Recent Developments In Family Limited Partnerships
Robert A. Briskin
Family limited partnerships (“FLPs”) are often used to reduce clients’ estate and gift taxes through valuation discounts. By combining FLPs with other estate planning techniques, such as grantor retained annuity trusts (known as GRATs) and defective income trusts, clients can reduce or even eliminate their transfer taxes. However, two 2007 Tax Court cases reiterate that to achieve their tax goals FLPs must be correctly formed and properly operated. 1
1. Are FLPs Respected by the Internal Revenue Service ? Yes, the IRS recently stated in its Appeals Settlement Guidelines that the IRS will respect FLPs.2 Limited partnership valuation discounts for minority interests and lack of marketability are well established by case law authority.3
2. What Types of Valuation Discounts Are Available for FLP Limited Partnership Interests ? Lack of marketability discounts are available because limited partnership interests are not readily saleable. Lack of control or minority discounts are available since a limited partner is not able to control the distribution, management, investments or liquidation of the FLP. Finally, additional valuation discounts can be obtained for fractional tenancy-in-common interests in real property contributed to the FLP and for subsidiary limited partnership interests owned by the FLP.4
3. Can Solely Liquid Assets Such as Stocks and Bonds Be Contributed to a FLP ? Yes. The IRS in its Appeals Settlement Guidelines acknowledges that solely passive securities can be held in a FLP, but such partnerships will be more closely scrutinized. Additionally, case law authority supports the fact that a FLP can own solely passive securities.5
4. How Far Prior to a Client’s Death Should the FLP Be Formed ? Preferably the FLP should be formed and funded well before the client’s date of death and have an operating history. Otherwise, the IRS is likely to challenge the FLP as a “deathbed partnership formation” and allege that the FLP is simply a substitute for a testamentary transfer.6
5. Should the Clients Give up FLP Management Control ? This is a controversial area with those clients who desire to retain control over the FLP’s assets and operations. The IRS was successful in arguing in Estate of Albert Strangi that control over the general partner was a prohibited retained section 2036(a)(2) power. Therefore, preferably the client’s children, or a trust for those children’s benefit, should be the FLP general partner or should control the FLP general partner. Where the client is the FLP general partner, the FLP’s partnership agreement should at a minimum preserve the general partner’s state law imposed fiduciary duties in order to assist in defending against an IRS section 2036 “control” argument.7
6. Can the FLP Be Liquidated after the Last Parent’s Death ? It is helpful if the FLP continues to be operated after the client’s death since this evidences a lack of liquidity of the FLP’s limited partnership interests, which in turn supports greater valuation discounts.
7. What Are Some Guidelines to Structure and Operate FLPs in Order to Protect Against the IRS’s Application of Section 2036 ? Most recent successful IRS attacks on FLPs have been under section 2036, alleging that the deceased partner retained a prohibited interest in the FLP. Below are several guideposts to protect the FLP against such IRS attacks:
a. Clients Should Not Retain the Economic Benefits of the Assets Contributed to the FLP . The recent Estate of Hilde E. Erickson case restates the rule that clients should not utilize the FLP’s assets for their personal expenses.
b. The FLP Should Make Timely Annual Distributions to the FLP Partners in Proportion to Those Partners’ Percentage Interests as Stated in the Partnership Agreement .
c. Do Not Commingle the FLP’s Assets with the Partners’ Personal Assets .
d. Do Not Have the Client’s Personal Residence Owned in the FLP . Having the FLP own the client’s personal residence allows the IRS to argue that the client improperly retained the “enjoyment” of that residence, thereby including the FLP’s assets in the client’s estate under section 2036(a)(1).8
e. Preferably, Do Not Allow the FLP to Directly Pay the Client’s Estate Expenses or Estate Taxes at Death .
f. The Client Should Have Enough Liquid Assets Outside of the FLP to Pay That Client’s Living Expenses . Having enough liquid assets outside of the FLP to pay the client’s living expenses for the remainder of the client’s life prevents the IRS from arguing that the client has impliedly retained the economic benefits of the FLP. In Estate of Hilde E. Erickson, the Tax Court applied section 2036 in part because substantially all of the client’s assets were transferred to the FLP.
g. Avoid Loans by the Partnership to the FLP Partners . However, if loans are made by the FLP, then: (i) those loans’ principal and interest should be paid to the FLP on a regular payment schedule; (ii) the loans should be evidenced by written promissory notes signed at the time that the loan is made; and (iii) the loans should bear adequate interest.
h. Legally Title the Assets in the FLP’s Name and Properly Maintain and Show Those Assets on the FLP’s Financial Statements . In the recent Tax Court case of Estate of Sylvia Gore the FLP failed to hold title to the assets, and thus section 2036 applied to include the FLP’s assets in the decedent’s taxable estate.
i. Have the FLP Maintain Separate Checkbooks and Separate Brokerage Accounts in the FLP’s Name .
1 See the Tax Court decisions of Estate of Hilde E. Erickson, T.C. Memo 2007-107; and Estate of Sylvia Gore, T.C. Memo 2007-169.
2 See IRS Appeals Settlement Guidelines on Family Limited Partnerships and Family Limited Liability Corporations, dated October 18, 2006, released in redacted form, at BNA, Inc., Tax Core on January 31, 2007.
3 See, for example, the case of Webster E. Kelley, T.C. Memo 2005-235, where the Tax Court found a 12% minority discount and a 23% lack of marketability discount for a FLP consisting of cash equivalent assets and certificates of deposit.
4 See the case of Roy Martin Jr., T.C. Memo 1985-424, for an example of layered multiple valuation discounts in the corporate area.
5 See for example Webster E. Kelley, supra.
6 See Estate of Albert Strangi, T.C. Memo 2003-145, aff’d 417 F.3rd 468 (5th Cir. 2005); and Estate of Hilde E. Erickson, supra.
7 See the U.S. Supreme Court case of Marian A. Byrum, 408 U.S. 125 (1972) where the Court held that the fiduciary duties owed by the decedent, as the controlling shareholder, trumped the fact that the decedent retained voting rights in the transferred stock. The Supreme Court in Byrum held that section 2036 did not apply because the decedent had a fiduciary duty to not misuse the decedent’s powers by promoting the decedent’s personal interests at the expense of corporation’s interests.
8 See Estate of Charles E. Reichardt, 114 T.C. 144 (2000), where the decedent continued to live rent-free in his personal residence which he transferred to the FLP.