FAMILY LIMITED PARTNERSHIPS

Presented to the Phoenix Tax Workshop

February 5, 2002

By Thomas J. Murphy

Murphy Law Firm, Inc.

P O Box 51244

Ahwatukee Station

Phoenix, AZ 85076

480-838-4838

tom@murphylawaz.com

PART I --Three reasons to create an FLP:

#1. Asset protection

Creditor is limited to charging order

#2. Retention of control

Person creating FLP controls management of assets within the FLP.

#3. Discounted interests

#1. Asset protection.

A charging order is the “exclusive remedy” available to the creditor of a partner. ARS 29-341 (See ARS 29-655 for similar provision for LLCs.) A charging order is obtained by a judgment creditor (ie, the creditor must have first sued the partner and prevailed). It, in essence, states that any distributions from the FLP must be directed to the creditor and not the partner. But, the creditor has no management rights so he cannot force a distribution from the FLP to the debtor/partner nor can he reach the assets held within the FLP. ARS 29-227 & -1043.

Furthermore, a charging order has some very detrimental tax consequences since a creditor holding a charging order is treated as an assignee of the debtor/partner, thereby attributing taxable income to the creditor despite the fact that the creditor never received an actual distribution from the FLP. This “phantom income” concept is based on Rev. Rul. 77-137 and Evans v. Commissioner, 447 F2d 547 (7^th Cir., 1971). One commentator has referred to this as “getting KO’d by the K-1”.

#2. Retained control.

Occasionally, parents are reluctant to part with property. Either they fear that they will impoverish themselves or they don’t trust the child or child’s spouse. By gifting limited partnership interests, FLPs are a marvelous tool to gift to the child while the parents, as the general partner, retain control over the assets. But, as discussed later, this control must be exercised in a manner that will not run afoul of IRC sec. 2036.

Still, the FLP can be a very useful tool by limiting the outlay of cash to a child. It is less likely to diminish the child’s initiative or productivity. It may eliminate the need for a child to present to a spouse a distasteful pre- or post-nuptial agreement. The potential commingling of separate assets such a bank or brokerage account during marriage is eliminated. And never overlook the fact that a properly structured FLP can avoid probate proceedings due to a partner’s death or incapacity.

#3. Discounted valuations of FLP interests.

This is where all the action is taking place in the courts and will be the focus of this presentation. Discounts, based on the lack of marketability and minority interest, can be usually be obtained in the range of 25% to 40% or higher.

PART II – FLP or LLC?

For most legal, non-tax purposes (ie, governance, creditor protection, etc), there is no longer a significant difference between partnerships and limited liability companies. This is particularly so given the enactment of ARS 29-1101 et seq that permits the creation of limited liability limited partnerships that shield all partners, including general partners, from personal liability.

However, there remains a very significant distinction between them for purposes of discount valuation because it is easier to liquidate and dissolve an LLC, which translates into a smaller discount for membership interests in an LLC.

As subsequently discussed in more detail, the name of the game in discounting is determining how difficult it is for a partner/member to get a distribution from the FLP/LLC. Usually, this entails analyzing the applicable statutes governing the liquidation and dissolution rights of a partner/member.

In Arizona, there is a significant difference in these statutes. A partnership will require unanimous consent for dissolution. ARS 29-344. (This has been called the “Hotel California” problem – “you can check out any time you like but you can never leave”.) By contrast, an LLC only requires the consent of one-half of the members who collectively must hold liquidation rights to more than one-half of the value of the LLC’s assets. ARS 29-781. As an example, assume there are three equal (ie, 33%) members in an LLC. A vote by two of the three members can dissolve the LLC. But a partnership would require all three partners to consent.

It can be easy to obtain an administrative dissolution with an LLC. Among the grounds for an administrative dissolution are: 1) failure to make required amendments to the articles of organization, 2) failure to make required publications, 3) no statutory agent or registered office for a period of 60 days and 4) failure to notify the corporation commission of a change is statutory agent or registered office within 60 days of the change. ARS 29-786. Partnerships have no corresponding statute.

As for distributions, a majority of the LLC members can require a distribution. ARS 29-681. With a partnership, there is no right to a distribution until winding up. ARS 29-331 & -334.

For these reasons and in this setting, an FLP (or, more precisely, an FLLP) is the better choice.

PART III – The IRS arguments against discounting FLP interests and the court’s generally unfavorable view of those arguments.

A review of the recent FLP cases is largely an exercise in learning from the mistakes of other taxpayers. The IRS has been very careful in which cases have ended up in court. Nearly all of them have had bad facts for the taxpayer yet the results have overall been favorable to the taxpayer.

This is also an area that is still in flux. Several of the leading cases are either on appeal (Kerr, Shepherd, Strangi) or have been remanded to the trial court who have yet to act (Morrissey, Mitchell, Simplot, Jameson). Two more important cases have been tried before the Tax Court but no decision has yet been rendered (Estate of Thompson, a Philadelphia case, and Estate of Harper, a Los Angeles case).

And the courts deciding these cases are very divided. The Shepherd case (115 TC 30 (2000)) generated five opinions in the Tax Court’s decision. The federal circuits are split -- the 5th and 9^th circuits are reliably pro-taxpayer in their FLP cases but it is anything goes in other circuits.

For a summary of the various theories put forth by the IRS, see FSA 200049003

IRS argument #1 – IRC 2703 & lack of economic substance

The first contention of the IRS will be that no discount of any amount should be allowed. This is, in essence, a “sham transaction” or “lack of economic substance” argument. In other words, the IRS alleges that creating the FLP is simply rank tax avoidance and that there is no other reason for the formation of the FLP.

The IRS will zero in on three factors: a) marketable securities that make up virtually all of the FLP assets, b) an incapacitated parent who formed the FLP or an agent acting under a power of attorney and c) a deathbed formation, defined by the IRS as death within 6 months of formation.

The IRS dresses up this argument under the guise of IRC sec. 2703. That section states, in part, that “the value of any property shall be determined without regard to ….any restriction on the right to sell or use the property”. Subparagraph (b) of sec 2703 provides a safe harbor exception, stating that the restrictions can be considered if a) it is a “bona fide business arrangement”, b) it is not a device to transfer property to family members for less than full and adequate consideration and c) the terms are comparable to an arm’s-length transaction.

The good news is that the IRS has been soundly defeated in applying sec 2703 in that context. See Kerr and Knight. The IRS’s position has been that the FLP agreement is a restriction on the right to sell and use the assets held within the FLP. In other words, it is as if the FLP did not exist and that “the property” for purposes of sec 2703 is the underlying assets.

The courts have not agreed. As long as the FLP was properly formed and maintained under the applicable state law, it must be recognized. “The property” is the limited partnership interest and not the assets owned by the FLP. The courts have pointed out that the creation of the FLP agreement does change the legal relationships of the parties. For instance, there are now fiduciary obligations among the partners that would not have existed without the FLP agreement.

The IRS is also not succeeding with the “lack of economic substance” approach, as put forth in the seminal case of Gregory V. Helvering, 293 US 465 (1935) and which has been successfully used by the IRS in cases such as ACM Partnership v. Commissioner, 157 F3d 231 (3^rd Cir., 1998) . Yet, for FLPs, the courts have made short shrift of this approach, claiming that this is a concept recognized in income tax law but not in estate or other transfer tax matter.

A related IRS approach is the “piercing the corporate veil” argument. The IRS prevailed – and deservedly so – using this approach in the Reichart and Schauerhammer cases. Even though the FLP was validly formed, it was not properly maintained. Mr Reichart had deeded his home into the FLP and then lived rent-free in the home. He also used the FLP’s bank account to pay many of his personal obligations. In Schauerhammer, there was no partnership checking account and all partnership income went to the parents. In short, the FLP was not treated as a separate entity and the Tax Court had no problem in disregarding the FLP for valuation purposes.

Cases:

Estate of Dailey, TC Memo 2001-263

Estate of Strangi, 115 TC 478 (2000 – on appeal)

Estate of Knight, 115 TC 506 (2000)

Estate of Church, unpublished 5^th Cir opinion, decided 7-18-01

Estate of Trotter, TC Memo 2001-250

Estate of Reichart, 114 TC 9 (2000)

Estate of Schauerhammer, TC Memo 1997-242

IRS argument #2 – IRC 2704(b)

Anyone advising on FLPs must be intimately familiar with the workings of IRC sec 2704. It is of paramount importance in determining a discount.

The concept is rather simple but the confusing terminology makes this concept more difficult to understand than need be. In the viewpoint of the IRS, the taxpayer has taken a viable asset and has deflated the value of that asset through means of an onerous FLP agreement that greatly restricts the rights of the partners. While the IRS cannot stop anyone from entering into such a partnership, the IRS maintains that it should not be bound by unreasonable or unrealistic restrictions imposed by the FLP agreement.

So what are reasonable and realistic restrictions that deserve to be considered? According to IRC sec 2704(b), it is the applicable state law that would govern the partnership if there was no FLP agreement in the first place. In other words, lets pretend that no written FLP agreement ever existed – what restrictions would state law place on the partners? This is the key concept of sec 2704(b) – any terms that are more restrictive than state law will be disregarded.

It would be nice if the IRS called these “disregarded restrictions”. But that would be too simple. Instead, they are called “applicable restrictions”. Not “inapplicable” restrictions but “applicable” restrictions. The reasoning for this is that these are restrictions to which sec 2704 will apply which means that they will be disregarded.

Simply put, when one hears the term “applicable” restriction, think “disregarded” restriction.

So, again, the upshot of sec 2704(b) is that any terms of the FLP agreement pertaining to liquidation that are stricter than state law will be disregarded. This means that the appraiser must first look to state law rather than the terms of the FLP agreement.

But neither the appraiser nor the attorney advising the partnership can ignore the terms of the FLP agreement because, in this scenario, the IRS gets to have it both ways. As just stated, the IRS can disregard the stricter terms. Yet, on the other hand, the IRS can consider any terms that are more lenient than state law. This can be a trap for the unwary and it happened in the Jones case.

For instance, it has already been pointed out that, under Arizona law, unanimous consent by the partners is required to voluntarily dissolve a partnership. But the partnership agreement could provide that, say, only a majority of the partners need consent to dissolution. The IRS will want to use a majority consent, rather than a unanimous one, since that makes it easier to dissolve the partnership. And the easier it is to dissolve, the easier it is for a partner to get his or her money which will result in a smaller discount. This oversight needs to be avoided at all costs.

This sort of problem occurred in the Jones case. A son had been gifted an 83% limited partnership interest. The problem was that, under the FLP agreement, a general partner could be removed by a member or members holding a 75% partnership interest. (It was unclear in the opinion as to what percentage was required to remove under applicable Texas law but it appeared to more than 75%.) If the general partner was removed and never replaced, the partnership would dissolve under state law. This ability to remove and replace the general partner could ultimately constitute control of the FLP or lead to its liquidation after dissolution. As a result, the Jones court held that there was no minority discount.

The crux of all of this is that, for valuation purposes, state law and not the partnership agreement controls. I do not recommend having more onerous or stricter terms in a partnership agreement unless there are good reasons to do so. The reason for this is that if the terms of the agreement are too restrictive, some commentators are concerned that the IRS could claim that no present interest has been gifted so that there is no completed gift. The IRS will have a hard time making this argument if the partnership agreement corresponds to state law.

There is a comical aspect to the 2704 approach. The IRS got hoisted on its own petard. At the impetus of the local tax bars, many state legislatures including Arizona changed their state partnership laws so that, in many instances, the state laws became stricter what would customarily be in partnership agreements. This turned the sec 2704 argument on its head. Since the laws were stricter, fewer terms in the FLP agreement could be ignored for valuation purposes.

There is no question that the courts will allow the IRS to use the sec 2704 “applicable restrictions” approach. The fight is usually over what is or is not required under the applicable state law and comparing that to the FLP agreement.

Also be mindful of IRC sec 2704(a) (rather than (b)) that deals with lapsed voting and liquidation rights. The applicability of 2704(a) can be avoided by simply not allowing any partner to unilaterally exercise liquidation rights.

Cases:

Jones v. Commissioner, 116 TC 121 (2001)

Estate of Strangi, supra

Estate of Knight, supra

Estate of Harper, TC Memo 2000-202

Kerr v. Commissioner, 113 TC 449 (1999 – on appeal)

IRS argument #3 – IRC sec 2036 and implied agreements

This is the newest weapon in the IRS arsenal. This argument will be made much more frequently and forcefully than in the past due to some unfortunate and unnecessary comments by Judge Cohen of the Tax Court in the Strangi case.

Sec 2036 provides that all property transferred by a decedent in which the decedent retained possession, enjoyment or control will be includable in the decedent’s gross estate. Simply put, if you maintain all the control and receive all the income, then the IRS will treat the entire entity as yours. The question is -- has anything really changed? If the decedent is the general partner, the IRS will maintain that the decedent’s control of the FLP’s assets is sufficient to trigger inclusion under sec. 2036.

In Strangi, the IRS was not allowed to make a sec 2036 argument because it waited too long in the pre-trial process before raising the issue so that issue was never before the court. Nonetheless, Judge Cohen felt obliged to make some gratuitous comments to the effect that the IRS would have likely prevailed in Strangi if it had been allowed to raise the sec 2036 argument. The IRS has made it clear in its public pronouncements that it intends to vigorously pursue this approach. See, most recently, FSA 200143004, issued July 5, 2001. (This FSA is also important since it seems to indicate that the Service will finally give up on its “gift on formation” argument, which the courts have recently been uniformly rejecting.)

But this argument is not without its limits. First, while the IRS successfully used this argument in Reichart and Schauerhammer, those cases centered on the commingling and personal use of FLP assets. The IRS has never prevailed nor is likely to prevail in cases where the formalities of the FLP are respected.

Secondly, the courts have never addressed, in a sec 2036 setting, the existence of fiduciary duties that a general partner owes to the limited partners. These duties and obligations loomed large in Kerr and Strangi but those cases dealt with the sec 2703 and lack of economic substance issues. The importance of those duties would seem to be equally compelling to preclude a successful sec 2036 argument by the Service.

The Church case touched on this but not quite in these terms. In ruling that there was no sec 2036 inclusion, the District Court stressed Ms Church’s limitations as a partner precluded her from doing as she pleased with the ranch land that was owned by the FLP. Note that the District Court’s decision was upheld in July 2001 by the Fifth Circuit in a terse three paragraph, unpublished opinion.

In this regard, Stacy Eastland, the prominent Houston attorney, notes that this IRS argument flies in the face of the United States Supreme Court’s decision in United States v. Byrum, 408 US 125 (1972) holding that a trust settlor’s retention of broad management powers did not make the trust’s assets includible in the deceased settlor’s gross estate since the settlor, who had retained nearly all of the voting rights, had fiduciary duties to minority shareholders. See also TAM 9131006 and Rev Rul 81-15.

This needs to be addressed in the partnership agreement which should state some sort of standard or limitation on the GP’s discretion in administering the FLP. Make it clear – no unfettered discretion.

While a taxpayer victory, Strangi contained some ominous language about “implied agreements” among family members.

This was followed in October, 2001 with the Trotter case in which the Tax Court found an implied agreement among family members existed. In Trotter, the decedent created an irrevocable trust and deeded her residence into the trust. Ms Trotter continued to occupy the residence, paid all expenses and never paid any rent. Bad facts for the taxpayer and the timing of the opinion is even worse since this will only serve to encourage the IRS to use this argument.

PART IV -- BURDEN OF PROOF

One issue that is looming increasingly large over all of this is the new IRC sec 7491 which shifts the burden of proof to the IRS once the taxpayer “introduces credible evidence with respect to any factual issue”. But before this occurs, a taxpayer must have substantiation for the items in question and must have “cooperated with all reasonable requests by the Secretary for witnesses, information, documents, meetings and interviews”. It is not entirely clear what constitutes “cooperation” but the House Conference report states that a taxpayer “is not required to agree to extend the statute of limitations to be considered to have fully cooperated”.

The new statute may be the driving force behind the infamous FLP questionnaire that requests privileged information and asks for items like seminar materials that the attorney or advisor have used in public presentations. The concern id that the refusal – an entirely proper one – to provide all this information may be used by the IRS to constitute insufficient cooperation for the taxpayer to avail themselves of the new statute.

This new rule is in effect for all “examinations” commencing after July 22, 1998. Note that the term “examination” is not defined but that the Conference Agreement indicates that the term is not limited to audits.

This change in the burden of proof will likely have its biggest impact on valuation disputes. The Dailey case is an excellent example that was decided in favor of the taxpayer due to the burden having shifted to the IRS. It will also loom large when the IRS is alleging – and now having to prove – the lack of any non-tax motives by the taxpayer in establishing an FLP as well as the existence of implied agreements. In fact, the Trotter court seemed to suggest that the result (ie existence of the implied agreement) might have been different had the new sec 7491 been applicable.

For a recent Tax Court case (tried here in Phoenix) applying sec 7491 where the taxpayer failed to present credible evidence of certain deductions for income tax purposes, see Higbee v. Commissioner, 116 TC 28, decided June 6, 2001.

It has been my experience as a trial attorney that the side that has the burden of proof usually loses. One need look no further than the recent 9^th Circuit trilogy of Morrissey, Simplot and Mitchell where all three cases were reversed because the Tax Court had improperly failed to place the burden of proof on the IRS. Note that all three were valuation cases (and that Arizona is in the 9^th Circuit).

Cases:

Estate of Dailey, TC Memo 2001-263

Morrissey v. Comm. 243 F3d 1145 (9^th Cir, 2001)

Estate of Simplot, 249 F3d 1191 (9^th Cir, 2001)

Estate of Mitchell, 250 F3d 696 (9^th Cir, 2001)

Estate of Trotter, TC Memo 2001-250

PART V: LESSONS TO BE LEARNED

#1. Make sure you have valid non-tax reasons for creating an FLP. The creditor protection reason alone should be sufficient , Bramblett v. Commissioner, 960 F2d 526 (5^th Cir, 1992). There are many others – the need to avoid gifting cash that can lead to spoiled children or broken marriages, the ability to keep the property within the family, the need to avoid fractionalizing interests in real estate and other property and obtaining economies of scale through the consolidation of assets.

#2. Set forth these reasons in the partnership agreement so that you are creating a record for any subsequent IRS attack. This is particularly important if the parents are elderly or in ill health who may be dead or incapacitated when the audit occurs.

#3. Be careful what you put into the FLP. Leave out dangerous assets that could subject the FLP to liability. (For such assets, consider forming an LLC with the FLP owning the membership interest in the LLC.) Leave the residence out – this is a red flag to the IRS as we have seen in Reichart and Trotter. It makes it more difficult to claim a profit motive with a home as a significant asset. If you must deed in the residence, then it is imperative that rent at the prevailing rate be paid to the FLP.

#4. Don’t use the FLP as your personal checking account. Commingling of assets is a time honored IRS (and creditor) tactic to ignore the existence of an FLP. Distribute funds from the FLP for appropriate purposes (see #5 below) into the parents’ personal checking account and have the check written out of that account.

#5. Watch out for non-pro-rata distributions. Another red flag. If you are going to do so, treat it as a loan (with proper documentation and collateral) or as a management fee (with a W-2 generated)

#6. Document, document, document. Remember, your primary witnesses may be deceased or incapacitated when the auditor comes knocking. Consider recording certain transfers, especially gifting, so there is no question when it occurred. This prevents IRS from claiming documents were backdated. This could also be useful to contradict any assertions of implied agreements. Loans need to be in writing with reasonable amortization schedules and collateral. The essential point – it’s not over until it’s over. Even if you correctly create the entity, you must respect the FLP by properly maintaining the entity.

#7. Be cognizant of IRC 2704 and avoid the Jones mistake of making it easier to liquidate or force a distribution than state law would normally allow.

#8. Get a first rate appraisal. A few suggestions:

Make sure the appraiser is using current data and not 10 year old studies. The annual May/June edition of Partnership Spectrum (1-800-634-4614, $160.00 annually), while not favored by the IRS, is a good place to start.

Avoid simply applying a discount from a study to your case. Always explain in depth why the facts in your case are similar those in the study.

Watch out for a change in the appraiser’s discount – consistency throughout the course of litigation is key. The Tax Court has had great fun lambasting appraisers who have changed their discounts when it suits their purpose.

Make sure assumptions are consistent. For instance, don’t assume an orderly sale for purposes of NAV methodology while using a forced sale approach to justify lack of marketability.

Try to minimize inconsistent values over a period of time. Avoid the Jameson situation where two 706s done a year apart with large differences in the share price with a family agreement two years later with a third share price.

If you are appraising a controlling interest, don’t be using restricted or pre-IPO stock sales since these involve minority interests.

Be careful if you are factoring in a potential capital gain. It won’t be allowed if an IRC 754 election is available. And be on solid ground as to when you expect the gain will be realized since the longer it takes for a sale to occur, the smaller the discount will be because of the time value of money with the tax not being paid until later.

Don’t rely too heavily on buy-sell agreements – you need to have a valid formula that can be periodically reviewed and revised,

And always remember that you are using hypothetical buyers and hypothetical sellers and not the actual parties –this is particularly important if there is a swing vote issue.

If possible, avoid deathbed formations. The IRS will consider “deathbed” as formation within 6 months of death.

For some recent cases in the valuation area, see Adams v. Commissioner, 218 F3d 383 (5^th Cir, 2000) and Estate of True, TC Memo 2001-167.