Advanced Tax Strategies for LLC and Partnership Transactions

Chapter 1 - Partnership Tax Update

Learning Objectives

After completing this chapter, you should be able to

• Compute the qualified production activities deduction for partners based on tax law in effect for partnership years beginning on or after May 17, 2006;
  
• Evaluate the use of family limited partnerships to reduce estate taxes in light of the recent Korby decision;
  
• Consider the use of certain contingent estate tax liabilities in reducing the amount of taxable gifts in a family limited partnership situation similar to that in the recent McCord decision;
  
• Determine how to treat certain obligations of disregarded entities under the new final regulations;
  
• Know when Schedule M-3 is required for a partnership and what items are required to be disclosed on Schedule M-3; and
  
• Assess the probable position of the IRS with respect to the tax treatment of the distribution of a house to a partner as addressed in CCA 200650014.

W-2 Wages, Partnerships, and the Qualified Production Activities Deduction

Among the changes brought about by the American Jobs Creation Act of 2004 was a significant new deduction, the qualified production activities deduction (QPAD). In 2006 the annual QPAD is 3% of the lesser of (1) a taxpayer’s qualified production activities income (QPAI) or (2) taxable income (adjusted gross income (AGI) for individuals). However, the deduction cannot exceed 50% of the W-2 wages paid by the taxpayer during the calendar year that ends in the taxpayer’s taxable year. The percentage used to compute the deduction is 3% in taxable years beginning in 2006, 6% from 2007 to 2009, and 9% thereafter.

W-2 Wages Limitation

The QPAD for any year is limited to 50% of the W-2 wages paid by the taxpayer during the calendar year that ends in the taxable year in question. The term W-2 wages means the sum of the aggregate amounts the taxpayer is required to include on the Forms W-2 of the taxpayer's employees during the calendar year ending during the taxpayer's taxable year.

Example 1-1

The Local Corporation has QPAI for the fiscal and taxable year ending October 31, 2007 of $200,000. Its taxable income for that year is $30,000, and it pays W-2 wages for that fiscal year of $16,000. For the calendar year ending December 31, 2006, it only paid W-2 wages of $10,000, and for the 2007 calendar year it only paid W-2 wages of $5,000. Its QPAD before the W-2 wage limitation is $200,000 × .03 = $6,000 for the taxable year ending October 31, 2007. Since its W-2 wages for the 2006 calendar year are only $10,000, the W-2 wage limitation for the taxable year ending October 31, 2007 would be $10,000 × 50% = $5,000. The amount of fiscal year W-2 wages paid by the taxpayer is irrelevant in calculating the QPAD, and the calendar year 2007 W-2 wages paid would only affect the QPAD for the taxable year ending October 31, 2008. In general, a partner will add his or her share of the partnership’s W-2 wages to the partner’s other W-2 wages paid to come up with an aggregate W-2 wage amount that is used to calculate the W-2 wage limitation. However, for tax years beginning before May 18, 2006, for purposes of the 50%-of-W-2-wages limitation, W-2 wages did not have to be allocable to domestic production gross receipts, and a partner's share of the partnership's W-2 wages was limited to twice the specified percentage (3% in 2006) of the QPAI allocated to that partner by the partnership.

For partnership taxable years beginning on or after May 17, 2006, the partner's share of socalled “threshold” wages of a partnership (basically all wages of the partnership, whether or not related to domestic production gross receipts (DPGR)) equal the partner's allocable share of those wages for purposes of determining the partner's wage limitation. Threshold wages are also referred to as paragraph (e)(1) wages because the definition of these types of wages is found in §1.199-2T(e)(1). The partnership must generally allocate the amount of threshold wages among the partners in the same manner it allocates wage expense among those partners. The partner must add its share of the threshold wages from the partnership to the partner's threshold wages from other sources, if any. The partner’s W-2 wages (used to actually calculate the W-2 wage limitation) are the amount of the partner's total threshold wages properly allocable to DPGR.

Example 1-2

A and B, both individuals, are partners in PRS. PRS is a partnership that engages in manufacturing activities that generate both DPGR and non-DPGR. QPAI of the partnership is $500. A and B share all items of income, gain, loss, deduction, and credit equally. PRS has $200 in threshold wages, $150 of which are related to DPGR. A has trade or business activities outside of PRS (non-PRS activities). With respect to those activities, A has $50 of threshold wages. B has no trade or business activities outside of PRS. A has $150 of threshold wages ($100 from PRS + $50 from A's non-PRS activities). A determines, under a reasonable method satisfactory to the Secretary, that $75 of the PRS wages and $25 of the non-PRS wages are properly allocable to A's DPGR from PRS and non-PRS activities. A's tentative section 199 deduction is subject to the W-2 wage limitation of $50 (50% of W-2 wages of $100). B's W-2 wage limitation is $37.50 (50% of W-2 wages of $75). Note that the partnerships W-2 wages used to calculate the W-2 wage limitation of the partners are no longer dependent on the QPAI of the partnership.

Use of Family Limited Partnerships in Gift and Estate Planning

The family limited partnership is commonly used as a vehicle to reduce the estate tax, particularly on real estate or marketable securities that are to be eventually transferred to younger family members. The common approach has been for the parent or grandparent to transfer property to a family limited partnership, retain control of the assets through the partnership, and use the argument that the limited partnership interests lacked marketability to limit their value for estate tax purposes. Unfortunately, in 2002 the IRS began to be successful in attacking these types of arrangements.

Use of Family Limited Partnerships to Limit the Gross Estate

Section 2036 requires that the gross estate will include any transfers where the decedent retained possession, enjoyment, or the right to income from the transferred property. In order for the property to be included in the gross estate, however there does not have to be a legally enforceable right in favor of the decedent. There must, however, be an agreement that the decedent will retain some benefit from the transferred property. In addition, if the decedent sold the property to the recipient in a bona fide sale for full and adequate consideration, the property will not have to be included in the gross estate. Possibly the most significant recent case in this area is Strangi.1 However, a number of significant cases preceded Strangi, including Kimbell, another case from the Fifth Circuit Court of Appeals.

Kimbell

Ruth A. Kimbell died March 25, 1998. In 1991, she created a Trust, administered by Mrs. Kimbell and David as co-trustees. In January 1998, the Trust, David and his wife formed a limited liability company. The Trust contributed $20,000 to the LLC for a 50% interest. David and his wife each contributed $10,000 for 25% interests each. David was the sole manager of the LLC.

Later in January 1998, the Trust and the LLC formed a limited partnership. The Trust contributed approximately $2.5 million in cash, oil and gas working interests and royalty interests, securities, notes and other assets for a 99% pro rata limited partner interest. The LLC contributed approximately $25,000 in cash for a 1% pro rata general partner interest. As a result of these transfers, Mrs. Kimbell, through the Trust and the LLC, owned 99.5% of thepartnership. Not all of Mrs. Kimbell's assets were conveyed to the LLC and the partnership. She retained over $450,000 in assets outside of the LLC and the partnership for her personal expenses.

The estate claimed a 49% discount on the value of Mrs. Kimbell's interest in the partnership and her interest in the LLC for lack of control and lack of marketability of the partnership interest. The IRS disagreed with that discount, and the District Court found for the IRS. On appeal, the Fifth Circuit found that the assets were transferred by Mrs. Kimbell to the partnership for full and adequate consideration.

Strangi

While Kimbell provided many hints concerning what steps taxpayers should take to help ensure that a family limited partnership will reduce their estate tax obligations, Strangi provides a cautionary tale of what should not be done with respect to these arrangements. One of Strangi’s daughters from his first marriage was married to Michael J. Gulig, a local attorney. In 1993, Gulig took over management of Strangi's daily affairs.

In 1994 Gulig attended a seminar that explained a plan to use limited partnerships as a tool for (1) asset preservation, (2) estate planning, (3) income tax planning, and (4) charitable giving. The next day Gulig took actions to implement the recommendations he heard in the seminar. The result of Gulig's efforts was a three- tiered entity, with the Strangi Family Limited Partnership (SFLP) – and the roughly $10 million in assets Strangi had transferred into it – at the top. Strangi owned a 99% interest in SFLP, but was a limited partner, and thus had no formal control.

The IRS did not allow the discount in value that Gulig said resulted from this arrangement, and the Tax Court ruled against Strangi. The estate then appealed the decision of the Tax Court to the Fifth Circuit Court of Appeals. The Court of Appeals found that repeated distributions from the estate for Strangi’s expenses, both before and after death, provide strong circumstantial evidence of an understanding between Strangi and his children that partnership assets would be used to meet Strangi's expenses. The Court also found that Strangi's continued occupancy of his home after its transfer to the partnership was evidence of an implied agreement that Strangi would retain enjoyment of the assets of the partnership. Likewise, the Court considered Strangi's lack of liquid assets after the transfer to SFLP to be evidence that some arrangement to meet his expenses must have been made. The Court found that upon creation of SFLP, Strangi retained assets barely sufficient to meet his own living expenses for the low end of his life expectancy – that is, for about one year – assuming he was never required to pay rent, estate administration costs, outstanding personal debts, funeral expenses, or taxes. At the same time, Strangi began receiving substantial monthly payments out of SFLP's coffers. Given these circumstances, the Court could not say that the Tax Court clearly erred in holding that Strangi and his children had some implicit understanding by which Strangi would continue to use his assets as needed.

The Court noted that a sale is bona fide if the sale serves a “substantial business [or] other nontax” purpose. The estate proffered five discrete non- tax rationales for Strangi's transfer of assets