What is new with FLPs and FLLCs?
Recent court cases offer insight on how these estate planning tools will hold up against IRS scrutiny
Family limited partnerships (FLPs) and family limited liability companies (FLLCs) can be powerful tools for consolidating and managing family wealth while reducing gift and estate taxes. Unfortunately, the potential for significant tax savings makes FLPs and FLLCs targets for the IRS. But with careful planning and a solid defensive strategy, you can protect these entities against attack. Recent court cases provide invaluable guidance on designing and operating an FLP or FLLC that can help you achieve your financial and estate planning goals.
How they work, how they are challenged
The tax-saving power of FLPs and FLLCs comes from valuation discounts available for transfers of limited partnership interests, which are relatively unmarketable and provide the limited partner with little control over partnership affairs. For example, in a typical scenario the older generation transfers assets into the partnership or LLC and retains both general and limited shares. The limited shares are then gifted to the younger generation, using both annual exclusion and lifetime exemption amounts. The valuation discounts are a function of the fact that the limited shares have no control over the partnership or LLC activities, and because there are, in most cases, transfer restrictions on those shares.
Naturally, the IRS is suspicious of entities it believes were formed merely to avoid taxes. So the agency has repeatedly attacked what it considers abusive FLPs and FLLCs. One strategy has been to charge that the entity’s assets should be included in the taxable estate of the person who set it up. (See “IRS’s most effective FLP and FLLC killer: Sec. 2036(a)” in the sidebar below.) Another has been to challenge the valuation discounts applied to the gifts of interests in the entity.
In Holman v. Commissioner, a married couple formed an FLP, which they funded with almost $3 million in publicly traded stock. Six days later, they gifted limited partnership interests to trusts and custodial accounts for the benefit of their four children, applying valuation discounts for lack of control and lack of marketability totaling nearly 23% for that initial gift. Be aware that gifts in subsequent years were subject to different discount amounts. Specifically, the judge determined that all of the gifts were eligible for a marketability discount of 12.5%, but the discount for lack of control was 11.32% for the initial gift, 14.34% in the second year, and just 4.63% in the last year in question.
The IRS claimed that the transfers were indirect gifts of the stock to the limited partners, and that gift tax should be applied to the full value of the underlying shares. It argued that the transfer to the FLP and the subsequent transfer of limited partnership interests should be viewed as a single transaction under the “step-transaction” doctrine.
The Tax Court disagreed, finding that each transfer had independent significance. In reaching this conclusion, the court noted that the stock was heavily traded and highly volatile, and that the parents assumed the risk that the stock’s value would change during the six days before they transferred the limited partnership interests.
The court would not establish a “bright line” standard for the amount of time that must pass for a series of transactions to be deemed independent. In this case, six days was enough, but the court noted the result might be different if more stable assets were involved.
The IRS also argued that the limited partnership interests should be valued for gift tax purposes without regard to certain transfer restrictions. Had the judge decided to disregard such restrictions, including the right of the partnership to buy back an interest from an assignee in the event of an unpermitted assignment, the discount for lack of marketability likely would have been much lower. Internal Revenue Code Sec. 2703 permits the IRS to ignore the impact of such restrictions on value unless a transferor can prove, among other things, that the transaction:
- Is a bona fide business arrangement,
- Is not a device to transfer shares to family members for less than full and adequate consideration, and
- Has terms comparable to similar arrangements entered into by persons in an arm’s-length transaction.
In this case, the court found that the parents’ reasons for establishing the transfer restrictions were personal — including asset preservation and long-term growth. There was no business purpose for the transfer restrictions, as there would be if the FLP had been established to preserve family control of a family business. Thus, in this case the transfer restrictions included in the partnership document did not create any additional discount. Without saying so, the judge intimated that the discounts that were allowed would have been greater had the partnership included a business purpose for including the restrictions.
One of the issues in Astleford v. Commissioner was whether an FLP was entitled to “tiered” discounts based on multiple levels of ownership. The transferors in this case gifted limited partnership interests in an FLP that owned farmland and other assets.
One of the assets was a 50% interest in a real estate general partnership, raising an issue as to whether the general partnership interest was entitled to valuation discounts for lack of control and marketability within the FLP. In other words, did valuation discounts available for interests in the FLP apply to the discounted value of the FLP’s general partnership interest?
The Tax Court rejected the IRS’s argument that only one tier of valuation discounts applied. The limited partnership interests were entitled to combined discounts of 35.6% in addition to a 30% discount for the general partnership interest. The two tiers of discounts effectively reduced the value of the general partnership interest by around 55%.
In this case, the general partnership accounted for less than 16% of the FLP’s net asset value. The Tax Court noted, however, that tiered discounts might not be available when an interest constitutes a “significant” portion of the parent entity’s assets.
As the above cases demonstrate, whether an FLP or FLLC achieves your estate planning objectives depends on several factors, including the type of assets involved, the structure of the transaction, and the reasons for establishing and funding the entity. You can arm yourself against an IRS attack with careful planning and by documenting one or more legitimate, significant nontax purposes for an FLP or FLLC.
Sidebar: IRS’s most effective FLP and FLLC killer: Sec. 2036(a)
The IRS has had success challenging family limited partnerships (FLPs) and family limited liability companies (FLLCs) under Section 2036(a) of the Internal Revenue Code. This section permits the IRS to disregard an FLP or FLLC for estate tax purposes and bring the assets back into the transferor’s estate if the transferor retains “possession or enjoyment of, or the right to the income from, the property” or the right to determine who will do so. There is an exception, however, for assets transferred in a “bona fide sale for adequate and full consideration.”
Practically speaking, the IRS and the courts examine the same set of factors in determining whether there was a bona fide sale as they do in determining whether the transferor retained possession or enjoyment of the property or its income. Factors that tend to support an IRS challenge include:
- Failure to observe FLP or FLLC formalities,
- Commingling of entity and personal assets,
- Failure of the transferor to retain sufficient assets to meet his or her living expenses,
- Deathbed transfers of FLP or FLLC interests, and
- Failure to establish one or more legitimate and significant nontax reasons for forming the FLP or FLLC.
The last factor is probably the most important one, in part because it involves questions of subjective intent and can be difficult to prove.
In Estate of Mirowski v. Commissioner, the taxpayers prevailed in large part because they were able to provide convincing evidence that the transferor formed an FLLC for legitimate, nontax reasons:
1. To facilitate joint management of the family’s assets by the transferor’s daughters,
2. To maintain the bulk of the family’s assets in a single pool to allow for investment opportunities that otherwise would not be available, and
3. To provide for each of the transferor’s daughters and eventually each of her grandchildren on an equal basis.
The court also observed that there was no evidence of an implied understanding that the transferor would have access to the FLLC’s assets.