For nearly a dozen years, the IRS, the courts and taxpayers have been sparring over the validity and use of Family Limited Partnerships(FLPs) and Limited Liability Companies(LLCs) as pass-through entity vehicles for income tax purposes that also are expected to have estate planning advantages - including valuation discounts for entity equity interest transfers. Decades ago, in the 1950s, IRC Sec. 704(e) was enacted by Congress as an income tax "safe harbor" for family partnerships. Here treating the "donee" partners as real partners and having capital as a material income-producing factor allows the FLP(and its modern counterpart, the LLC) to be recognized for income tax purposes.
However, in the Federal transfer tax area, especially as to the estate tax, the Service has challenged FLPs and LLCs, often with considerable success. Heavily redacted IRS Appeals Guidelines issued in October, 2006, identify the issues involved - both as to FLP/LLC reality on various issues, especially estate tax provision IRC Sec. 2036(a), and as to valuation methodology.
Over the past year, there have been a number of judicial opinions on FLP/LLC plans that are worthy of review, some of which already have been the subject of prior newsletters here. These decisions cover several specific areas, namely, (1) Section 2036(a) application and availability of its exception for a "bona fide sale for full and adequate consideration", (2) the use of "fixed dollar value" formula gifts and estate transfers to backstop valuation appraisals obtained by taxpayers, and (3) developments in appropriate valuation methodologies for appraisers to use in valuing equity interests in an FLP or LLC. First, this newsletter outlines these developments, and second, I present a summary of "Factors for Success" in the use of FLP/LLC planning as part of an overall integrated Family Wealth Plan.
I. The 2036(a) Estate Tax Trap and How to Avoid It!
There are several court decisions here that provide taxpayers, their tax counel and appraisers with guidance in having a successful FLP/LLC plan for estate tax purposes. However, the first and second of these cases are taxpayer defeats, namely the Bigelow and Rector cases. I have commented in previous newsletters on cases such as Erickson, another taxpayer defeat. The first of the modern day 2036(a) cases was one I handled in Tax Court, namely, Estate of Dorothy Schauerhamer v. Comm'r, T.C. Memo. 1997-242 - which illustrated the importance of clearly following the partnership plan, including as to bank accounts and deposits of partnership income into same.
(1) Estate of Virginia Bigelow v. Comm'r, 2007 U.S. App. LEXIS 22030, 9th Circuit Court of Appeals(September, 2007) - The appellate court affirmed the Tax Court's decision that there was an implied agreement for Mrs. Bigelow to enjoy FLP income and benefits beyond her pro rata share based on capital interest in the FLP. Thus, the claimed 37% estate tax valuation discount was lost by the estate in a poorly designed and improperly operated FLP. Mrs. Bigelow remained personally liable on liabilities encumbering assets transferred to the entity, the FLP failed to observe partnership formalities, there was no real shield from personal liability, and, most important of all, Mrs. Bigelow was left "impoverished" after the FLP was set up, but for receiving partnership distributions. No clear non-tax purposes were served here, which spelled disaster for the estate!
(2) Estate of Concetta Rector v. Comm'r, T.C. Memo. 2007-367(January, 2008) - Under 2036(a), Judge Laro appeared to set an extremely high standard for success in using an FLP or LLC. The court applied 2036(a)(1), the "implied agreement" provision, and thus ignored the entity, resulting in loss of valuation discounts all around. The key here was that the decedent had transferred most of her assets to the entity and was left with insufficient personal assets to support herself. No partnership formalities were followed, cash distributions to decedent were made without equalizing distributions to other family members who were partners, etc. Judge Laro stated that the 2036(a) "bona fide sale" exception could only be applicable if there was a significant non-tax business purpose for the entity, and that "gift-giving" was not a business purpose(disputed in Morowski, discussed below).
(3) And now we come to the taxpayer victory, a significant one applying the "bona fide sale" exception to application of 2036(a)(and 2038 as well) so that the entity is respected and the discounts have an opportunity to work! This case is Estate of Anna Morowski v. Comm'r, T.C. Memo. 2008-74, in which Tax Court Judge Chiechi delivered a welcome boost to tax advisors and appraisers who try and establish workable FLP/LLC plans. The court was very impressed with the Morowski Family values, close personal relationships and the desire of the mother Anna to keep the family together through common investment pool arrangements, including trusts and the LLC established in August 2001 after a year or so of consideration of the plan. The LLC was set up in late August, 2001, a few days later it was funded and then almost immediately gifts of 16% of LLC member interests were made to trusts for the three (3) Morowski daughters - Just 4 days later, on the infamous date of 9/11/01, Mrs. Morowski suddenly died, losing her long fight with diabetes.For the gifts, in a pre-trial settlement with IRS, it was agreed that the gifts were to be valued net of over 40% in discounts! See my earlier newsletter on this important case which shows, as does the case of Stone v. Comm'r, T.C. Memo. 2003-309, that FLP/LLC plans can work with good facts.
(4) How to win FLP/LLC cases, in addition to utilizing the services of a qualified, experienced business valuation appraiser? Here are some "factors for success":
a. Design an effective plan at the outset, especially developing realistic, well-support non-tax purposes for using the entity.
b. Avoid senior generation impoverishment, i.e. by keeping out of the entity assets sufficient to continue to support the founding partner(s).
c. Transfer assets with their related liabilities.
d. Consider using a non-transferor general partner or managing partner.
e. Maintain proper capital accounts, proportionately credited or charged with contributions and distributions.
f. Always follow entity formalities and provisions of the entity agreements.
g. Avoid non-pro rata distributions.
h. Consider changing the entity's direction and set up a "business plan" for the future.
i. Show the entity to be a true educational experience for younger generation family members, a "training ground" for the future.
j. Use an LLC as the general partner of the FLP to be able to evidence "asset protection".
II. "Fixed Dollar Value" Formula Clauses - McCord and Christiansen.
As a protective backstop for appraisals, the concept here is to state that the gifted or estate transfer value is that number of shares or units in the entity that equals X dollars, "as finally determined for gift(or estate) tax purposes." There must be a clear and understandable adjustment clause, rather than any elimination of the transfer.
In McCord v. Comm'r, 120 TC 358(2002), a gift tax case, such a formula clause was used by the taxpayer, but the Tax Court went off on its own - which resulted in a stinging reversal by the 5th Circuit. Then in 2008, an estate tax case with a charitable disclaimer provision based on a formula clause determination, was issued, namely, Estate of Helen Christiansen v. Comm'r, 130 TC No. 1(January, 2008). The Service challenged the formula clause as a "condition subsequent" and as "against public policy" - but lost on both grounds! At least where charitable giving is involved, it appears the Tax Court would find now that there is no public policy argument supporting the IRS attack. While there is continuing uncertainty here, no doubt formula clauses will be used more often now.
III. Astleford and Holman - Instructive Gift Tax Decisions.
These two (2) gift tax cases provide interesting legal and fact issues for review. Both cases are Tax Court opinions, with different judges and they deserve careful study and consideration by tax advisors and business valuation appraisers alike.
(1) First, Astleford v. Comm'r, T.C. Memo. 2008-128, involved a real estate investment FLP and various gifts of partnership interests therein. Among the assets contributed to the partnership was a 50% interest in a real estate venture, a general partnership, in which the donor mother was a venture partner. Therefore, the issue of "layered" or "tiered" discounts was present, and Judge Swift found here that such a tiered discount was available, giving footnote guidance to standards for same. The court determined that a partnership interest was transferred to the FLP, not merely an assignee interest, and finally, but see Holman below, the court was not bothered on a "step transaction" principle by the virtually simultaneous transfer of assets to the FLP and gifts of FLP interests. In the valuation methodology area, the court exercised its long stated prerogative of "mixing and matching" appraisers' opinions and methodology to arrive at its own value conclusions. There were a total of 6 appraisers involved in the case!
(2) Second, we have another gift tax case, i.e. Holman v. Comm'r, 130 T.C. No. 12(5/27/08), in which the FLP had as its sole asset, contributed by the parents, shares of Dell Computer stock. Dell, a public company, has a volatile stock price history, which was important here in avoiding a "step transaction" disaster - as only 6 days separated the contribution of Dell shares to the entity from the gifts of entity interests to children of the founders of the FLP. Also here there was a detailed discussion of IRC Sec. 2703 which, unless a "safe harbor" applies, disregards transfer restrictions in a family-controlled entity. But even though the court determined the safe harbor was inapplicable and the restrictions should be disregarded, the entity was allowed to be recognized and substantial discounts still present. On appraisals, the court stated it "lacked confidence" in the taxpayer's appraiser, and so the case is worth reading to see how the court deals with discount methodology and the strengths and weaknesses of individual appraisers.
Upcoming education events -
First of all, for CPELink(www.cpelink.com) I have two (2) four-hour webcast courses, the first on Valuation(9/25/08) and the second on FLP/LLC planning(10/7/08) - check out the course descriptions, how to sign up, etc. on the CPELink website. These courses are interactive, with email questions and answers involved, with each course also having downloadable course materials - over 100 pages for each one!
And then I present both "Hot Topics in Estate Planning" and "FLP/LLC Planning", each course a 6-hour live presentation, at the Ritz-Carlton Kapalua on Maui in Hawaii November 13 and 14, respectively - check out the WesternCPE website for these courses - see www.westerncpe.com.
Later this week I attend a special "Summit on the Discount for Lack of Marketability" in San Diego, sponsored by USD School of Law, Business Valuation Resources and the ASA(Thursday), and then the 4th Annual Jerry A. Kasner Estate Planning Institute on Friday in San Jose. As most know, Professor Jerry Kasner was a giant in the tax and estate planning field, and such a good friend to so many of us, including me.
Hope you enjoy this newsletter - more coming soon!
