Family limited partnerships (FLPs) and limited liability companies (LLCs) are viewed by many as modern day reverse-alchemy able to turn valuable marketable securities into devalued interests for estate tax purposes. A recent case points out (yet again!) that this stuff is not child's play, and risks abound. And as with so many estate, financial planning, asset protection and other techniques, most folks remain their own worst enemy by not taking the time to meet regularly with their advisers, adhere to formalities, and follow up. Yes Virginia you have to come back regularly and meet with that crusty lawyer of yours. This is like making gumbo, all of the many ingredients collectively have to pass the smell and taste test when its done.
The following discussion is merely a starting point for how to do an FLP/LLC right. Several of the issues in the recent case, Estate of Concetta H. Rector, v. Comr. T.C. No. 20860-05; T.C. Memo 2007-367 (12/13/07). Judge Laro's again reminds taxpayers that FLPs and Professor McGonagall's Wand are not one and the same. Concetta and her revocable trust formed an FLP with assets consisting of cash and marketable securities, comprising most of her wealth. No significant change in the assets occurred following the formation of the FLP. Concetta made gifts of limited partnership ("LP") interests. When she died she owned a 2% general partnership interest and more than 70% of the LP interests. The Court found that the FLP was really just a mechanism to transfer her assets at death, It was primarily a "testamentary substitute." The Court found that there was an implied understanding that she would have access to FLP assets. The Court noted that no principal distributions were made from the by pass trust for her benefit set up under her husband's will. No surprise there. The kids were simply trying to keep assets in the by pass trust and out of her estate.
What lessons can be learned this and other recent cases? We also consulted with Carnac the Magnificent (he crossed the picket lines to help us on FLPs) for some ideas:
● While some advisers are now advocating structuring arrangements as a co-tenancies (i.e., without the use of an entity) a co-tenancy may be treated as a partnership under state law. Such an effort may be a vain attempt to highlight lack-of-form over substance. Therefore, if such an alternative is used, still address every issue in this checklist (and applicable case law). Don't rely on using a non-entity approach as a panacea. It won't prove to be.
● There should be a significant non-tax business purpose for the FLP. What a novel idea, a business purposes for a business! Saving estate taxes (and making gifts) doesn't get you any Brownie points. The amazing thing about this requirement is that there are a host of benefits you can score with an FLP with proper planning. FLPs can be a tremendous tool to protect assets from lawsuits, keep ex-spouse's at bay, open up new investment opportunities, consolidate assets, maintain control, provide business succession planning, and more. Corroborate them.
● The longer before death that the FLP is set up and funded the less it will look like a testamentary substitute (i.e. a mechanism to transfer wealth at death). Since the Grim Reaper doesn't usually send "reserve the date" notices, do it sooner, not later.
● When the FLP is being set up, have separate lawyers represent different partners. Follow Dr. Phil's advice and make it a "real deal" (maybe everywhere but California). Real deals aren't typically done with one lawyer. Each partner gets her own lawyer (you need to maximize those legal fees). Have each partner's attorney provide written comments which can be saved to demonstrate this. Using Microsoft Word with track changes and comments is a great way to corroborate that the different attorneys and partners each had input. Real deals have negotiated changes, not the first draft document being signed without comment.
● Purchase and maintain a kit (analogous to a corporate kit). It's a good repository for all the original signed documents. Issue certificates (analogous to stock certificates).
● Let the assets you transfer to the FLP age a bit before you make gifts. While in real deals with unrelated parties transfers of equity interests are commonly made at the same table as asset transfers, the courts have for some reason stated that time should elapse. At minimum all transfer documents and steps should be completed before gifts are made. This is why calling your attorney to form and make FLP gifts a just prior to the end of the year isn't advisable.
● Have periodic (at least annual) entity meetings. Having your advisers attend the annual meeting (by conference call if necessary to minimize costs). Minutes should be prepared and signed.
● Have entity operations reviewed and monitored by all appropriate advisers.
● Persons and entities other than the parents/donors should invest significant assets on the formation of the entity. Having mom alone put most of her assets into an FLP just doesn't look great.
● Some modest distributions in proportion to equity interests should be made to corroborate that the ownership interests are being respected. Get the percentages right. The income tax return for each partner should reflect their actual ownership. This can be tricky during years when the ownership percentages change (e.g. a new partner was admitted, or an existing partner made an additional contribution so that her ownership interests increased). Have your CPA prepare spreadsheet showing the changes in ownership interests in such years.
● No significant distributions should be made that could be used to pay ongoing expenses of the parents or other senior family members/donors. Don't make distributions every time mom needs money. Having FLP distributions track Mom's personal expenditures is a great proof for the IRS that mom had an implied agreement with the rest of the family/partners to control the underlying FLP assets for her use.
● Prepare a budget demonstrating that more than adequate resources have been left outside the entity to meet the needs of the parents. No magic numbers.
● Negotiations of the transaction is cited in many cases as an important factor. Use a Word document and track change comments from the various investors, accountant and attorneys to demonstrate that this has been done (yes, this means you actually have to read the document).
● Decedent's advanced age and poor health are cited in many cases as negative factors. The concept is that the entity is being used as a will substitute. Obtain a written medical opinion of the parents have a life expectancy.
● Courts pretty uniformly look askance at only cash and marketable securities being the sole assets contributed into the entity. When feasible, contribute other non-liquid assets as well. Importantly, whatever assets are contributed initially, the more significantly the nature of those assets changes will demonstrate a real pooling of family resources to undertake new and hopefully more financially profitable investments. Personal assets don't belong in investment type FLPs.
● Have a pre-contribution investment analysis completed, and then a post-contribution investment policy statement (IPS) prepared, to demonstrate the changes made. Corroborate the proper adherence to independent entity investment planning. Ideally there should there be a marked change in investments, but the pre-contribution IPS should reflect the parents pre-contribution risk tolerance and other objectives, and the post-contribution IPS should reflect the entities risk tolerance and investment objectives.
● Have your CPA review who will be taxed on any gains realized if old assets are liquidated. IRC Sec. 704(c), etc.
● The donor/senior generation should not serve as managers, general partners or otherwise control the entity. That being said, many of you just won't give up the reigns. Hold them at your kids risk, they bear the burden of the estate tax cost of your retaining control (absent a Ouija Board, you won't know).
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