Individuals typically transfer assets to family partnerships hoping to achieve large estate tax discounts for the assets that would not otherwise be available if the assets were retained in outright ownership. The discounts, in turn, could result in substantial tax savings. However, in order to achieve the desired results, a number of hurdles must be overcome.The Internal Revenue Service has issued Appeals Settlement Guidelines for family limited partnerships and family limited liability companies. These guidelines can help practitioners overcome some of the hurdles. By carefully examining this document and the pro- and anti-taxpayer cases examined in it, a practitioner should be in a position to craft an FLP or FLLC that will achieve a desired level of discounts for a client's estate.
As spelled out in more detail below, the ASG document focuses on four key issues - discounts for the transferred interests; includibility in the estate under Code Sec. 2036 or Code Sec. 2038; indirect gifts of the entity's underlying assets; and whether accuracy-related penalties should be imposed - and examines a number of cases addressing these issues.
The ASG document notes that FLPs and family corporations have long been used in the conduct of active businesses, primarily to provide a vehicle for family involvement in the enterprise and for succession planning. In the early 1990s, however, estate planners began using FLPs and FLLCs to hold and transfer passive assets for the "business" of engaging a younger generation in investment decision-making.
The ASG document observes that the IRS initially focused on the question of whether the FLP was valid for tax purposes, but lost in many cases. There is now a set of recognized criteria that estate planners can use in establishing FLPs and FLLCs that head off such challenges. The IRS still raises the issue of legitimacy, however, when these criteria have not been followed.
Where the IRS cannot successfully argue to set aside the FLP's existence for tax purposes, the focus shifts to determining the correct valuation of its assets. The amount of discount to be applied to the fair market value of the assets is often a source of dispute, with taxpayers arguing that lack of marketability and minority-interest factors should result in deep discounts that significantly reduce the tax base.
In addition to the validity (often known as the Code Sec. 2036 and Code Sec. 2038 issue) and the valuation issue, the IRS also raises the issue of indirect-type gifts, where the transfers of FLP interests are made before, at the same time as, or shortly after funding.
This issue examines whether the fair market value of transfers of FLP or FLLC interests by death or gift is properly discounted from the pro rata value of the underlying assets. The IRS takes the position that under certain circumstances, there should be minimal discounts or no discounts from the pro rata value of the underlying asset value of the entity. On the other hand, taxpayers contend that, because of the illiquid nature of the assets involved, the transfers have an FMV that is substantially less than the underlying pro rata value of the assets held by the entity.
Discounts for minority interest, lack of marketability and possibly portfolio composition are used by taxpayers to reduce the value of the assets transferred. In addition, the methods of valuation used by the appraiser valuing the entity may contribute to reductions from the underlying pro rata value of the assets.
The ASG notes that cases in this area are fact-specific and that, as a result, each case needs to be individually assessed to determine the appropriate discounts. It examines some recent cases in this area, including Knight (2000) 115 TC 506, where the Tax Court recognized the validity, for gift tax purposes, of an FLP, but did not allow valuation discounts for gifts of interests in it to the extent claimed by the donors.
This issue examines whether the transferred interests should be included in the transferor's estate at their fair market value as of the date of his death under Code Sec. 2036 or Code Sec. 2038. Under Code Sec. 2036, a decedent's gross estate includes transfers under which he retained the possession or enjoyment of, or the right to the income from, the transferred property. The decedent need not have a legally enforceable right, but there must be an agreement, either expressed or implied, that the decedent will retain the benefit.
Under Code Sec. 2038, a decedent's gross estate includes a lifetime transfer if the enjoyment of the transferred property was subject at his death to any change through the exercise by him of a power to alter, amend, revoke or terminate. This includes any power affecting the time or manner of enjoyment of property or its income. Inclusion is not required under Sec. 2036 or Sec. 2038 if the transfer was a bona fide sale for full and adequate consideration.
The IRS's position is that, where the facts and circumstances indicate that the decedent retained a sufficient interest in the transferred property, the property is includible under Sec. 2036 or Sec. 2038.
The taxpayer's position is that the transfer of property to an FLP is excepted from the reach of these provisions as a bona fide sale for full and adequate consideration, or that the taxpayer has not retained the powers needed to trigger application of either provision.
This issue looks at whether there is an indirect gift of the underlying assets, rather than the FLP interests, where the transfers of assets to the FLP occurred either before, at the same time or after the gifts of the limited partnership interests were made to family members.
The ASG document notes that, under current case law, transfers of assets to an FLP after transfers of limited partnership interests were made to family members are indirect gifts and subject to the Tax Code's gift tax provisions. Taxpayers contend that transfers of assets to an FLP after transfers of the limited partnership interests themselves are actually transfers of partnership interests.
The ASG document also examines the circumstances under which the IRS may seek to impose accuracy-related penalties under Code Sec. 6662 in cases involving transfers of interests in FLPs or FLLCs.
William E. Massey, Esq., is senior tax analyst at Thomson Tax & Accounting.
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