transferred interest for purposes of IRC Sec. 2512. Consequently, a minority discount will not be disallowed solely because a transferred interest, when aggregated with interests held by family members, would be a part of a controlling interest. This would be the case whether the donor held 100% or some lesser percentage of the stock immediately before the gift.

This ruling is the basis for discounts when FLIP interests are transferred.

The typical structure for a FLIP is shown in the following example:

H and W, a married couple with four children, have a potential gross estate of $10 million consisting mostly of marketable securities. Husband and wife create FLIP and initially are the only partners. They have a 1% General Partnership interest and a 99% Limited Partnership interest. H and W, as the General Partners, retain control but all interests have the same rights to capital, income, loss, deductions, and gain.

After formation, interests in the
entity can be gifted to family members to achieve a variety of tax and
nontax goals.

Organized Management of Assets. Use of the FLIP enables the family to invest through a single vehicle, resulting in lower investment advisory fees and brokerage commissions. Record keeping and filing requirements may be greatly simplified when FLIPS are compared to typical family structures, such as multiple trusts.

Simplified Annual Giving. The annual gift tax exclusion can shelter gifts of FLIP interests. Over time, significant assets can be transferred through a combination of gift-splitting and discounting without eroding a transferor's unified credit. Where the assets transferred to the FLIP are likely to appreciate, the unified credit can be used to shelter large gifts. FLIP interests are divisible and readily transferable. In addition, gifts of partnership units are gifts of present interest, eliminating the administrative headaches associated with trusts. For example, Crummey notices are unnecessary in the context of a FLIP.

Control of Wealth. Concern for loss of control dominates the thinking of many senior family members and often inhibits planning. As each year passes, the opportunity to use the annual exclusion is lost. The FLIP enables the donor/GP to retain almost absolute control over partnership management and the timing of cash distributions without causing inclusion of the gifted interests in the donor's estate.

Creditor Protection. Unless a partner has made a fraudulent conveyance to a partnership or unless the GP's personal bankruptcy dissolves the partnership, creditors generally cannot reach the partnership assets. The creditor usually only can receive a "charging order" against the partner's interest in the partnership. The creditor may then receive distributions, if any, and have no access to partnership books and records. Failed marriages can similarly be circumvented; FLIP interests are easily distinguishable as separate property whereas stocks and bonds are prone to comingling.

Flexibility. Partnership agreements can be amended from time to time in response to tax law changes. Similarly, a partnership can be terminated without the adverse tax consequences associated with corporations and the court intervention associated with trusts.

Out-of-State Probate. Because a partnership interest is an intangible asset, administration of the transferor's estate would be required only in the jurisdiction of the domicile, not in the jurisdiction where the property owned by the FLIP is located.

Entity Classification. Historically, limited partnership agreements had to be drafted carefully to assure partnership classification for Federal income tax purposes. The proliferation of LLCs, with its promise of limited liability for all partnership members, required meticulous attention to the details of operating agreements. Responding to the detail problem, on May 9, 1996, the IRS issued
long awaited "check-the-box" entity
classification proposed rules (PS-43-95)
to simplify the process and resolve
one obstacle to the formation of FLIPS.

Some commentators have hinted that the nontax reasons for establishing
the FLIPS are so compelling that
the gifted interest should attract a
premium. For now, however, clients should feel comfortable with discounts as long as proper care is taken at
the formation and operation stages of the FLIPS. *

BOOK REVIEW: TAX ASPECTS OF COOPERATIVES AND CONDOMINIUMS

By Fred Weinshank
Review by Alan J. Straus, CPA

First written in 1990, Fred Weinshank has revised his reference work on the tax aspects of cooperatives and condominiums. The newly updated work has recently been published, and is available for sale. Mr. Weinshank is a CPA with the firm of Kleinman and Weinshank where he is in charge of that firm's co-op and condo accounting practice. It is apparent from this publication that Mr. Weinshank has devoted a significant portion of his professional
career to this topic. Clearly, he has established his "bona fides" as an expert in this area.

This book makes for easy reading. It can easily serve the dual roles of a primer on the subject for the professional who has just obtained his first engagement in the area or reference book for someone encountering an unusual issue. Because this softcover book is not designed as a treatise, however, practitioners with more complex matters may find additional sources and research necessary. In addition, the book lacks an index and appendices where illustrative forms, rulings, and other source material would prove helpful.

The majority of Tax Aspects is devoted to the Federal rules regarding housing cooperatives and condominium associations. Mr. Weinshank discusses the
basics, including the difference between the two forms of organization. He
discusses how to qualify as a co-op and points out the intricacies of "The
Infamous 80/20 Rule." The law requires that at least 80% of the co-op's gross income must be derived from "tenant-stockholders." In some instances, careless planning may result in a co-op receiving too much "bad income," as Mr. Weinshank calls it, thus destroying its
co-op status.

Not So Simple

Every CPA who has prepared even a few income tax returns for individuals, has run across Form 1098 reporting the client's share of his or her deduction for interest and taxes associated with co-op ownership. We never think about how the amounts reflected on the Form 1098 were computed--unless we were engaged by the co-op to compute them. In this instance, I learned the computation may not be as simple as might
be assumed. Federal rules require
special allocations of these expenses when the co-op has income from sources other than its tenant-
stockholders.

Mr. Weinshank points out other "traps" and planning opportunities along the way as well. One particularly important area, carefully detailed, is the election to be made to file a condominium association's tax return using Form 1120-H rather than Form 1120, which must then be weighed against the right to elect treatment under Revenue Ruling 70-604. Each of these three alternatives can result in a different amount of Federal tax liability. If nothing else, this section of the book clearly points out the need to do more than simply copy what was done on the prior
year's tax return. The elections can
be made annually and, depending
on the income in any one given
year, may or may not warrant repeating.

The remaining portion of this book is devoted to various New York State and New York City tax matters. Mr. Weinshank covers everything from the tax on capital to sales tax on porter's duties. One gets the impression there is a good deal more going on in the field at the state and local level than at the Federal level. There are numerous ways for the state and city to attack. For example: The method by which basement storage space is made available to tenants might result in the imposition of sales tax on that fee; whether a condominium association is or is not subject to New York City's General Corporation Tax may depend on the type of election it makes at the Federal level; and associations, even though not corporations for Federal purposes, may still be subject to New York State Corporate Taxation. One area sorely lacking at the state and local level, however, is a discussion of the various transfer taxes that are imposed when units or stock is sold. It would certainly be both appropriate and helpful to consider adding this material in future editions. Incidentally, states other than New York are not mentioned.

The book is an excellent starting
point for someone just getting his
or her feet wet in this area. It should
also be in the library of any firm that
prepares tax returns for co-ops or
condos.

For ordering information, call
Stephanie Forbes at (212) 719-8392 or (800) 633-6320 *

WEINSHANK COVERS EVERYTHING from the tax on capital to sales tax on porter's duties.

David Kahn, CPA
Goldstein, Golub, Kessler, & Co. PC