Savvy estate planning lawyers and accountants have for years used family limited partnerships (FLPs) and limited liability companies (LLCs) to promote wealthy family management.
These structures allow family members to simultaneously share economic benefits with relatives and to participate as limited partners (in the case of FLPs) or as members (in the case of LLCs).
These estate-planning benefits are significant. They amount to unified control of family wealth investment and its wealth preservation inside an entity. They also offer protection from claims of creditors or spouses. Plus, they pave the way for significant discounts in the value of the interests in the entity, whether held by the founder or by others due to lack of voting control and lack of marketability. Valuation discounts – in the range of 25% to 40% from the value of the underlying assets – have been achieved with significant estate tax savings upon the death of the holder of such interests.
Moreover, it generally has been believed that the senior generation founder of the entity may continue to control or manage the entity by acting as general partner of the FLP or manager of the LLC even after other family members have become partners or members.
The GP or manager can retain a small financial interest in the entity, without estate tax exposure, since the general partner/manager has fiduciary responsibility to manage the entity fairly. And those duties prevent the general partner/manager from misusing his or her control.
However, the Internal Revenue Service is hostile to the use of FLPs and LLCs for estate planning purposes, and it has repeatedly challenged the validity of partnerships that it considers to primarily have been established for tax avoidance, rather than for business or investment purposes.
These attacks had been largely unsuccessful, except when FLPs are established by elderly persons shortly before death with little or no long-term business or investment motives. In the case of such “death bed” partnerships, the IRS has prevailed, and valuation discounts claimed for estate tax purposes have been reduced or disallowed completely.
However, recent cases have raised concerns about the viability of using FLPs/LLCs for estate tax reduction, even when established by a healthy founder with valid business investment goals. These cases suggest that retention of control over the FLP/LLC by the founder may risk estate tax inclusion at full value under IRC 2036(a)(1), not only of the decedent’s interest in the entity, but also of the value of the underlying assets previously transferred to the entity as gifts.
Heed the Code
In the case of Estate of Strangi, the U.S. Tax Court, on remand from the Fifth U.S. Circuit Court of Appeals, concluded that Strangi, on whose behalf an FLP was formed by a son-in-law acting pursuant to a financial power of attorney, had retained the “beneficial enjoyment” of all property transferred to the partnership and that the amounts so transferred were includible in his gross estate under IRC 2036(a)(1) with no valuation discounts.
Strangi was seriously ill when the FLP was established and died two months thereafter.
The U.S. Tax Court noted that Strangi had transferred virtually all of his assets to the FLP, including his personal residence, in exchange for a 99% LP interest. Strangi paid no rent for the continued use of the residence after the transfer, and the FLP made distributions for Strangi’s medical and nursing care expenses during his lifetime and, after his death, to his estate for funeral and administration expenses and estate taxes. At all times, the son-in-law under the power of attorney managed the FLP.
This was the second case involving the IRS’s successful estate tax inclusion of FLP interests under IRC 2036(a)(1). Previously, in Kimbell v. Commissioner, the decedent, Kimbell, had formed an FLP to which she transferred investment assets in exchange for a 99% LP interest; the other 1% general partnership interest was contributed by an LLC owned 50% by Kimbell and 50% by her son and daughter-in-law. The son was the nominal manager of the LLC. Kimbell died two months after the FLP was formed, at the age of 96.
The Federal District Court ruled that the transfer of property to the partnership was a transfer subject to inclusion in Kimbell’s estate under IRC 2036(a)(1), resulting in the disallowance of claimed valuation discounts.
In challenging the discounts, the IRS had asserted that the partnership agreement gave Kimbell extensive powers that would enable her to control the operation of the FLP through her ability to replace the general partner, thereby controlling distributions of income from the partnership.
The court was not impressed by the argument that Mrs. Kimbell would owe fiduciary duties to the limited partners if she took charge, noting that she was the sole limited partner and thus would owe such duties only to herself.
These two cases appear to represent an extreme set of facts in the continuum of FLP/LLC tax litigation. But they send a warning to taxpayers and their advisers who make use of such entities.
If you already have established or plan to establish an FLP/LLC for estate planning purposes, you should observe the following ground rules:
1. The entity should be formed while the founder is in good health and has a reasonable life expectancy.
2. The entity must be properly established under state law and run like a business. For example, it should have its own taxpayer identification number and bank account; it should file in a timely fashion tax returns and such period reports as may be required in its state of organization; there should be an annual meeting with a financial report of the prior year’s operations to the holders of the interests in the entity; and the purposes for forming the entity should be documented.
3. Only business or investment assets (real estate, marketable entities, stock options, private family business interests, or venture capital interests) should be transferred into the entity.
4. Personal assets (such as primary residences or vacation homes) or tangible property (such as furniture or artwork) should not be placed in the entity. Nor should the founder transfer substantially all assets to the entity. Instead, the founder should retain sufficient assets to provide for his or her support, maintenance and medical care without reliance on future distributions from the entity.
5. If possible, have other parties contribute funds or property to the entity at its formation, or transfer interests in the entity to others as gifts once the entity has been established.
6. Make sure that any distributions from the entity are made proportionately to all persons holding an interest in the entity (although reasonable compensation may be paid to persons rendering services to the entity).
The preceding ground rules won’t guarantee that an FLP/LLC is immune from any IRS attack, but they will help significantly to reduce the risk of a challenge, as well as improve the taxpayer’s likelihood of success if a challenge is made.
George Cushing is a Boston-based partner at Kirkpatrick & Lockhart LLP. His practice focuses on estate planning and administration.