Forming a family partnership with marketable securities.

Fact's: Warren, age 68, has accumulated a significant portfolio of marketable securities over the years. He has a wide variety of stocks and other securities, including low-basis issues he has held for a long time, more recent higher-basis issues, and everything in between. He and his wife, Buffy, would like to remove some of this wealth from his estate and allow their children and grandchildren to benefit from this value and from future appreciation. At the same time, they would not like their descendants (especially the younger ones) to have immediate access to the wealth, for fear they would spend it unwisely. After discussing various alternatives, they decide a family limited partnership (FLP), with Warren as the general partner, stands the best chance of achieving their objectives. Issue' How should Warren go about selecting and contributing marketable investment assets when forming an FLP?

Analysis

Warren and his tax adviser should first determine which assets to contribute to the partnership. The tax adviser strongly suggests that Warren select stocks and other securities with a high basis-to-value ratio. He has two reasons for doing so. First, the contributed assets will have built-in gain (BIG), which eventually will be subject to income tax when realized by the partnership; under Sec. 704(c), this BIG is taxed to the contributor. However, if the contributor transfers all or a portion of his partnership interest, the BIG (or a proportionate share of such gain) remains attached to the transferred interest and will ultimately be allocated and taxed to the transferee. If Warren contributes low-basis assets, there will be more BIG and built-in future income tax liability. This will ultimately be the burden of his donees.

Moreover, upon Warren's death, the assets included in his gross estate will receive a basis adjustment to their fair market values (FMVs). For appreciated assets, this adjustment will eliminate the potential income tax on the difference between the asset's basis and FMV immediately prior to death. The value of this step-up will be greatest when the difference between the basis and increased FMV of an asset is the greatest.

To illustrate, assume Warren could contribute stock of either X Company or Y Company, each with a value of $10,000 and each expected to appreciate in the furore. The basis of the X stock is $2,000, while the basis of the Y stock is $9,000. While the transfer tax effect of a gift of either stock would be identical, the ultimate income tax effect would not.

If Warren contributed the X stock, the FLP would obtain a carryover basis of $2,000 in the stock, and the stock would have $8,000 of BIG. Assume then that Warren gives away all of his partnership interests to his children and dies one year later, when both blocks of stock have appreciated to $12,000. Assume also that the FLP and the estate sold the X and Y stock, respectively. The FLP would recognize taxable gain of $10,000-- the $12,000 proceeds less the $2,000 basis. Of this, $8,000 would be Sec. 704(c) BIG, taxed to Warren's donees as his successors in interest. Warren's estate, on the other hand, would recognize no gain on the sale of the Y stock; its basis in that stock will have increased by $3,000 to its FMV on Warren's death.

If Warren had contributed the Y stock instead of the X stock and the same chain of events occurred, the FLP would recognize a $3,000 gain--the $12,000 proceeds less the $9,000 basis. Of this, $1,000 would be Sec. 704(c) BIG. Again, the estate would recognize no gain, as its basis in the X stock would reflect a $10,000 step-up. Under this set of facts, $7,000 less gain would be taxed for income tax purposes, with no damage to Warren's estate plan.

Even if the stocks were sold prior to Warren's death, transferring they stock would likely be more consistent with Warren's estate plan. Assuming Warren and his children would all be taxed at the same rate on these gains, if Warren (rather than the FLP) recognized and paid the income tax on the extra $7,000 of gain, the tax payment would reduce the value of Warren's estate while allowing his descendants to retain equal value.

It is likely that Warren would maximize the combined income and estate tax benefits by retaining low-basis assets in his estate and contributing the higher-basis assets to the FLE Moreover, since the transfer tax benefits will depend on the assets' values and will not be affected by their bases, this decision will not affect potential transfer tax benefits from the partnership. (Of course, the nature of the assets, potential future appreciation and other factors must be taken into account when making the selection of assets for contribution.)

Once Warren has selected the assets he wishes to contribute, he must determine how to form the FLP. A "partnership" requires two or more partners. Warren suggested that he join with his daughter, Betty, who also would like to contribute assets to the partnership. (Betty believes she can benefit from asset management services available to the FLP.) While Betty wishes to contribute marketable securities, they are quite different from the assets selected by Warren. The tax adviser should strongly caution against such a contribution. While contributions to a partnership are normally not taxable, the contribution of securities to a partnership could be if the contributor's interests in a pool of securities are diversified in a way that violates "investment company" rules on partnership contributions.

Instead, Warren should make a gift of an undivided interest in the specified assets to his wife, Buffy, and they should jointly form the partnership. A gift to a spouse is not a taxable event for purposes of the income tax (unless the spouse is a nonresident alien) or transfer taxes (unless the spouse is not a U.S. citizen). Warren and Buffy could then form the FLP, contribute the assets and later make gifts to their children and grandchildren.

If Buffy had predeceased Warren, another alternative would be for Warren to give a very small undivided interest in the portfolio to one of his children, after which Warren and the child could contribute these interests to form the partnership. As long as they each owned a proportionate interest in the assets, there would be no diversification and the investment company rules would not be violated. (This gift would not be discounted from the securities' full value, so it should be a gift of only a small interest.)

Another possibility would be for Warren to use a limited liability company (LLC), rather than a limited partnership, and form a single-member LLC. Warren could contribute the entire portfolio to the new LLC. Under the "check-the-box" rules, the LLC would be disregarded for tax purposes, and Warren would still be considered the owner of the portfolio at this point. Warren could then make gifts of LLC interests. On the first gift of an interest in the LLC, the entity would have more than one member, and the gift would create a partnership.

It is not entirely clear whether this would be treated as if it were a gift of a partnership interest or a gift of a pro rata portion of the portfolio for transfer tax purposes, but it would result in the creation of the partnership. Because of the uncertainty of the treatment of the initial gift, it might be advisable for Warren to make a modest interest gift to a single transferee at first. After that (i.e., once the arrangement was established for tax purposes), he could continue his gifting program.

As they discussed the formation of the partnership, the tax adviser also advised Warren of other tax considerations when dealing with marketable securities and contributed properties. For example, a distribution of contributed properties within seven years after contribution could trigger a recognition of BIG taxable to the contributor (or successor), as could distributions of properties to the contributor. In addition, marketable securities are treated differently from other property in other ways. All in all, he advised Warren to consult with him every time he considers making any distributions other than cash.

Finally, the tax adviser advised Warren that it would probably not make sense to contribute additional marketable securities to this partnership at a later date. If the marketable securities were contributed to the existing partnership, all of the "investment company" considerations involved in formation would again apply, with less flexibility in restructuring the ownership of the securities to avoid the problem. If Warren later wished to make additional gifts, a better course would be to form a new partnership entity in a similar way and make gifts of the new entity.

Conclusion

Forming a FLP with marketable securities can provide a number of transfer tax benefits. However, careful planning is necessary to maximize the combination of income and transfer tax benefits, as well as avoid some potential income tax pitfalls that must be considered when marketable securities are involved.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Partnerships," 12th edition, by Grover A. Cleveland, William D. Klein, Terry W. Lovelace, Sara S. McMurrian, Linda A. Markwood and Richard D. Thorsen, published by Practitioners Publishing Company, Fort Worth, Tex. 1998.