Protecting Your Family Limited Partnership

Overview

A popular estate planning vehicle used to achieve estate and gift tax savings and to facilitate the succession of family assets from one generation to the next is the family limited partnership. A family limited liability company can be used to achieve similar results. For purposes of this discussion, the term "FLP" will be used to refer to both family limited partnerships and family limited liability companies since they are taxed in the same manner.

A FLP is a limited partnership consisting of one or more general partners and limited partners. General partners control the management of the partnership, whereas limited partners have little control over the management of the partnership. General partners are personally liable for all partnership obligations. Limited partners are only liable to the extent of their capital contributions to the partnership.

In general, family members, which include both parents and children, transfer assets to the FLP in exchange for partnership interests. A husband and wife (or a corporation owned by them) often act as the general partners and as the initial limited partners. However, both parents and children can contribute assets to the FLP. The general partners typically own a 1% or 2% interest in the partnership, and the balance of the partnership interests is owned by the limited partners. The parents then make gifts of limited partnership interests to their children and other remote descendants over time. This results in a shift in wealth, but not control, over the limited partnership interests from one generation to the next. Such transfers can also facilitate business succession planning in certain situations where closely-held business interests are involved.

Potential Tax and Non-Tax Benefits Offered

If implemented and managed properly in accordance with the governing instruments, FLPs offer many tax and non-tax benefits. FLPs can offer the following non-tax benefits:

• Consolidate and coordinate family assets and investments, especially closely-held business interests;
• Avoid probate in multiple jurisdictions;
• Provide economies of scale for investments;
• Centralize management and control and allow the most skilled managers to manage family assets;
• Restrict the transferability of assets outside of the family (beneficial particularly in the event of a divorce); and
• Provide liability insulation and protection from creditors.

Partnership agreements typically restrict the transferability of partnership interests and the withdrawal of partnership assets. The lack of marketability and the lack of control inherent in a limited partnership create the possibility of valuation discounts if partnership interests are transferred. Valuation discounts allow limited partnership interests to be transferred at a fraction of the value of the actual underlying assets, which can result in substantial gift and estate tax savings. A FLP can benefit from valuation discounts for lack of control since limited partners are precluded from participating in the management and control of the partnership even though they may own a significant interest in the partnership. A FLP can also benefit from valuation discounts for lack of marketability since the ability to quickly convert a partnership asset to cash is significantly reduced.

Another tax benefit offered by FLPs is that they are pass-through entities for income tax purposes. In other words, all income and losses are taxed to the individual partners and not to the partnership itself. Thus, a second level of tax is not imposed at the entity level.

IRS Attack

Since FLPs have so many attractive features that can result in significant tax savings, it is not surprising that the Internal Revenue Service ("IRS") has challenged the use of FLPs as a wealth transfer vehicle. The IRS has traditionally attacked FLPs based on such grounds based on lack of business purpose, non-recognition of present interests and gift upon formation of the entity theories. Up until recently, the IRS has been unsuccessful in its attacks absent egregious fact patterns.

Recent cases emphasize the need for taxpayers to be more vigilant in operating and managing FLPs. Assuring that the partnership agreement is properly structured and drafted is only the first step in guarding against potential adverse gift and estate tax consequences. A series of recent cases resulting in victory for the IRS have involved facts and circumstances reflecting a disregard of the FLP as a separate legal entity (e.g., commingling of partnership assets with personal funds; residing rent-free in a residence transferred to the partnership; failing to maintain books and records; etc.). In such cases, the IRS has argued that an implied agreement exists among the partners to use the assets transferred to the partnership by the donor for his or her personal needs. In effect, the donor still retains control over the assets. If the donor retains such control at death, 100% of the value of all the partnership assets could be in included in the donor's estate.

This article will focus on the IRS's latest weapon against FLPs, namely the application of Internal Revenue Code ("IRC") § 2036(a). Section 2036 provides that property transferred by a decedent during life must be included in the decedent's estate for estate tax purposes upon death if the decedent retained control over such property or its income. Under § 2036, a decedent's gross estate will include the value of property transferred (except for bona fide sales for full and adequate consideration ), in trust or otherwise, if the decedent retains: (1) the use, possession, right to income, or other enjoyment of the transferred property; or (2) the right, either in conjunction with any other person, to designate the person(s) who will possess or enjoy the transferred property or the income therefrom.

Recent cases have addressed the application of § 2036(a) and have undermined the viability of this popular estate planning and asset protection vehicle. Among them is the Estate of Albert Strangi, Deceased, Rosalie Guilig, Independent Executrix v. Commissioner of Internal Revenue,T.C. Memo 2003-145 ("Strangi II"), a case remanded by the Fifth Circuit (Estate of Strangi v. Commissioner, 115 T.C. 478 (2000), aff'd in part and rev'd and remanded in part, 293 F.3d 279 (5th Cir. 2002)). In this case, discussed below, the United States Tax Court applied § 2036(a)(1) and (a)(2) in concluding that the full amount of a FLP's underlying assets were included in the decedent's estate.

Strangi II

In Strangi II, the United States Tax Court determined that the full date of death value of the assets transferred by the decedent to his FLP was included in his estate under both § 2036(a)(1) and (a)(2) and subjected the FLP assets to estate taxes. The IRS argued that the FLP assets were included in the decedent's estate because he had retained control over the assets through the corporate general partner. Some of the pertinent facts of this case are as follows.

The decedent was very ill and formed the FLP and its corporate general partner about two months before his death. The entities were formed through a durable power of attorney granted to the attorney-in-fact who happened to be the decedent's his son-in-law. The power of attorney also granted the attorney-in-fact the power to manage the affairs of the FLP. The decedent transferred substantially all of his assets to the FLP in exchange for a 99% limited partnership interest. His assets consisted of cash, securities and his personal residence. The decedent owned 47% of the corporate general partner, which had sole authority over the FLP's management. All partnership formalities were observed when the FLP was created.

After the decedent's death, distributions were made from the FLP to the decedent's estate to pay estate taxes and estate administration expenses. Distributions were also made to pay for other personal expenses of the decedent such as his nurse's health care prior to his death. Thus, distributions tended to be based on the needs of the decedent or his estate and no other partner.

In applying § 2036(a)(1), the Tax Court found that the decedent retained the right to income over the transferred assets, and that several key facts substantiated an implied agreement for retained possession or enjoyment of the transferred assets. Essentially, the decedent retained the same relationship with the transferred assets that he had before establishment of the FLP. The decedent contributed nearly all of his assets to the FLP. The corporate general partner had sole authority over distributions. He also died about two months after the FLP and corporate general partner were created. In addition, the decedent, acting through his attorney-in-fact, had retained the right to control the enjoyment of the property and income from the FLP and its general corporate partner. Non pro rata distributions were also made for the decedent's needs or his estate's needs. Thus, the court concluded that all valuation discounts were disallowed on the estate tax return, and the entire value of the assets transferred to the FLP were included in the decedent's estate.

The second ground for inclusion of the FLP assets in the decedent's estate involved the application of § 2036(a)(2). The court in Strangi II noted that the fiduciary duties that a general partner owes to limited partners under state law were not sufficient to protect the decedent from the reach of § 2036(a)(2). Prior to this case, donors acting as general partners of a FLP did not typically worry about retained control issues because the existence of state law fiduciary duties owed by the general partner to the limited partners negated such issues. However, in this case, the court found that the other partners would not realistically be able to enforce any such fiduciary duties to limit the decedent's control over the FLP or corporate general partner.

Relying on the reasoning in Strangi II, the IRS may continue to aggressively assert the § 2036(a)(2) argument in situations where the partner establishing the FLP and contributing most of the assets is also the general partner (or is one of several family members that are shareholders of another entity acting as the general partner). Typically the partner establishing the FLP wishes to retain management control and therefore acts as the general partner. However, a successful attack by the IRS could result in inclusion in that partner's estate of assets contributed to the FLP under such circumstances. To date, Strangi II has not been appealed.

Conclusion

It remains to be seen how sweeping the Strangi II decision will be. For now, individuals should be more vigilant than ever in establishing and operating the FLP to guard against possible inclusion of underlying partnership assets in one's estate and disallowance of valuation discounts.

Although it is impossible to predict exactly what type of activity will trigger an IRS challenge, precautions could be taken to protect your FLP. Below are a few ideas which may help increase the chance of success against a possible challenge by the IRS:

• Avoid deathbed establishment of and transfers to FLPs;
• Ensure that the partnership agreement is properly structured in order to achieve appropriate discounts and carry out the family's intentions;
• Avoid transferring assets that may be used for a partner's personal use (e.g., residence) unless a written lease arrangement is made and fair market value rates and rents are actually paid;
• Avoid transferring virtually all of a partner's assets to the FLP;
• Respect all partnership formalities at all times;
• Comply with the terms of the partnership agreement;
• Maintain partnership books and records;
• Hold partnership meetings;
• Segregate personal assets from those contributed to the partnership;
• Prepare assignments transferring assets to the partnership;
• Prepare deeds transferring real estate to partnership;
• Comply with annual state filings (e.g., certificate of limited partnership) and federal filings (e.g., income and gift tax returns);
• Make distributions pro rata based upon ownership percentages; and
• Give up control as general partner.

In light of the recent cases attacking FLPs, now may be a good time to have your partnership agreement and other documents relating to the operations of the FLP reviewed. An in-depth review in conjunction with your current estate plan can determine if the partnership agreement is drafted to carry out the original tax and non-tax objectives of the partners and is operated in compliance with the state and federal requirements.

Anyone who contemplates forming a FLP should be aware of the inherent risks under § 2036(a)(1) and (a)(2). One can minimize the risk of possible IRS attacks by being more cognizant of the situations under which the IRS questions the legitimacy of the entity, such as failing to respect the FLP as a separate entity. FLPs could continue to achieve many non-tax and tax benefits discussed at the beginning of this article, but establishing and maintaining them must be done with caution and the guidance of competent tax professionals. Those who wish to form a FLP must also weigh the importance of achieving tax savings versus losing control over assets transferred to the FLP.

John Hayes is a partner of the Wealth Preservation Practice Group at Pedersen & Houpt. He can be reached at 312 261 2121.

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