October 23, 2003

Family Limited Partnerships as Estate Planning Vehicles: All Vehicles Should Be Driven Defensively

Holland & Knight Newsletter
William R. Lane Jr.

“Defensive drivers” exhibit behaviors that enhance their safety: scanning the road, gripping the steering wheel at 10 and 2 (o’clock) and anticipating the actions of other drivers. In a number of recent cases, the IRS has challenged the estate and gift tax benefits offered by family limited partnerships (FLPs).  In each of these cases, family members failed to respect the integrity of the entity and drove a perfectly good estate planning vehicle into a ditch.  A review of these cases provides a number of defensive driving techniques to increase the chances that your FLP will stay safely on the road.   

Recently, the IRS has attacked FLPs by challenging valuation discounts claimed by taxpayers for lack of marketability and lack of control and by seeking to invalidate the FLP altogether for federal transfer tax purposes. While the former situation is a “pothole,” the latter is a “car wreck.”

Challenges to Valuation Discounts –Kicking the Tires

Valuation discounts result from the fact that the fair market value of an interest in a FLP is worth less than a corresponding share of the fair market value of its underlying assets.  For instance, assume that a FLP owns assets valued at $10 million.  A limited partner with a one-percent interest in the FLP might perceive that she owns one percent of the underlying assets with a net asset value of $100,000.  If that limited partner transfers her one-percent interest to another party in a transaction subject to federal gift or estate taxes, its fair market value is determined based upon the price that a hypothetical buyer would pay to a hypothetical seller. 

Most FLPs restrict the liquidation and distribution rights of their limited partners and, therefore, a hypothetical buyer of the partnership interest is not likely to pay an amount equal to the net asset value of the partnership interest. In addition, unlike the owner of publicly traded securities, an owner of an interest in a FLP does not have an established market to facilitate the sale of these
privately held property interests and thus a partner wishing to sell her partnership interest could not count on immediate liquidity. Both of these factors make it appropriate to discount the underlying assets of the FLP when valuing a partner’s interest. To complete the foregoing example, if the fair market value of the one-percent partnership interest (having a net asset value of $100,000) is found to be $60,000, it can be said that the “discount” applied to the partnership interest is 40 percent.

In the absence of recent sales, the best available evidence of the fair market value of a FLP partnership interest is the expert opinion of a qualified business appraiser.  The IRS is most successful in challenging the valuation of FLP interests when the taxpayer has no objective basis for the value he reported on a gift or estate tax return or where the taxpayer hired an appraiser who failed to provide sufficient information and objective analysis to persuade the court that his opinion on the FLP’s value is more accurate than that reached by the appraiser retained by the IRS.  A recent decision illustrates this point very well.

In Peracchio (2003), the taxpayer offered the testimony of two expert witnesses in support of discounts he claimed on gift tax returns for transfers of FLP interests. The taxpayer’s experts testified that discounts of 35 to 40 percent for lack of marketability and five to 7.7 percent for lack of control were appropriate measures. Meanwhile, the expert for the IRS arrived at discounts of 15 percent for lack of marketability and 4.4 percent for lack of control. While the Court found deficiencies with the analysis offered by all three experts, the Court ultimately split the difference and sustained discounts of 25 percent for lack of marketability and six percent for lack of control.

In the final analysis, it comes down to a battle of appraisers, and the defensive driver who anticipates IRS challenge will take care to hire the best appraiser he can find.

Challenges to Validity of FLP – Pull Over Buddy

In a number of recent cases where the courts have allowed the IRS to completely ignore the existence of the FLP for federal transfer tax purposes,  the creator of the partnership or members of her family failed to respect the partnership as an entity separate and apart from the family members who own it.  

In Strangi ‘III’ (2003), the Tax Court held that the FLP should be ignored for transfer tax purposes, largely because the family did not manage it as a legitimate independent entity.  The Court found an implied agreement between Mr. Strangi and his family that he could retain the right to the income from the assets contributed by him to the partnership because he transferred virtually all of his assets to the partnership and had retained virtually no assets for his own support.  His residence was among the assets contributed to the FLP and he paid no rent to the partnership for his use of the property. Furthermore, the partnership paid Mr. Strangi’s personal living expenses. 

In Kimbell (2003), the U.S. District Court for the Northern District of Texas found that Mrs. Kimbell had retained the enjoyment of the property transferred to the FLP because she had retained sufficient voting interests to replace the general partner of the partnership with herself or anyone else of her choosing.  Together with the unlimited discretion granted to the general partner to make distributions, this meant that Mrs. Kimbell had either retained the power to personally benefit from the income of the partnership or to designate the persons who would benefit from the partnership.  Enabling the court’s decision in Kimbell was a provision of the partnership agreement that the general partner did not owe any fiduciary duties to the other partners. 

In Harper (2002), the Tax Court found that the partnership had a history of making disproportionate distributions in favor of Mr. Harper and to the detriment of his children, ignoring their respective partnership interests. In addition, FLP assets were commingled with Mr. Harper’s personal assets.

In Thompson (2002), the Tax Court found an implied agreement between Mr. Thompson and his family that he could continue to use and enjoy the assets contributed to the partnership by reference to the distributions of partnership assets made to him to facilitate his prior history of annual cash gifts to the family.  Also, funds from the partnership were used directly to pay his personal expenses. 

In Reichardt (2000), the Tax Court allowed the IRS to ignore the FLP where the senior partner of the FLP had transferred virtually all of his property, including his residence, to the FLP, for which he paid no rent.  Additionally, partnership income was deposited directly into his personal accounts, and the partnership checking account was used as one of his personal accounts.

In Schauerhamer (1997), the Tax Court allowed the IRS to ignore the partnership where the partnership’s income was deposited not into its bank accounts, but directly into Mrs. Schauerhamer’s personal accounts.  Checks were written from those personal accounts to pay both personal and partnership expenses. 

Read the Operator’s Manual

As demonstrated by these recent decisions, the IRS is likely to succeed in its efforts to invalidate a FLP for transfer tax purposes where the family failed to properly operate the partnership.  The IRS will examine FLP books and records, bank statements and documents conveying property into the FLP in exchange for partnership interests in an effort to challenge its validity. It will review distributions to assure that distributions from the partnership were made in accordance with the partnership agreement.  Thus, the second important defensive driving technique for your FLP is to operate the vehicle in accordance with the operator’s manual.   

Ask for Directions

IRS agents around the country cite these recent cases as evidence that valuation discounts should be reduced to a nominal amount or that FLPs should be ignored altogether for transfer tax purposes.  In the absence of a court decision clearly intended to have much broader application than any such holding to date, nothing could be further from the truth. However, these cases do reinforce the importance of getting good directions prior to departure with your FLP and periodically checking to see that you remain on course. The following checklist may serve as a reference:

  • Follow all formalities in forming and operating the FLP.
  • The FLP should maintain its own checking account and maintain good books and records.
  • The creator of the FLP should retain sufficient assets to pay for living expenses.
  • If the creator transfers his personal residence to the FLP and continues to occupy the residence, he should pay fair market rent in a timely manner.
  • Partnership distributions should be made on a pro-rata basis.
  • Partnership distributions should not be keyed to the needs of the creator or his estate.
  • The FLP should be formed well in advance of the creator’s death.
  • The FLP should have a bona fide, non-tax business purpose.
  • Each family member should contribute sufficient assets in exchange for an interest in the FLP where the interest is being purchased and not gifted.

Many tax practitioners are troubled by the apparent breadth of the recent holdings in the Strangi ‘III’ and Kimbell decisions, which are being appealed.  These decisions are uniformly viewed by practitioners as the latest examples of IRS success in dealing with FLPs that were poorly operated.  Some practitioners view these decisions as an ill wind for all FLPs, but it may be too early to reach that conclusion.  It is important to monitor these cases as they progress through the appeals courts to see if their rationales will be more broadly applied providing a permanent roadblock to the transfer tax benefits afforded by FLPs.

Arrive Alive

In summary, defensive driving of the FLP can be practiced by obtaining a qualified, well-reasoned and objective valuation report when an interfamily transfer of FLP interests takes place.  It is also essential that the entity be respected and operated in accordance with the terms of the partnership agreement. Finally, for federal estate tax purposes, it may be prudent to have the senior family member cede control of the partnership (either as general partner or as the controlling owner of an entity that is the general partner) before death, while assuring that the remaining FLP interests held are not sufficient to allow the senior family member to participate in the power to remove and replace the general partner at the time of death.  Some practitioners argue that all partnership interests should be divested, but that seems overly cautious. 

Nevertheless, those families where the senior members are prepared to deal with a real change in their relationship to their assets, and in fact do so, are driving defensively.  Those families who treat the FLP as merely a recycling or repackaging of assets, may be on their way to a head-on collision with the IRS.  On the other hand, those who drive their FLP defensively should arrive at their destination safe and financially sound.

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