A recent Tax Court case, Thomas Holman, 130 TC No. 12, 5/27/08, has some several important lessons for planners and taxpayers using family limited partnerships ("FLPs") and limited liability companies ("LLCs"), especially for gifts. Last month's lead article, Holman Part I, provided an overview and analysis of the case. This month's article, Part II, reviews planning lessons, and several important points that seem to have gotten short shrift in the professional literature.
General Planning Considerations of the Holman Case.
The IRS has had a lot of success attacking FLPs and LLCs for estate tax purposes under Code Section 2036. The Section 2703 attack may become the IRS' new weapon of choice on gifts of FLP and LLC interests. Expect repeat performances. To protect yourself from a lawsuit, you should: Evaluate the magnitude of discount that may be achievable. Weigh the potential estate tax benefit versus the income tax detriment (no step up in basis, and the possibility of higher capital gains rates under the next administration). Weigh the discount benefits of an FLP (or LLC) versus mere tenants in common ownership which is cheaper and simpler (but it doesn't provide control, asset protection, or other FLP non-tax benefits). Compare the hoped for tax benefits of each possible approach against the real non-tax benefits that each provides.
Document real non-tax business reasons for the FLP and the transactions. These should be reflected in the partnership agreement. Observe all formalities that an independent real business would (well, at least as the Tax Court defines "real"). File tax returns. Have a CPA prepare a statement (or at least have annual Quicken, Quickbooks, or equivalent reports). Be sure all appraisal assumptions are subjected to sensitivity analysis. What happens if a fact or assumption changes? What are the consequences if an assumption or calculation is carried through or projected forward? Do the results remain reasonable? All positions and arguments should be consistent. The Holman court was clearly disturbed by inconsistent assumptions and positions in the taxpayer's appraiser. Appraisals should not use guesstimates. But, in many situations it is impractical or impossible not to do so. If it is essential, at least discuss the rationale and implications of the guesstimates so that they are supported as reasonable, and determine the consequences of changing the guesstimates (sensitivity analysis). Use a letterhead. Have partners other than parents contribute assets to the FLP on formation (something more than the .14% contributed by the Trust in Holman would probably be a good thing). Have a written business plan (or an investment policy statement, or both). Execute governing documents (e.g. partnership agreement) for each phase, and transfer to corroborate that each step of the transaction (e.g., after each gift) is a complete and meaningful step. This should help demonstrate that each step is independent and legally sufficient. File gift tax returns. Obtain an FLP telephone listing. Every document should be dated the day it is signed (regardless of whether it has a different effective date). Clients should understand the partnership agreement or other governing documents. The Holman Court said "Tom impressed us with his intelligence and understanding of the partnership agreement..." Taxpayers should make changes to conform them to their wishes. Corroborate this development trail (e.g., save track change documents, etc.). Hold non-marketable assets. The Holman Court accepted the use of general equity funds for the evaluation of discounts of the Holman FLP holding only the Dell stock. Introduce non-marketable assets and your discount may differ favorably from those found by the Holman Court and some of the analysis of the Holman court that was detrimental to the taxpayer may take a different spin for your case. If later contributions are made to the FLP formally treat them as being made for additional FLP interests of the appropriate value, and document the change in ownership interests in an amended and restated partnership agreement.
How long do assets have to age in an FLP before you can make gifts? How long must they age to face a "real economic risk of change in value"? The Court said "We draw no bright lines." Thanks, you could have at least left a light on! If you only make annual gifts, how can you cost effectively comply with the Holman standards? It is not reasonable to obtain the level and quality of appraisals and analysis the Holman court seeks if you are merely giving a couple of kids $12,000 gifts. The Holman Court considered a private market for limited partnership interests among the FLP's partners. This completely violates the tax law prescription for determining "fair market value" for a gift based on a hypothetical willing buyer and willing seller. There are lots of definitions of "fair value". The highest value for many assets is "strategic value"- when the asset or business involved fulfills a unique need of the buyer, so that the buyer is willing to pay far more than the going rate because of the unique value of the asset to them. The Holman Court took a dangerous misstep in this direction. What happens to the definition of value next?
Important Points Overlooked in Some Articles Examining Holman.
Formalities: The kids' trust to which the Holman's made gifts was signed by the parents on 11/2, the trustee on 11/4 and made effective 9/10. This is reasonable and realistic, but looser then the ǘber perfection some courts have demanded of FLPs. The partnership agreement was signed 11/2 but the FLP was formed 11/3. The court and most commentators were silent on this snafu. The 11/8/99 gift was made by a document saying it was effective 11/8/99 but which itself was undated. When was it signed? It's one thing to forgo a witness or notary, but a date? Count the dating goof-ups - at least three! Yet the Court felt that the formalities in the case sufficed! Commentators noted that the appropriate steps were taken in proper order. But were they? While Holman will undoubtedly be cited by taxpayers that have a dating error if challenged, more care is certainly advisable.
Fiduciary Obligations: The general partner of a limited partnership is held, vis-à-vis the limited partners to a fiduciary standard. Could the general partner of the Holman FLP have generally adhered to such a standard if he did not diversify the Dell holdings as generally required under the Prudent Investor Act (PIA)? Might the IRS argue that a failure to follow the PIA indicates a failure to respect fiduciary obligations? This is no small issue. Central to the Court's analysis was a discussion of a case, the Estate of Amlie v. Commr., TC Memo. 2006-76, which involved a conservator entering into a series of agreements while "...seeking to exercise prudent management of decedent's assets...consistent with the conservator's fiduciary obligations to decedent." The Court noted that a fiduciary's efforts to hedge the risk of a ward's holdings and plan for estate liquidity may serve a business purpose under IRC 2703(b)(1). Would the result have differed had Holman had a wealth manager create an IPS and implemented an asset allocation model to hedge the risks of the limited partners to whom the GP owes a fiduciary duty? The Holman Court was not convinced by the taxpayer's appraisal expert that a lack of portfolio diversity and professional management should justify an increased discount. So you get no discount benefit (not to mention investment return) from lousy investing, and you undermine your business purpose as a fiduciary. Should all FLPs have IPS's? Yes, they should.
Fair Market Value: The Holman court found a low discount because it was swayed by the argument that there was no economic reason as to why the FLP would not be willing to let somebody be bought out, because the remaining partners would be left holding the same portion of assets and the same types of asset after the buyout. If the FLP held real estate or business interests, which would affect the remaining partners share of the assets, this might not be true. Creditworthiness of the FLP to obtain credit for new real estate or business interests could be adversely impacted. But the Holman Court's conclusions may not even apply to an FLP holding marketable securities. If the FLP assets are reduced to below the minimum accounts size for the asset manager the FLP had used, a change might be mandated. That could be very significant. If FLP assets drop below a certain threshold certain types of investment products may no longer be available. So the Holman conclusion may be distinguishable in other marketable securities FLPs.
The Holman case can be classified as another fact specific FLP case, full of good facts, bad facts, and new theories that do not fully make sense. Planning with FLPs (and LLCs), as before, remains complex and uncertain. Yet, as before, when business and personal reasons, independent of any sought after tax benefits, are served by an FLP structure, they can and should be used. Planning, especially for gifts of FLP interests, should proceed with consideration to the new lessons gleaned from Holman.
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