January 1999 Issue

GIFTING LIMITED PARTNERSHIP INTERESTS: ARE ANNUAL EXCLUSIONS AVAILABLE?

By Lawrence M. Lipoff, CEBS, CPA, Rogoff & Company, P.C.

For the last few years, one of the most common wealth preservation techniques has been gifts of interests in limited partnerships. In addition to valuation discounts for gifts of minority interests and lack of marketability, the tax-exclusive nature of the gift tax as opposed to the tax-inclusive nature of the estate tax can lead to significant tax savings. Furthermore, state partnership law allows asset protection features.

Until recently, both commentators and the IRS appeared to be in agreement that another benefit would be available. Specifically, a gift of a limited partnership interest would entitle the transferor to the $10,000 annual gift tax exclusion. In Technical Advice Memorandum (TAM) 9751003, an agent asked whether "the gifts of limited partnership interests made by the donor qualify for the annual exclusion provided for in IRC section 2503(b)." Should the answer be "no," most of the transfer tax benefits of limited partnership benefits would remain. However, many taxpayers may rethink whether they should proceed with the formation of a limited partnership. On a very practical level, the mechanics in the preparation of gift tax returns (including the need to amend prior returns) would change.

The fact pattern of the TAM was based upon a childless widow who transferred limited partnership interests to various family members. The partnership's underlying assets were industrial buildings. An S corporation with the widow as the sole shareholder became the general partner. Five of the limited partnership interest donees assigned their interests to three other donees. Subsequently, an additional capital contribution allowed the partnership to purchase a tract of land. Then, the widow transferred 35 limited partnership interests to relatives who were minors. After all the transfers, the S corporation owned a five percent general partnership interest and various family members owned 95% limited partnership interests.

The limited partnership agreement had certain clauses, which differed from "boilerplate" agreements. The general partner was provided with authority to retain funds in the partnership "for any other reason whatsoever." Assignments or transfers of limited partnership interests would be void ab initio. Furthermore, for a limited partnership assignee to become a "substitute limited partner," several conditions in excess of state requirements had to be met.

An initial question is whether the clause granting the general partner authority over funds allows a transfer of a limited partnership interest to be a complete, inter vivos gift. Does the clause mean that the general partner would not have a fiduciary responsibility to look out for the interest of the limited partners? If the answer is yes, then the annual gift tax exclusion issue may be insignificant compared to whether the taxable estate of a general partner (or in this case, the estate of the sole shareholder of the general partner) would include the entire value of the partnership. Has the general partner given anything away?

A second concern is whether an argument can be made that this fact pattern is really a conditional inter vivos transfer, the value of which will only be known in the future. That is, what does the assignee actually own? To make matters worse, the general partner is a corporation, which has unlimited life under state statute. The uncertainty as to when the transfer will become complete can continue forever. Perhaps, a testamentary transfer has taken place. If the transfer is testamentary, then the benefit of a family limited partnership as an estate tax planning tool might be lost.

Accordingly, it is very understandable why the examining agent asked his question to the IRS national office. In fact, one may wonder why he did not ask if a completed gift had actually occurred. A further question is why the national office did not raise this issue. It is unfortunate that these questions remain outstanding.

The national office's analysis addressing the availability of an annual exclusion focused on the uncertainty over "whether any income would be distributed to the limited partners." The IRS national office felt that, "because the income component of the limited partnership interests did not entitle the donees to the immediate use, possession, or enjoyment of the income," the present interest requirements of IRC section 2503(b) were not met. Those requirements are defined in Treasury Regulations section 25.2503-3(b).

A major discrepancy in the national office's analysis is that in quoting the law, it stated that Regulations section 25.2503-3(b) "provided that an unrestricted right to the immediate use, possession, or enjoyment of property, or the income from property is a present interest." However, in their analysis they stated that "the income component of the limited partnership interests did not entitle the donees to the immediate use, possession or enjoyment of the income." In theory, property rights consist of a principal and an income element. Additionally, property rights can be divided into current or future interests. The national office focused exclusively on the income component of the limited partnership interest to the exclusion of other property rights.

The transfer tax and property rights of limited partnership interests are interconnected. The majority of these rules are contained in Article 7 of the Revised Uniform Limited Partnership Act (RULPA) and related case history. An understanding of Article 7 of RULPA provides a basis to determine whether the national office's analysis is correct under the framework of Regulations section 25.2503-3(b).

A limited partner does not acquire any legal or equitable property right to partnership assets. Rather, she acquires an assignable, personal interest in a share of partnership profits and surplus. A sale of a limited partnership interest is similar to a sale of securities. Should a limited partner assign her interest, in whole or in part, the assignment does not allow the assignee the ability to exercise any of the rights of a limited partner. Rather the assignee is entitled only to the assignor's share of profits and losses and to receive any distribution to which the assignor would have been entitled. The right to examine the books of a limited partnership is given to a limited partner so that she may exercise her limited partner rights, such as the right to vote in special elections. An assignee does not have limited partner rights. Therefore, an assignee is not entitled to examine the books of the limited partnership. Incidentally, a general partner is allowed to consent to the admission of an assignee as a limited partner.

A key to asset protection planning is the idea that a judgment creditor may apply to a court of competent authority, which may charge the partnership interest as a means of allowing a creditor access to future assets of the debtor. With this judgment or charging order, the creditor receives the status of an assignee. While this appears to be an excellent way to obtain an amount owed (albeit in the future), the holder of a charging order may not appreciate the trap contained. Specifically, if the limited partnership earns income but no distributions are authorized by the general partner, Revenue Ruling 77-137 has been interpreted to require a creditor holding a charging order to recognize taxable income. This is despite the fact that the creditor is not entitled to a distribution of cash to pay the taxes unless all parties receive distributions. Many creditors, who understand this "phantom taxable income" issue, are willing to settle a debt at less cost per dollar and move on.

A rationale for the existence of the charging order is that a person should be able to choose whom she wants to have as a partner. The fact that one of the partners cannot handle her financial affairs properly should not create a situation where the courts impose a partner on someone else. While this theory has precedent and is generally accepted in common law, a contrary case in California, Centurion Corp. v. Crock National Bank, 222 Cal. Rptr. 794 (Cal. Ct. App. 1991), interestingly allowed the foreclosure of a limited partner interest in favor of a creditor. As a result, a creditor became a partner. However, this case appears to have been driven by its particular fact pattern. Most commentators believe that Centurion Corp. does not portend a change in common law across the country.

Returning to Regulations section 25.2503-3(b), an assignee is clearly provided with "an unrestricted right to the immediate use, possession, or enjoyment of property, or the income from property." In theory, the test is not specific to the income component. While the restrictions in the limited partnership agreement in TAM 9751003 may upset the ability to claim an annual exclusion, limited partnership interest gifts under most agreements, where the assignee has the general rights provided by Article 7 of RULPA, should meet the Regulations section 25.2503-3(b) present interest test.

The national office quoted Fondren v. Comm'r, 324 U.S. 18, 20 (1945), and Comm'r v. Disston, 325 U.S. 442 (1945), to prove that if a gift partially qualifies as a present interest, only that portion is entitled to an annual exclusion. "Nevertheless, a right to income is a present interest only if, at the time of the gift, there is a requirement for a steady and ascertainable flow of income to the donee" [Comm'r v. Disston, supra; Maryland National Bank v. United States, 609 F.2d 1078 (4th Cir. 1980); Calder v. Comm'r, 85 T.C. 713 (1985)]. To use this argument as a basis to deny an annual exclusion, upon the gift of a limited partnership interest, contradicts Revenue Ruling 77-137, which recognizes an assignee's right to income. Furthermore, RULPA's restrictions are on distribution demand rights, not on an assignee's right to his percentage of income allocation. As such, an assignee has "an unrestricted right to the immediate use, possession, or enjoyment of property, or the income from property."

To summarize, RULPA's creditor protection attributes are derived from its property law clauses, which enable a limited partnership interest to be assignable. Unless approvals are obtained, an assignee will not receive the complete rights of a limited partner. A limited partnership agreement should be able to meet the present interest test of Regulations section 25.2503-3(b) for transfers of limited partnership interest. Specifically, a limited partner provides an assignee the "unrestricted right to the immediate use, possession, or enjoyment of property, or the income from property." Clearly, the limited partner has transferred her economic right. The only thing she cannot transfer is her personal right to participate in partnership management (to the reduced extent that a limited partner may). Even if one would apply the mistaken citation of the regulation as stated by the national office in TAM 9751003, the requirement to the "immediate use, possession, or enjoyment of property, or the income from property" would be met per Revenue Ruling 77-137.

Generally, based upon the above analysis, it should be clear that a transfer of a limited partnership interest will 1) meet the standards of Regulations section 25.2503-3(b), and 2) be subject to a facts and circumstances test concerning the specifically drafted limited partnership agreement. Therefore, unless unusually drafted, as in TAM 9751003, donors of limited partnership interests should be entitled to the $10,000 annual gift tax exclusion. *

LIFE INSURANCE PLANNING

By Melvin I. Feit, CPA

In planning an estate, life insurance proceeds can be excluded from the gross estate if the insured does not have incidents of ownership. This will also apply to the spouse's estate, if the spouse is the beneficiary of the insurance. To accomplish this, neither the insured nor the spouse can own the policy. This technique provides for a substantial amount of funds to go to beneficiaries free of estate taxes.

The common technique is to create an irrevocable life insurance trust (ILIT) to own the policy. This allows for exclusion of the proceeds of the policy from estate and gift taxes. This does not present a problem unless the insured wants to have control of the insurance policy. If the insured wants to have control, a Family Limited Partnership (FLP) may be the appropriate vehicle for owning the policy. If an FLP is formed and the insured retains a one percent general partnership interest in the partnership, it appears that only one percent of the insurance proceeds would be included in the gross estate. Since the general partner is subject to fiduciary obligations, the general partner should not be deemed to own the policy. If the partners have the right to withdraw certain amounts from the partnership (Crummey Powers), these rights may be considered a present interest. Thus, the transfers into the FLP to pay premiums may avoid gift tax (or using up the unified credit) during the insured's lifetime. The premium would be paid from the proceeds of the gift each year, whether from an ILIT or an FLP.

An ILIT can shelter the policy's proceeds from Generation-Skipping Transfer Tax; an FLP cannot. At this time, some of the laws concerning FLPs are unclear, so life insurance planning utilizing FLPs should be done very carefully.

In general, an FLP can be amended, so it provides more flexibility than an ILIT. The ILIT is a better vehicle for life insurance planning, but the FLP does provide an alternative for those who desire to retain control over a life insurance policy. *

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