The Family Limited Partnership:

Transcription

1 The Family Limited Partnership: Forming, Funding, and Defending John F. Ramsbacher John W. Prokey Erin M. Wilms FLPs refuse to die. You can increase their longevity with careful planning. THE FAMILY LIMITED PARTNERSHIP (and Limited Liability Company) (FLP) is the basic building block of estate plans for both tax reasons and nontax reasons. Even in light of recent court developments, the FLP continues to be a controversial estate planning technique. If an FLP is part of an estate plan, it is imperative the estate planner focus not only on the formation and structure of the FLP, but also on running the FLP on a day-to-day basis. NONTAX REASONS Taxpayers are free to structure transactions as they please, and even a tax avoidance purpose is acceptable. Gregory v. Helvering, 293 U.S. 465 (1935). Tax avoidance, however, should not be the only motivation for John F. Ramsbacher, a partner of Ramsbacher Prokey LLP, is an Adjunct Faculty member at Golden Gate University Masters in Taxation program. He has also lectured extensively on various estate planning topics. He is a member of the Executive Committee of the Taxation Section of the State Bar of California and the Past-Chair of the Estate and Gift Tax Committee of that Section, as well as a Fellow of the American College of Trust and Estate Counsel (ACTEC). John W. Prokey and Erin M. Wilms are attorneys in Ramsbacher Prokey LLP. This article is adapted and updated from a paper Mr. Ramsbacher prepared for an August 2003 presentation sponsored by the ABA Real Property, Probate and Trust Law Section. 29

2 30 The Practical Tax Lawyer Summer 2004 setting up an FLP. See Kimbell v. United States, 244 F. Supp. 2d 700 (N. D. Tex. 2003), vacated, 2004 U.S. App. LEXIS 9911 (5th Cir. May 20, 2004). Some of the nontax reasons for using an FLP include: Continued control over the management of the assets; Asset protection from future claimants; Consolidation of fractional interests in family assets; Consolidation or maintenance of a significant stock holding in a public company; An efficient and economic framework to manage like assets; Amechanism for dispute resolution among family members; Protection of assets from failed marriages; Protection of the family assets from outsiders; and Promotion of family knowledge of assets and a mechanism for asset management. TAX REASONS Of course, the biggest tax reason, in the estate planning context, for using FLPs is the valuation adjustments that can be achieved through their use. Range Of Downward Valuation Adjustments Combined (applied sequentially) downward valuation adjustments for lack of marketability and lack of control of FLP interests can vary from five percent to in excess of 50 percent. The level of discount turns on several factors such as asset make-up, amount and frequency of distributions, size of equity interest valued, and other such issues. Recent Tax Court cases further illustrate the importance of operating the FLP properly. See the cases discussed below. Role Of The Appraiser In valuation planning the attorney must work closely with the appraiser. Their joint goal is to provide credible, reliable, and relevant conclusions of value supported by a detailed appraisal report meeting applicable criteria and standards. When should the business valuation appraiser become involved, assuming there is a substantial transfer tax value case? If filing the transfer tax return (Forms 709 or 706) is the beginning of the tax dispute process, then the appraiser, at least as a consulting expert, can be of great assistance to the client and his other advisers early on including during the valuation discount/entity plan design and documentation. Various Tax Court opinions show the wide range of transfer tax valuation issues and possibilities. Appraisers, usually due to ineptness of tax counsel or the proclivities of the Tax Court judge, often have fared rather poorly in Tax Court. For a recent example of the Tax Court throwing out the taxpayer s appraisal, see Knight v. Commissioner, 115 T.C. 506 (2000). Several especially important points should be kept in mind by the practitioner: The written valuation report must contain all data and reasoning supporting the appraiser s estimate(s) of value if he or she expects the Tax Court to give the report substantive weight. This is due to the Federal Rules of Evidence, Tax Court Rules, and the Standing Pretrial Order of the Tax Court. Post-transfer date (gift or estate) events, facts, and circumstances are relevant, in the Tax Court Judge s discretion, under the minimal logical relevancy standard of the Federal Rules of Evidence. The appraiser is entitled to, and must demand from the client and other advisers, all the facts, good news, and bad news. Once known, such information cannot be ignored. Especially in the FLP interest valuation area, recognize that there are disputes of a sort even among appraisers, i.e. as to the relevance, appropriateness, and weight of certain data.

3 Family Limited Partnership 31 Look for new opportunities for service review appraisal, comparison of prior IRS and taxpayer reports, participation in mediation, and Tax Court Rule 124 (voluntary binding arbitration). FORMALITIES OF FORMATION AND FUNDING Make sure all the proverbial i s are dotted and t s are crossed. In Estate of Strangi v. Commissioner (Strangi I), 115 T.C. 478 (2000), the Tax Court found, among other things, that the FLP had sufficient substance to be recognized for tax purposes. In reaching this finding, the court noted that the FLP was validly formed under state law and that all formalities were followed. Thus, when forming the FLP make sure all state requirements are met and make sure you actually have a partnership when assets are transferred to the FLP. See also Shepherd v. Commissioner, 115 T.C. 376 (2000), aff d, 283 F.3d 1258 (11th Cir. 2002). Investment Company Rules The investment company rules are an issue when two or more individuals are forming an FLP which holds marketable securities. Generally speaking, when partners transfer property to a partnership in exchange for partnership interests, no gain or loss is recognized. 721(a). (All section references are to the Internal Revenue Code of 1986, as amended, unless otherwise specified.) There is an exception to this nonrecognition rule, however, for a transfer of property to a partnership which would be treated as an investment company under section 351 were it instead formed as a corporation. 721(b). Therefore, if an FLP is an investment company within the meaning of section 351, the funding of the partnership will trigger all built-in gain of partnership assets. Section 351(e)(1) provides the framework for the determination of whether an entity is an investment company. An entity is deemed to be an investment company when, after the funding of the entity, (i) the transfer results, directly or indirectly, in diversification of the transferors interests, and (ii) the transferee...is a corporation [partnership] more than 80 percent of the value of whose assets (excluding cash and nonconvertible debt obligations from consideration) are held for investment and are readily marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts. Treas. Reg (c)(1). Diversification occurs if two or more persons transfer nonidentical assets to a corporation in the exchange. Treas. Reg (c)(5). It is extremely rare that two individuals forming an FLP will hold identical securities. Diversification will therefore usually occur. There are exceptions, however, to the diversification rule to be found in the Regulations. First, there is a de minimis exception. Second, if the transfer meets either the 25 percent or 50 percent tests of section 368, the stock portfolio is considered diversified, and the exception to the nonrecognition rule under section 721(b) is avoided. Treas. Reg (c)(5). The 25 percent and 50 percent rules of section 368 provide that if not more than 25% of the value of its total assets is invested in the stock and securities of any one issuer, and not more than 50% of the value of its total assets is invested in the stock and securities of 5 or fewer issuers, the tests are met. 368(a)(2)(F)(ii). Note, however, that government securities are included in total assets for purposes of the denominator, but are not treated as securities of an issuer for purposes of the numerator of the 25 percent and 50 percent tests. Treas. Reg (c)(6). Cash is excluded when determining total assets. 368(a)(2)(F)(iv). Therefore, if the portfolio is sufficiently diversified by meeting the 25 percent or 50 percent test, there will be no gain upon funding of the FLP. Note that the investment company rules generally will not be an issue for a hus-

4 32 The Practical Tax Lawyer Summer 2004 band and wife forming an FLP since the marketable securities are generally community property. If, however, an FLP is being formed between a QTIP and the survivor s trust, or by a parent and children, the investment company rules should always be considered. Prop 13 And California Property Tax Real property owned by clients in California may be subject to very low assessed values for real property taxes as a result of Proposition 13. But transfers of the property may in some circumstances cause an undesirable (upward) reassessment. When forming an FLP with real property in California or similar jurisdictions with low assessed values for real estate, be aware of these issues, and plan properly so as to avoid property tax reassessment. General Principles Generally speaking, real property will be reassessed and therefore subject to a higher real property tax basis upon a change in ownership. Cal. Rev. & Tax. Code 60 (2004). There are special rules relating to the formation of business entities and subsequent transfers of interests in business entities that make an analysis of property tax issues critical for clients entering into FLPs and whether their actions will trigger a change in ownership. Formation Of FLP Section 62 of the Cal. Rev. & Tax. Code states the general rule that a transfer that changes the method of holding title but not the identity of the holder and the proportion of title held does not trigger change of ownership. Therefore, if two co-tenants who own a piece of property transfer the property to an FLP and their proportional ownership in the FLP is the same as it was in the property in co-tenancy, there is no change of ownership for real property tax purposes. To illustrate: John and Judy each own an undivided 50 percent interest in Blackacre. John and Judy form an FLP, and transfer Blackacre to the FLP. In exchange for this capital contribution, John receives a one percent interest as a general partner, and a 49 percent interest as a limited partner. Judy as well receives a one percent interest as a general partner, and a 49 percent interest as a limited partner. Because the proportion of title did not change, there is no property tax reassessment. Transfers of FLP Interests Section 64(a) of the Cal. Rev. & Tax. Code provides the general rule that transfer of interests in an entity do not trigger a change in ownership. Section 64(c) provides an exception to this general rule, however, and provides that when a person or legal entity obtains direct or indirect control over more than 50 percent of the total interests in a partnership capital and profits, there is a change of ownership and the property is reassessed. The 50 percent rule is cumulative, and the change in control does not have to occur in one transaction. Further, section 64(d) provides that when interests cumulatively representing more than 50 percent ownership are transferred by any of the original co-owners, a change in ownership will occur. Therefore, if partners cumulatively transfer over time more than 50 percent of an FLP, any of the underlying real estate which was transferred into the partnership subject to an exclusion from reassessment will be reassessed for real property tax purposes. Reassessment Avoidance On Formation To avoid property tax reassessment upon formation of the FLP, the partners must have the same proportional interest of ownership in the partnership that they had as co-owners in the real estate. For a husband and wife who own the real estate as community property, this is not an issue they owned 50 percent interests

5 Family Limited Partnership 33 in the property, and they will own 50 percent interests in the partnership. For a husband and wife who want to immediately make gifts of partnership interests to their children, however, and want to take advantage of the $1 million parent-child exclusion from property tax reassessment provided for in section 63.1 of the Cal. Rev. and Tax. Code, they can structure the formation of the partnership differently. Under California law, partners can hold title to partnership property in their names as cotenants. Assume Husband and Wife own Whiteacre, and wish to form an FLP to hold the property. Assume further that Husband and Wife have two children, and want to gift 10 percent limited partnership interests to each child immediately upon formation of the partnership. Husband, Wife, Child 1, and Child 2 all sign the Family Limited Partnership Agreement, with a statement in the agreement that partnership property may be owned in co-tenancy. Whiteacre is listed on the schedule of property. The partnership agreement states that all property listed on the schedule is a partnership asset, and the owners shall contribute the listed properties as their capital contributions to the partnership. After the Family Limited Partnership Agreement is signed, Husband and Wife deed 10 percent interests in Whiteacre to each child. Husband, Wife, Child 1, and Child 2 then deed Whiteacre into Family Limited Partnership. The legislative history under section 63.1 states that the step transaction doctrine will be ignored if the steps are followed exactly. Because the real property owners own the same percentage in Whiteacre as they do in the partnership, there has been no change of ownership and the property will not be reassessed. Additionally, for valuation purposes, 10 percent limited partnership interests have been transferred to Child 1 and Child 2, since the deeds transferring the 10 percent co-tenancy interests were signed by Husband and Wife subject to the partnership agreement. Reassessment Avoidance With Gifts Generally speaking, partners should avoid making cumulative transfers of more than 50 percent of the FLP and avoid shifting more than 50 percent of the interests in the FLP to one person (a change in control). The facts of each FLP case will vary, and thus should be carefully reviewed for these issues. RECENT CASE LAW AFFECTING FLPS The Service thus far has been unsuccessful in obtaining relief from Congress in the FLP/LLC area, and also was rebuffed by Congress in 1994 when Treasury sought to include the transfer tax, and especially FLPs, etc., in its partnership anti-abuse Regulations (Treas. Reg ). Therefore, beginning in 1997, rulings by the Service (FSAs, TAMs) developed the multiple attacks on FLP/LLC plans that are well-known to practitioners and have been drilled into IRS Estate Tax Attorneys ( ETAs or examiners ). Illustrative of these rulings are the following: TAM (FLP), FSA (LLC), and FSA ( S corporation). However, the Service recognized such rulings did not have the desired effect of broadly discouraging FLP/LLC plans that generally are perceived by the IRS to be a threat to the integrity of the transfer tax. So in recent years, with mixed success, the IRS has sought to identify and pursue appropriate cases via litigation. What are the attack arguments, how effective have they been, and, most importantly, how do we as estate planners properly and fully advise our clients so they can make prudent judgments and give informed consent to proposed entity and transactional planning that results, at least in part, in substantial valuation adjustments or discounts? The cases demonstrate that once the FLP is properly formed under state law, the attorney and CPA still need to be involved to make sure that the family is treating the FLP as the distinct