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FAMILY LIMITED PARTNERSHIPS Practice Tips To Deal with Recent Developments By Thomas J. Murphy Murphy Law Firm, Inc. P O Box 51244 Ahwatukee Station Phoenix, AZ 85076 480-838-4838
Presented to the Phoenix Tax Workshop September 20, 2003
FAMILY LIMITED PARTNERSHIPS AFTER STRANGI By Thomas J. Murphy September 20, 2003
The big news – IRC 2036 is where all the action will be taking place. The IRS seems to have finally given up on some of its creative – and lame – theories, such as gift on formation or the 2703 look-only-to-the-underlying-assets arguments. Instead, the IRS has followed the promptings of the Tax Court in the Strangi I and Thompson cases by applying the retained use or control theory of 2036(a)(1) & (2). Likewise, expect the IRS to emphasize the “implied agreement” concept that the Tax Court has been very receptive to in cases such as Harper – this will be an easy way for the IRS to maneuver around the burden of proof set forth in IRC 7491.
Three points to keep in mind:
#1. Bad facts make bad law. In the ten years or so that the case law has been developing in this area, the IRS has never – not once – challenged an FLP that was properly formed and maintained. Every reported case or TAM has involved FLPs with serious defects that made for an inviting target.
#2. It is better to FLP’ed and lost than to never have FLP’ed at all. Within the past two years, highly placed IRS officials have publicly stated that they will likely concede a discount in the range of 25% to 35%. But this may change in light of the Strangi, McCord and Kimbell cases. My colleagues throughout the country continue to receive settlements in excess of this although no word since Strangi.
#3. A very divided Tax Court. Strangi is “only” a memorandum decision, very unusual for a case that blazes new ground and creates such attention. The Shepherd case (115 TC 30 (2000) and the recent McCord case each generated five opinions in the Tax Court’s decisions. In McCord, the trial judge had the case taken away from him and was relegated to a dissenting opinion. Reliable sources tell me that, last month, Judge Laro emphasized this divisiveness at an estate planning conference.
IRC sec. 2036(a) “The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent…has retained for his life…(1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or income therefrom”. See also Reg. 20.2036-1.
The Do’s and Don’ts of FLPs
Do not commingle partnership assets. Make sure all bank and brokerage accounts are titled in the name of the FLP. And do not use the FLP account to pay for personal expenses. This includes post-mortem expenses – funeral, estate taxes, costs of administration, etc.
Respect the entity and play by the rules. File the 1065 each year. Make sure the partners are paying taxes on the K-1 income. File annual reports with the Secretary of State (FLPs) or Corporation Commission (LLCs). Hold annual meetings and keep minutes. Make sure the capital accounts are accurate and continually adjusted to reflect gifting or additional contributions.
Pro-rata distributions. Easier said than done but extremely helpful. A huge weapon is taken out of the IRS’s hands if this is followed. Loans to partners are perfectly OK but make sure there are signed notes with, if possible, some collateral. In view of the recent Hackl decision, some commentators suggest creating a Crummey-type withdrawal right so that any gifted interests will qualify as a present interest and therefore a completed gift.
Do not transfer all major assets into the FLP. Never transfer the house. If a vacation property is transferred, make sure reasonable rent is paid. Make sure there is a separate checking account with sufficient funds and income to pay for foreseeable living expenses. Otherwise, the IRS will take the position that there is an implied agreement among the partners that the FLP will pay for these personal expenses and argue for inclusion in the decedent’s estate.
Use a qualified valuation expert and be consistent. Avoid, at all costs, an expert using outdated data and studies or who overlooks or minimizes factors that would impact valuation. At a minimum, the expert should be using the surveys in the most recent May/June edition of Partnership Spectrum (www.PartnershipProfiles.com). Make sure the expert fully understands and discusses the default provisions of the applicable statutes and the impact that this will have for 2704 purposes. Make sure, at the outset, that the expert is willing to testify to defend his/her positions. Make sure that the valuations are consistent – the gift tax returns should jibe with the estate tax return and there should be no significant change in valuation after that point. The Tax Court makes no secret that it is very skeptical of these guys – see, most recently, Hess v. Commissioner, TC Memo 2003-251, and Estate of Deputy, TC Memo 2003-176 where taxpayers still made out quite well, and Estate of Leichter, TC Memo 2003-66, where the estate got creamed.
Always emphasize the fiduciary duties of the general partner. A key battleground in the 2036 fight. In the partnership agreement, be very hesitant to lessen any statutory duty that the GP may owe to the other partners. Be familiar with United States v. Byrum, 408 US 125 (1972) and Rev Rul 81-15. Be particularly diligent if using an LLC since the Arizona LLC statutes are silent as to fiduciary duties as between members.
Be careful with removal powers. When drafting the partnership agreement, try to structure the agreement so that the parents do not, by themselves, have a large enough percentage interest to remove the GP. Or, if this cannot initially be done, then keep this in mind when gifting LP interests so that, over time, the children will have a large enough combined share to preclude the GP’s removal without their consent.
Emphasize the non-tax reasons for the FLP’s existence. In my opinion, the creditor protection afforded under ARS 29-341 & -655 alone is sufficient. Bramblett v. Commissioner, 960 F2d 526 (5th Cir, 1992). I am amazed that very few taxpayers have made an issue of this in the reported cases. There are many other reasons – 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.
If at all possible, avoid deathbed planning. IRS considers “deathbed” to mean formation of FLP within six months of death. But do not overlook the cause of death – even if terminal was the onset of death much sooner than expected? And concede the obvious – there is nothing wrong with having tax savings as a primary motivating force.
Consider bringing in third parties as partners. Gift a small percentage interest to charities. Use an irrevocable trust as a limited partner to hold the children’s interest and have a private or corporate fiduciary as trustee. This makes it harder to the IRS to claim that all partners/family members are acting in collusion or as part of an implied agreement. Very helpful on the Byrum issue.
Consider having children contribute for their LP interests. The children then have more of a monetary stake in the entity and make it harder for the IRS to claim that Dad as GP could do whatever he pleased. A large enough contribution may also bring it within the “bona fide sale” safe harbor of IRC 2036(a).
Do-It-Yourselfers are asking for trouble. The Tax Court in Strangi and Thompson are very wary of the “Family Fortress” kits being sold to the semi-sophisticated who tried to form and maintain FLPs on their own. And the Court has repeatedly emphasized the importance of observing the formalities, often overlooked or ignored by the DIYers.
Might it be easier to simply to do an outright gift? Especially for property expected to greatly appreciate
The Cases:
Estate of Strangi (aka Strangi II), TCM 2003-145 (2003). Decedent had 99% LP interest and a 47% interest in corporate GP with a charity holding a 1% interest. Dangerous language that equates the management rights of a GP with the 2036(a) retained interest. Distinguishes Byrum. Finds implied agreement among family members. Appeal seems likely.
Estate of McCord, 120 TC 13 (2003). It doesn’t get much more complicated than this case that had it all – formula clauses, two classes of LP interests, assignees, charities, call rights, allocation by LPs of gifts, contingent obligations on LPs to pay estate taxes and so on. Still, McCord did fairly well – 10 to 15% minority discount depending on the type of asset and a 20% marketability discount. Has been appealed to the 5th Circuit
Estate of Kimbell, 244 F Supp 2d 700 (DC, Texas, 2003). Partnership agreement permitted removal of GP with approval of 70% of LPs. Agreement eliminated GP’s fiduciary duties. GP had a 1% interest owned by an LLC that was, in turn, owned 50% by decedent’s revocable trust and with decedent’s two children each owning 25%. Since the decedent owned 99% LP interest, decedent could remove GP at any time. Key point in the case, overlooked by many – if decedent had named himself as GP, there would have been no other partners to whom a fiduciary duty was owed. District Court rules that is enough for inclusion under 2036. Holds (incorrectly) that Byrum was overruled by the enactment of 2036(b).
Estate of Thompson, TCM 2002-246 (2002). Tax Court includes the FLP by finding that parents had continued use and enjoyment of property. It strongly suggests that the IRS look into “the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property”, as set forth in IRC 2036(a)(2).
Estate of Harper, TCM 2002-121. Tax Court includes the FLP in decedent’s estate by finding an implied agreement. The record “shows a consistent pattern of acting in response to particular needs of decedent or his estate”. |