Practically IRS proof: preserving the tax benefits of family limited partnerships. (Planning).

A family limited partnership can reduce or eliminate a client's estate taxes, especially when combined with defective income trusts and gifts. The estate and gift tax benefits of FLPs have most recently been confirmed in Charles T. McCord Jr. [120 TC 13 (decided May 13, 2003)] where the Tax Court again recognized minority and lack of marketability discounts for gifted FLP interests.

Recent IRS actions on FLPs have only been successful when the partnership fails to follow certain basic tax rules. Accordingly, clients should verify that their partnership agreement and partnership operations comply with tax rules as discussed in recent court decisions.

These guidelines will help keep your FLPs IRS-proof.

1. Clients should not retain the economic benefits of the gifted or sold FLP interest.

If the client retains the economic benefit of the property transferred to the FLP, the IRS will attempt to include that property in the client's taxable estate under Subsection 2036(a)(1).

In the recent Strangi case, [TC Memo 2003-45 rem'd by 293 F. 3d 279 (5th Cir. 2002)] the IRS was successful with this Sec. 2036 argument where the FLP paid the decedent's personal expenses and made disproportionate partnership distributions. The IRS also has been successful in making this argument in Reichardt, 114 TC 144 (2000); Harper, TC Memo 2002-121; and Thompson, TC Memo 2002-246, where the FLP's partnership formalities were not observed.

To avoid this adverse tax result, the FLP should make distributions each year to the partners in proportion to their percentage interests, and should not make preferential distributions to the client. It is also advisable to show that the client is not the sole beneficiary or distributee of the FLP's assets. Rather, other family members should become substantial partners by way of gifts, sales of partnership interests, or by investing their own capital in the FLP. Furthermore, clients should not co-mingle their personal assets with the FLP's assets, and no FLP monies or assets should be used to pay the client's personal expenses. Finally, no personal residence of the client should be owned by the FLP.

2. Do not allow FLP to pay the client's estate's expenses or estate taxes.

If the FLP pays a deceased client's estate's expenses or estate taxes, then the IRS, as it did in the Strangi case, may assert that this represents the decedent's retention of the FLP's economic benefits to include the FLP's assets in the client's taxable estate under Subsection 2036(a)(1). To avoid this, the client's estate plan should provide that the client's estate's expenses and estate taxes will be paid from a source other than the FLP.

3. Clients should have liquid assets outside of the FLP to pay their living expenses.

The IRS asserts that taxpayers retain an economic benefit in the FLP if they rely on the FLP's assets for their living expenses. Thus, clients should retain enough liquid assets outside of the FLP to pay their living expenses.

4. Clients should consider giving up FLP management rights.

The IRS successfully asserted in Strangi that a client's management control over a FLP's general partner interest is a prohibited Subsection 2036(a)(2) power. Thus, FLP assets were included in the decedent's taxable estate based upon the theory that the decedent's retention of the general partner's management power was a prohibited Subsection 2036(a) power. In Strangi, the decedent's retained management rights were based upon the decedent's family's control of the general partner interest.

It is unclear if the IRS will be successful in achieving this same Strangi result in future tax cases. Other courts may not follow the Strangi decision.

One approach to avoid the potential adverse tax result of Strangi is to have the client not be the general partner and not have the power to remove or replace the general partner. Where the client's family is left in control of the general partner, the partnership agreement should clearly state that the general partner has fiduciary duties to the limited partners (which includes the decedent), that the limited partners have no management rights, and that family members are acting independent of the decedent.

A more conservative tax approach would be to have the general partner be a trust with a trustee independent of the client's family. The general partner should not be delegated partnership management powers by the client through agreements or powers of attorney. Such a tax approach may be contrary to the client's desire to control the FLP's assets, so consideration must be made of the client's goals.

5. Clients should follow partnership formalities in operating the FLP.

The FLP should be operated in compliance with the terms and distribution provisions of the FLP's partnership agreement. All FLP assets should be legally titled in the name of the partnership, which should maintain separate records, have separate checking and brokerage accounts, prepare financial statements at least annually, and timely file state and federal tax returns. Preferably, the FLP should engage in an active business, and not just be a passive investor in securities.

Passive investments can be owned in FLPs--and a business purpose for such ownership should be established--but will be subject to greater IRS scrutiny.

6. The FLP should preserve the general partner's fiduciary duties toward the limited partners.

The FLP's partnership agreement should not waive the state-imposed fiduciary duties of the general partner toward the limited partners. In Kimbell, (91 AFTR2d 2003-585 [ND Tx, 2003]), the District Court found it was significant that the partnership agreement waived the general partner's fiduciary duties toward the limited partners, and concluded there was no fiduciary standard to prevent the decedent from retaining the economic benefits of the partnership.

7. The FLP should be formed well before the client's date of death.

The IRS will challenge FLPs formed shortly before a taxpayer's date of death--so-called "death bed partnerships." In Kimbell and Strangi, the FLP was formed two months before date of death, and in Harper, the FLP was formed eight months before date of death. FLPs should be formed as far in advance as possible before the client's death and have a history of operation.

8. Obtain a qualified appraisal of the gifted FLP interests.

To have the gift tax statute of limitations begin, a qualified appraisal of the FLP interests should be attached to the gift tax return to be filed with the IRS. The gift tax regulations [See Reg. Subsection 301.6501(c)-1(f)(2)] set forth required items to include in a qualified appraisal, such as comparable sales and the specific basis of valuation discounts.

9. FLP interest should be structured as a present interest to qualify for the annual gift tax exclusion.

For a gifted FLP limited partner interest to qualify for the annual gift tax exclusion under Subsection 2503(b)--$11,000 per donee, per year--the limited partner interest must be a present interest.

In Hackl [118 TC 14 (2002)] the Tax Court held that a gifted limited liability company membership interest did not qualify as a present interest because the donee could not require distributions from the company, the gifted interest could not be transferred without the manager's consent and the donee could not cause the company's liquidation. Though Hacki was a family limited liability company, the case's tax principles apply to FLPs.

To avoid the adverse tax result of Hacki, FLP agreements should require annual distributions, provide limited partners with the ability to sell their interest without the consent of the general partner and allow the partnership's liquidation only pursuant to state law.

In California, the partners, by the consent of the general partner plus 51 percent of the limited partners, can cause the FLP to liquidate [see California Corporations Code Subsection 15681(b)]. Furthermore, the default provisions of California law state that partners can only withdraw from the FLP upon the occurrence of an event specified in the partnership agreement [see California Corporations Code Subsection 15661].

Strangi and other court decisions confirm that proper drafting and operation of an FLP agreement are necessary to achieve valuation discounts. Following the lessons from these cases will preserve the FLP's tax benefits.

Ca/CPA Estate Planning Committee members can answer your questions at www.calcpaweb.org/estate.

RELATED ARTICLE: BY KEITH SCHILLER, ESQ.

Tax Court Strangles FLP With Sec. 2036 Noose

Strangi Decision has Ominous Implications for Estate Planners 

FLPs can make a really hip score, but not when made on death's door, nor when the formalities you do ignore, or attain mortality with little more.

The IRS prevailed on the issue of retained control under IRC Sec. 2036 on the remanded trial of Strangi v. Comr. 2003-145 ("Strangi II," rendered on 5/20/03), rem'd by 293 F. 2d 279 (5th Cir. 2002), aff'g in part and rev'g 115 T.C. 478 (2000) (Strangi I). In Strangi II, the valuation of the entire entity was included in the decedent's gross estate. Although the facts reflect a highly aggressive application of family limited partnership planning, the Court's decision continues and expands a trend with more ominous implications for estate planners.

Approximately 98 percent of the decedent's wealth, including his home, were transferred to the FLP. The decedent retained a 99 percent interest, with about 75 percent of the FLP's assets consisting of cash and securities. The decedent's children acquired an interest in Stranco, with 99 percent of the stock held in the family and 1 percent contributed to a charitable foundation.

Two months prior to death (and the day after attending an estate planning seminar), the Strangi FLP was established with a newly formed corporation (Stranco) as the general partner, and owner of a 1 percent interest. The decedent's son-in-law acted for the decedent under a power of attorney.

In Strangi I, the IRS recognized the partnership for estate tax purposes, rejected application of Sec. 2703, declined to determine that a gift was made on formation and allowed the IRS' 30-percent valuation discount. The Fifth Circuit reversed only the denial of the IRS' request to amend its answer to consider Sec. 2036.

The IRS carried its burden of proof under the "new matter" doctrine on three independent principles of Sec. 2036:

* The existence of the right to income over gifted property;

* Implied agreement for retained possession and control; and

* Power to designate the control.

In the process, the case followed a recent trend in the Tax Court to reject FLP discounts through a finding of retained control under Sec. 2036. Schauhamer v. Comr. 73 TCM 2855 (1997), Reichadt v. Comr. 114 TC 3 (2000), Estate of Harper v. Comr. TC Memo. 2002-121, Estate of Thompson v. Comr. TC Memo. 2002-246), Estate of Shepherd v. Comr. 115 TC 376 (2000), aff'd 2001- USTC 2001- (11th Cir.), Estate of Kimbell v. U.S. 2003-1 USTC 60,455 (ND TX).

The Court acknowledged, generally, that the "I's were dotted and the T's were crossed" and that organizational formalities were satisfied. The Court reasoned that the two entities reflected "sufficient substance to be recognized as legal entities in the context of valuation ... [but did] not preclude implicit retention by decedent of economic benefit from the transferred properly for purposes of section 2036 (a)(1)."

Central to the Court's reasoning was that virtually nothing changed from the time before and after the entities were created. The Court rejected as meaningless the existence or tights of the charitable foundation which held a 1 percent interest in Stanco.

In addition, the Court held that Sec. 2036(a)(2) mandated inclusion in the gross estate because the decedent retained the right to designate the individuals who shall possess or enjoy the property or its income. The Court distinguished U.S. v. Byrum 408 U.S. 125 (1972), wherein the Supreme Court declined to disregard legal duties under state law and fiduciary duties for fear of creating a standard "so vague and amorphous so as to be impossible of ascertainment in many instances." Strangi II rejects that application of fiduciary duties as restrictions on the tights of directors or other fiduciaries. Several PLRs that supported the taxpayer in other matters were disregarded.

The decision solidifies the IRS' challenge to the use of entities in an increasingly broad context: lessening of the role of fiduciary duties, continuation of prior arrangements, dismissal of legal rights which can be enforced because right exists among family members, and connection to the estate plan. The Byrum rejection of such vague applications is receiving less respect.

WAYS TO TAKE ACTION

Given these challenges, the taxpayer and practitioner should consider the following action steps:

1. Include some operating business or real estate investment in the partnership.

2. Create the partnership well before death.

3. Keep on top of the details. (Transfer assets to the partnership, operate as provided in the agreement, file partnership returns, avoid having to make accounting for accrued obligations or rights of family members, and run the partnership as though the partners were strangers.)

4. Use different trusts as partners, particularly after the death of the first spouse. This will make it easier to fractionalize ownership. [Estate of Mellinger v. Comr. 112 TC No.4 (1999)].

5. Document the business purpose. Sensitive estate tax oriented letters should be protected by attorney-client privilege. Avoid circulating confidential documents in a manner that would waive the privilege.

6. Keep discounts within amounts that are less likely to draw audit attention, particularly in tough cases.

7. Leave the decedent liquid apart from the FLP.

8. Have annual partnership meetings to update events.

9. Review the general ledger and cash for business purpose.

10. When possible, have each partner contribute capital to the partnership, not relying exclusively on gifts of partnership interests.

11. After the death of the first spouse, make sales--not gifts--of FLP interests. Note that payments provide income for the older client and enable younger family members to own a larger share. Consider Sec. 1239.

12. Advise clients of the risks and rewards with entity planning.

Keith Schiller, Esq. is an attorney with Schofield & Schiller of Walnut Creek and a frequent lecturer and author for the California CPA Education Foundation. You can reach him at www.cpas411.com.

Robert A. Briskin, Esq. is a Los Angeles-based attorney who specializes in taxation law. You can reach him at [phone] or [e-mail].