IRS factual inquiries in audits of family limited partnerships and sample entity appraisal checklist.

The list of inquiries has been assembled from several sources and is more extensive than any list the author is aware has been sent to any particular taxpayer.

The first part of this month's column is a recitation of the detailed factual inquiries being made by Internal Revenue Service gift and estate tax return examiners in audits of those returns that have reported gratuitous transfers of interests in so-called "family limited partnerships." The remainder of this column contains a sample form of checklist practitioners might wish to consider using in evaluating entity valuation appraisal reports, such as those prepared in connection with gift and estate tax return reporting of transfers of family limited partnership interests.

IRS Family Limited Partnership Audit Factual Inquiries

The proliferation of the use of family limited partnerships in estate planning and the Internal Revenue Service's frequent contention that many of them are mere devices created solely to avoid federal gift and estate taxes have resulted in close scrutiny by gift and estate tax return examiners of those returns reporting gratuitous transfers of family limited partnership interests. Many estate planning practitioners around the country already have assisted clients in audits of those types of returns and in the course of which have been confronted with detailed factual inquiries by the Internal Revenue Service. While those inquiries have not been identical, the examiners at least appear to have been reading from a common script as to the types of facts they want to consider in those audits. The intent of the examiners' factual inquiries appears to be to obtain information so the examiners can determine whether the family limited partnership was formed for valid business reasons or merely to achieve transfer tax savings. Their factual inquiries focus on the subjective "why" and objective "how" the family limited partnership was created and the subjective and objective "how" it has been operated since creation.

Based on the notion that "forewarned is forearmed," practitioners assisting clients in the creation and operation of family limited partnerships would be wise to consider the factual inquiries the Internal Revenue Service might later raise upon audit. For family limited partnership interest transfers that already have been reported to the Internal Revenue Service and that are likely to be audited, in light of these inquiries, practitioners might wish to consider reviewing their files now in anticipation of those audits. Note that the list of factual inquiries below has been assembled from several different sources and is more extensive than any list the author is aware has been sent to any particular taxpayer.

List of IRS Factual Inquiries

1. Partnership documents. Provide copies of the following documents:

A. All documents filed with state authorities in connection with the formation and operation of the partnership (such as the certificate of limited partnership and any amendments thereto, and annual reports filed with the Florida Department of State).

B. All partnership governing and management documents, such as the partnership agreement.

C. If the general partner is a corporation, that corporation's articles of incorporation and shareholders agreement, if any.

D. Minutes of partnership meetings.

E. Copies of all documents showing:

1. The dates property was transferred to the partnership;

2. A description of that property; and

3. A list of who transferred what items of property to the partnership.

II. Other partnership formation and operation information. Provide a statement describing all the facts and circumstances in connection with the formation and operation of the partnership that contains the information described below.

A. A description of the purposes for establishing the partnership.

B. An explanation of why those purposes could not have been accomplished equally as well through outright gifts of property, trusts, or other means.

C. A description of the unique advantages of the partnership structure that compelled its use in this case.

D. A statement regarding and a copy of the applicable income tax return showing where the costs (legal, accounting, and appraisal fees) relating to the creation of the partnership were deducted.

E. A statement signed by the taxpayer/personal representative describing the bona fide business purposes for the formation of the partnership.

F. A statement signed by the taxpayer/personal representative confirming that the partnership arrangement was not a device to transfer objects to the natural bounty of the taxpayer at less than full and adequate consideration in money or money's worth.

G. A statement signed by the taxpayer/personal representative affirming that the partnership arrangement is comparable to similar arrangements entered into by persons at arm's length.

III. Information supporting the decision to use the partnership arrangement.

A. Provide a list of all the parties who recommended the use of the partnership arrangement and their addresses.

B. Provide copies of all documents (letters, memos, etc.) showing:

1. When and by whom recommendations to use the partnership structure were made and

2. The reasons set forth to the taxpayer for the use of the partnership.

IV. With respect to the partnership's assets and liabilities, provide the following information:

A. A list of all the assets contributed to the partnership, by date of contribution and by whom contributed.

B. Copies of all documents, including deeds if applicable, transferring assets to the partnership.

C. Describe how the assets contributed to the partnership were managed before they were contributed, by whom, and the approximate amount of time spent in management of those assets.

D. Describe how the assets contributed to the partnership were managed after they were contributed, by whom, and the approximate amount of time spent in management of those assets and the educational background and occupations or professions of those persons, if any.

E. A statement of the expertise required of the general partner to manage the partnership and what of that expertise the general partner possessed.

F. A statement of the duties actually performed by the general partner.

G. Copies of any debt instruments entered into by the partnership, copies of financial statements submitted in support of those loans, loan applications, and credit reports obtained.

V. Information regarding the taxpayer (donor or decedent). As of the time of formation of the partnership and any transfers of partnership interests by the taxpayer, provide the following information:

A. The age of the taxpayer.

B. A statement of the taxpayer's educational background and occupation or profession, if any.

C. A statement regarding whether the taxpayer joined the partnership solely upon his own volition or whether it was accomplished pursuant to a power of attorney.

D. A statement regarding whether the assets contributed to the partnership by the taxpayer were held in trust before their transfer to the partnership.

E. A statement of the taxpayer's health.

F. Copies of the taxpayer's medical records.

G. A list of the names and addresses of all physicians who treated the taxpayer within three years before the date of the gifts/taxpayer's death and releases signed by the taxpayer/personal representative authorizing the Internal Revenue Service access to any records maintained by those physicians concerning their care and treatment of the taxpayer during that period.

H. A list of the names and addresses of all hospitals in which the taxpayer was hospitalized during the three-year period before the date of the gifts/taxpayer's death and releases signed by the taxpayer/personal representative authorizing the Internal Revenue Service access to any records maintained by those hospitals concerning their care and treatment of the taxpayer during that period.

VI. Information concerning the professional advisors (attorneys, accountants, and others) to the taxpayer and the partnership. Provide the following information:

A. Copies of all bills or invoices submitted by those advisors in connection with the recommendation, formation of, and operation of the partnership.

B. Copies of all articles written by the foregoing regarding the use of family limited partnerships.

C. A statement identifying all groups to which any of the foregoing lectured concerning the use of family limited partnerships, the dates of those lectures, and copies of any lecture materials.

D. A statement whether any of the foregoing sent marketing or other promotional materials as part of a general mailing to their clients regarding the use of family limited partnerships.

Checklist for Review of Entity Appraisal Reports

A key attachment to a gift or estate tax return reporting a gratuitous transfer of an interest in a business entity, such as a family limited partnership, is an appraisal report prepared by a competent, independent appraiser. The following checklist lists the information that should be contained in any such report, if applicable, and a series of reviewer judgment questions that should be asked about every such report:

I. Basic Information.

A. Name of party who hired the appraiser.

B. Description of property or interest being appraised (e.g., minority limited partner interest).

C. Purpose of appraisal (e.g., estate planning purposes; determination of value for federal estate/gift tax purposes).

D. Valuation date (Be sure the report distinguishes between the date of death and the IRC [sections] 2032 alternate valuation date if the latter is used).

E. Date of report.

F. Standard of value, including reference to statutory or other standards if applicable (e.g., IRC [subsections] 2701-2704; Rul. 59-60, 1959-1 C.B. 237).

G. Statement of appraiser's independence.

H. Appraiser's signature and certificate.

I. Clear definitions and consistent use of all terms.

J. Statement of any limitations of scope or sources of information considered.

II. Entity Information.

A. Form (e.g., partnership or corporation).

B. History, including date created, and the entity's prospects.

C. Products or services.

D. Major assets, including goodwill and other non-balance-sheet items.

E. Markets and customers.

F. Competitors and their prospects.

G. Management.

H. Capitalization. I. Ownership.

J. Industry and its prospects.

K. Information about prior sales or values of other dispositions of ownership interests.

L. Financial information.

1. Presentation and analysis of entity's financial statements for suitable period of time, including five years of statements of net earnings or operating results and dividends paid.

2. Explanation of any adjustments to financial statements.

M. Discussion of key entity or interest holder agreement provisions (e.g., family limited partnership agreement or shareholders agreement). As applicable, the appraisal report should list and describe:

1. Parties to the agreement;

2. Date of the agreement;

3. Term of the agreement (or the entity itself);

4. Capital contribution requirements;

5. Capital withdrawal rights and restrictions;

6. Profit and loss sharing provisions;

7. Interest holder rights to distributions of cash and other property;

8. Drawing account provisions;

9. Entity termination provisions;

10. Restrictions on transferability of entity interests; and

11. Legal implications of any restrictions in those agreements implicated under IRC [sections] 2704 compared to state law default provisions.

III. Comparable Entity Information.

A. Information about sales of comparable interests in similar entities, if available.

B. Information about sales of comparable interests in publicly traded entities.

C. Explanation of why selected entities were determined to be comparable.

D. Explanation of derivation of subject company's value from information about sales of interests in comparable entities.

IV. Valuation Methodology.

A. Discussion of possible valuation methods and reason for selecting the one used.

B. Extensive and detailed discussion of analysis of entity being appraised. The report must relate and recite the facts of the entity being appraised to the analytical procedures of the valuation method being applied.

V. Appraiser's Qualifications.

A. Formal education.

B. Continuing professional education.

C. Other specialized training.

D. Work experience.

E. Professional designations.

F. Professional organization memberships and activities.

G. Expert witness experience and qualifications in particular courts.

VI. Reviewer's Judgment Questions.

A. Have all relevant facts been recited and analyzed?

B. Are the appraiser's analyses and conclusions consistent with:

1. The purpose of the appraisal;

2. The appraisal standard, including any statutory standard, applied; and

3. The nature and type of the entity being appraised?

C. Are the appraiser's analyses and conclusions consistent with the industry to which the appraised entity belongs and the overall economic climate?

D. Is the appraiser's selection of the appraisal method convincing?

E. Does the appraiser's recitation of the valuation analysis applied compel the valuation conclusions reached?

F. Are the appraiser's conclusions reasonable and well supported by the report on its face, without need to refer to external sources of information? (Watch out for the appraiser who says that even though essential information or analysis is not in his or her report, the appraiser will be prepared to discuss the report with the Internal Revenue Service or testify as to those points should it become necessary. To state the obvious, the appraiser might not be available to testify when needed if, for example, he or she has gone out of business or died.)

Brian C. Sparks is a partner in the Tampa office of Holland & Knight, LLP. He received his J.D. from Saint Louis University and an LL.M. in Taxation from New York University. He also is a certified public accountant (Missouri). He is the co-editor of this column along with William P. Sklar.

This column is submitted on behalf of the Real Property, Probate and Trust Law Section, Bruce M. Stone, chair