Partnership interest for services regs. offer estate planners a "bona fide" solution.
As estate planners know, the IRS is on the warpath against family limited partnerships (FLPs), claiming they are non-bona fide arrangements that should be ignored for estate tax purposes. It has been particularly successful in using Sec. 2036(a) to include transfers that decedents made during life for less than adequate and full consideration, in their gross estates; see Est. of Albert Strangi, TC Memo 2003-145, aff'd, 5th Cir., 8/8/05; Est. of Edna Korby, TC Memo 2005-102; Est. of Austin Korby, TC Memo 2005-103; Est. of Virginia A. Bigelow, TC Memo 2005-65; Est. of Wayne C. Bongard, 124 TC No. 8 (2005); Est. of Ida Abraham, TC Memo 2004-39, aff'd, 408 F3d 26 (1st Cir. 2005); Est. of Theodore R. Thompson, TC Memo 2002-246, aff'd sub nom Betsy R. Turner, 382 F3d 367 (3d Cir. 2004); Est. of Charles E. Reichardt, 114 TC 144 (2000); Est. of Morton B. Harper, TC Memo 2002-121; Est. of Eleanor T.R. Trotter, TC Memo 2001-250; and Est. of Dorothy M. Schauerhamer, TC Memo 1997-242. These IRS successes have caused practitioners to pay greater attention to using the Sec. 2036(a) bona fide sale exception to avoid estate inclusion. In that regard, granting partnership interests for services may offer a solution.
Permitted Services by Limited Partners
There are several types of services a limited partner may render without incurring liability as a general partner (GP) for "participating in the control" of a business. The Uniform Limited Partnership Act (1976) (ULPA), adopted in approximately 43 states plus the District of Columbia and the U.S. Virgin Islands, permits a limited partner to act in one or more capacities without violating this rule; see Uniform Limited Partnership Act (1976) with 1985 Amendments, Section 303, available at www.law.upenn.edu/bll/ulc/fnact99/1 980s/ulpa7685.htm. Such capacities include:
* Acting as contractor, agent or employee of the limited partnership or of a GP;
* Advising a GP on the limited partnership's business;
* Guaranteeing or assuming the limited partnership's obligations;
* Participating in a derivative action in the right of the limited partnership;
* Requesting or attending partner meetings;
* Voting or participating in the dissolution and winding up of the partnership; the sale, exchange, lease, mortgage, pledge or other transfer of partnership assets; the assumption of debt by the partnership other than in the ordinary course of business; a change in the nature of the business; the admission or removal of a partner; a transaction involving a conflict of interest among the partners and the partnership; an amendment to the partnership agreement or certificate of limited partnership, or other matters that the partnership agreement states may be subject to the approval or disapproval of limited partners; or
* Winding up the limited partnership under ULPA Section 803.
Because each state has adopted its own version of the ULPA, partners should determine which services their own state permits before entering into a partnership service contract. Further, about six states have adopted the Uniform Limited Partnership Act (2001) (Florida, Hawaii, Illinois, Iowa, Minnesota and North Dakota; pending in a few others), which eliminates the "control rule" altogether for personal liability for partnership obligations; see Uniform Limited Partnership Act (2001), Section 303, available at www.law.upenn.edu/bll/ulc/ulpa/final2001.htm. Thus, the 2001 Act provides a full, status-based liability shield for each limited partner, "even if the limited partner participates in the management and control of the limited partnership" (2001 Act, Section 303, at comment). This brings limited partners into parity with limited liability company members, limited liability partnership partners and corporate shareholders; see 2001 Act, Section 303, at comment.
Estate Planning Advantages
Granting a partnership interest for services can meet the bona fide sale exception under Sec. 2036(a) and, thus, defeat the Service's main resource to include transferred FLP interests in a decedent's taxable estate. Under Sec. 2036(a) and Regs. Sec. 20.2036-1(a), estate property is included in the decedent's gross estate when "... the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life ..." the possession or enjoyment of, or the right to the income from the property, or the right to designate, alone or in conjunction with others, those who will. (Emphasis added.)
Thus, the statute provides two exceptions that allow a transfer to escape its operation. First, if the transfer is a bona fide sale for adequate and full consideration, Sec. 2036(a) does not apply, because the value of the property received in the exchange will theoretically be included in the transferor's estate. Second, Sec. 2036(a) does not apply if the decedent made a transfer for less than adequate and full consideration, but did not retain either the (1) possession, enjoyment or rights to the transferred property or (2) the right to designate the persons who would possess or enjoy the transferred property. If decedents satisfy the bona fide sale test, they need not worry about possession or enjoyment to escape Sec. 2036(a).
Partnership as the Transferor
There are two reasons why granting a partnership interest for services should meet the bona fide sale exception. First, the decedent did not make a transfer; the partnership is the transferor. Although the transfer dilutes the historic partners' interests (including the decedent's), the partnership is treated as the transferor under Sec. 83, as long as the transferee renders services to the partnership and not to the individual partner(s), according to Regs. Sec. 1.83-6(d)(1). Under Kegs. Sec. 25.2511-1(h)(1) and Rev. Rul. 80-196, a similar role treats a corporation that grants property to a person as the transferor, rather than the individual shareholders, as long as the corporation receives adequate and flail consideration. This rule should apply to partnerships as well.
Bona Fide Sale for Adequate and Full Consideration
An IRS attempt to recast a transaction as a disguised transfer by the existing partners (including the decedent) invokes the second reason that the transfer should be excluded under the Sec. 2036(a) bona fide sale exception--the transfer is bona fide and for adequate and flail consideration; see Strangi; Bongard; David A. Kimbell, Sr., 371 F3d 257 (5th Cir. 2004); and Est. of Eugene E. Stone III, TC Memo 2003-309.
To be bona fide, a sale must be in good faith and offer the transferor some potential benefit other than estate tax advantages (i.e., the transaction should be motivated by significant nontax reasons); see Strangi, Bigelow, Bongard and Turner. Neither Sec. 2036(a) nor the regulations require the parties to a "bona fide sale" to be unrelated; see Kimbell. However, intrafamily transfers will receive heightened scrutiny to ensure that the substance justifies the claimed tax treatment; see Bongard; Kimbell; and John M. Wheeler, 116 F3d 749 (5th Cir. 1997). Thus, the partnership should ensure that the value of the services rendered justifies a grant that is reasonable and serves a substantial business or nontax purpose.
There is certainly ample public and private industry data to determine an appropriate grant size for a variety of services; see www.towersperrin.com (website of Towers Perrin, a global human resources consulting firm); www.naspp.com (website of the National Association of Stock Plan Professionals, a member organization of public and private companies that offer their employees equity compensation programs); and www.nceo.org (website of the National Center for Employee Ownership, a private nonprofit information and research organization on equity compensation). Basing a partner's compensation on such readily available market data should satisfy the adequate and full consideration requirement.
Besides a Sec. 2036(a) defense, a side benefit of granting partnership interests for services eliminates any sir tax filing requirement, because there is no gift. Thus, the transfers are not limited by the annual gift tax exclusion of $11,000 per year and the $1 million lifetime exemption; see Secs. 2503(b) and 2505.
Prop. Regs. Overview
One of the unstated goals of the new proposed regulations is bringing taxation of compensatory partnership interests into parity with corporate stock and options, which have been used for years as an incentive compensation device. Like corporate stock, a vested partnership interest is taxable compensation to the service partner and deductible by the partnership in the year granted, according to Prop. Regs. Sec. 1.83-3(e); see also the preamble to REG-105346-03. Special rules apply to options and unvested interests. This discussion focuses on vested partnership interests, which, for FLPs, are probably more advantageous than options or unvested interests.
The value of a partnership interest granted for services is taxable on the first date that the interest is vested, or sooner if the partner makes a Sec. 83(b) election for an unvested interest; see Prop. Regs. Secs. 1.83-3(e), 1.721-1(b)(4)(i) and 1.761-1(b). Under Prop. Regs. Sec. 1.761-1(b) and Regs. Sec. 1.83-3(b), a partnership interest is vested if it is either transferable or not subject to a substantial risk of forfeiture. A person's rights in property are transferable if the person can transfer the property to any person other than the transferor, and the transferee's rights are not thereafter subject to a substantial risk of forfeiture; see Regs. Sec. 1.83-3(d). Most FLP interests are not transferable. However, they are rarely subject to a substantial risk of forfeiture; see Regs. Sec. 1.83-3(c).
According to Regs. Sec. 1.83-3(c), a substantial risk of forfeiture means that rights to the property transferred are conditioned on the performance of substantial services by any person, or the occurrence of a condition related to the transfer's purpose. Such conditions are usually employment-related and designed to retain and motivate the service provider. Arguably, a similar, if not greater, need exists to motivate FLP members. Nonetheless, under Prop. Regs. Sec. 1.761-1(b), most FLPs will grant their service providers vested interests to obtain partner treatment for tax purposes.
According to Prop. Regs. Sec. 1.721-1(b)(4)(i), on receipt of a partnership interest for services, the service partner reports the interest's value as income, and, under Regs. Sec. 1.83-6(a) and -7, the partnership takes a corresponding deduction. Under Regs. Sec. 1.83-4(b), the service partner's basis in the partnership interest equals the cost to acquire it (if any), plus the compensation income reported. Thus, the partnership must determine the transferred interest's value. The partnership may use any reasonable method, as long as it does not take into account any lapse restriction, according to Regs. Sec. 1.83-1(a)(1)(i).
Lapse and Nonlapse Restrictions
Under Regs. Sec. 1.83-3(i), a lapse restriction is any restriction other than a nonlapse restriction. A nonlapse restriction, according to Regs. Sec. 1.83-3(h), is a permanent limit on transferability that (1) requires the owner to sell it based on a pre-determined formula and (2) continues to apply to the holder and any subsequent holder, other than the transferor of the property. The regulations contain a few examples of lapse and nonlapse restrictions; see Regs. Sec. 1.83-5(c).
Examples describe a nonlapse restriction as a requirement to resell the interest to the entity at book value, or at some fixed multiple of book value or earnings; see Regs. Sec. 1.83-5(c), Examples (1), (2) and (4). The examples indicate that it may be reasonable to discount the value of a service partner's interest for lack of majority and marketability, as long as these restrictions will never lapse.
A minority discount should not be treated as a lapse restriction, because it is not a restriction imposed by the partnership but, rather, a function of market forces that must be considered in any valuation analysis. The IRS, however, has tried to argue that a discount precludes a finding that the transfer is for adequate and full consideration; see Strangi. However, in Kimbell, the Fifth Circuit cut that argument short, when it held "[t]he business decision to exchange cash or other assets for a transfer-restricted, non-managerial interest in a limited partnership involves financial considerations other than the purchaser's ability to turn around and sell the newly acquired limited partnership interest for 100 cents on the dollar." Thus, the partnership should be able to apply normal discounts without violating either the Sec. 83 valuation roles or the adequate and full consideration rule.
To avoid these types of valuation disputes, Notice 2005-43 allows a partnership to use a safe-harbor liquidation-value method when all the partners agree; see Prop. Regs. Sec. 1.83-3(t). The safe-harbor value would presumably be the cash that the interest holder would receive if, immediately after transferring the interest, the partnership sold all of its assets (including goodwill, going concern value and any other intangibles associated with its operations) for cash equal to the assets' fair market value, and then liquidated; see REG-105346-03, Preamble Section 5.
Because FLPs rarely have goodwill or going concern value unless they own a family business, liquidation value is the value of the underlying cash, securities, real estate and other tangible assets. The safe harbor appears to leave little or no room for discounts based on minority interest, lack of marketability and other reasons commonly employed by business valuation analysts. Thus, FLPs may wish to forgo the safe-harbor method in favor of other valuation methods.
Timing and Reporting
A service partner's compensation is a guaranteed payment under Sec. 707(c), according to Prop. Regs. Sec. 1.721l(b)(4)(i). However, instead of the normal timing rules for guaranteed payments, the service partner reports the income in the tax year in which he or she receives the interest; see Prop. Regs. Sec. 1.707-1 (c); REG-105346-03, Preamble Section 2 (contrast with the normal timing rules for guaranteed payments that require a partner to report the payment in his or her tax year within which ends the partnership's tax year).The IRS may also require the partnership to report the compensation on Form 1099-MISC, Miscellaneous Income; see REG-105346-03, Preamble Section 10.
The Partnership's Deduction
According to Sec. 706(d)(1), Regs. Sec. 1.706-1(c) and Prop. Regs. Sec. 1.706-3(a), a partnership can allocate its compensation deduction by closing its books on the new partner's entry date. Alternatively, it can allocate the deduction based either on the pro-rata share that a partner would have included had he or she been a partner for the full tax year, or on some other reasonable method; see Regs. Sec. 1.706-1(c)(2)(ii) and Cecil R. Richardson, 693 F2d 1189 (5th Cir. 1982). Closing the books allows the partnership to allocate the deduction among only the historic partners, or to include the incoming partner, as long as it reflects economic reality and not tax avoidance; see Joseph A. Roccaforte, Jr., 77 TC 263 (1981), rev'd on another issue, 708 F2d 986 (5th Cir. 1983). For example, if the new partner's compensation is for future services, it seems reasonable to allocate his or her portion of the compensation deduction by closing the books. Under Prop. Regs. Sec. 1.706-3(a), the partnership can use either that method or the pro-rata method for guaranteed payments subject to Sec. 83.
Under the pro-rata method, the partnership can allocate the deduction to all of the partners during the year, including the incoming partner, based on the me (days, weeks, months, etc.) the person holds a partnership interest during the year, according to Regs. Sec. 1.706l(c)(2)(ii).
Example: On July 1, 2006, ABC Partnership grants J a 5% vested partnership interest as compensation for his investment advisory services for the upcoming year. ABC has $1 million in marketable securities, uses the cash method and has a December tax year-end. An appraisal indicates that a 25% discount is appropriate for a nonmarketable minority interest in the partnership.
In 2006, ABC reports a $37,500 guaranteed payment to J (($1,000,000 x 0.05) --0.25 discount), which J reports as income and ABC deducts in 2006. ABC can allocate its compensation deduction by either (1) closing its books just before J's entry, (2) closing them just after his entry or (3) pro-rating the deduction among all the partners based on the time they were a partner during the tax year.
Historic Compensation J's partners' allocation options portion portion Close the books just before J enters -- $37,500 Close the books just after J enters (0.05 x $37,500) $1,875 $35,625 Pro-rate based on time as a partner (($37,500 X 0.05 x 181)/365 $930 $36,750
The proposed regulations clarify years of confusion on the taxation of granting a partnership interest for services. In the process, they also give FLPs a valuable new estate planning opportunity. As long as the service partner renders legitimate services to the FLP and receives a reasonable grant in return, the transfer should be excluded under the Sec. 2036(a) bona fide sale exception, because the decedent is not the transferor and the transfer is for adequate and full consideration. Despite the obvious income tax disadvantage to the service partner, the historic partners receive a corresponding deduction and the opportunity to transfer potentially appreciating assets to the service partner.
Editor's note: For further information about this column, contact Mr. Minker at (212) 790-5826 or firstname.lastname@example.org, or Ms. Cantrell at (713) 667-9147 or email@example.com.
Marc J. Minker, CPA, PFS, RIA
Managing Director, Private Client & Family Office Services
Mahoney Cohen & Company
New York, NY
Carol Ann Cantrell, J.D., CPA
Briggs & Veselka Co.
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|Author:||Cantrell, Carol A.|
|Publication:||The Tax Adviser|
|Date:||Oct 1, 2005|
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