Dr. Wallace Wrightwood: “You’ve seen hundreds, thousands of pigeons, right?”
George Henderson: “Of course.”
Dr. Wallace Wrightwood: “Have you ever seen a baby pigeon? Well neither have I. I got a hunch they exist.”[i]
When was the last time you pored over a judge’s analysis of the bona fides of a family limited partnership (“FLP”), or pondered a court’s Solomon-like judgement regarding the fair market value of an interest in a FLP? [ii]
It used to be that such decisions were de rigeur in the world of estate and gift tax planning for family-owned business and investment entities, and planners would wait breathlessly for the outcome of the next learned opinion and the direction it would provide.
Then the federal transfer tax exemption began its seemingly inexorable climb, which spawned an interest in how to best leverage the increased exemption amount and remove still more of a family’s wealth from the transfer tax system.
Of course, there was a bump in 2016, with the issuance of proposed regulations that many believed would, if finalized, mark the end of the valuation discounts that made the use of FLPs, and the transfer of interests in family-owned businesses generally, so attractive as a gift planning tool. [iii]
The presidential election results ended the IRS’s regulatory efforts to clamp down on the abuse of FLPs, and the “temporary” mega-increase of the federal exemption, beginning with 2018, gave many taxpayers a comfortable “margin of error” for any valuation missteps. [iv]
Notwithstanding the relatively “favorable” environment for gift and estate tax planning in which we find ourselves, it will still behoove taxpayers and their advisers to remain attuned to the factors on which the IRS and the courts have historically focused in their analyses of FLPs and the transfer of interests in family-owned businesses, some of which were highlighted in a recent Tax Court decision. https://www.ustaxcourt.gov/ustcinop/OpinionViewer.aspx?ID=11800 [v]
“I’ll Take Care of Everything, Dad”
Decedent, acting through his attorney-in-fact [vi] (his daughter, “Daughter”), formed FLP as a limited partnership. The partnership agreement (the “Agreement”) stated that FLP’s purpose was to “provide a means for [D]ecedent’s family to manage and preserve family assets.” Decedent funded FLP primarily with marketable securities, municipal bonds, mutual funds, and cash. Its portfolio was managed by professional money managers. FLP never held any meetings.
F-LLC was FLP’s sole general partner (“GP”). Daughter was manager of F-LLC. The Agreement provided that the GP “shall perform or cause to be performed * * * the trade or business of the Partnership,” subject only to limitations set forth expressly in the Agreement.
Decedent and his children were FLP’s original limited partners (“LPs”) under the Agreement. The LPs, other than Decedent, received their LP interests as gifts. Decedent reported these gifts on a federal gift tax return (IRS Form 709).
The Agreement provided that FLP would terminate in 2075, unless terminated sooner; for example, upon the removal of the GP. The LPs could remove the GP by written agreement of the LPs owning 75% or more of the partnership interests held by all LPs. If the partnership terminated by reason of the GP’s removal, then 75% of the LPs could reconstitute the partnership and elect a successor GP. LPs owning at least 75% of the ownership percentage in FLP could approve the admission of additional LPs to the partnership.
The Agreement provided that an LP could not sell or assign an interest in FLP without obtaining the written approval of the GP, which the Agreement provided would not be unreasonably withheld. Any partner who assigned their interest remained liable to the partnership for promised contributions or excessive distributions unless and until the assignee was admitted as a substituted LP. The GP could elect to treat an assignee as a substituted LP in the place of the assignor. An assignor was deemed to continue to hold the assigned interest for the purposes of any vote taken by LPs under the Agreement until the assignee was admitted as a substituted LP.
All transfers of interests in FLP were subject to limitations. Partners were allowed to make only permitted transfers of their interests. “Permitted transfers” were transfers (1) to any member of the transferor’s family, (2) to the transferor’s executor, trustee, or personal representative to whom his or her interest would pass at death or by operation of law, or (3) to any purchaser, but subject to the right of first refusal held by the certain partners.
Any partner who received an outside purchase offer for their interest was required, before accepting the offer, to provide each of the “priority family”, the partnership, and the general partner an opportunity to acquire the interest. Whether FLP exercised its right of first refusal to purchase a partner’s interest was subject to the approval of the GP and the LPs owning at least 50% of FLP’s interests held by all LPs (with the exception of the seller if they were an LP).
The Agreement referred to persons who acquired interests in FLP, but who were not admitted as substituted LPs, as “assignees”. Such “assignees” were entitled only to allocations and distributions in respect of their acquired interests. “Assignees” had no right to any information or accounting of the affairs of FLP, were not entitled to inspect its books or records, and did not have any of the rights of a partner under state law.
The Agreement provided that a transferee of an interest in FLP could become a substituted LP upon satisfying the following conditions: (1) the GP consented; (2) the transferee was a permitted transferee; and (3) the transferee became a party to the Agreement as an LP. The Agreement provided that an interest holder who was admitted to FLP as a substituted LP would be treated the same as an original LP under the terms of the Agreement.
On the same day that Decedent formed FLP, he established a revocable trust (the “Trust”), and also transferred his 88.99% LP interest in FLP to Trust. Decedent held the power during his life to amend, alter, revoke, or terminate Trust. He was its sole beneficiary, and Daughter was the trustee. Decedent was entitled to receive distributions of trust income and could receive distributions of trust principal upon his request.
Decedent, through Daughter, executed an agreement (the “Assignment”), which designated Decedent as “assignor” and the Trust as “assignee”. The Assignment provided that Decedent assigned all of his LP interests in FLP, and that the Trust, “by signing this [Assignment], hereby agrees to abide by all the terms and provisions in that certain [Agreement] of [FLP].”
Decedent’s transfer of his interest was a permitted transfer under the Agreement. Daughter signed the Assignment in her capacities as Decedent’s attorney-in-fact, as trustee of the Trust, and as managing member of F-LLC.
Estate Tax Return
Following Decedent’s death, [vii] his estate (the “Estate”) filed a federal estate tax return (IRS Form 706). The Estate reported on the estate tax return that Decedent had made revocable transfers during his lifetime. It identified on the estate tax return the transfers of Decedent’s LP interests to the Trust. [viii]
The Estate described the property transferred to the Trust as an “assignee interest” in an 88.99% LP interest. The Estate reported the value of the transferred interest on the tax return; in a supplemental statement, the Estate indicated that it claimed discounts for “lack of marketability, lack of control, and lack of liquidity.”
The IRS issued a notice of deficiency asserting an estate tax deficiency. The attached Forms 886-A set forth the IRS’s determination that the corrected value of decedent’s interest in FLP was greater than that reported by the Estate.
The Estate petitioned the Tax Court.
The Court’s Approach
The Court distinguished between the nature of the property interest transferred to the Trust (a legal issue) and the fair market value (“FMV”) of such interest (a question of fact). The parties, the Court stated, disagreed as to the type of interest that had to be valued in Decedent’s gross estate.
The Estate claimed that the Assignment created an assignee interest in Decedent’s LP interest under the Agreement. It valued Decedent’s interest in the Trust as an assignee interest.
The IRS asserted that the Assignment did not create an assignee interest held by the Trust. The IRS argued that Decedent transferred his 88.99% LP interest to the Trust and the value to be included in the gross estate should be that of an LP interest.
Thus, the Court had to determine whether the interest Decedent transferred to the Trust was an LP interest or an assignee interest.
Generally, state law determines the nature of the property interest that has been transferred for federal estate tax purposes. [x] The Court explained that, under applicable state law, a partnership interest was assignable unless the partnership agreement provided otherwise. An assignee of a partnership interest was entitled to receive allocations of income, gain, loss, deduction, credit, or similar items, and to receive distributions to which the assignor was entitled, but was not entitled “to exercise rights or powers of a partner”. The assignee may become a partner, with all rights and powers of a partner under a partnership agreement, if admitted in the manner that the agreement provided.
The Court emphasized, however, that the federal tax effect of a particular transaction was governed by the substance of the transaction rather than its form. “The doctrine that the substance of a transaction will prevail over its form,” the Court stated, “indicates a willingness to look beyond the formalities of intra-family partnership transfers to determine what, in substance, was transferred.”
With that, the Court considered both the form and the substance of Decedent’s transfer to the Trust to determine whether the property interest transferred was an assignee interest or an LP interest.
The Court’s Analysis
The Agreement allowed the transfer of LP interests, and for the admission of a transferee as a substituted LP, provided certain conditions were met. [xi]
The Estate contended that these conditions were never met with respect to the interest that Decedent transferred to the Trust and that, upon the execution of the Assignment, the Trust received only an assignee interest in Decedent’s 88.99% LP interest.
The Court observed that, although the transfer was labeled an “assignment,” the Assignment stated that the Trust was entitled to all rights associated with the ownership of Decedent’s 88.99% LP interest, not just those of an assignee. All “rights and appurtenances” belonging to Decedent’s interest, the Court continued, included the right to vote as an LP and exercise certain powers as provided in the Agreement. The Assignment also required that Decedent was bound to provide any documentation necessary “to provide * * * [the Trust] all the rights * * * [Decedent] may have had” in the LP interest.
The Assignment, the Court added, satisfied all the conditions for the transfer of Decedent’s LP interest and the admission of the Trust as a substituted LP. In order for a transferee to be admitted as a substituted LP in respect of a transferred interest in FLP, (1) the GP had to consent to the transferee’s admission, (2) the transfer had to be a permitted transfer, and (3) the transferee had to agree to be bound by the terms of the Agreement. Daughter signed the Assignment as manager of FLP’s GP and consented to its terms, which provided for the transfer of all of Decedent’s rights in his LP interest to the Trust. The transfer was a permitted transfer. Lastly, the Assignment provided that the Trust agreed to abide by all terms and provisions of the Agreement, and Daughter executed the Agreement on behalf of the Trust.
The Court concluded that the form of the Assignment established that Decedent transferred to the Trust an LP interest and not an assignee interest.
What’s the Difference Anyway?
The economic realities underlying the transfer of Decedent’s interest, the Court stated, supported the conclusion that the transferred interest should be treated as an LP interest for federal estate tax purposes; regardless of whether an assignee or an LP interest had been transferred, there would have been no substantial difference before and after the transfer to the Trust.
Pursuant to the Agreement, only the GP had the right to direct the FLP; neither LPs nor assignees had managerial rights. The Agreement provided that assignees had no rights to any information regarding FLP’s business or to inspection of its books or records.
However, according to the Court, this distinction made no difference in the present case because Daughter was both a partner who was entitled to information regarding FLP (i.e., the manager of the GP) and the trustee of the Trust.
The Agreement also provided that an “assignee” did not have the right to vote as an LP. However, this difference was not significant – whether the Trust held the voting rights associated with an LP interest was of no practical significance, the Court stated.
There were no votes by LPs following the execution of the Assignment. Additionally, during his life, Decedent held the power to revoke the transfer to the Trust. If he had revoked the transfer, he would have held all the rights of an LP in FLP, including the right to vote on partnership matters. Also, F-LLC, as the GP, could have treated the holder of an assignee interest as a substitute LP.
Therefore, under the facts and circumstances of this case, the Court determined there was no difference in substance between the transfer of an LP interest in FLP and the transfer of an assignee interest in that LP interest. Accordingly, as a matter of both form and substance, the interest to be valued for estate tax purposes was an 88.99% LP interest in FLP, rather than an assignee interest. [xii]
Bad facts, etc., but some may see a silver lining in the result of this case.
A taxpayer who cannot act on his own; his attorney-in-fact/Daughter creates the partnership and funds it with marketable securities and cash on his behalf; she appoints herself as the manager of the GP; she creates and funds the Trust with most of the LP interests on his behalf, and appoints herself as trustee of the Trust. Sounds perfect.
Notwithstanding the foregoing, the Court respected the partnership; [xiii] in fact, it appears that the IRS did not even challenge the partnership’s bona fides.
Query what business purpose the FLP had where it held only marketable securities and cash (all provided by Decedent), where its securities were managed by a professional money manager, and where it never held any meetings. This was just a valuation play.
Silver lining? Nope. Dodged one? Yep. A map to follow? Please don’t.
i From “Harry and the Hendersons.” C’mon, don’t pretend you haven’t seen it.
ii Usually with a beverage for inspiration.
iii https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-one/ ; https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-two/ ; https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-three/ .
iv The exemption amount had been set to increase from $5.49 MM in 2017 to $5.62 MM in 2018. The Tax Cuts and Jobs Act doubled the exemption to $11.2 MM for 2018, adjusted for inflation beginning in 2019, with a return to the pre-2018 levels after 2025. P.L. 115-97.
v T.C. Memo. 2018-178.
vi Anyone remember Strangi?
vii The 706 was filed August 2012. If this filing was timely, then the DOD was in November 2011. The FLP and Trust were created in October 2008, three years earlier.
viii IRC Sec. 2038; Schedule G to the Form 706. Because the transfers were revocable by the Decedent – specifically, by his attorney-in-fact in this case – the property transferred was included in his gross estate for tax purposes.
ix You can’t make this up.
x See Commissioner v. Estate of Bosch, 387 U.S. 456 (1967).
xi See above.
xii The Court then turned to the FMV of the Trust’s interest in FLP. Based on its finding that the interest transferred was an 88.99% LP interest, the Court concluded that the interest did not lack control. Accordingly, no discount for lack of control was allowed. The Court agreed with the Estate that there should be a discount for lack of marketability. However, because the Court concluded that the interest Decedent transferred was an LP interest, not an assignee interest, it found the Estate’s discount was too generous and accepted the lower discounted applied by the IRS.
xiii Yet it did, and also allowed a lack of marketability discount in determining the FMV of the interest held by the Trust. Go figure.