By Laurence Keiser
FLPs Transfer Wealth Effectively
The IRS has unsuccessfully challenged the valuation discounts available for transfers of interests in family limited partnerships. Arguments made under several IRC sections have not found favor with the courts. The sole area of success for the IRS has been challenges to arrangements where the transferor has retained control of the property transferred into the partnership.
This judicial trend appears to validate the use of FLPs with a valid business purpose. Careful planning and management of the affairs of the transferor and the partnership will avoid the remaining potential pitfalls in FLP preparation and ensure that the substantial valuation discounts of gift transfers will be permitted.
Over the protestations of the IRS, family limited partnerships (FLP) continue to flourish. They are by no means a new tool; Sam Walton established an FLP even before the first Wal-Mart store was opened.
In many ways, the IRS itself is accountable for the proliferation of the FLP as an estate-planning tool. While the IRS (and the courts) generally allowed discounts for ownership interests less than 50%, for many years the IRS fought discounts for a minority interest and lack of marketability where the balance of the ownership of a business or other asset was held in the same family. The IRS’s attacks found only limited support in the courts, which never took seriously the IRS argument that family relations are always harmonious and that family members would always vote the same way. In 1993, the IRS abandoned its efforts in the courts to limit discounts based on these arguments.
The IRS itself provided an opening for FLPs in Revenue Ruling 93-12. An individual owning 100% of the stock of an S corporation conveyed a 20% block to each of his five children. The IRS conceded that each 20% block was to be separately valued for gift tax purposes with appropriate discounts. The IRS thus established the principle that the sum of the parts can be worth less than the whole, the concept at the heart of the FLP. When an interest in property is transformed into an interest in an entity, the relevant consideration for transfer tax valuation purposes becomes the interest in the entity subject to the restrictions imposed in the agreement itself as well as those imposed by state law. Therefore, that interest must be discounted.
Since 1993, the IRS has tried to “put the toothpaste back in the tube.” It has not only fought the nature and extent of the discounts, but also attacked the business purpose for the establishment of the partnership and the authenticity of the discount under several IRC sections.
While the court has become more taxpayer-friendly and discounts have increased, taxpayers cannot merely rely on precedent and must get their own appraisal reports. There is simply no substitute for appraisal testimony on the nature and size of the discount. Discounts have been allowed for minority interest (i.e., lack of control) because the interest is subject to the whims of another. Discounts have also been allowed for lack of marketability (i.e., the absence of an exchange or other ready market renders the interest unsellable). A taxpayer cannot assume that these discounts will be allowed. Nor should a taxpayer rely solely on the advice of an accountant or lawyer; retaining a qualified appraiser has become a key element of the FLP planning strategy.
Some observers question the availability of discounts for a partnership consisting largely of marketable securities. Appraisers justify the discounts by appealing to empirical studies on publicly traded investment companies and the differences between their trading price and net asset values. They also use market data (restricted stock studies, for example) to support the discount for lack of marketability, which can reach 45%.
The IRS is attacking the size of the discounts wherever possible by setting up a “battle of the appraisers.” Many valuation cases docketed in the tax court have been settled without going to trial, indicating that significant discounts have been negotiated.
The Private Letter Rulings
Beginning in 1997, the IRS began issuing attacks against FLPs through private letter rulings. The first major ruling (PLR 9719006) involved an FLP formed by a terminally ill individual after she was removed from life support, two days before her death. Her children signed all of the documents under powers of attorney. She contributed rental realty and marketable securities (valued at $2.25 million) to the FLP in exchange for a 98% limited partnership interest. Her children contributed the cash for two 1% general partnership interests. Upon death, the mother’s interest was valued for estate tax purposes at about $1.2 million.
The IRS argued that this was a sham with no purpose other than estate tax savings, citing Estate of Murphy (T.C. Memo 1990-472), wherein a decedent transferred 1.76% of the stock in a closely held corporation 18 days before death, reducing her interest from just more than 50% to just less than 50%. The Tax Court disallowed a minority interest discount, concluding that the sole purpose of the lifetime transfer was to reduce tax by creating a minority discount. The IRS did not discuss, or even cite, a later case, Estate of Frank, Sr. (69 T.C. Memo 2225), which upheld a transfer two days before death that reduced a 50.3% interest to a 32.1% interest and upheld a 30% marketability and 20% minority interest discount.
Later, the IRS issued PLR 9842003, addressing a case involving New York partnership law. The FLP was formed in June 1995 and funded in September 1995. The limited partner died in October 1995. The IRS asserted that the limited partner made a gift on the formation of the partnership.
Upon first glance, the IRS argument appeals to logic: Suppose a mother exchanges a $990,000 portfolio of securities for a 99% limited partnership and a son exchanges $10,000 for a 1% general partnership interest. If the mother dies two days later and her 99% limited partnership interest in the partnership is valued at $650,000, where did the other $350,000 go? The IRS would suggest it went to the general partner. (Would anyone pay $350,000 for the son’s 1% interest?) Luckily for the high-net-worth taxpayer, this argument has been defeated in at least one recent case.
Private letter rulings and technical advice memos apply only to the cases they address. They do not constitute legal precedence, and neither the IRS nor practitioners are bound by them. The IRS needed to establish case law to effectively reduce the use of FLPs and valuation discounts; its attempts in court have been unsuccessful.
Business Purpose Argument
The IRS requires a business purpose for establishing an FLP; creating discounts for transfer tax purposes is not considered a business purpose.
An FLP is useful for many business purposes: It maintains ownership of property within the family and establishes a succession plan, allows control over distributions, allows for some flexibility in allocation of profits and losses, and permits control over cash distributions.
A major business purpose is asset protection. After an FLP is formed, a creditor can no longer levy on the underlying assets. The creditor can only levy on the partnership interest and get a charging order on distributions if and when they are made. A creditor with a charging order is often more amenable to a percentage cash settlement.
Finally, if the taxpayer owns out-of-state real property, placing the property in an FLP eliminates the need for ancillary probate in the other state, thereby simplifying estate administration.
IRC section 2703(a)(2), added to Chapter XIV in 1990, provides that the value of any property is determined without regard to any restriction on the right to sell or use property unless the agreement is—
The IRS held in PLR 9719006 that the series of transactions (the creation and funding of the partnership and the transfer of partnership interests) were in substance one integrated transaction, subject to the partnership agreement. Hence, this was a transfer of the underlying partnership property permitting the partnership agreement to be ignored.
IRC section 2704(b), also added to Chapter XIV in 1990, provides that when valuing a transfer of interest in a controlled entity to a family member, restrictions on the ability to liquidate the entity are disregarded if they are more limiting than state partnership law.
Prior to 1990, most limited partnership statutes allowed withdrawal by limited partners, the only exception being found in Georgia. Delaware changed its law early on, becoming the jurisdiction of choice, but as FLPs gained popularity, many states followed suit. Historically, New York law allowed a limited partner to withdraw from the partnership upon six months notice. Hence, a more restrictive provision under the partnership agreement could run afoul of section 2704(b). New York amended its partnership statute to eliminate the withdrawal right, effective August 31, 1999.
Kerr v. Commissioner
Baine P. Kerr was a former partner of Baker & Botts, a Houston law firm, where he met S. Stacy Eastland, a long time proponent of FLPs as an estate planning tool. In 1993 Kerr, advised by Eastland, formed two partnerships, one with life insurance and one with about $11 million of real estate and securities. He gave some limited partnership interests to his children, some to a grantor retained annuity trust, and some to the University of Texas as a charitable contribution.
For gift tax purposes, Kerr took a 17.5% minority interest discount and a 35% lack of marketability discount. The IRS, in its notice of deficiency, alleged that section 2704(b) applied to the transaction and that Kerr made a gift of the underlying fair market value of the partnership assets, unreduced by discounts.
Kerr motioned the Tax Court for a summary judgment that section 2704(b) was not applicable. The Tax Court held that under Texas partnership law, the provisions of the partnership agreement were not more restrictive than state law; hence, the partnership agreement did not contain an “applicable restriction” within the meaning of section 2704(b).
As in PLR 9842003, which dealt with New York law, the IRS focused on a provision in the Texas Revised Limited Partnership Act allowing a limited partner to withdraw on six months written notice. The Tax Court, however, held that section 2704 (b) relates to restrictions on the partnership to liquidate, not the ability of an individual partner to withdraw his interest. State law did not allow a partner to liquidate the partnership.
Church v. U.S.
Elsie I. Church formed an FLP on October 22, 1993. She had been treated for breast cancer since July 1990, had undergone chemotherapy twice, and the disease was considered to be in clinical remission. She contributed her interest in the family ranch consisting of 23,000 acres used for grazing and hunting and an oil and gas lease to the FLP. Her children contributed undivided interests in the ranch, and Elsie contributed $1 million of marketable securities. The children each owned 18% as limited partners, Elsie owned a 62% interest as a limited partner, and there was a corporate general partner.
Two days after these transactions, Church died suddenly and unexpectedly of cardiopulmonary collapse. Upon her death, the FLP certificate had not been filed, the corporate general partner had not been formed, the new deed had not been recorded, and the securities had not yet been transferred. At the time of death, the fair market value of Church’s contributions to the partnership was $1,467,748. Her limited partnership interest was valued on her estate return at $617,519, a discount of 58% from the appraisal.
The IRS argued that it was a sham: The partnership had no business purpose, the assets had not been legally transferred, and IRC section 2703 applied. Though the IRS made the argument in this case, it should be noted that the IRS had abandoned the section 2703 argument in at least one docketed Tax Court case.
The U.S. District Court for the Western District of Texas rejected all of the IRS arguments. Moreover, since the IRS did not contest the appraisal and entered no valuation testimony of its own, the court held for the estate. The court also rejected the IRS argument that there was a gift upon formation of the FLP. A taxable gift must involve a gratuitous transfer, which by definition requires a donee. Because there was no donee in this case, there could have been no transfer of assets.
Retention of Control
The IRS has also attacked the validity of FLPs on the basis that the transferor retains control of the property. The IRS has had more success with this argument. Formation of an FLP requires care in how assets are owned and how income is received and reflected: Ownership of assets must be transferred to the FLP and income must flow to the FLP and be deposited in FLP accounts. Otherwise, the IRS will argue that the decedent retained the benefit of the property and include it under IRC 2036(a). Consequently, in Schauerhamer v. Comm’r (T.C. Memo 1997-242), the Tax Court sustained the IRS position that the property in the FLP should be included in the estate because the decedent took checks issued to the FLP and deposited them directly in his own account.
The Tax Court held similarly in the recent case of Estate of Reichardt v. Comm’r (114 T.C.__No. 9). Reichardt had recently inherited property from his deceased wife and shortly thereafter formed a revocable living trust and an FLP. The revocable living trust was the 1% general partner of the FLP. He gave 30% limited partnership interests to each of his children and retained the rest. However, except for transferring title of the assets to the FLP, nothing changed. Reichardt continued to manage the property, commingle partnership and personal funds, and use the partnership account as his own. The Tax Court concluded that the decedent, Reichardt, and his children must have entered into an implied agreement that Reichardt could continue to possess and enjoy the assets and retain the right to the income during his lifetime. The full value of the property was included in Reichardt’s taxable estate.
Additionally, in a recent private letter ruling, the IRS invoked section 2036(b), which provides that retention of the right to vote shares of stock in a controlled corporation is considered to be the retention of the enjoyment of the transferred property and, hence, includable in the decedent’s taxable estate.
In PLR 199938005, the decedent and his brother owned 50% each of a corporation. They each transferred their stock to an FLP and gave limited partnership interests to their children, retaining the general partnership interest. The IRS held that the decedent’s retention of the right to vote, in the capacity of general partner, was the retention of the right of control and, hence, the stock was includable in his estate. If the decedent had retained another class of voting stock, if only nonvoting stock was transferred to the FLP, and if gifts had been made, it might have been more difficult to successfully argue that section 2036(b) should have applied.
The Future of FLPs
Despite IRS attacks, FLPs live on. Their numbers increase and the discounts get higher. Appraisers are becoming more aggressive with their discounting and the IRS’s private letter rulings are not sustaining challenges in the courts. It seems unlikely that this judicial trend will be reversed by legislation; it hardly seems likely that a Congress that has voted for the repeal of the estate tax would enact antitaxpayer estate legislation. A fair conclusion is that the IRS has neither the statutory tools nor the congressional mandate to stop the continuing proliferation of FLPs as a valuable wealth transfer tool.
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