Beware of FLP traps.

Think the answer to a client's needs is a family limited partnership? Fine, but be aware that the IRS may be on the warpath, challenging entity formation, business purpose, income allocations, distributions and estate tax valuation. This article explains the IRS attacks in these areas and offers planning guidance.

Recently, the IRS has taken a dim view of using family limited partnerships (FLPs) for tax avoidance, especially in death-bed planning situations.(1) In addition, the Treasury has promulgated anti-abuse regulations in the partnership area that give the IRS additional authority to scrutinize FLPs. When these government initiatives are combined with relatively long-standing tax law restrictions, a host of tax traps arise.

FLPs have become a popular business planning strategy for tax advisers, due to the available income and estate tax savings. FLPs have been used to shift income and property appreciation to younger family members, thereby minimizing both income and estate taxes. With maximum individual income tax rates nearing 40% and estate tax rates as high as 55% (with a 5% surtax on estates over $10 million), an enormous amount of tax can potentially be saved by using a FLP.

In addition to tax savings, FLPs provide several nontax benefits. Often, a wealthy taxpayer who owns all (or substantially all) of a family business wants to keep its assets in the family. Such a taxpayer usually wants to control the business, but transfer a portion of it to a spouse and/or children. A partnership can be used to restrict the transfer of interests in the business to ensure continued management by the family. Moreover, the taxpayer typically wants a business form that limits individual liability and protects business assets from creditors of individual partners. Although the Revised Uniform Limited Partnership Act (RULPA) provides that a creditor can obtain a court order charging a limited partner's interest for unsatisfied claims, such a creditor can obtain only the rights of an assignee.(2) The assignee will be subject to tax on the partner's allocable share of partnership income, even if no partnership distributions are made.(3)

This article focuses on these traps and offers guidance in the areas of FLP formation, business purpose, income allocation, current distributions and estate tax valuation.

Formation

Forming a partnership can be relatively simple or extremely complex, depending on the property contributed, the parties involved and the provisions (e.g., income allocations) included in the partnership agreement. Typically, a partnership agreement consistent with the Revised Uniform Partnership Act or RULPA adopted by the resident state of the partnership is drafted; such an agreement identifies the partners' rights, duties and responsibilities.

A FLP is typically comprised of (1) a general partner (a corporation or limited liability company owned by an older taxpayer) and (2) limited partners (the older taxpayer and perhaps, a spouse and/or children).

Example: F, age 58, owns a working ranch that generates $500,000 in annual income and is worth $6,000,000. F and his wife, W, have two sons and a daughter. After exemptions and deductions, F's and W's joint income tax liability is $160,000. If F forms a FLP and gifts limited partnership interests to his three children (thereby allocating to them a portion of the ranch's income), considerable income tax savings may be realized. In addition, on F's and W's deaths, the appreciation in the limited partnership interests held by the children would escape estate tax.

Although F's plan of forming a limited partnership should work, there are some traps to consider.

Gift vs. Purchase of a Partnership Interest

The method of acquiring a partnership interest is important, especially when family members are involved. In gift or bargain purchase situations involving family members, there is a risk that the transfer will not be recognized for income tax purposes, or that no partnership will be deemed to exist.

If the partnership is one in which capital (as opposed to services) is a material income-producing factor, Sec. 704(e)(1) provides that an individual is a partner as long as he actually owns a capital interest, regardless of whether the transfer was by gift or purchase. Thus, the method (gift vs. purchase) of acquiring a partnership interest is irrelevant for family members under Sec. 704(e). Prior to enactment of that provision, the validity of a partnership interest was determined by judicial doctrines, such as assignment-of-income and business purpose.

For example, in Culbertson,(4) the taxpayer had operated a cattle partnership; his partner wanted to dissolve the partnership because of ill health. All but 1,500 head of cattle were sold. The taxpayer wanted to keep these cattle and approached his partner about buying his share. The partner agreed, but only if the taxpayer would sell an undivided one-half interest to his four sons at the same price. The partner wanted to maintain a particular cattle strain and felt that the taxpayer was too old to carry on the business alone. The taxpayer's sons provided him with a promissory note and a partnership was created.

Parties' intent: The IRS argued that no partnership had been formed, because the taxpayer's sons did not contribute original capital or services for their partnership interests. The Tax Court had agreed with the IRS, but the Fifth Circuit had reversed, holding that a family partnership created with no intention of tax avoidance should be recognized for tax purposes, regardless of whether it was intended that some of the partners contribute either capital or services during the tax year. The Supreme Court, reversing and remanding, stated that the question is whether the parties acted in good faith and with a business purpose to join together in the present conduct of the enterprise.

If Sec. 704(e) does not apply (i.e., capital is not a material income-producing factor), the principles established in Culbertson still apply. However, as can be seen from that case, such principles are more subjective than Sec. 704(e). Determining whether a partner actually owns a capital interest under Sec. 704(e) is also somewhat subjective.

Retained control: A key element in determining whether a partnership interest has been transferred is whether the transferor has retained control of the interest, Regs. Sec. 1.704-1(e) (2) (ii) identifies four controls. First, the transferor cannot retain unreasonable control over the distribution of partnership income, other than income retained in the partnership for business reasons. Second, the transferor cannot limit the donee's right to liquidate or sell his partnership interest at his discretion without financial detriment. Third, the transferor cannot retain control of assets essential to partnership operations. Finally, the transferor cannot retain management powers that would ordinarily be transferred with the partnership interest.

In Reynolds,(5) the Tax Court held that a partnership's gain from the sale of mineral rights was income to the taxpayer, because he had retained substantial dominion and control over his coal mining business even though his wife, child and two trusts were partners. The taxpayer managed every aspect of the mining business; he solicited all the contacts in the coal fields and made all the selling and financing arrangements before the other partners signed documents. The other partners were allocated substantial amounts of partnership income, even though they had no business experience and did not contribute to the production of partnership income.

The granting of management powers to a transferee (e.g., a child) is often a concern in family partnerships. Regs. Sec. 1.704-1(e)(2)(iv) provides that the transferee's substantial participation in the control and management of the partnership business is strong evidence that he has the requisite control. However, in a limited partnership, a limited partner cannot participate in day-today management decisions or the setting of business policy on substantially the same basis as the general partner without becoming liable for partnership debt as a general partner(6); thus, the control problem should be minimal in FLPs. Limited partners can be granted the right to vote on partnership policies that directly affect management powers; their rights to do so should not be restricted.

Principal partner as trustee: A limited partnership interest can be transferred to minor children; however, such interests must generally be held in trust. A trap exists if the trustee is the taxpayer (e.g., the father), because the trustee will be treated as a partner under Regs. Sec. 1.704-1(e)(2)(vii). Thus, the transferor will not be viewed as having relinquished control of the partnership interest. As the regulation indicates, the trustee should be a party independent and unrelated to the transferor who functions as a true third-party partner.(7)

Capital as a Material Income-Producing Factor

Because Sec. 704(e) applies only if capital is a material income-producing factor, the types of property used to form a FLP are important. Regs. Sec. 1.704-1(e)(1)(iv) notes that capital is not a material income-producing factor for partnerships deriving most of their gross income from fees, commissions or other compensation for personal services performed by the partnership's members or employees. In contrast, capital is generally a material income-producing factor for partnerships maintaining substantial inventories or investment in plant, machinery or other equipment.

Case law provides some guidance on the type of property considered a material income-producing factor. In Woodbury,(8) the Tax Court concluded that capital was a material income-producing factor for a ranching partnership to which ranch land, farm machinery and cattle had been contributed, even though the partners `contributed substantial services to the partnership's operation.

Capital was also held to be a material income-producing factor in Cirelli,(9) in which a partnership was formed by the taxpayer's five children. The partnership leased equipment and a yacht to a construction contractor that was a C corporation. However, due to the absolute control that the taxpayer exercised over every aspect of the partnership, the IRS held it was a sham under either Sec. 704(e) or Culbertson.

In Ketter,(10) the taxpayer operated an accounting practice as a sole proprietorship. He established eight trusts; his children and college alma mater were the beneficiaries. The trusts were funded with work-in-progress of his accounting practice and employee employment contracts. The trusts formed a partnership funded by those assets; they hired the taxpayer as the manager and all accounting work was performed at his direction. The IRS disregarded the partnership for tax purposes, stating that capital was not a material income-producing factor; thus, all income from accounting services was the taxpayer's.

Beyond See. 704(e): The type of property held by the partnership is also important for estate tax valuation purposes. A limited partnership interest in a partnership holding property may be of less value than a similar interest in the property itself due to, for example, marketability and minority discounts. However, a limited partnership created merely to hold assets to obtain discounts will likely be challenged by the IRS.(11)

In addition to estate tax provisions, the partnership anti-abuse regulations must be considered. Regs. Sec. 1.701-2(a) requires a partnership to be bona fide and each partnership transaction be entered into for a substantial business purpose.

Regardless of the type of assets involved, a key element in determining partnership validity is the business purpose for transferring assets to it.

Business Purpose

The importance of a business purpose in forming a FLP cannot be overemphasized. Regs. Sec. 301.7701-1(a) (2) provides that the carrying on of a trade, business, financial operation or venture and the agreement to divide the profits therefrom, distinguishes a partnership from a mere co-ownership of property. As was discussed, Sec. 704(e) only applies when the transferee partner actually owns the partnership interest; this requirement presumes that a valid partnership exists. Without a valid business purpose for the partnership, neither Sec. 704(e) nor the facts-and-circumstances test established in Culbertson can apply. The thrust of Culbertson is whether the individuals in good faith joined together as partners for a business purpose to conduct business.

In addition to Sec. 704(e) and the Culbertson test, Regs. Sec. 1.701-2(a) requires a business purpose. Kegs. Sec. 1.701-2(b) allows the IRS to recast a partnership formation transaction if the entity was formed for the principal purpose of substantially reducing the present value of the partners' Federal tax liability. Under Kegs. Sec. 1.7012(a)(1)-(3):

1. The partnership must be bona fide and its transactions must possess a substantial business purpose.

2. The form of each partnership transaction must be respected under substance-over-form doctrine.

3. Subject to exceptions, the partnership operations and transactions between the partnership and partners must reflect the partners' economic agreement and clearly reflect income.

If the IRS seeks to recast a partnership formation transaction, Regs. Sec. 1.701-2(b) provides several alternatives:

1. The purported partnership can be disregarded in whole or in part in determining the tax effects of the transaction.

2. One or more of the purported partners can be treated as a non-partner.

3. The methods of accounting used by the partnership or a partner can be adjusted to clearly reflect the partnership's or partners' income.

4. The partnership's items of income, gain, loss, deduction or credit can be reallocated.

5. The intended tax treatment could be adjusted or modified.

These regulations arm the IRS with substantial authority to disregard the partnership form if the business purpose of a transaction is in question. The IRS does not have to rely on its own rulings or case law to challenge a partnership's existence if it perceives business purpose is lacking.

Definition

Given the importance of business purpose, taxpayers may ask what qualifies as a business purpose for tax purposes. Although a precise definition does not exist, case law provides some guidance.

In Duhon,(12) the Tax Court disregarded a partnership purportedly established to own and operate an oil-drilling rig, due to a lack of business purpose. According to the taxpayer, a general partnership had been formed to provide key employees of a related corporation with a source of additional income and an opportunity to obtain ownership interests in different aspects of the oil and gas industry. The only capital was $1,000, contributed by the related corporation. The partnership was disregarded because the related corporation undertook all operational responsibilities and liabilities associated with ownership of the rig and the partnership's drilling activities, no partner had invested capital in the partnership and no risks were associated with the partners' investment in the partnership.

Timing

Often, the timing of transfers to a partnership can create traps. In Letter Ruling (TAM) 9723009,(13) the IRS disregarded a partnership for purposes of estate tax valuation. Less than two months before the decedent's death, she had created a FLP and transferred all her assets to it. The decedent's resulting 98% limited partnership interest and stock in a corporation that owned a 1% general partnership interest were transferred to her inter vivos trust. At her death, the trust interests were distributed to her son, and a 46% valuation discount was taken for estate tax purposes. The IRS disregarded the partnership and the discount.

Substantiating a business purpose in a FLP may prove difficult. In applying Sec. 2703(b)(1), under which the value of property for estate tax purposes is determined by disregarding certain rights and restrictions, the IRS uses an arm's-length crhteria in determining whether a bona fide business arrangement exists. If it exists, that right or restriction must be respected; however, proving an arm's-length transaction in a family setting can be difficult.

Some courts have given FLPs latitude in defining business purpose. In Est. of Lauder,(14) the Tax Court held that a desire to retain assets within the family unit is sufficient business purpose to create a partnership; further, the desire to maintain family ownership of an operating business was held to be a valid business purpose for restricting the transfer of FLP interests. However, the court ultimately held that an intrafamily agreement to restrict the transfer of stock was intended to pass shares from the decedent to heirs for less than full consideration.

Income Allocations and Payments

Once a FLP has been formed and partnership interests have actually been conveyed (e.g., by gift or purchase) to family members, the partners can use a variety of income allocation arrangements. However, Sec. 704(e) provides that a donor must be reasonably compensated for services rendered and the distributive share on his capital cannot be proportionately less than the distributive share on all donated capital. Under Regs. Sec. 1.704-1(e)(3)(i)(B), if the partnership agreement does not allocate partnership income in this manner (i.e., using compensation for services and comparable return on capital), the distributive shares of the partnership income of the donor and donee are reallocated by making a reasonable allowance for services of the donor and by attributing the balance of such income to the partnership capital of the donor and donee based on their respective interests in partnership capital.

Reasonable Compensation

In Woodbury, the Tax Court reallocated the distributive shares of partners in a ranching partnership based on the partners' services and capital interests. The taxpayer had contributed various assets to a partnership, then gifted a one-half interest to his son. However, the allocation of partners' distributive shares of income did not properly reflect reasonable compensation for their services.

In determining reasonable compensation, all facts and circumstances must be considered, including the compensation required if an independent third party were hired to perform the services. In Gorrill,(15) the taxpayer was a partner in a family farming partnership and served as the farm manager. The partnership agreement specified an amount for his managerial services. However, the IRS argued that reasonable compensation would have been three times higher. The Tax Court considered the duties of a farm manager and the extent to which the taxpayer fulfilled them. Based on this analysis, the court determined that twice the compensation provided in the partnership agreement was reasonable (and income to the taxpayer).

Return on Capital

The IRS argued in Bennett(16) that profits allocated to a trust (as a partner) should have been allocated to the taxpayer-trustee; further, the taxpayer's capital account should include the personal goodwill he generated for the partnership, which would increase the income allocated (after a reasonable compensation allowance) to him based on the proportion of partners' capital. The Tax Court held the trust to be a valid partner; the compensation allowed the taxpayer prior to the distribution of profits was adequate for his services and the goodwill created thereby. Because children typically do not have personal goodwill, parents in a FLP would likely have more capital (and thus, more taxable income) allocated to them.

Income Triggered by Distributions

Partnership distributions can present traps. Typically, a partner recognizes neither gain nor loss under Sec. 731 on the distribution of cash or property from a partnership, assuming he has sufficient basis in his partnership interest. However, Sec. 704(c)(1)(B) will trigger a gain to a partner who contributes appreciated property distributed to another partner within seven years.(17) Thus, a parent could not contribute appreciated land to a partnership and then have the partnership distribute the land to his child (a partner) within seven years without recognizing gain. The transaction is treated as though the partnership sold the land to the child at fair market value (FMV), which would trigger recognition of the built-in gain under Sec. 704(c) (1)03)0).(18)

Estate Tax Valuation

As mentioned earlier, the IRS may disregard a partnership's existence for estate tax valuation purposes if the reason for the partnership is solely to lower the taxpayer's estate value, thereby reducing estate tax. Even if the partnership entity is respected, certain restrictions on a limited partnership interest may be disregarded in determining a discount for valuation purposes.

A typical goal in creating a FLP is to reduce the value of property subject to gift and estate taxes, but Secs. 2701 and 2703 contain restrictions. In general, the Chapter 14 (Secs. 2701-2704) approach to valuing a transferred interest is first to value the entity as a whole, then subtract the value of the interest retained by the transferor. Sec. 2701(a) (3) (A) and (b)(1) assign a zero value to most distribution, liquidation, put, call or conversion rights on entity interests retained by the transferor family member. The effect of assigning a zero value to these rights is to shift a greater portion of the value of the entity to the transferred interests, thereby increasing the amount subject to transfer tax. Under Regs. Sec. 25.2701-2(b)(3), a distribution right that constitutes a "qualified payment" (i.e., a fixed-rate payment payable on a periodic basis) is an exception to the zero-value rule.

Example: F owns both general and limited partnership interests in FG Partnership. As holder of the general partnership interest, F has the right to receive a $100,000 non-cumulative preferential distribution each year. F gifts his limited partnership interest to his three children. The right to receive the preferential distribution would have a zero value under Sec. 2701(a). Thus, the limited partnership interest transferred to F's children would have a greater value for gift tax purposes than if a value could be assigned to the preferential distribution right. If the $100,000 non-cumulative preferential distribution right were made cumulative, it would be a qualified payment under Sec. 2701(c)(3)(A) and Regs. Sec. 25.2701-2(b)(6) and the zero-value rule would not apply.

Further, if a limited partnership interest (or any interest in which the rights to income and capital are junior to the rights of all other partnership interests) is transferred, Sec. 2701(a)(4) values all such junior interests (including the transferred interest) at no less than 10% of the sum of all equity interests plus the debt the entity owes to the transferor family member. The effect of this provision is to establish a valuation floor for limited partnership interests.

In addition to Sec. 2701, Sec. 2703, including the IRS's position on discounts, provides another trap in valuing a partnership interest for gift or estate tax purposes. Sec. 2703(a) states that the value of any property (e.g., a partnership interest) is determined without regard to (1) any provision that transfers the property at a price less than FMV or (2) any restriction on the right to sell or use the property.(19) The significance of Sec. 2703 is its effect on discounts applied to limited partnership interests that contain transfer restrictions. The IRS has taken a strict approach to valuation discounts since Sec. 2703's enactment. For example, in TAM 9723009, the IRS ruled that the creation of a FLP, the transfer of property to it and the subsequent transfer of a limited partnership interest to the decedent's revocable trust was a single testamentary transaction. As a result, the partnership was disregarded for estate tax purposes. Alternatively, the IRS ruled that any restrictions on a limited partnership interest that give rise to valuation discounts are disregarded under Sec. 2703(a)(2) in determining FMV.

Conclusion

The FLP can be an attractive business form for both tax and nontax reasons; tax advisers must avoid certain traps that can cause significant adverse tax consequences. When forming a FLP and transferring partnership interests, taxpayers must show they intend to join together for a business purpose. Donors should avoid retaining controls on transferred interests. To use the Sec. 704(e) safe harbor, partnership capital must be a material income-producing factor. As to income allocations, donors must be fairly compensated for services and a fair return paid on their capital balances. Finally, taxpayers should avoid using a FLP just to reduce the value of their estates through minority or marketability discounts. By avoiding these tax traps, which are summarized in Exhibit 1 above, taxpayers can reduce the likelihood of an IRS challenge, while accomplishing the objective of significantly lowering their tax burdens.

Exhibit 1: Potential FLP Traps

Potential Trap                     Cause

Formation:
Transfer of partnership interest   1. Absence of requisite intent.
                                   2. Retained control of
                                      partnership interest.
                                   3. Principal partner is trustee
                                      for minor children.
                                   4. Capital is not a material
                                      income-producing factor.
                                   5. Partnership properly consists
                                      of passive assets.
Business purpose:
Reason for transfer                1. Lack of substantial
                                      business purpose.
                                   2. Fails substance-over-form
                                      doctrine.
                                   3. Partners' economic agreement
                                      is not properly reflected.
                                   4. Income is not properly
                                      reflected among partners.
                                   5. Tax avoidance is exclusive
                                      reason for partnership.
                                   6. Timing of transfer is
                                      questionable.

Income allocations/payments:
Compensation for services          1. Compensation arrangement is
                                      not consistent with services
                                      rendered.
                                   2. Compensation is not comparable
                                      to amount paid to third
                                      parties.
Return on capital                  1. Disproportionate return paid
                                      on partners' capital.
                                   2. In computing return, capital
                                      may be understated.
Income triggered by                1. Previously contributed
 distributions                        appreciated properly is
                                      distributed to other partners.
                                   2. Contribution of appreciated
                                      property with a related
                                      distribution from the
                                      partnership.
Estate tax valuation:
Restriction on limited             Substantial discounts from
 partnership interest               net value due to restrictions.

EXECUTIVE SUMMARY

* FLPs have been used to shift income and property appreciation to younger family members, thereby minimizing income and estate taxes.

* A FLP is typically comprised of(l) a general partner (a corporation or limited liability company owned by an older taxpayer) and (2) limited partners (the older taxpayer and perhaps, a spouse and/or children).

* Regs. Sec. 1.701-2(b) allows the IRS to recast a partnership formation transaction if the entity was formed for the principal purpose of substantially reducing the present value of the partners' Federal tax liability.

(1) See, e.g., Strobel II, "Refuting IRS Challenges to the Use of FLPs," 30 The Tax Adviser 28 (January 1999).

(2) RULPA (1985), Section 703; see Cavitch, Business Organizations with Tax Planning (Matthew Bender & Co., 1998), [paragraph] 30.06[3].

(3) Rev. Rul. 77-137, 1977-1 CB 178; see Sheppard, "Can the IRS Challenge Family Limited Partnerships?" 63 Tax Notes 1389 (6/13/94).

(4) W.O. Culbertson, Sr., 337 US 733 (1949) (37 AFTR 1391, 49-1 [paragraph] USTC 9323).

(5) Harold M. Reynolds, TC Memo 1987-261.

(6) RULPA (1985), Section 303.

(7) See Willis, Pennell and Postlewaite, Partnership Taxation (Warren, Gorham & Lamont, 6th ed., 1998), [Paragraph] 2.02 (4).

(8) Leo A. Woodbury, 49 TC 180 (1967).

(9) Joyce Ann Cirelli, 82 TC 335 (1984).

(10) Melvin P. Ketter, 70 TC 637 (1978).

(11) For a discussion, see Strobel II, note 1.

(12) Willis J. Duhon, TC Memo 1991-369; see Lewis A. Merryman, 873 F2d 879 (5th Cir. 1989)(64 AFTR2d 89-5009, 89-1 USTC [paragraph] 9338), aff'g TC Memo 1988-72.

(13) IRS Letter Ruling (TAM) 9723009 (2/24/97).

(14) Estate of Joseph H. Lauder, TC Memo 1992-736.

(15) Ralph C. Gorrill, TC Memo 1963-168.

(16) James N. Bennett, TC Memo 1962-163.

(17) Sec. 704(c)(2) provides an exception if the contributing partner receives a Sec. 1031 like-kind distribution within 180 days of the distribution to the other partner.

(18) In addition, Sec. 737(a) will trigger a gain if a partner contributes appreciated property to a partnership and within seven years receives a distribution of property other than money. Further, Sec. 707(a)(2)(B) will trigger a gain on contributed property if a related distribution of money or other property is made to the contributing partner. A related distribution occurs, for example, if the partnership assumes or takes property subject to a partner's nonqualified liability (e.g., a liability created within two years of the transfer), under Regs. Sec. 1.707-5(a)(1).

(19) Sec. 2703(b) overrides Sec. 2703(a); all such restrictions can be considered in valuations if three requirements are met: the restriction (1) is a bona fide business arrangement, (2) is not a device to transfer the property to the decedent's family for less than full and adequate consideration and (3) has terms comparable to similar arrangements entered into by individuals engaged in arm's-length transactions.

Danny P. Hollingsworth CPA Arthur Andersen Professor of Accounting Baylor University Waco, TX