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FLPs and the indirect gift trap.

Over the years, the IRS has used various theories to attack family limited partnerships (FLPs); the courts have overwhelmingly rejected most of these. The taxpayer victories, however, have turned out to be a double-edged sword, because taxpayers and their advisers have gotten increasingly careless about following the proper creation and administration procedures for FLPs. This failure to respect the form of the transaction has led to IRS victories on many fronts, including the successful application of the indirect gift rule to asset transfers to a FLP.

Background

According to Regs. Sec. 25.2511-1(h)(1), a shareholder's property transfer (for less than full and adequate consideration) to a corporation is a gift by the taxpayer to the corporation's other shareholders, to the extent of their proportionate corporate interests. It is well established that the same principle can apply to transfers to partnerships made for less than full and adequate consideration. For contributions to partnerships in exchange for partnership interests, the courts have held that if the contributing partner's capital account is increased for the contributed property's fair market value (FMV), the transfer will be for full and adequate consideration, because the partner will be able to recoup such amounts if the partnership liquidates; see Est. of Jones II, 116 TC 121 (2001). Thus, to avoid the indirect gift rule, taxpayers must be able to prove that (1) the contributing partner received partnership interests in exchange for his or her contribution, (2) his or her capital account was credited for the transfers' FMV and (3) crediting of the capital account preceded the gifting of the partnership interests.

Shepard

Shepard, 283 F3d 1258 (11th Cir. 2002), aff'g 115 TC 336 (2000), was the first case to which the IRS successfully applied the indirect gift rule. In that case, the Eleventh Circuit affirmed the Tax Court's holding that transfers of land and stock to a partnership formed under Alabama law were indirect gifts to the taxpayer's sons, who were also partners. The taxpayer signed the FLP agreement on Aug. 1, 1991 and executed deeds transferring land to it on the same date. The sons, however, did not sign the partnership agreement until August 2; thus, under Alabama law, the partnership did not exist until then.

The Tax Court had reasoned that because the partnership was nonexistent under Alabama law when the land transfer took place, the transfer was not effective until after the partnership was formed (Aug. 2, 1991). On that date, each son already held a 25% partnership interest. Under the partnership agreement, additional capital contributions were to be allocated to all of the partners' capital accounts according to their respective ownership percentages. Thus, the land transfer resulted in increases not only to the taxpayer's capital account, but also to his sons' capital accounts, and resulted in indirect gifts to the sons of a portion of the assets transferred to the FLP.

Senda

In another case, Senda, TC Memo 2004-160, Mark and Michele Senda formed two FLPs--the Mark W. Senda Family Limited Partnership (SFLP I) and Senda & Associates, L.P. (SFLP II)--under Missouri law. According to the SFLP I agreement, which was signed on April 1, 1998, the Sendas collectively owned a 10% general partnership (GP) interest and a 89.97% limited partnership (LP) interest, while their minor children owned the remaining .03% LP interest through trusts.

On Dec. 28, 1998, the Sendas transferred 28,500 shares of MCI WorldCom from their joint brokerage accounts to SFLP I in exchange for their GP and LP interests. On the same day, they transferred their 89.97% LP interest to the trusts for their children. New ownership certificates, however, were not issued until several years after the transfers. The children purportedly contributed receivables for their respective initial LP interests. The receivables, however, were not documented in writing and had no repayment schedule (and were still outstanding at time of trial).

SFLP II had a similar structure; the Sendas collectively owned a 1% GP interest and a 98.97% LP interest, while their minor children owned the remaining .03% LP interest through trusts. On Dec. 20, 1999, the Sendas transferred 18,477 shares of MCI WorldCom in exchange for their GP and LP interests. As was the case in SFLP I, the children purportedly contributed receivables for their initial LP interest, but they were not documented in writing (and were without repayment terms). The Sendas transferred most of their LP interests to the children's trusts on Dec. 20, 1999; they transferred the remaining LP interests on Jan. 31, 2000. The ownership certificates were not issued until several weeks after the transfer dates.

These transaction were reported on gift tax returns filed for 1998-2000 as gifts of LP interests, and their value was based on the transferred property's FMV net of marketability and minority interest discounts (38.82%, 45% and 46.13%, respectively, for each of the years).

Service's position: The IRS issued deficiency notices and, in the ensuing litigation, argued that the stock transfer to the partnerships, coupled with the transfer of LP interests to the children in 1998 and 1999, were indirect gifts of stock to them. According to the Service, "... the transitory allocations to petitioners' capital accounts, if such allocations even occurred at all, were merely steps in integrated transactions intended to pass the stock to the petitioners' children in partnership form." The taxpayers argued that they first funded the partnerships, then transferred the FLP interests to the children and, thus, there were no indirect gifts.

Decision: The Tax Court held for the IRS, stating that the taxpayers offered no reliable evidence that they contributed the stock to the partnerships before they transferred the FLP interests to the children. "At best the transactions were integrated ... and, in effect simultaneous," the court said.

In making such a determination, the court noted Mr. Senda's evasive testimony when questioned about the transfer dates. It also noted that, as general partner, he did not maintain any partnership books or records other than brokerage account statements and partnership tax returns, even though the partnership agreement explicitly required him to do so. It dismissed the tax returns as unreliable in showing whether the donors transferred the partnership interests to the children before or after they contributed the stock to the FLPs, as the returns were prepared months after the contributions occurred. The ownership certificates were insufficient proof, because they were not prepared until several weeks after the transfers.

The taxpayers also tendered as evidence a fax informing their accountant that they had funded SFLP II and requesting advice as to the percentage of partnership interests they should transfer to the children to maximize use of the gift tax annual exclusion and applicable unified credits. The Tax Court said the fax did not show what the partnership ownership interests were immediately before funding or how the stock was allocated among the partners' capital accounts at the time of the funding; thus, they did not clearly establish that the capital accounts were credited before the transfers. In addition, the fax was dated two days after the date the interests were transferred.

Conclusion

The failure to follow procedural formalities is usually inadvertent. Typically, multiple advisers are involved in the FLP planning stage, but no single one is appointed to ensure the actual implementation of steps discussed during planning.

Taxpayers may not clearly understand their rights and responsibilities under a FLP agreement. As a result, the general partner's simple and mundane tasks (e.g., signing agreements/deeds of transfer, opening a separate bank account, maintaining proper records, making distributions according to the agreement terms and providing information to the other partners) are often ignored for months (or years) after FLP formation. Senda is yet another reminder of the drastic tax consequences that await those who fail to follow the formalities. However, when FLPs are properly created and administered, they continue to be a powerful estate planning tool.

FROM VINU SATCHIT, CPA, HIGH POINT, NC
COPYRIGHT 2005 American Institute of CPA's
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Title Annotation:family limited partnerships
Author:Satchit, Vinu
Publication:The Tax Adviser
Date:May 1, 2005
Words:1322
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