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Recent Valuation Cases Involving FLPs Bring Mixed Results

In recent years, the Internal Revenue Service has attacked the use of pass-through entities, such as family limited partnerships (FLPs) and limited liability companies (LLCs), as a method of family wealth transfer and preservation. A common technique is to establish an FLP and contribute marketable securities and real estate to it. Then, gifts of minority partnership interests are made to younger generations, claiming valuation discounts on the gift or estate tax returns for a lack of marketability and/or a lack of control. This reduces the amount of lifetime exemption used or gift taxes paid.

The IRS has argued that the use of FLPs is an abusive gift and estate tax avoidance technique. It claims that the existence of the family limited partnership entity should be ignored, and that the fair market value of the transferred interests should be determined by reference to the transferor’s proportionate share of the entity’s net asset value, without the application of any discounts.

Many tax and financial planners disagree, contending that there is no authority for disregarding the fact that where a partnership is validly organized under state law, the transferred property is the partnership interest itself, not the partnership’s assets. They hold this view particularly because the application of valuation discounts is only an ancillary benefit of establishing an FLP. (For a detailed discussion of the benefits of FLPs, see Dylan Kehoe’s article “Plan Today For Gift And Estate Tax Changes” in the December 2000 issue of Sentinel.)

Chapter 14 of the Internal Revenue Code, comprising Sections 2701 through 2704, establishes special rules for valuing transferred interests under certain circumstances. Those rules might require that some provisions of the limited partnership agreement, though legally binding, be disregarded in determining the fair market value of limited partnership interests, thus eliminating the potential to apply valuation discounts.

The U.S. Tax Court recently decided several cases involving the application of this chapter, and delivered some blows to the IRS argument that the existence of the pass-through entity should be disregarded for gift tax valuations.

‘Substance’ Salvages Strangi

Section 2703 was central in Estate of Albert Strangi v. Commissioner, (115 T.C. 478 [2000]). Shortly before his death, Strangi set up an FLP with a corporate general partner. He owned the corporate general partner along with three other family members. He gave FLP interests to his children, leaving his estate with a minority interest. His estate tax return applied a significant valuation discount.

The Tax Court found that the partnership “... was validly formed under state law ... Regardless of subjective intentions, the partnership had sufficient substance to be recognized for tax purposes.” Because the entity was not disregarded and had “economic substance,” the court ruled that “neither the language of the statute nor the language of the regulation” supported the IRS contention that the term “property” in the Code means the underlying assets of the partnership and not the partnership interest itself. In June 2002, the Fifth U.S. Circuit Court of Appeals upheld the Tax Court’s determination that Section 2703 did not apply in the Strangi case, (293 F.3d 279 [2002]).

Restrictions Relevant

Limited partnership agreements, the documents that govern FLPs, are often structured with significant restrictions on the sale or transfer of limited partner interests. These restrictions increase the amount of the discount applied when determining fair market value. The IRS has unsuccessfully argued that these restrictions should also be disregarded under Section 2704(b).

This was illustrated in Kerr et. ux v. Commissioner (113 T.C. 30 [Dec. 23, 1999]), which was upheld by the Fifth U.S. Circuit Court of Appeals in June 2002. The Tax Court concluded that Section 2704(b) did not apply for purposes of valuing the transfer of a limited partnership interest. The restrictions on liquidation in the limited partnership agreement in Kerr were no more prohibitive than those imposed under the applicable state law, which disqualified the restrictions as an “applicable restriction” that can be disregarded under Section 2704(b).

Future, Not Present, Interests

Having lost many of the battles regarding the validity of the pass-through entity and the disregarding of restrictions in the limited partnership agreement, the IRS sought another avenue of attack in Hackl v. Commissioner (118 T.C. 14 [March 17, 2002]). Under Section 2503(b), a taxpayer is entitled to an inflation-indexed annual gift tax exclusion for the first $11,000 per recipient of present interests in property. A present interest is defined as “an unrestricted and noncontingent right to the immediate use, possession, or enjoyment of (1) property or (2) income from the property.” The Tax Court sided with the IRS and determined that the LLC interests were not present interests, but future interests, and that the taxpayer was not entitled to the annual gift tax exclusion.

The court determined that the LLC interests did not qualify as present interests because of the excessive restrictions on the sale or transfer of the interests, and the fact that Albert J. Hackl maintained control of the LLC for life. There also was no expectation of an income stream from the company for a very long period. The Seventh U.S. Circuit Court of Appeals affirmed this case in July.

Possession Of Property

Other decisions that favor the IRS’ position relate to the application of Section 2036, which deals with the inclusion of transferred property in the decedent’s gross estate. Section 2036 states that the value of the gross estate includes the value of transferred property if the decedent retained, by express or implied agreement, the “use, possession, right to the income, or other enjoyment of the transferred property.”

In the Estate of Harper v. Commissioner (T.C. Memo 2002-121 [May 15, 2002]), the IRS won the Section 2036 claim, and gifts of limited partnership interests were ignored despite the fact that the partnership agreement was legal and binding. The court determined that 100% of the property within the partnership was includable in the decedent’s gross estate. It reached this conclusion primarily because the decedent commingled personal funds with funds of the partnership, and distributions were disproportionately made to the decedent. Therefore, the court felt that the decedent retained use of the property transferred to the partnership for the remainder of his life.

Another IRS victory on the 2036 issue came in Kimbell v. United States (2003 U.S. Dist. LEXIS 523 [Jan. 15, 2003]), in which the court ruled that because the decedent retained the right to appoint the general partner of the partnership she “retained the power to either personally benefit from the income of the partnership or to designate the persons who would benefit from the income of the partnership.” The transfer of property in this case did not qualify for the bona fide sale exception because the decedent stood on both ends of the transaction; therefore it was not conducted at arm’s length, a requirement for the exception.

In the Strangi case, the Court of Appeals remanded to the Tax Court to consider whether Section 2036 should apply. The Tax Court again determined (T.C. Memo 2003-145 [May 20, 2003]) that the full value of the assets transferred to the FLP were includable in the decedent’s gross estate because the decedent retained the right to the income from the FLP. The Tax Court also found that an implicit agreement existed among the family members that the decedent would retain the possession or enjoyment of the property. The fact that 98% of the decedent’s assets were transferred to the FLP contributed to this decision. The Court went on to find that the decedent also retained the right to designate who could benefit from the property and income from the property, and that the transactions were not conducted at arm’s length, but were “a mere recycling of value.”

These recent cases brought mixed results for taxpayers who use FLPs to transfer wealth to younger generations. The validity of the entity has been upheld for gift tax purposes, which will allow the application of valuation discounts to FLP interests on the gift tax return. However, some of the reduction in gift taxes is lost because under the Hackl ruling, FLP interests with significant restrictions lose the potential for the annual gift tax exclusion. Additionally, the entire value of the partnership, including transferred interests, may be included in the gross estate of a decedent if he/she retains enjoyment of the property for the remainder of his/her life.

Vice President Eric Meeermann, who is based in our Stamford, Connecticut office, contributed several chapters to our firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 11, “Social Security And Medicare;” Chapter 18, “Philanthropy;” and Chapter 19, “A Second Act: Starting A New Venture.”

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