Summary: FLPs and LLCs remain the focus of many estate plans, and the tax implications are significant. Common use, however, does not imply simple or assured tax results. The following comments were gleaned from a presentation by a panel consisting of Michael Mulligan, Esq., Richard Oshins, Esq., John Porter, Esq., Sanford Schlesinger, Esq. and Martin Shenkman, Esq., at the recent NYU Institute of Taxation in NYC.
◙ Creative Auditing 101: On some audits the IRS has started arguing a new position. If you sell FLP/LLC interests to a trust for a note interest should be set at the Applicable Federal Rate (“AFR”), an interest rate prescribed under the Code. The IRS has argued in some cases that the AFR is not sufficient and that the difference between the AFR and the fair market interest rate is a gift.
◙ The Dating Game: In Pierre v. Commr. 133 TC No. 21, No. 753-07, 8/24/09) the taxpayer
gave 5% of an FLP and sold 45%. The taxpayer’s valuation expert set a 45% discount on FLP interests. Since the IRS said both transfers were made the same day to the same transferee it was really equivalent to a transfer of a 50% interest which should not be afforded that discount. The Tax Court agreed, reasoning that transfers on the same day when nothing of tax significance occurred between the transfers, should be aggregated. So, a seed gift to a trust (e.g. $250,000 of interests in an FLP), followed by sale of interests in same FLP to the trust, may be aggregated. If the combined FLP interests gives you supermajority power you might even get tagged with a control premium instead of the sought after discount elixir. So how long does your seed gift have to bake before you can consummate a transaction? In the Holman case the Court looked at the underlying FLP asset, Dell stock, and felt it was sufficiently volatile that a 6 day wait sufficed. Some chefs recommend 30 or 60 days between the transfers. Some recommend using a guarantee in lieu of seed gift since you cannot aggregate a guarantee for a note given by a trust with the FLP interests sold to a trust. Other gurus suggest a tax year so an intervening income tax return is filed (e.g., make the seed gift in November and the sale the following February). There is no shortage of opinions. The more time between the gift and sale the better. Finally, when you’re a contestant on the Dating Game documents should be signed and notarized as of the date they were signed. This is preferable to signing a document when the only dates is an “effective as of” date. Having documents notarized gives independent corroborating evidence that it was transferred as of that date. That’s why all important documents are always notarized by the taxpayer’s personal secretary or the lawyers secretary --- independent corroboration.
◙ Indirect Gift Argument. If you gift assets to an FLP (e.g. rental real estate), and on the same day gift limited partnership interests in the FLP owning the real estate to your heirs, the IRS and some courts wills view this no differently than if you had simply given the underlying real estate assets directly to your heirs. The IRS position is that the transfer of assets to the FLP (funding) and gifts pf the FLP should be collapsed. The more time that passes between funding the FLP and the gifts of FLP interest (sounds a tad like the time recipe above), the better your tax cake will be baked. Time in between is good. Independent risk during that time period (e.g. volatility of the assets) is good. In the Gross case 11 days baking with ingredients consisting of a mixed portfolio was a sufficient recipe. In Senda interests transferred at same time the entity was funded were viewed by the IRS as a transfer of the underlying assets. The documents were not sufficient to show that the transfers of assets to the FLP occurred before the transfers of interests in the FLP to the family members. If viewed as an indirect gift, the transfer won’t support discounts for lack of control or marketability. While Holman and Gross permitted a short waiting period for volatile assets, a longer time is required for non-volatile assets. What is volatile and how long do you wait? Ah, that is the question for your tax psychic. The moral of this tax tale: Maintain a clear paper trail proving your FLP was funded before the transfer of your FLP interests.
◙ Annual Gifts: Many folks make annual gifts of interests in family business entities, FLPs, etc. It’s a simple and inexpensive (so you thought) way to use your annual exclusion, conserve cash, and shift wealth to the next generation. In 2002 the Hackl case nailed a taxpayer trying annual gift planning. The Hackl court held that the gifts did not qualify for the annual exclusion because they were not gifts of a “present interest.” The Hackl LLC owned raw land that had once been a tree farm but the trees were cut and it would take 30 years for new trees to grow. Mr. Hackl made 200+ gifts to family members. But the IRS argued that none of these gifts constituted present interests because of nature of LLC assets (growing trees) and the restrictions on transfer in the LLC operating agreement. The Tax Court agreed with the IRS, and the Sixth Circuit affirmed. T.C. Memo 2010-2 (1/4/10). Recently in the Price case, an FLP held marketable securities and the partnership agreement included common transfer restrictions (e.g. consent of all partners is required for a transfer, there was no right to withdraw capital, distributions could only be made in the discretion of the GP, etc.) There were even significant actual distributions made. Nevertheless, the IRS argued that the gifts of LP interests should not qualify for the annual exclusion since the LP interests given did not satisfy the “present interest” requirement. This was because the donees did not have a right to the immediate enjoyment of the LP interests given to them. The Tax Court agreed because the LP interests were subject to tough restrictions on transfer. No capital could be withdrawn. The LPs were mere assignees. This reasoning is disturbing because real partnership agreements between unrelated folks commonly have these clauses (don’t confuse “tax reality” with “real reality”). How can a typical FLP survive the Price test? Consider including a “put” right (partners can sell their interests back to the partnership). This might be similar to the annual demand or “Crummey power” withdrawal right included in many trusts to support characterization of gifts to the trust as constituting present interest gifts. Perhaps you can give an LP the right to put back an amount of the LP interest at a fair market value for a specified period of time. But this isn’t a cake walk either. The IRS has argued that a put rights are not always valid. But if you win the “put” right you might sacrifice discounts, after all if the LP donee can realize the fair value of the LP interest how can you argue its value is reduced as not being marketable? The IRS may get you coming or going! The IRS can argue that the put right makes the interest more liquid and hence worth more (i.e., lower discount). Giving LPs a right to sell subject to a right of first refusal with reasonable provisions might provide another option.
◙ Costs: Is it even worth making an annual gift of $13,000 of FLP interests? You need an appraisal for the gift. The fact that you are only making $13,000 annual gifts doesn’t absolve you from needing a proper appraisal to determine the percentage interest in the FLP that is worth $13,000. It is probably advisable to file a gift tax return reporting the gift of the partnership interest in order to toll the statute of limitations. If you “adequately disclose” the gift on the return after there years you’re entitled to a “Get out of Audit Free” Monopoly card. This is all quite cumbersome and costly for a mere $13,000 annual gift. Seems that the time honored way most small family businesses were passed to the succeeding generation is under harsh and unfair attack.
◙ Buy Sell Agreements. Rights of first refusal and transfer restriction were ignored in Holman. IRC Sec. 2703. In the Blount case, rights of first refusal in buy sell agreement that would have reduced the value of the interests, were ignored for valuation purposes. The IRS had argued that the FLP itself should be ignored for valuation purposes but lost that argument in Strangi and other cases. So the IRS has refocused on a new approach, attacking not the FLP but the transfer restrictions in the partnership agreement that restrict an owner’s ability to transfer interests in the entity. To be respected the restrictions must: (1) be a bona fide business arrangement; (2) not be a device to transfer interests to heirs; (3) be comparable to arm’s length agreements between unrelated parties. There is a shortcoming to the IRS attack. Even if you ignore all these restrictions, what is left is an LP interest that has only limited rights under state law, so that it still must be worth substantially less than full underlying asset values. But in some instances this risk could have a substantial tax impact. Stay tuned!
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