TAX AND ESTATE PLANNING WITH FAMILY LIMITED PARTNERSHIPS. George L. Cushing, Esq. Amiel Z. Weinstock, Esq. K&L Gates, LLP Boston, Massachusetts

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1 TAX AND ESTATE PLANNING WITH FAMILY LIMITED PARTNERSHIPS George L. Cushing, Esq. Amiel Z. Weinstock, Esq. K&L Gates, LLP Boston, Massachusetts I. General Attributes of Family Limited Partnerships A. What is a Family Limited Partnership? A Family Limited Partnership ( FLP ) is a limited partnership, validly established under state law, through which a group of individuals, generally members of the same family, voluntarily combine to pool their business and/or investment resources in order to achieve long term financial goals. These goals often include providing centralized management and cost effective administration of family wealth, through economies of scale, as well as limiting the rights of individual family members to gain access to, and potentially dissipate, the underlying investment assets held in the partnership. There are two classes of partners involved with an FLP. The partnership is controlled by one or more General Partners, who may be individuals or entities (such as a Limited Liability Company ( LLC ) or Corporation); the other family members who participate in the FLP are the Limited Partners. The General Partner (a) is authorized to manage the partnership assets and can decide what distributions, if any, are to be made to the partners; (b) has full power to act on behalf of the partnership and is personally liable for actions taken; and (c) has fiduciary duties to the other Partners and to the partnership and must act accordingly in his/its administration of the partnership. The Limited Partners own an interest in the partnership which reflects their percentage ownership interest in the underlying partnership assets. In addition, the Limited Partners have certain legal rights with respect to the ongoing administration and future liquidation of the partnership. However, limited partners do not have any powers with respect to the management of the partnership or the investment of its assets; by the same token, as passive investors their potential liability to creditors of the FLP is limited to their investment in the partnership (i.e., their proportionate interest in the underlying partnership assets, as reflected by their respective partnership interests). B. Alternative Family Wealth Management Structures. In recent years, legislation authorizing the formation of Limited Liability Companies ( LLCs ) has been adopted in every state. LLCs offer operational and tax planning benefits similar to those offered by FLPs, although there are some significant legal differences. A detailed discussion of the different uses of LLCs, as compared to FLPs, is beyond the scope of this outline. 1

2 Some families utilize corporations and/or trusts to accomplish similar financial, management and investment goals. Trusts may offer comparable opportunities for centralized management and long term investment prospects; however, the standard of care applied in evaluating the performance of trustees may be higher than that applied to mangers of business entities, including FLPs. In addition, trusts do not offer the opportunity for making discounted gifts, which will be described further, below. Like FLPs, corporations also offer opportunities for centralized management and for making discounted gifts; however, in certain circumstances, corporations may be taxed disadvantageously as compared to partnerships and trusts. Such differences will be explained in greater detail, below. C. Non-tax planning. FLPs can be used for a variety of goals that are not tax related: 1. Instilling family values without creating trust fund children. FLPs may be utilized for teaching younger generation family members (i.e., children and grandchildren) to invest and spend with responsibility while permitting the older generation family members (i.e., the patriarch and/or matriarch) to maintain control over the partnership, either directly or indirectly. 2. Teaching younger generation family members about the family s investment strategies and philanthropic goals. 3. Spreading the expense of asset management among a larger pool of investable assets and potentially achieving a greater degree of investment diversification, both as to asset classes and through the employment of multiple money managers. 4. Making it easier for older generation family members to make gifts of partnership interests (which can be transferred by a simple Assignment ) as opposed to gifting interests in property which may be hard to value and/or cumbersome to transfer (such as real estate or an unincorporated business). NOTE: An FLP is a voluntary contractual arrangement among family members which often permits the family to retain ownership of the partnership interests (and therefore the underlying assets) through restrictive buy-sell provisions set forth in the Partnership Agreement. Typically, the Partnership Agreement will include a requirement that all partners must agree to admit an assignee of any transferred partnership interest as a partner before that assignee will acquire the rights of a partner (if not admitted as a partner, the assignee will only have a right to his/her share of the income from the partnership). 5. Protection from future creditors. 2

3 a. The creditors of a limited partner may be limited to the partner s share of partnership distributions; if no distributions occur, those creditors will receive nothing. b. The Partnership Agreement may include a provision requiring the partnership to buy-back the interest of any limited partner upon whose partnership interest a creditor has tried to levy; the Partnership Agreement may set a formula price to pay the creditor, which price may be substantially less than the value of the underlying assets allocable to that partnership interest (this also protects the other partners from including a creditor as a partner). c. The Partnership Agreement may prohibit the pledging of the partnership interests by the partners to secure personal loans. 6. Protection against divorce of children. a. The Partnership Agreement may provide for Buy-Sell provisions which are triggered by the divorce of a limited partner similar to those which apply in the event of levy by a judgment creditor of a limited partner. b. It is also relatively easy to provide, via a prenuptial agreement, that a partnership interest will be treated as the separate property of the limited partner/spouse which will not be subject to equitable division in the event of a divorce. 7. Flexibility of Partnership Agreement. a. Since a partnership is a voluntary arrangement, the terms of the Partnership Agreement may be modified by the agreement of the partners as may be necessary or desirable from time to time. b. Irrevocable trusts, by comparison, can never be modified by the trust s Grantor. Some trusts permit the terms of the trust to be amended by the Trustees or by an individual or committee acting as the Trust Protector. Such amendments are, however, quite limited in scope and purpose. 8. Business Judgment. Applicability of the business judgment rule to partnerships (as opposed to the prudent man rule which applies in the case of trusts) offers more latitude in investment decision-making for the managers of the FLP than for Trustees of irrevocable trusts. 9. Potential for mandatory arbitration or mediation. Because an FLP is a voluntary arrangement, the Partnership Agreement can require that any disputes which arise relating to the management or administration of the Partnership be submitted to arbitration or mediation instead of resorting to costly litigation. 3

4 10. Costs of controversy. As a contractual arrangement, the Partnership Agreement can mandate that the English rule apply with respect to the costs of any dispute (i.e., that an unsuccessful litigant pays all of the costs of all parties to the dispute). 11. Avoiding ancillary probate and state taxes. To the extent that the partnership owns real property located outside the state of residence of the partner, such ownership will not require ancillary probate administration upon the death of the partner since interests in a partnership owning real property are nonetheless considered to be intangible personal property for probate and state estate tax purposes (as opposed to the outright ownership of the underlying real property by the decedent). In addition, for clients who are current or prospective residents of Florida, the use of an FLP to hold marketable securities may avoid the Florida intangible personal property tax (FSA exempts from the tax any interest as a partner in a partnership, either general or limited ). 12. Investment flexibility with respect to the beneficiaries. The General Partner of an FLP may make distributions to the Limited Partners based on the partnership s current financial return and does not need to limit distributions to the income of the partnership. Moreover, where the partnership interests are owned by a trust or trusts, the partnership distributions are all considered to be income for trust accounting purposes, regardless of the actual source of the funds from which those distributions were derived. 13. One level of income tax. A partnership is a pass through entity, which means that all partnership income and losses are passed through to the partners for each taxable year, regardless of the actual amounts distributed to the partners from the a partnership. The amounts taxable to the partners are proportionate to their interests in the partnership II. Estate and Gift Tax Aspects of Family Limited Partnerships A. The U.S. transfer tax system imposes an excise tax on the transfer of property, either by gift or at death. 1. It is a tax on the privilege of passing on property, not a tax on the privilege of receiving property 1 1 Ahmanson Foundation v. United States, 674 F.2d 761, 768 (9 th Cir. 1981) 4

5 2. In order to be subject to the transfer tax system at death, the decedent must own the property immediately before death, and the property must be transferable. B. The determination of the value of the transferred asset for estate tax purposes reflects the nature of the asset upon its distribution from the estate (e.g., if, upon death, the decedent can only transfer an assignee interest in the partnership, the value will not be the same as the value of his general partnership interest immediately prior to death). C. The relationship between the transferor and the transferee is irrelevant for valuation purposes. In Revenue Ruling 93-12, C.B. 202, in which a father transferred all of his stock in a closely held business in five equal (20%) shares to his children, the IRS ruled that each of the gifts of the separate 20% interests in the business were entitled to a minority interest discount in valuing the transferred shares, even though, before the transfer, the transferor had owned 100% of the value of the enterprise (and thus, the business would have been included in his estate at 100% of its value had he retained the ownership until death). D. The identity of the remaining partners is relevant for valuation purposes in measuring the value of the transferred interest. 1. Under the laws of most states, which govern the undefined terms of a limited partnership, a transferee takes only as an assignee, and has no management rights, unless approved as a partner by the remaining partners. 2. If the transferee will be the only non-family outsider in an FLP controlled by family members, it is not likely that they will vote to approve his admission as a limited partner so that he will only have the rights of an assignee. 3. For valuation purposes, the hypothetical willing buyer must therefore assess whether the remaining partners will admit him as a partner in the partnership, and, if not, should offer a lower purchase price for the partnership interest. 4. There may be a right to withdraw as a partner under state law and, in such case, to receive fair value for the partnership interest within a reasonable period of time. However, this right may be limited by the terms of the Partnership Agreement or may not exist unless provided by that agreement. NOTE: Fair value does not generally mean liquidation value. Under the laws of most states, fair value means the present value of the expected cash distributions from the partnership - that is, the discounted cash flow. E. The value of the partnership interest to the willing buyer more closely approximates the value of the interest in an ongoing business (i.e., the present value of the expected future cash distributions from the partnership) and not the liquidation value of the assets (since he will likely have no control over liquidation). 5

6 F. State law determines the nature of the property interest; federal law determines how such property interest will be taxed. 1. In valuing a partnership interest, the appraiser must take into account the rights of the partner under the terms of the Partnership Agreement and state law and then determine what a willing buyer would pay for those rights in light of the nature and value of the underlying assets of the partnership, the history of partnership distributions and the identity of the other partners. 2. Historically, the IRS has sought to value partnership interests on the basis of the net value of the underlying assets (i.e., liquidation value ), while taxpayers have argued in favor of the capitalization approach (i.e., the going concern value ). Courts have sought valuation opinions based on both approaches and then weighed the appropriateness of each approach in arriving at a determination of fair market value of a partnership interest in specific cases. G. Valuation discounts. 1. Valuation discounts are appropriate in valuing limited partnership interests because the holder of a limited partnership interest has no right to control the management of the partnership assets, cannot compel the liquidation of the partnership, and owns a property right which is not readily marketable. 2. Discounts are recognized by the public securities markets in pricing interests in publicly traded entities similar to partnerships, such as real estate investment trusts, closed end investment companies and similar investments. 3. The discounts recognized in valuing interests in non-public entities, such as an FLP, should logically be more pronounced than in syndicated partnerships, since: a. The FLP generally will have a less experienced general partner; b. The FLP is not professionally managed; c. The FLP offers a less diversified investment portfolio, therefore subjecting the investor to higher risk; d. There is less certainty of cash flow/distributions; and e. There is no secondary market for the sale of interests in the FLP. H. Discount for built-in capital gains costs. 1. A willing buyer should also be entitled to take into account the costs which will likely be incurred in the event that partnership assets are liquidated by the general partner, generating capital gains which each partner must report in proportion to his partnership interests. 2. Even if the buyer has proportionately greater outside basis in the liquidated partnership assets (through the purchase price he has paid for his partnership interest) 6

7 than the inside cost basis of the partnership assets, he cannot offset his outside basis against his share of the capital gains realized at the partnership level unless he disposes of his partnership interest within the same taxable year as the partnership gains are realized or unless the partnership is liquidated in that same year. 3. While he may be entitled to an offsetting loss in a future year, it is uncertain whether that loss will be fully usable in that year and the timing costs of the earlier recognition of capital gains (and payment of capital gains taxes) could be significant. I. Annual exclusion for gift of limited partnership interest. 1. Requirement of a present interest. IRC 2503(b) establishes the availability of an annual exclusion for gifts other than gifts of future interests in property (emphasis added). Future interest is defined in the Regulations as an interest in property limited to commence in use, possession or enjoyment at some future date or time. Any postponement of the donee s right to present possession or enjoyment, however brief, makes the gift a gift of a future interest. See, e.g., Estate of Jardell v. Commissioner, 24 T.C. 652 (1955) (outright gifts of mineral royalty interests in October 1949 effective for production commencing January 1, 1950 held not to qualify for annual exclusion). The annual exclusion is generally available with respect to outright transfers of property, even property that is not currently productive of income; the annual exclusion should be available so long as there is no restriction on the donee s right to possession or enjoyment of the property. For example, the transfer of the ownership of a life insurance policy to the donee and the subsequent payment of premiums by the donor qualify for the present interest exclusion. See Treas. Reg (c), Example 6. A different result follows if the policy is owned by a trust and the donee s rights in the trust income are postponed until the owner s death. See Treas. Reg (c), Example 2. Future interests are commonly, but not exclusively, associated with transfers in trust. However, where the trust confers an enforceable right on one or more beneficiaries which is presently exercisable, a present interest sufficient to support a present interest exclusion may be established. For example, the transfer of property to a trust which grants the right to income to the beneficiary (a so-called 2503(b) Trust ) is eligible for a present interest exclusion to the extent of the value of the income interest, determined in accordance with the actuarial principles governing valuation of income and remainder interests set forth in Treas. Reg and Where the property is not producing income at the time of the gift in trust, the Service has sought to challenge the availability of an annual exclusion for the value of the income interest, even though a right to receive income is conferred by the trust. The Service s theory is that the income interest cannot be valued or has no value. 7

8 See, Berzon v. Commissioner, 534 F.2d 528 (2d Cir. 1976). Thus, although actuarial computation based on the value of the transferred property, rather than the discounted cash flow from the transferred property, is the valuation method prescribed by the Treasury Regulations, the Service may seek to disallow an annual exclusion for an income interest in non-income producing property. 2. Annual Exclusion for transferred interests in business. The requirement that the donee have the right to substantial, present economic benefit has given rise to litigation in the context of transfers of interests in family businesses, particularly FLPs, due to the nature and extent of the restrictions on the rights of the donees of limited partnership interests to receive distributions from the partnership or to transfer their interests to a third party. So long as (1) the donee of a limited partnership interest has the right to receive distributions from the partnership, (2) the general partner has a fiduciary duty with respect to the management of the partnership and can only withhold distributions for business reasons; and (3) the donee can assign the donated interest to a third party (subject to acceptable restrictions on the right of an assignee to become a substituted limited partner), annual exclusions should be allowable. See, e.g. TAM , PLR See also PLR (donees granted right to sell donated FLP interests within 90 days after receipt). But see TAM (partnership provision granted general partner so much discretion that it obviated the normal fiduciary duties and annual exclusions disallowed.) The most recent judicial pronouncement regarding the allowance of annual exclusions in connection with gifts of interests in a closely-held business is Hackl v. Commissioner, 118 T.C. 279 (3/27/02) (Nims, J.). This case involved transfers of voting and non-voting interests in an LLC controlled by the donor, Mr. Hackl, to the donor s eight children, their spouses and an irrevocable trust for the benefit of his 25 grandchildren for the year Gift splitting was elected with respect to all of the gifts. The Service challenged the annual exclusions for the 1996 gifts (similar gifts were made by the taxpayer in 1995 but the availability of the annual exclusions for 1995 was not challenged). The Court noted that the LLC was engaged in tree farming and, in order to achieve Mr. Hackl s investment goals of long-term growth, the LLC invested in tree farm property which contained no merchantable timber. From the outset, the LLC was expected to experience losses through the year 2000, and the LLC had not yet produced net profits at the time of trial in Due to restrictions on the rights of the holders of the LLC interests to transfer their interests, the Court concluded that the annual exclusions should not be allowed for the gifts of the LLC interests, since the donees lacked the substantial economic benefit of the type necessary for the annual exclusion. Those restrictions included: 8

9 a. The Manager, Mr. Hackl, had sole control over distributions; moreover, he was manager for life and could appoint his successor, both during life and at death by his will. b. Members of the LLC had no right to withdraw capital or to demand distributions, except as approved by the Manager and had no right to have the LLC property partitioned. c. Members who wished to withdraw could offer their units for sale to the company, which the Manager had exclusive authority to accept or reject. d. A Member s interests were not assignable except with the prior written consent of the Manager which could be given or withheld in the Manager s sole discretion. Nonetheless, in spite of the express provision of the LLC operating agreement described in (d) above, the Tax Court noted that if a transfer were made in violation of the LLC operating agreement, the transferee, while not permitted to participate in the business affairs of the LLC (or to become a Member) would be entitled to receive the share of profits and distributions which would otherwise have inured to the transferor. Thus, in fact the donees could assign their LLC interests without the manager s consent and such a transfer would confer rights on the transferee comparable to the rights held by the assignee of a limited partnership interest, which have been held in the past to be adequate to support the present interest exclusion. See e.g. TAM , involving a family limited partnership, in which transfers of limited partnership interests were held to qualify for the annual exclusion. The Tax Court opinion creates confusion about the operative standard for qualifying for the gift tax annual exclusion. One element, the receipt of accounting income, was clearly lacking; however, it appears that the donees did have the ability to sell their interests, an alternate basis for allowing the annual exclusion. Due to the Hackl precedent, which was affirmed by the Court of Appeals without any re-examination of the underlying issues (335 F.3rd 664, 7th Cir. 2003), donors who plan to make gifts of LP interests in an FLP (or membership interests in an LLC) should make sure that the restrictions on transfer imposed by the Partnership (or Operating/Management) Agreement do not limit the limited partner s interests in the underlying partnership to such an extent that the annual exclusion could be lost. Specifically, the restrictions should provide either: a. A right of first refusal which gives the other partners the right to purchase the LP interests of any limited partner who wishes to transfer the interest, on specified advance notice of any proposed transfer; or b. A Crummey type withdrawal power, exercisable within a specified period of time after the partnership interest is transferred to the limited partner, within 9

10 which the partner could elect to withdraw assets from the partnership equal to the value of the partnership interest. J. Valuation issues on transfers involving partnerships. 1. Gift on formation. a. The IRS has asserted in a number of litigated cases that, by establishing a partnership in which the partnership interests received by the transferor in exchange for the assets contributed to the partnerships have a lower value than the underlying assets themselves, the transferor has made a taxable gift to the other partners to the extent of the valuation differential. b. This argument has been successful in circumstances in which the IRS has been able to establish that property was added to a partnership or other business entity, resulting in the augmentation of the interests of the other partners. See, e.g. J.C. Shepard v. Comm r, 115 T.C. 376 (2000), Aff d 283 F.3d 1258 (11th Cir. 2002); Kincaid v. U.S., 682 F.2d 1220 (5th Cir. 1982). c. However, where the transferred property is an LP interest in the partnership and the partnership is determined to be a valid legal entity under state law, no gift on formation can be argued and the taxpayer is entitled to value the gifts of interests at the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. Reg and (b), as quoted in Ina F. Knight v. Comm r 115 T.C. 506 (2000). d. In the recent case of Estate of Albert Strangi v. Commissioner, 115 T.C. 478 (2000), aff d in part and rev d and remanded in part, 89 AFTR 2d 2977, 293 F.3d 279 (CA-5, 2002), ( Strangi I ) the gift on formation argument was rejected by the Tax Court. In Strangi I, an FLP was created through a power of attorney through which Mr. Strangi, the transferor, contributed almost $10,000,000 of property (representing 98% of his assets) to the partnership; Mr. Strangi, who was advanced in years, died two months after the formation of the partnership. In exchange for his contribution, Mr. Strangi took back a 99% LP interest. A corporate general partner owned the remaining 1% interest in the FLP, of which Mr. Strangi owned 47% of the equity and his four children owned the rest (the four children subsequently transferred a 1% interest in the corporate general partner to a charitable foundation). The estate claimed a significant discount for the LP interests owned by Mr. Strangi s estate on Mr. Strangi s estate tax return. e. The Tax Court pointed out that Mr. Strangi had not given up control over the assets; his beneficial interest in the partnership exceeded 99% and his contribution was allocated to his own capital account. The Tax Court concluded 10

11 that Mr. Strangi had not transferred the value which was lost in the conveyance of his assets to the partnership. f. The underlying legal basis for the Tax Court s decision in Strangi I was as follows: i. Since the partnership was a valid partnership under state law, the transfer to the partnership was a bona-fide, arm s length transaction free from donative intent: 1. IRC 2512(b) provides that where property is transferred for less than an adequate and full consideration in money or money s worth, then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift. 2. Likewise, Treas. Reg provides as follows: Transfers reached by the gift tax are not confined to those only which, being without a valuable consideration, accord with the common law concept of gifts, but embrace as well sales, exchanges, and other dispositions of property for a consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money s worth of the consideration given therefore. However, a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm s length, and free from any donative intent), will be considered as made for an adequate and full consideration in money or money s worth. 3. Because a pro rata partnership is generally a bona fide arrangement, its creation should not be treated as a gift, even if a hypothetical willing buyer would not pay the same consideration to an original partner that the partner contributed to the partnership on formation. 4. The willing-buyer/willing-seller test applies in determining the value of the gift, not in determining whether a gift was made under 2512(b). ii. There was no increase in the net worth of the transferee. iii. 1. Just because there is a decline in the net worth of the transferor does not mean that the value shifted to another person. With the creation of a pro rata partnership, there is no shift in value to any of the other partners as a result of the transaction. 2. There is no such thing as a transfer to the partnership, as an entity, for purposes of determining whether there has been a gift; there can only be a gift to an individual donee, not an entity. The decline in value of the decedent s property resulted from the business decision to utilize a partnership for the ongoing management of this property. The Court noted that: Realistically, the disparity between the value of the 11

12 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. It does not reflect a taxable gift. K. Application of Chapter 14 of the Code to ignore the partnership agreement, or some of its terms, in valuing a gift of a partnership interest. Chapter 14 consists of four code sections designed to deal with estate tax freeze techniques which had become popular in the 1980s. However, since its enactment in 1990, the IRS has been largely unsuccessful in using Chapter 14 to combat the use and/or abuse of an FLP. The rules apply only to entities with junior and senior equity interests, which is not the case with a with respect to a partnership in which all of the partners have proportionate fractional interests (a pro-rata partnership). Estate of Church v. United States, 85 AFTR 2d 804 (2000): Held generally that a partnership created two days prior to the death of decedent should be recognized for estate tax purposes and that 2703 did not apply, as a matter of law, and factually. As a consequence, the government s arguments that (1) the term property as used in the federal estate tax law was to be applied to the underlying assets transferred to the partnership, rather than the partnership interests owned by the decedent s estate at the time of the decedent s death; and, in the alternative, (2) the restrictive terms of the partnership should be disregarded in valuing the partnership interest, were rejected. The estate tax is imposed on that which a decedent transfers at death without regard to the nature of the property interest before or after death Term restrictions, or those on the sale or assignment of a partnership interest that preclude partnership status for a buyer, are part and parcel of the property interest created by section Strangi I: In discussing the applicability of 2703, the court concluded, after making reference to Kerr v. Commissioner, 113 T.C. 449 (1999) (which dealt with a similar issue with respect to the interpretation of 2704), that Congress did not intend, by the enactment of section 2703, to treat partnership assets as if they were assets of the estate where the legal interest owned by the decedent at the time of death was a limited partnership or corporate interest. Section 2704 applies (and makes the transfer subject to gift or estate taxes) if a lapse occurs in the assignee s voting or liquidation rights. This is rarely a problem with FLPs because assignees of a general or limited partnership interest never have voting or liquidation rights. Consequently, unless there is an unusual provision in the partnership agreement, the transfer value of a general or limited partnership interest will be the same before and after death. In general, a lapse of a voting or liquidation right occurs when a presently exercisable right is restricted or eliminated as a result of the occurrence of an event (such as the death of the partner); however, there is no lapse when a controlling partner transfers away a minority interest that eliminates his control. 12

13 Section 2704 should not apply where a partnership has reconstitution or continuance provisions because the owners of the partnership interests have greater (or at least the same) liquidation rights after the lapse. In addition, Section 2704 should not apply when non-family owners of the partnership own enough interest to block liquidation efforts by the family owners. Kerr v. Commissioner, 113 T.C. 449 (1999): Court held that 2704(b) did not affect the valuation of limited partnership interests transferred by the taxpayers because the restrictions on liquidation in the partnership agreements at issue were not applicable restrictions under 2704(b). As defined therein, an applicable restriction is one which places a limitation on the ability to liquidate that is more restrictive than the default limitations under the applicable state law, and which restriction either lapses after the transfer or may be removed after the transfer by the transferor or any member of his or her family. L. Is the partnership a sham? 1. This is the substance over form argument. The IRS argues that there has been no change in the ownership of the underlying assets and that the partnership s existence should therefore be disregarded. a. In Reichardt v. Commissioner, 114 T.C. 144 (2000) the court agreed with the IRS that the form of the partnership had not in fact changed the substance of the ownership of the assets. Despite the formation of the partnership, Mr. Reichardt continued to manage the property in the same manner as he had before the partnership was established; he commingled the partnership funds with his personal funds, he made use of the personal residence that was now an asset of the partnership without payment of rent, and he was solely responsible for the operation of the partnership. 2. The courts may recognize the intent of the transferor in certain situations, as seen in Church. In Church there was no substance as the partnership papers had not yet been filed with the Secretary of State at the time of Mrs. Church s death. In addition, the LLC that was to be the corporate general partner had not yet been formed. Despite these shortcomings, the court held that, under Texas law, ownership of property intended to be partnership property is not determined by legal title, but rather by the intention of the parties. 3. The partnership should not be the alter ego of the initial donor. The transferor(s) should take all appropriate steps to formally establish the partnership and all related entities as required by the laws of the state in which the partnership is formed. a. Establish and maintain a separate partnership bank account use it only for partnership expenses, not personal; b. Partnership distributions should follow the terms of the partnership agreement (e.g., a pro rata partnership should only make pro rata distributions); 13

14 c. The partnership agreement should include language that obligates all partners with normal fiduciary duties; and d. The partnership agreement should be clear that there is an ascertainable standard for distributions based on a standard of reasonableness. M. Does an investment partnership lack substance? 1. As long as there is a valid business, investment or financial purpose for using a partnership form, it should not matter that a primary purpose (or benefit) is the reduction of estate tax liability. 2. Section 7701(a)(2) defines the term partnership to include a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on. Based on this code section, the IRS has recognized passive investment clubs. See Rev. Rul , C.B. 257 and Rev. Rul , C.B These are additional tax rules that apply to partnerships holding passive investment assets: a. Section 721: contributions of appreciated property to a partnership can result in recognition of capital gains by the contributing partner if the partnership is an investment company unless each partner s contributed stock portfolio is substantially diversified; b. Section 731(c)(3)(A)(iii): favorable tax treatment is accorded to distributions of marketable securities made to partners of investment partnerships; c. Treas. Reg (e)(3): special aggregation rule for securities partnerships; and d. Treas. Reg (a): unless a contrary election is made, an investment partnership will be treated as a partnership under subchapter K. N. Application of the step-transaction doctrine. 1. The step-transaction doctrine is a judicially developed concept which treats formally separate steps as a single transaction if such steps are in substance integrated, interdependent and focused toward a particular end result. 2 At bottom, it is a subset of the substance over form doctrine. 2. The step-transaction doctrine should not generally be applied in transfer tax cases; it is primarily an income tax doctrine. Nevertheless, even if it does apply, the case law indicates that as long as the first step in the transaction is not a sham and has independent significance, the steps cannot be collapsed. 2 Rev. Rul , C.B. 156, modified by Rev. Rul , C.B

15 3. The IRS argued for the application of the step-transaction doctrine in Strangi I. The three steps were: (1) creation of the partnership shortly before death, (2) transfer of the partnership interest at death, and (3) termination of the partnership at death. However, because the formation of the partnership was recognized under state law, the first step had independent significance, nullifying application of the steptransaction doctrine. O. Preservation of Valuation Discounts after Death of Founder 1. If the partnership will not continue after the death of the founding partner, the IRS may claim that the partnership should be ignored and the decedent s partnership interests valued at liquidation value (i.e., without discounts). 2. To achieve valuation discounts on LP interests of a deceased partner, the remaining partners must show an intention to continue, as well as the actual continuation of, the partnership s business/investment operations. This can be built into the partnership s structure by having the founding general partner place his GP interest into an entity such as an LLC or corporate general partner so that the partnership is not automatically dissolved upon the general partner s death. P. IRC 2036(a)(1). 1. IRC 2036(a)(1) causes the inclusion in the decedent s taxable estate of property which has been transferred, other than in a bona fide sale for adequate consideration, subject to a retained right of beneficial enjoyment. 2. The IRS has asserted that partnership assets should be included in the estate of the deceased transferor where it appears from all the facts and circumstances that there was an implied agreement that the transferor would continue to enjoy the economic benefit of the property transferred to the FLP. This argument has been accepted in several cases, including Estate of Albert Strangi, 85 T.C.M (T.C. 2003) ( Strangi II ); Estate of Thompson 84 T.C.M. 374, and Estate of Harper v. Comm r, 83 T.C.M The Tax Court concluded in these cases that, when a family partnership is only a vehicle for changing the form in which the decedent held his property a mere recycling of value the decedent s receipt of a partnership interest in exchange for his testamentary assets does not qualify as a bona fide sale for adequate and full consideration and thus the transferred assets are bought back into the transferor s estate at full market value with no discount for the fact that those assets were subject to the terms of a partnership agreement. Estate of Thompson. 4. In Kimbell v. U.S., 371 F.3d 257 (5th Cir. 2004), the U.S. Court of Appeals for the Fifth Circuit addressed the asserted application of 2036(a) to a transfer by the 96- year old Mrs. Kimbell to an FLP in which she owned a 99% LP interest and a 50% interest in an LLC which owned a 1% GP interest shortly before her death. Only 15% of the partnership assets were oil and gas interests. 15

16 In spite of the advanced age of the transferor, the Court of Appeals concluded that the transfers to the partnership and LLC were bona fide sales and not a disguised gift or sham transaction. The Appeals Court found that those were legitimate business reasons to have established the partnership, pointing to the need for active management of oil and gas interests. i. Adequacy of Consideration Although transactions between family members are subject to heightened scrutiny, such transactions are not automatically to be considered entered into for less than adequate consideration. The Appeals Court then noted that unrelated parties commonly exchange assets which are owned outright and are unrestricted for transfer restricted, non-managerial interests in a partnership in which there are financial considerations other than immediate financial gain at 100 cents on the dollar (such as management expertise, security, capital appreciation, and avoidance of personal liability). So the mere fact that the exchange involves a decline in value of the transferor s property does not prevent adequate consideration from having been exchanged. The Court of Appeals stated that the proper focus is on whether the interests credited to the partners are proportionate to the assets each partner contributed to the partnership; whether the assets so contributed were credited to the respective capital accounts of each partner; and whether on termination or dissolution, the partners were entitled to distributions from the partnership equal to their capital accounts. ii. Bona Fide Sale The Court of Appeals analyzed the record and determined that the decedent s transfer of assts to the partnership was a bona fide sale. The decedent had retained sufficient assets outside the partnership for her support, and there was no commingling of partnership and personal assets after the transfer. The partnership was established with proper formalities and the assets were placed in the name of the partnership. The assets included working oil and gas interests which required active management. There were a number of non-tax reasons for using the partnership, including protection from creditors claims, including environmental claims arising from the oil and gas interests; reducing administrative costs; and preserving the family s capital in a single pool which would be enhanced over time for the benefit of the decedents descendents. In spite of the de minimis contributions to the partnership by other parties, the Court concluded that a bona fide sale had occurred. The Court of Appeals ruled that 2036(a) was inapplicable to the decedent s partnership interests and remanded the case to the District Court for a determination of the proper value at which to include those interests in her estate for estate tax purposes. Q. IRC Section 2036(a)(2). IRC 2036(a)(2) requires the inclusion in the decedent s gross estate of all property which the decedent has transferred during his lifetime (except in the case of a bona fide 16

17 sale for adequate and full consideration) subject to the retention of the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom. As a general proposition, 2036(a)(2) precludes the retention by a transferor of rights which enable the transferor to control the management of and distributions from property after the transfer has occurred, for example, as trustee of a trust to which the property has been transferred. The retention of the powers as trustee does not preclude the completion of a taxable gift; however, the retention of trustee powers may result in estate tax inclusion of the trust assets, depending on the scope of the retained powers. In a number of estate tax cases and rulings, if the transferor s retained powers to control distributions was limited by a so-called ascertainable standard, the fiduciary duties requiring the transferor to exercise the powers only in accordance with the distribution standards (such as support in reasonable comfort, health, education, reasonable maintenance, etc.) have been considered sufficiently restrictive on the transferor s retained powers to preclude estate tax inclusion. See, e.g. Revenue Ruling , C.B. 407; Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947); Hurd v. Comm r, 160 F.2d 610 (1 st Cir. 1947); Estate of Walter E. Frew, 8 T.C (1947), acq C.B. 1. In United States v. Byrum the Supreme Court rejected the arguments of the IRS that Section 2036(a)(2) caused transferred assets (namely, stock in a business corporation transferred to an irrevocable trust as to which Mr. Byrum had retained the power to vote) to be included in the decedent s estate, holding that 2036(a)(2) should not be applied to the retained voting power even though that power gave Mr. Byrum some ability to affect the income received by the trust beneficiaries. (In fact, Mr. Byrum owned or controlled the vote on 71% of the corporate stock.) The Supreme Court held that the power to manage assets that may affect a transferee, including assets transferred to a trust, is not subject to 2036(a)(2), citing Reinecke v. Northern Trust Co., 278 U.S. 339 (1929), a case which predated the enactment of 2036, and Estate of King v. Commissioner, 37 T.C. 973 (1962). The IRS argued that Mr. Byrum had the power to use his majority position and influence over the corporate directors to regulate the flow of dividends [from the corporation] to the trust. However, [a] majority shareholder has a fiduciary duty not to misuse his power by promoting his personal interests at the expense of corporate interests. Moreover, the directors also have a fiduciary duty to promote the interests of the corporation. However great Mr. Byrum s influence may have been with the corporate directors, their responsibilities were to all stockholders and were enforceable according to legal standards entirely unrelated to the needs of the trust or to Mr. Byrum s desires with respect thereto. The Supreme Court also pointed out that Mr. Byrum had no real control over dividend distributions made to the trust because of the business and economic practicalities involved. So, in Byrum, the Supreme Court held that the rights 17

18 retained by Mr. Byrum do not amount to a retained right as contemplated by 2036(a)(2). 2. The same principles that applied to a corporate structure in Byrum should also apply to a partnership. However, in Strangi II, after remand from the Fifth Circuit, the Tax Court distinguished Byrum by finding that the management rights retained by Mr. Strangi exceeded the administrative powers in Byrum and that the management in Strangi did not owe fiduciary duties to the limited partners sufficient to avoid the application of the statute. a. In Strangi, the corporate general partner, 47% of which was owned by decedent, had the power to distribute the assets of the partnership in the sole and absolute discretion of the managing general partner. On remand, in Strangi II, Judge Cohen found that the decedent, in conjunction with other individuals, had the power to accumulate partnership income for the benefit of each partner, rather than disperse that income, which in turn constituted a right to designate under section 2036(a)(2). 3. Moreover, the fiduciary duties owed to the holders of the LP interests were illusory, since the decedent owned a 99% LP interest and thus the duties were owed to himself, rather than to third parties. 4. Drafting to avoid application of 2036(a)(2). a. Affirm normal partnership fiduciary duties in the agreement; b. Provide for arbitration for partner disagreements with management; c. Liability for management only to the extent the decision is outside the business judgment rule; d. English rule on costs of the arbitration; e. Partners must respect the terms and form of the partnership; f. Limit the distribution power of the managing partner to an ascertainable standard; and g. General partner should only make transfers that are for full and adequate consideration (perhaps using a defined value formula). R. Section 2036(b). In response to Byrum, Congress provided that the retention of the right to vote shares of closely held stock (whether directly or indirectly) will result in the inclusion of the transferred shares in the decedent s estate. This is potentially relevant where the transferor transfers closely held stock to the partnership. 18

19 S. Section The retention of the right to alter or amend a partnership agreement will cause inclusion of any transferred partnership interests in the estate of the transferor. Therefore, the partnership agreement should contain a provision that the partnership cannot be amended except by the unanimous consent of the partners. IV. Avoiding Income Tax Problems A. Only one level of tax for a partnership under the check the box regulations. B. Avoid being considered an investment company under 351 which would trigger gain on the contribution of appreciated property to the partnership (as opposed to the general nonrecognition treatment offered under 721(a)). The general intent of the rule is to prevent individuals who are not diversified from achieving a tax-free diversification simply by forming a partnership. When planning for an FLP, it is important to be aware of the diversification rules which may inadvertently trigger gain on the contribution of the various partners. As initially promulgated in letter rulings, and later in the regulations, there is no diversification problem if the assets contributed by each party: 1. Do not include as more than 25% of such assets the stock or securities of one issuer, and 2. Do not include as more than 50% of such assets the stock or securities of five or fewer issuers. The Regulations under 351 provide further that a transfer of stock and securities will not be treated as resulting in a diversification of the transferor s interests if each transferor transfers a diversified portfolio of stocks and securities [Reg (b)(6)(i)]. C. Be aware of potential gain or loss on the distribution of assets in kind to a partner. 1. Disguised sales under 707(a)(2)(B): Applies when a partner makes a contribution, either directly or indirectly, to the partnership and the partnership transfers money or other property to that partner or any other partner. The regulations provide the following rebuttable presumption for transfers occurring within a two-year period: If within a two-year period a partner transfers property to a partnership and the partnership transfers money or other consideration to the partner (without regard to the order of the transfers), the transfers are presumed to be a sale of the property to the partnership unless the facts and circumstances clearly establish that the transfers do not constitute a sale. Treas. Reg (c). Additionally, the regulations establish the converse of that presumption for transactions that are made more than two years apart; that is, such transactions are presumed not to be a sale unless otherwise indicated by the facts and circumstances. Treas. Reg (d). 19