Repair Clinic on Family Limited Partnerships
Fix it, disband it or retool it.
February 14, 2008
by Michael Hauser, Esq./CPA
Family limited partnerships (“FLPs”) and limited liability companies (“LLCs”) became popular, largely in the 1990s, as a method for pooling family investment capital, gifting unfractionalized assets and transferring wealth “down” generations. The rub, from a tax perspective, was the potential reduction in estate and gift tax resulting from valuation discounts inherent in unmarketable, illiquid interests in closely-held entities compared to directly valuing the underlying assets.
You have likely read that many negative court decisions have emerged in the last 10 years in which the IRS succeeded in unwinding the estate and gift tax benefits of an FLP by arguing, among other things, that the FLP was not in compliance with entity formalities, that it had no business purpose, that the FLP creator retained too much control or that the family had an “implied agreement” to allow the FLP creator beneficial enjoyment of the FLP assets if needed. Many articles and commentaries have been published on the negative FLP cases and also on the more limited number of positive cases.
Below, we’ll explore what you, as an adviser, should recommend to FLPs among your clients that are on the “wrong side of the tracks,” and whose facts align with the negative FLP cases. The IRS, energized by its successes, is routinely scrutinizing FLPs in estate and gift tax situations and thus it is critically important to review existing FLPs and consider modifications or else your clients might end up much worse off than if they had never created the FLP (and had just made cash gifts).
Five FLP Repair Tactics
The following outlines five general categories of FLP repair options. For simplicity, I will assume the FLP creator is “Grandparent” and the other FLP members are “Children” and “Grandchildren.”
- Leave FLP intact but amend the partnership agreement and revisit the “outside facts.” This option may work for an FLP that has generally followed its business/legal formalities but needs some patches to distinguish its facts from the negative cases.
For example, the partnership agreement may provide Grandparent with either management rights, majority voting rights, a right to force dissolution or a right to demand distributions. Any of these powers, whether or not exercised, could either spoil the valuation discount or, worse, cause Grandparent to be considered the de facto owner of the entire FLP under Section 2036 (the Code provision covering a transferor who retains an interest in assets transferred, including a power to control beneficial enjoyment of assets). The partnership agreement could be revised as needed, for example to appoint Children (or one specific Child) into the sole managers or general partners and to require super-majority votes on the other items.
A review of “outside facts” may reveal any number of negative facts, such as: distributions that have been timed to cover Grandparent’s personal expenses; Grandparent lacks sufficient cash flow from non-FLP investments to cover living expenses; or Grandparent has continued ordering stock trades on the FLP account even though Children are nominally the managers of the FLP. These types of facts may be correctable — for example, by having a set formula for distributions, by having Grandparent’s non-FLP assets invested in high-income bonds (rather than growth assets) to cover living expenses and by having Children be the sole communicators with the stock brokers, investment advisers, etc. (and the Children could even replace the current advisers with the Children’s personal brokers).
Furthermore, if the FLP cannot justify that its creation has provided some nontax benefits (e.g. business purpose), the FLP is subject to be disregarded (unless it can convincingly demonstrate there was no implied agreement for Grandparent’s benefit, which can be hard to disprove). For example, the FLP’s organizational documents may have stressed that it was being formed to facilitate pooled family investments in illiquid ventures — well, have any such investments been made? Consider recommending investments in syndicated real estate partnerships or hedge funds that have high minimum investments, as it can be argued that any one family member would not be able to make these investments but that only the family entity with pooled capital could do so (or would do so as the risk would be spread among Grandparent, Children and Grandchildren).
- Accelerate gifting of FLP interests to ensure that Grandparent will have no interest left. Clearly, the strongest part of the IRS anti-FLP arsenal is Section 2036, which brings back into a decedent’s estate all property transferred during life in which the decedent retained an interest (as discussed above), even if the decedent properly reported the transfer as a gift and already paid gift tax. However, if Grandparent gifts away their entire FLP interest during life, the IRS does not have Section 2036 and generally the only tax issue would be the proper valuation discount for the gifts (in extreme cases, the IRS could still argue that all FLP assets were being held for Grandparent’s benefit if his assets get depleted, but that argument could be made with any gift). No business purpose is necessary in the gift tax context. The downside to the accelerated gift approach would be payment of gift tax, if the sum of maximum annual exclusion gifts and lifetime exemption gifts will not be enough — still, for clients willing to do it, paying gift tax will sometimes be a good option.
- Sell Grandparent’s remaining FLP interests, preventing any residual ownership at death. This option is similar to option 2, but would prevent Grandparent from having to pay gift tax. Grandparent would receive either cash or a note in exchange for his FLP interest and this cash or note would be in the estate at death. However, Section 2036 concerns would be reduced (in terms of bringing back the entire FLP into the estate). There are various ways to structure such sales — for example, the sale can be an installment sale to a “grantor” trust in which Grandparent is considered the owner for income tax purposes, but not estate/gift purposes. Doing this would: (a) prevent current income tax on the sale, as Grandparent would be selling to himself or herself for income tax purposes; and (b) enable Grandparent to continue paying all of the income tax on the FLP assets, consistent with Rev. Rul. 2004-64 which holds that the payment of income taxes in such situations would not be deemed an additional gift. In addition, the note could be at a relatively low interest rate and further the sales price for the FLP interest could be discounted to reflect the inherent valuation discount.
- Dissolve FLP and start over with new FLP. Sometimes, the facts of the FLP are too negative to salvage. The FLP’s distributions may have been disproportionate between the members or perhaps non-arm’s-length transactions or loans with members have occurred or FLP assets have been used to pay Grandparent’s personal expenses. Alternatively, Grandparent’s entire net worth may have been transferred to the FLP (giving rise to a clear case for the IRS to argue there was an implied agreement to let Grandparent retain an interest in the income or principal of the FLP). In these cases, the best option is probably to distribute out all FLP assets pro rata to the members (or to trusts created for their benefit). After this occurs, the members could still decide to create a new FLP if a solid nontax reason exists for doing so — for example, to pool family capital to invest in one or more specific illiquid ventures or to hold the family’s stock in an active business (shifting voting control of the family business to the Children in their capacities as FLP managers).
- Dissolve FLP and distribute out all assets. If the other options will not work from a legal or practical perspective, just dissolving the FLP may be better than leaving the FLP intact and undertaking a significant Section 2036 risk when Grandparent dies. To the extent that gifts have been made prior to such dissolution and valuation discounts have been taken on such gifts, the clients have benefited from the FLP in terms of estate and gift taxes and they are better off cutting the FLP there than to run the risk of losing all benefits of the gifts by virtue of Section 2036 bringing everything back to Grandparent’s estate.
It will not usually pay to just do nothing. It is highly recommended to closely examine existing FLPs (including outside facts and circumstances) and to analyze the tax and nontax issues based on the fairly expansive body of law that has developed on this subject in the last decade.
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Michael K. Hauser, Esq./CPA, is a tax attorney with Maddin, Hauser, Wartell, Roth and Heller, P.C. in Southfield, Michigan, where he specializes in tax planning for owners of small businesses. He is also an adjunct professor in the Tax LLM program at Cooley Law School, where he teaches taxation of real estate.
© Michael Hauser