The Lochsa, Selway and Middlefork of the Clearwater Rivers
Summer has arrived and in our North Central Idaho area we are blessed with free-flowing rivers – the Lochsa and Selway Rivers flowing from near the Idaho-Montana border in the Selway-Bitteroot Wilderness Area, form the Middlefork of the Clearwater River that runs by our Syringa, ID home. Mary Ann and I enjoyed some trailer camping up the Lochsa a few days ago, and the syringas were in bloom, as were many other flowers and plants. Truly, summer is a beautiful time here in North Central Idaho.
We soon will celebrate our 51st wedding anniversary with several days relaxation and enjoyment at the famed Coeur d’Alene Resort on North Idaho’s Lake Coeur d’Alene. And then we will look forward to family and friends visiting us in Syringa. In late June, we travel to Southern California where I will have some consulting meetings and also attend my 55th(!) Loyola High School Reunion!
Reality and Usefulness of FLP/LLC Planning Established
As many of the readers of this newsletter know, my four decades of tax and estate planning law practice often utilized pass-through entities, such as family limited partnerships(FLPs) and limited liability companies(since California adopted its legislation on LLCs in 1994) to develop asset protection, management succession and estate and income tax savings for clients.
However, due to overly aggressive use of FLPs and LLCs, including “death bed” transfers and excessive discounts on entity interests transferred, the IRS over 10 years ago embarked on audit, Appeals and litigation efforts to attack these entities so as to destroy valuation adjustments(“discounts”). The result of the Service attacks, while succeeding in a number of cases to reduce or even eliminate claimed discounts, generally has been to confirm the reality and usefulness of FLP/LLC planning. This is due to the emphasis by IRS on “bad facts” cases which have led to guidelines and principles for entity success being provided by the courts. In 2006, the heavily redacted IRS Appeals Settlement Guidelines for FLPs, etc. confirmed the issues and provide an additional source to guidance for tax practitioners and their clients.
Where the facts in any given case are pro-taxpayer, the Service has been forced to back off its attack positions and to accept the reality of the entity or entities as well as the appropriate level of discounts for entity equity interest transfers. This of course assumes that the taxpayer obtains the support for so-called discounts with a report from a qualified business valuation appraiser providing credible appraisal evidence.
The Tax Court and various Circuit Courts of Appeal(not including the 9th Circuit, which includes California) have dealt extensively with IRS FLP/LLC attacks, especially those under the broad IRC Sec. 2036(a) – which, if applicable, can bring inter-vivos asset transfers back into the decedent’s estate without consideration of the pass-through entity.
Key Factors Involved in FLP/LLC Plan Reality
The key factors to be considered in supporting the reality of an FLP/LLC plan, and thus being able to value, at discount, the transferred entity equity interests, include the following:
1. Plan design with non-tax and/or business purpose(s), rather than merely transfer tax avoidance.
2. Attention to the guidance as to structure, implementation and operation of FLP/LLC plans furnished by judicial decisions.
3. Consideration of the formalities of the entity, proper document drafting, sensible funding and operational integrity according to plan.
4. Utilization of a qualified business valuation appraiser who understands the issues and who develops properly supported and credible data for the valuation discounts, with legal counsel providing the assumptions of value.
5. Avoidance of the “red flags” considered(at least in combination) fatal by IRS and supported in part by the courts:a. Near date of death entity formation.
b. Transfer to the entity of virtually all the taxpayer’s assets.
c. Funding the entity with personal assets, e.g. taxpayer’s home.
d. Absence of active involvement or understanding of the younger generation family members in managing or forming the entity.
e. Non pro-rata distributions from the entity to members or partners, especially to the senior person/taxpayer/decedent.
(And this list goes on and on!)
2036(a) – From Schauerhamer to Erickson
IRS has achieved substantial success in application of IRC 2036(a) to a number of mostly “bad facts” cases over the past 10 years. The initial Tax Court decision here was in the Estate of Dorothy Schauerhamer, T.C. Memo. 1997-242 – and in that case my former law partner, John Ramsbacher, and I were co-counsel at trial for the taxpayer estate. In Schauerhamer, regardless of legal arguments advanced based on the partnership agreement, the decedent’s retained managing general partner status coupled with the deposit of all partnership asset income in decedent’s personal bank account for the 11-month period from entity formation to her death was enough for Tax Court Judge Foley to conclude there was at least an implied understanding that until her death, Dorothy would be in total control of the assets of the entity. A number of other cases followed, largely being the source of the indicated key factors above to avoid the 2036(a) result.
Then, 10 years after Schauerhamer, the most recent Tax Court decision on 2036(a)(1) recently was issued, namely, Estate of Hilde Erickson, T.C. Memo. 2007-107(4/30/07). In Erickson, there were present numerous “bad facts” – aged taxpayer suffering from advanced Alzheimer’s disease, one of two daughters (per durable power of attorney) developing the planning, one legal counsel representing everyone involved, completion of transfers only 2 days prior to Hilde’s death, transfer of virtually all decedent’s asset to the partnership and gifting, again 2 days before her death, over 70% of Hilde’s limited partnership interests to her 5 grandchildren, and so forth. The Tax Court had little difficulty finding 2036(a)(1) applicable, i.e. inter-vivos transfers of assets to the FLP retaining, by express or implied agreement, control over and/or the right to income from the transferred assets until death.
The issue of whether the “bona fide sale for full and adequate consideration” exception to 2036(A) estate tax inclusion of the transferred assets(without recognition of the FLP) also was dealt with by the court. A review of the detailed facts and record in the case supports the court’s conclusion and determination that there was no substantial non-tax business or investment purpose for the FLP, and thus no “bona fide sale” took place.
Fortunately, however, in better fact situations, the courts have found that the “bona fide sale”, et al exception applies, and thus trumps the broad reach of 2036(a). There are two(2) requirements for this exception to apply – (1) existence of a demonstrated, substantial non-tax business or investment purpose for the entity, and (2) pro-rata(per FMV) entity records treatment of capital contributions by the partners of the FLP or by the members of the LLC.
Tax and financial advisors need to pay close attention to the judicial decisions, the Appeals Settlement Guidelines, and the facts involved in each client situation. New plans using these entities require careful analysis, proper documentation and funding, plus the full understanding of clients respecting the above-referenced key factors for success. Further, as to existing plans, now after 10 years of reported litigation, advisors should “audit” previously set up plans and transactions to insure that the best possible fact pattern was established and has been maintained. My non-lawyer consulting engagements often have involved such an audit effort and then working with legal counsel, the CPA and the clients themselves.
Owen Fiore
