Until recently, David Weinstock, a principal with Weiser Capital Management in New York, was reluctant to recommend family limited partnerships (FLPs) to clients if the only partnership investment was to be securities. "I personally tend to be very conservative and securities-only partnerships always made me nervous," he says. Weinstock's position, however, has changed thanks to three taxpayer-friendly Tax Court cases involving FLPs and family limited liability companies (FLLCs) handed down this year. Now, says Weinstock, if a client presents a good fact pattern, he is discussing securities-only FLPs as an appropriate estate-planning tool.
In recent years, the utility of FLPs and FLLCs--business entities used not only to maintain and run family businesses, but also to transfer assets to future generations--was thrown into doubt because of IRS challenges and a spate of rulings that were unfriendly to taxpayers, according to Radd L. Riebe, managing director, Valuation &Financial Opinions at Stout Risius Ross, a financial advisory firm with headquarters in Chicago.
The frequent IRS challenges to FLPs/FLLCs made planners nervous about using them, particularly since tax courts tended to side with the IRS, says Neil Fang, an attorney with Schwartz & Fang PC in Lake Success, N.Y. The IRS relied on Section 2036 of the Internal Revenue Code to challenge the exclusion of assets transferred into FLPs and FLLCs from decedents' estates--and frequently won.
This year, however, advisors and their clients got some good news. Tax courts have signaled that if established properly, with all conventions observed, FLP/FLLCs can reduce the estate and/or gift tax burden for families--as long as tax avoidance is not the primary reason for the partnership. "These were very taxpayer-friendly cases and make family limited partnerships even more attractive to taxpayers then before," says Steve R. Akers, a managing director with Bessemer Trust in Dallas. Properly set up and documented, say the experts, FLPs and FLLCs have a good chance of surviving IRS and Tax Court scrutiny.
Estate of Mirowski v. Commissioner, decided in late March 2008, involved estate taxes. The widow of an inventor wanted to engage her daughters in managing family finances. She set up an FLLC, but died unexpectedly, shortly thereafter. The Tax Court permitted the assets transferred to the FLLC to be excluded from the widow's estate, holding that section 2036 did not cause inclusion of the FLLC assets in her estate.
In reviewing the validity of the Mirowski FLLC, the court cited the following as legitimate and significant non-tax reasons for creating the FLLC:
Joint management of the family's assets by the decedent's daughters and eventually, her grandchildren;
Maintenance of the bulk of the family's assets in a single pool in order to allow for investment opportunities that would not be available if the decedent were to make a separate gift of a portion of her assets to each of her daughters or to each of her daughters' irrevocable trusts, and providing for each of the decedent's daughters--and eventually, each of her grandchildren--on an equal basis...none of which reasons directly benefited the decedent as compared to owning the assets directly.
The court found another reason advanced by the petitioner for the creation of the Mirowski FLLC--to increase asset protection--not to be significant.
More importantly, the court rejected the IRS claim that facilitation of lifetime giving can never be a significant non-tax reason to form and fund an FLLC. Also rejected was the IRS contention that a business purpose was needed to validate the transaction. While the IRS has frequently asserted and won the argument that transactions need a bona fide business purpose to pass muster in other cases, says Fang, here the IRS lost.
At a minimum, Mirowski will lead IRS agents to have second thoughts in marginal cases, says Milford B. Hatcher, Jr., a partner at Jones Day, a law firm in Atlanta. Prior to Mirowski, says Hatcher, the IRS took increasingly strong positions in the field regarding cases practitioners thought were not strong, and were not inclined to work out settlements. Since Mirowski, however, agents have been more reasonable about working out settlements, says Hatcher.
Gift taxes were the issue in another significant case decided by the Tax Court in early May. In Astleford v. Commissioner, the court allowed multi-level discounts where an FLP owned an interest in a real estate subsidiary general partnership.
Over the past few years, explains Fang, the IRS has tried to prevent taxpayers from taking multi-tiered discounts. Here the court allowed the general partnership interest to be discounted, then allowed a further discount when that general partnership interest was dropped into a limited partnership, he says.
Astleford provided validation to tiered discounts, says Hatcher, but only if there is a minority position in the underlying organization. "It clearly supports tiered discounts with respect to minority interests, but not with regard to controlled interests," he points out.
Holman v. Commissioner, handed down in June, was another gift-tax case. This time, the decision addressed the so-called "integrated transaction" theory the IRS had pressed over the last several years when a gift of a limited partnership interest is made soon after an FLP/FLLC is funded. Increasingly, the service had been trying to attack gifts on the grounds of step transactions, says Hatcher, effectively saying that if you set up a partnership and then made a gift of the partnership, the discount would not be allowed. Instead, the transaction should be treated as an indirect gift to the donee.
In Holman, a taxpayer created a FLP in 1999 and funded it with Dell Corp. stock. A week later, the taxpayer made gifts of limited partnership interests to family members and filed a gift tax return taking a discount on the value of the stock. The IRS argued against the discount saying it was an indirect gift of the stock itself and not limited partnership interests.
The good news for taxpayers was that the court refused to treat the transaction as if there were an indirect gift of assets in the FLP without a discount. Holman states that if there is a material economic risk of a change in value, it is not necessary to wait months between creation of a partnership and the transfer of interests, says Hatcher. Conversely, if there is no big economic risk--e.g. if the investments transferred were bonds--then more time would be required to escape the step transaction doctrine, says Hatcher. When the underlying investments are not that volatile, it would be prudent to wait longer.
However, Holman was not a complete loss for the IRS. The court refused to consider the effect that transfer restrictions in the partnership agreement might have on value. The court struck down the taxpayer's original claim for a 49.5 percent discount as too aggressive and replaced it with a discount of 22.5 percent.
"Holman is the most restrictive valuation case to date," says Hatcher. The discounts allowed were the lowest he has seen. The court only permitted an approximate 12.5 percent lack of marketability discount, says Hatcher. Previously, he says, courts have allowed marketability discounts in the range of 20 percent to 24 percent. When you take into account lack of control and lack of marketability, discounts for minority interests were typically around 30 percent, says Hatcher. In Holman, it was closer to 20 percent.
Essentially, says Riebe, the discount was small--an estimate of the nuisance and legal cost of dissolving and reforming the entity. The analysis, he says, does not hold together in terms of honoring the entity. "You don't form an entity to dissolve it," he says.
The downward pressure on discounts is part of a trend. Six years ago, says Hatcher, the range of discounts for marketable securities for a non-controlling interest was approximately 33.3 percent to 35 percent. In a 2003 Tax Court case, that discount dropped to 30 percent. If other judges adopt the methodology used in the Holman decision, says Hatcher, the discount will probably range from 20 percent to 24 percent.
The long-term implications of Holman are not really known, says Riebe, but potentially, buy-out restrictions may need to be less severe than those put in place in the past. Akers says he already knows of audits where IRS agents are arguing that discounts should be between 16 and 25 percent instead of discounts ranging from 25 to 30 percent.
Mirowski, Astleford and Holman create roadmaps advisors can use to determine whether FLPs or FLLCs are appropriate for their clients and if so, how to set them up. Mirowski, in particular, establishes guidelines for the advisor, Fang says. Essentially, Mirowski says that if you can show a non-tax reason for creating a FLP/FLLC, then the court is likely to uphold the discount. If you can come up with a non-tax reason and document that non-tax reason for the transaction, Fang says, the transaction should be upheld. You can have a tax reason as well, he adds, but you need sufficient non-tax reasons.
One important factor in the court's upholding of the Mirowski transaction, Fang continues, is that the taxpayer was left with sufficient liquidity after the transaction to pay taxes and living expenses. She did not fund the transaction with all her assets. So, when setting up an FLP/FLLC, advisors should be sure the client has sufficient assets left to cover living expenses and taxes.
Another lesson gleaned from Mirowski, says Riebe, is to document everything and be ready to support the non-tax purposes for the FLP/FLLC. "You need something more than saving gift taxes for it to stand," he says. Advisors must document the underlying reason why the FLP/FLLC was created, because whether or not the entity will be respected will likely turn on the distinct facts, he adds.
Akers notes that advisors should also take comfort from the fact that the Mirowski court did not find abusive the decedent's apparent need to get a distribution to pay her gift taxes, in the event she lived. The IRS argued that if assets were transferred to an entity, and the transferor expected a distribution, then it was an implied agreement that they could get a distribution Therefore, IRS section 2036 applied, and the assets should be drawn back into the estate. The Mirowski court, however, did not find it abusive that the decedent needed a distribution to pay her gift taxes.
Astleford, on the other hand, shows that multiple discounts are available for tiered entities, says Riebe, but advisors cannot create a FLP/FLLC, stack something on top and expect multiple discounts to be upheld. "It can't be an artificial stacking of shell entities," Riebe says. The upper-tiered entity must hold some other investment in addition to the lower-tiered investment. Moreover, there must be non-tax reasons for the transaction, says Akers. Dropping one entity into another simply to get the discount is less likely to pass muster in the Tax Court.
Fang says that multi-tiered discounts are probably best suited for existing investments. In Astleford, he notes, the general partnership interest had existed for 20 years prior to the transaction. "It wasn't created overnight and gifted," he says. In allowing the discount, the court, he says, took into account that it was an existing investment. Thus, he adds, if you have existing general partnership investments, there is a planning opportunity. But do not create general partnership interests in an attempt to take advantage of multi-tiered discounts.
Riebe also recommends that if advisors want to support tiered discounts, a detailed analysis of all assets in the entities should be done to make sure they are independent, stand-alone entities.
Holman demonstrates that if clients want to contribute stock to a FLP and receive a discount, it is extremely important that the stock is contributed to the FLP prior to the contribution of the limited partnership interests, Fang says.
The Holman court held there was no indirect gift, because the stock was contributed prior to gifting of the limited partnership interests. If the limited partnership interests had been gifted prior to contribution of the stock, the court suggested, it would have constituted an indirect gift resulting in no discount. "So always make sure that the limited partnership is funded before the gifts are made," says Fang.
Holman also indicates that less time may be required between funding the partnership and making the gifts. Previously, Akers points out, he liked to put several months between partnership funding and making gifts of partnership interests. Now, however, he will not feel as hard-pressed to put so much time between the two. "You still need time," he says, "but maybe not six to twelve months."
Mirowski, Astleford and Holman represent probably the most significant taxpayer victories in the FLP/FLLC area since Estate of Bongarde in 2005, says Hatcher. Taken together, these three cases mean that with proper planning and the following of proper procedures, FLPs and FLLCs are valuable tools to help clients transfer wealth to future generations. But, he is quick to note, although Bongarde was very taxpayer friendly, a number of subsequent cases eroded Bongarde's taxpayer-friendly standards.
Over the last 10 years, says Weinstock, Tax Court decisions and IRS challenges have given advisors guidelines to what works and what does not. These cases, he says, further clarify issues such as ensuring that clients retain enough assets outside of the FLP/FLLC to pay their expenses and taxes. "Although past cases made planners nervous, if you follow the rules--and [are not] too piggish on taking discounts, then you'll do a great service to your client," says Fang. Advisors must have a non-tax reason for creating a FLP/FLLC, he emphasizes, and cannot expect to take excessive discounts.
"I'm still tentative with partnerships because I'm conservative, and I know the IRS still actively challenges partnerships on gift tax audits," says Weinstock, "but I'm more comfortable and will be more prone to speak with clients regarding partnership planning." However, he adds, he will also make sure clients are fully aware of the risk of an IRS challenge.
Elayne Robertson Demby has written extensively on executive compensation, employee benefits and financial issues.