Dedon on Estate Planning

Family Partnerships and Estate Planning

A recent Tax Court Memorandum Opinion, Estate of Miller v. Commissioner, T.C. Memo 2009-119 (May 27, 2009), adds to the long line of cases involving taxpayers who claim valuation discounts for transfers of assets to family members. The intended result is that, because the asset values are reduced for tax purposes, significant estate tax saving result. As in Estate of Miller, the preferred entity to obtain discounts is often a Family Limited Partnership (FLP). Limited Liability Companies are also often used.

For purposes of highlighting the importance of Estate of Miller, I am eliminating details of the facts. Simply assume the taxpayer transferred marketable securities into an FLP and then gifted limited partnership interests to her children. The gifts occurred over a two year period. The taxpayer claimed a 35% discount from the asset value of the publicly traded securities inside the FLP because the gifts consisted of limited partnership interests. That is, although the marketable securities were in Merrill Lynch and Fidelity accounts, because they had first been transferred into the FLP, and then limited partnership interests were transferred not the public securities, discounts for lack of market and control should apply.

The Tax Court agreed with the taxpayer in concept and allowed discounts for the gifts made in Year One but not Year Two. In broad terms, the importance of the Tax Court’s decision is the following:

Taxpayers can obtain discounts for gifts of limited partnership interests even when the FLP holds marketable securities.

• A 35% discount may be reasonable. Indeed, the IRS did not challenge the amount of the discount. Thus, in theory a discount more or less may be appropriate, depending on the facts.

There must be a business purpose for the creation of the FLP. A "business purpose" means, in essence, a non-tax reason. The Tax Court concluded actively managing marketable securities is a valid "business purpose." Thus, taxpayers do not need to operate a "business" in the sense of a car dealership or government contracting business to rise to the level of a valid business purpose.

So, what did the Tax Court determine was the distinguishing factor between Year One when the gift (and 35% discount) was allowed and the second year when the Court said there was not a legitimate gift? It comes back to business purpose and the non-tax reason for creating the FLP and making the gifts. (The relevant Internal Revenue Code Section is 2036.) The Tax Court stated there was a legitimate non-tax reason to create the FLP. Here, it was primarily the need for an entity to allow a child to continue the active investment philosophy of his parents. The child worked full-time in this activity. Perhaps other factors were important, such as asset protection, succession planning for the family and centralized management. The court also noted the taxpayer had other assets to live on beyond those gifted to her children. Thus, the Year One gift was legitimate.

However, in Year Two when the second round of gifts was disallowed, the taxpayer was not in good health. The Court concluded the gifts were motivated by death bed planning. Also, after this round of gifts, the taxpayer did not have other assets in her own name sufficient to pay her bills. Thus, the Court held the gifts in Year Two were motivated by the taxpayer’s desire to reduce estate tax.

In general, Estate of Miller v. Commissioner is a pro-taxpayer case because it illustrates that FLP’s and LLC’s remain viable gift and estate tax planning tools if set up for valid reasons. However, if thrown together at the last minute as part of death bed planning or without any credible non-tax reason, they will be subject to challenge. The IRS will also challenge the discounts if the formality of the structure is not observed, e.g., commingling assets, failure to make pro rata distributions, opening appropriate accounts, etc.

As I have written about in the past, whether Congress renders these cases moot through legislation that would curb or eliminate discounting in family settings remains an open question.

Looking For The Silver Lining In Economic Clouds: Family Partnerships and Marketable Securities

As bad as our balance sheets appear in these dire times, if we strain we can try to find the silver lining. A possible silver lining is for parents and grandparents who are considering generational transfers to reduce their taxable estates. They can take advantage of hard economic times by removing marketable securities from their taxable estates. The combination of low stock values, and market and minority discounts resulting from using family limited partnerships (FLP), can result in substantial estate tax savings.

Granted, many taxpayers who previously considered gifts to reduce their taxable estates are no longer concerned or at least do not view it as a priority. On the other hand, the depressed stock market presents a unique opportunity to make current gifts and save significant gift and estate taxes. Therefore, if the estate is still substantial, now is the time to gift marketable securities.

I have previously written about GRATs. Another tried and true transfer tool with a long history is the FLP. In an FLP, the senior generation typically contributes the bulk of the assets and retains control as the general partners. (The general partnership interests are analogous to voting stock of a corporation.) They gift limited partnership interests to children and grandchildren. These limited partnership interests, which represent equity in the FLP, do not have any voting rights. The absence of voting rights and control often result in discounted asset values for estate and gift purposes.

Taxpayers and the IRS have had many battles regarding whether FLP’s can be used to reduce estate taxes, either by lifetime gifts or upon death. Broadly stated, taxpayers assert FLP restrictions prohibiting limited partners from freely selling or controlling the FLP assets significantly depress the value of the limited partnership interests, and hence the partnership assets. These "market and minority" discounts typically reduce the partnership asset values anywhere between 20% and 50%, depending on the type of asset, income generated from the asset, and other factors. The IRS’ positions are varied: they include 1) there is no business purpose for the FLP, rather it is only a device to artificially reduce gift and estate taxes; 2) purported transfers were illusory because the transferors retained indirect control; 3) the formalities were not observed, such as FLP bank accounts were not opened, capital accounts, schedules, and tax returns were not prepared; 4) pro rata distributions to the partners were not made; 5) the discounts were too high, and on and on.

Notwithstanding these IRS assaults, FLP’s are still a valid planning tool if created properly and implemented appropriately. A recent case, Holman v. Commissioner, 130 T.C. No. 12 (May 27, 2008), supports FLP’s to reduce gift taxes even if the FLP consists only of marketable securities. In Holman, the taxpayer contributed solely Dell Computer stock. The Tax Court rejected the 49.25% discount claimed by the Holman’s for the gift of limited partnership interests to their children. However, the Tax Court did allow discounts exceeding 20%, simply because the Holman’s used an FLP to gift limited partnership interests rather than gift the Dell stock directly. The Tax Court rejected the IRS’ position that the transfers were indirect transfers of the Dell stock and the FLP should be disregarded. The Court also disagreed with the IRS position that Internal Revenue Code Section 2703 trumps the FLP agreement and treats limited partnership interests as freely transferable, thereby eliminating any market and minority discounts.

What does Holman mean to taxpayers seeking to reduce gift and estate tax? Consider this example:

Mr. and Mrs. Taxpayer have marketable securities that were worth $12 million in 2006. In 2008, their portfolio fell 25% to $9 million. They want to gift roughly 1/3 of the $9 million portfolio to their children. They first create an FLP, next they contribute the marketable securities to the FLP, and then they gift FLP limited partnership interests to their children. They obtain an appraisal which discounts the limited partnership interests by 31%, so that the FLP assets are worth $6,210,000. They gift 30% of their FLP limited partnership interest to their children, which is worth only $1,863,000 for tax purposes. The underlying asset value, however, is $2.7 million. If the assets bounce back to $12 million, they have removed $3.6 million from their estates. By taking advantage of the FLP and discounts, the estate tax savings based on a $9 million valuation is almost $400,000 (tax savings on a transfer of $1,863,000 instead of $2.7 million). If the portfolio bounces back to $12 million, the estate tax savings are approximately $800,000 (tax savings on a transfer of $1,863,000 instead of $3.6 million). These savings do not take into account the future appreciation also removed from the estate.

In sum, FLP’s satisfy a number of advantages. They can provide asset protection for assets inside the FLP; they can maintain assets for future generations by providing a management structure; and as discussed above, FLP’s provide significant estate tax savings for individuals seeking estate tax relief without losing complete control over the assets.