Planning With Family Limited Partnerships: The IRS Attack Continues – But Opportunity Remains
By: DAVID B. GOLLIN
Considering the ferocity of the Internal Revenue Service (IRS)’s recent attacks on the use of family limited partnerships (FLPs) as wealth transfer vehicles, not to mention its recent court victories, one couldn’t be faulted for thinking the FLP has gone the way of the Vikings’ chances of winning the Super Bowl (for a historical reference see the Dodo Bird). While there is reason for concern, those who heed the proper advice of counsel can still obtain significant benefits from the FLP.
Families have utilized FLPs for many years for a variety of non-tax related benefits, including creditor protection, investment diversification, and the education of junior family members. The use of FLPs proliferated when it became apparent that lack of control discounts in family controlled entities were available, resulting in significant estate and gift tax-savings.
Needless to say, the Service was not happy to see significant tax dollars escape the government coffers. The IRS fought back, initially to little or no avail. However, the tide began to turn when the IRS started arguing that the underlying assets of the FLP were includable in the deceased contributor’s estate because the decedent retained the right to benefit from or enjoy the transferred property until death. Given the egregious facts in the initial cases won by the government, the results were neither surprising nor alarming.
Then the U.S. Tax Court’s (second) decision in Estate of Strangi gave the IRS a watershed victory. In this case, the Tax Court agreed with the Service that the underlying assets contributed by the decedent to the FLP were includable in his estate on a non-discounted basis. While the result in Strangi was not unexpected due to the number of bad facts present, the Tax Court’s analysis of family limited partnerships was cause for concern.
At the age of 80 and in very bad health, Mr. Strangi – through his son-in-law as agent under a power of attorney – established Stranco, a corporation, to act as general partner of Strangi FLP. Mr. Strangi contributed nearly $10,000,000 of assets (amounting to 98% of his estate), including his personal residence, to the two entities in exchange for a combined 99.47% interest. Stranco had absolute authority regarding distributions from the FLP and Mr. Strangi’s son-in-law had complete management control over Stranco. Numerous payments were made for Mr. Strangi’s benefit – including over $3,000,000 for his estate taxes. Mr. Strangi died two months after formation of the two entities. His estate tax return valued his interests in the entities at approximately $6,600,000, while the net asset value of the corporate and partnership assets exceeded $11,000,000.
In reaching its decision in favor of the IRS, the Tax Court offered two separate theories. Under Theory 1, the transferred assets were includable in Mr. Strangi’s estate because he retained not only the right to the income from, but also the possession and enjoyment of, the transferred property. In the Court’s opinion, the facts clearly indicated an implied agreement between the parties for Mr. Strangi’s retained possession and enjoyment of the transferred property. Under Theory 2, estate inclusion was also appropriate because Mr. Strangi retained the right (either alone or in conjunction with others) to designate the persons who would possess or enjoy the property or its income. Mr. Strangi’s agent controlled Stranco, and Stranco made all distribution decisions for the FLP.
The Tax Court also determined that the exception to Theories 1 and 2 – the “bona fide sale exception” – did not apply. First, no “bona fide” sale occurred because the formation of Stranco and Strangi FLP were not arm’s length transactions. Second, Mr. Strangi’s contribution of assets to the FLP in exchange for stock and limited partnership interests did not constitute “full and adequate consideration in money or money’s worth.”
All in all, the result in Strangi (and the Court’s analysis under Theory 1) was not surprising given the classic “bad facts” present in the case. Although the Court’s analysis under Theory 2 appears to be unwarranted and incorrect, many have called the Strangi decision the death knell of FLPs. However, the properly planned and implemented FLP still has its place in the pantheon of wealth transfer planning vehicles.
There have been a number of court decisions (some favorable) on FLPs since the landmark Strangi case. In the Estate of E. Stone, III, the US Tax Court again considered the “bona fide sale exception,” this time finding in favor of the taxpayers despite the number of so-called “bad facts” present (e.g. the taxpayers’ children had agreed that the FLP assets would be used to take care of their parents if the parents’ financial resources became insufficient). Nevertheless, the Tax Court determined there was a bona fide sale for full and adequate consideration. The Tax Court highlighted as particularly important that there had been no commingling of the assets and each of the parties were separately represented. Furthermore, the taxpayers retained sufficient assets outside of the FLP. The Tax Court also found sufficient investment and business purposes for establishing the FLP. Finally, the Tax Court emphasized that the partnership rules were respected.
In Kimbell v. United States, the 5th Circuit Court of Appeals again found for the taxpayer and clarified the “bona fide sale for full and adequate consideration” exception. Kimbell was another example of an elderly taxpayer forming an FLP shortly before death and transferring a significant portion of her estate to the FLP in exchange for a vast majority (99.5%) of the partnership interests. The Court held that if the transaction is real and not a sham and is made in good faith, then it is “bona fide”, regardless of the fact that it might be a transaction between family members. The existence of tax planning motives, if other valid businesses purposes are also present, is acceptable. Active management of FLP assets is important. Furthermore, the “full and adequate consideration” test will be satisfied if the partnership rules are respected:
(i) each partner’s interest in an FLP is proportionate to the value of the underlying property contributed by such partner to the FLP; (ii) the capital account for each partner reflects the full value of the property contributed by such partner, and (iii) upon termination, each partner is entitled to his or her pro rata share of the distributions.
The facts in Turner v. Commissioner were very similar to those in the Strangi case. Not surprisingly, both the Tax Court and the 3rd Circuit Court of Appeals found an implied agreement that the taxpayer would retain the right to the income from, or the possession and enjoyment of, the property he transferred to the partnerships. Both Courts also determined that the “bona fide sale for full and adequate consideration” exception did not apply. The Turner case is important because the 3rd Circuit Court narrowed the “bona fide sale” exception as outlined by the 5th Circuit in Kimball. Unfortunately, we in Minnesota (the 8th Circuit) are left with no direct authority and a divergence of opinion in other jurisdictions.
We have learned over the last two years that, despite many potential pitfalls, FLPs that are properly structured and operated will be respected and will continue to provide an efficient means for transferring wealth to younger generations.
The following precautions (among others) should be taken to avoid estate inclusion under Theory 1:
- Establish non-tax reasons for creation of the FLP;
- Comply with all formalities required by state law;
- Do not transfer personal use assets (e.g. a personal residence) to the FLP;
- Other family members should contribute to the FLP to create a true “pooling of assets;”
- The primary transferor should maintain sufficient assets outside the FLP;
- Avoid establishing FLPs in the first place if the primary transferor is too old or too ill;
- Do not commingle assets;
- Actively manage the FLP’s assets; and
- Do not make non pro rata distributions to the primary transferor.
To avoid estate inclusion under Theory 2, the following precautions should be taken:
- The primary transferor should not control the general partner;
- Neither the primary transferor nor his/her agent or trustee should have the power to control FLP distributions;
- The general partner’s fiduciary duties should not be waived;
- Other family members should have more than a de minimus ownership interest in the FLP; and
- Gifts of FLP units to a trust with an independent trustee are helpful.
Finally, in order to support the “bona fide sale” exception to Theories 1 and 2, the following steps should be taken:
- Establish objective factors indicating that the transaction was done in good faith and not a sham (i.e. non-tax motives);
- Other family members should have more than a de minimus ownership interest in the FLP;
- Actually transfer assets to the FLP;
- Actively manage the FLP assets; and
- Respect the partnership rules: Each contributor should receive a proportionate FLP interest relative to the value of such person’s contribution; the value of the assets contributed should be reflected in the contributor’s capital account; and upon dissolution of the FLP, each contributor should be entitled to the value of his or her capital account.
If you have an existing FLP (or other family entity), or wish to discuss the creation and implementation of an FLP, contact your current estate planning attorney or any of us in the Trusts & Estates Group at Fredrikson & Byron.