PERSONAL FINANCIAL PLANNING

September 2001

FLP Litigation Update

By Laurence Keiser, LLM (Tax), CPA, Stern Keiser Panken & Wohl, LLP, White Plains, N.Y.

Litigation over the family limited partnership (FLP) as an effective estate planning tool has not abated, and is unlikely to even under the new tax law. Two decisions—Kerr, in the Tax Court [113 T.C. 449 (1999)], and Church, in the Texas District Court [85 AFTR 2d 2000-804 (W.D. Tex.2000)]—set the stage for FLP acceptance. (See “Shielding the Family Limited Partnership from IRS Attacks,” The CPA Journal, September 2000.) More recently, the Tax Court—in three authoritative, well-reasoned, and strongly analytical decisions—has validated the FLP while warning practitioners against overly aggressive valuation discounts.

Pro-FLP Decisions

Kerr. The taxpayer in Kerr formed an FLP in Texas with about $11 million of real estate and securities. In valuing gifts of the FLP interests, Kerr took a 17.5% minority interest discount and a 35% marketability discount. The IRS disallowed the discounts, alleging that under IRC section 2704(b) certain “applicable restrictions” on liquidation of a family partnership may be disregarded if the agreement is more restrictive than the provisions of state law.

The Tax Court granted Kerr’s motion for summary judgment that IRC section 2704(b) did not apply. The partnership agreement did not contain applicable restrictions and its provisions were no more restrictive than state law.

Church. The taxpayer in Church contributed real estate and securities to a Texas FLP in exchange for a limited partnership interest. Her adult children also contributed property for limited partnership interests. A corporate general partner was controlled by the children.

Church died two days after the FLP was formed, and the estate argued for combined valuation discounts of 58%. The IRS argued that the partnership should be ignored because under IRC section 2703(a) the value of property is determined without regard to any restrictions on the right to sell or use property unless the agreement is a bona fide business arrangement, not intended to transfer property to family members for less than full and adequate consideration, and conducted at arm’s length.

The Church decision held that IRC section 2703(a) did not apply to FLPs. In addition, the IRS had argued in Church that if the property was valued at $1.5 million when transferred but the interest received in exchange for the property was worth only $600,000 two days later, there must have been a gift upon formation of the partnership. The court found there was no gift and no donee. In essence, the court held that just because the decedent’s interest was worth less, other partners’ interests were not necessarily worth more.

IRS response. On September 1, 2000, after the Church and Kerr decisions, the IRS published field service advice (FSA 200049003) involving an LLC (not an FLP). The decedent transferred property to the LLC and contributed LLC interests to his children. Discounts were taken in valuing the gifts and on the estate’s tax return. The IRS set forth six legal theories to attack the discounts:

IRS Attacks Appraisals

Shepard. In J C Shepard v. Comm’r (115 T.C. No. 30), a father had executed an FLP document on August 1, 1991. On August 2, his two sons executed the document. The father was the 50% managing partner and each son owned 25%. On August 1, the father also executed deeds to transfer leased land subject to leases to the partnership; the deeds were recorded on August 30. On September 9, the father transferred shares in three operating banks to the partnership.

The questions presented to the court were: What was gifted? What was its value? The taxpayer argued that the two 25% partnership interests were gifted, but the court held that because the land was conveyed before the partnership was created, these were indirect gifts of 25% interests in the property from the father to his sons. Although the parties had stipulated to a combined discount of 33.5% for the transfer of partnership interests, in light of the court’s conclusion, a discount of only 15% was allowed.

To some extent, Shepard is correct on its facts. At the time that the real property was transferred, the partnership was not yet in existence because it lacked partners. So the court could conclude that these were not gifts of partnership interest, but of individual interests in property. Therefore the allowed discount was 15%, not 33.5%. This difference seems great, but the taxpayer testimony on this valuation issue was weak. It also appears that the IRS’s appraisal of the land, which the court accepted, valued it as a transfer of a 50% interest, not two 25% interests. The IRS has long argued against discounts for coownership because of the right to bring an action for partition.

The IRS also argued that this was an indirect gift; that is, this was not a transfer of property to taxpayer’s children, but rather a transfer to an entity of which the children were part owners, thereby increasing the value of their interests. Under this theory, the father transferred a 100% interest on the land and no discount would be appropriate. The court rejected this argument, ruling that an indirect gift was in fact made, but that gift should still be entitled to a 15% discount.

Knight. In Knight v. Comm’r (115 T.C. No. 36), a husband and wife with combined assets of about $10 million created an FLP in Texas. A newly created trust, with the husband as the trustee, was constituted as the 1% general partner. In exchange for the 99% limited partnership interest, the petitioners transferred $10,000 in cash, $510,239 from a Dreyfus Municipal Bond Fund, $553,653 from another municipal bond fund, $461,345 of Treasury notes, insurance policies with a cash value of $51,885, the family ranch (290 acres, valued at $182,251), and two residences (one occupied by their son, valued at $166,880, and one occupied by their daughter, valued at $145,070).

Each petitioner gave a 22.3% limited interest in the partnership to two trusts created for each of their adult children. The petitioners valued the interest by taking the total value of the assets ($2,081,323) and reducing it by discounts for portfolio, minority interest, and lack of marketability (totaling 44%), resulting in a value of $263,165 for each.

The IRS contended that the partnership should be disregarded for gift tax purposes. The court upheld the validity of the partnership: Its creation satisfied all requirements of Texas law. The court found that a hypothetical buyer or seller would not disregard the partnership. The court also rejected the IRS’s argument that the economic substance doctrine should apply and agreed that the petitioners were indeed valuing the substance of the transaction, that is, a gift of partnership interests.

The IRS also argued that the provisions of the partnership agreement should be disregarded under IRC section 2704(b)(2) because they were more restrictive than state law. The court said that it had already dealt with the IRS arguments under Texas law in Kerr.

As for the valuation, the court disallowed the 10% portfolio discount. (A portfolio discount applies if a company owns a combination of assets that would not be particularly attractive to a buyer.) The petitioner argued for a 10% lack of control discount based on a comparison to publicly traded closed-end bond funds, but the court held that the 10 funds the appraiser used were not comparable.

The petitioner also argued for a 30% lack of marketability discount, citing studies of restricted stock, but the court held that the appraiser had not established that the companies in the study were comparable to the partnership or demonstrated how he arrived at the discount. The court seemed upset by the appraiser’s attitude, indicating that he was acting as an advocate, not an expert, and that his testimony was not objective. The court allowed a total discount of 15%.

Two judges concurred in the result. The partnership could not be disregarded because it was a valid, legal entity and it did not matter whether a hypothetical purchaser would disregard it. Second, the economic substance doctrine, developed in a business context, does not fit into typically donative transfers and should not be applied in the transfer tax regime to disregarded entities. One judge dissented, indicating that the valuation should ignore the transfer of partnership interests and focus instead on the assets transferred to the partnership.

Strangi. In Estate of Albert Strangi (115 T.C. No. 35), Strangi was diagnosed with a brain disorder that would gradually reduce his ability to communicate. His son-in-law, a lawyer, possessed power of attorney and formed an FLP with a corporate general partner under Texas law on August 12, 1994.

Assignments of assets were made to the FLP under the power of attorney. The value of decedent’s contributed property was $9,877,000, about 75% of which was cash and securities, for a 99% limited partnership interest. A 1% general partnership interest was owned by the corporation, in which Strangi owned 47% and his four children 53%. Strangi died on October 14, 1994. On Form 706, the estate claimed a 33% discount for lack of control and lack of marketability. In July 1995, the partnership distributed $3,187,800 to the estate for payment of federal and state estate taxes. The estate also made distributions to the estate heirs.

The IRS argued that the partnership should be disregarded because it had no economic substance. The estate cited various business purposes for creating the FLP: to reduce fees and commissions, to provide asset protection, and to provide a family investment vehicle. The court was skeptical about the nontax motives, suggesting that they were “mere window dressing to conceal tax motives.” Nevertheless, it held that the formalities were followed and the partnership had sufficient substance to be recognized for tax purposes.

The IRS also argued that the partnership should be ignored under IRC section 2703(a)(2). Following the rationale of its earlier decision in Kerr, the Tax Court held that the IRS’s position was not supported by the statutory or legislative history of Chapter XIV. The court also cited Church with approval. In a proposed amendment to its answer filed just before trial, the IRS alleged that IRC section 2036(a) should apply because control was retained by the transferor (the attorney). The court dismissed the motion but indicated possible approval of the theory had the amendment been timely.

Finally, the IRS argued that Strangi made a gift when the property was transferred to the partnership. The court cited a Fifth Circuit case dealing with a transfer of property to a corporation [Kincaid (682 F.2d 1220, 1982)]. The court suggested that because the decedent did in fact give up control of the assets, because his beneficial interest in them exceeded 99%, and because his contribution was allocated to his own capital account, a gift was not in fact made. But, the court said, “realistically, the disparity between the value of the assets in the hands of the decedent and the alleged value of his partnership interest reflects on the credibility of the claimed discount applicable to the partnership interest.”

At trial, the estate argued for a blended discount of 43.75%: 25% for minority interest, and 25% for lack of marketability. The IRS agreed with the 25% lack of marketability discount but argued there should be only an 8% discount for lack of control because the decedent retained effective control of the corporate general partner. This resulted in a 31% blended discount. The court accepted the IRS’s view, stating “the result of respondent’s expert’s discounts may still be over[ly] generous to petitioners, but that result is the one that we must reach under the evidence and under the applicable statutes.”

Three judges filed concurring opinions indicating that the court should not apply the economic substance doctrine to disregard a validly formed entity for purposes of estate and gift tax valuation. Five judges dissented in three separate opinions. One opinion said the decedent retained effective control of the partnership, and therefore value should be based on the agreement in fact rather than the written agreement, which had no relationship to ownership and control of assets. Another opinion said that the partnership should be disregarded under the step-transaction doctrine. The third opinion, with which all five dissenting judges concurred, was that there should in fact be a gift: “By failing to apply IRC section 2512(b), the majority thwarts its purpose, which the Supreme Court described as ‘the evident desire of Congress to hit all the protean arrangements which the wit of men can devise that are not business transactions within the meaning of ordinary speech’” [citing Comm’r v. Wemyss 324 U.S. 303 (1945)].

Small Victories for the IRS

The courts in this litigation series have consistently rejected the IRS’s technical arguments. The IRS cannot disregard a validly formed FLP that has economic substance. Apparently, the taxpayer does not even need a business purpose. IRC sections 2703 and 2704 do not apply. There is no gift upon formation of the partnership.

The IRS’s only victories have been in cases where the transferor retained control or where the legal formalities have not been exactly followed (as in Shepard).

The Tax Court has indicated, however, that although the IRS cannot prevail on the law, it may prevail on the facts (i.e., the valuation). In recent cases, the high-water mark for the combined discount has been 31%, and that determination followed from the court’s decision to award at least the discount percentage of the IRS appraiser. Even where the court has discredited the IRS appraiser, it has not upheld the the taxpayer’s appraiser. The taxpayer’s appraisal must be credible and supported by the evidence. Even in the absence of an IRS appraisal, the Tax Court will, on its own, determine a proper discount. (Contrast this with Church, where the U.S. District Court in Texas upheld the estate’s 58% discount because the IRS did not present any appraisal testimony, and the Tax Court’s own decision in Ellie B. Williams, which upheld a 44% discount for a coownership of real property because the IRS did not present a contrary appraisal.)

Although the court rejected the IRS’s argument for gift on formation, it pointed out the valuation dilemma: Why would a taxpayer transfer property to an entity in exchange for an interest in the entity worth only 60% of the property? Would the taxpayer make such an exchange if the other partners were not family members? Obviously, this affects the discount.

The Tax Court’s suggestion in Strangi that it would entertain a IRC section 2036(a) argument is not very surprising. Most tax lawyers would acknowledge that retained control (either as general partner or controlling shareholder of a corporate general partner) would eliminate a discount. However, Strangi owned only 47% of the corporate general partner, which is not a controlling interest. At the same time, his son-in-law, who had his power of attorney, might have possessed practical control, considering that his wife owned 13.25% directly.

In short, if all of the requirements are followed, the FLP should be respected. The focus will be on the strength of the appraiser and the expert testimony.


Editors:
Milton Miller, CPA
Consultant

William Bregman, CFP, CPA/PFS

Contributing Editor:
Theodore J. Sarenski, CPA
Dermody Burke & Brown P.C.

David R. Marcus, JD, CPA
Marks, Paneth & Shron LLP


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