Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
FAMILY LIMITED PARTNERSHIPS: THE BEAT GOES ON
Walter D. Schwidetzky*
* Professor of Law, University of Baltimore School of Law; University of Denver Sturm College of Law, J.D., 1978, LL.M., 1984
In 2001, I published an article that discussed the estate tax consequences of family limited liability entities (FLLEs). A FLLE is a family limited partnership (FLP) or family limited liability company (FLLC or LLC) formed for family estate planning purposes (under the default rule, an LLC that has two or more members is considered to be a partnership for federal tax purposes). FLLEs are used for estate planning purposes that can be wide-ranging and often perfectly legitimate. They can be used to provide a family business with a liability shield or be a vehicle for distributing ownership interests in family assets, but often the primary purpose for their use is the reduction of estate taxes.
Using an FLP as an example, commonly a parent contributes assets to the FLP and takes back the limited partnership interests. Others, typically children or other relatives, but sometimes banks or other independent persons, hold the general partnership interests (in an FLLC it would be the managerial interests). Contributions to a tax partnership are normally tax free under section 721(a). In an attempt to avoid the contributed assets being included in her estate under section 2036, the parent usually does not control the FLP, though courts have been applying section 2036 even where the parent does not have technical control (discussed below). The parent’s limited partnership interests in the FLP are typically worth less than the assets she contributed to the FLP. Valuation discounts are commonly applied because the parent’s limited partnership interests lack control and are usually not as readily marketable as the underlying assets would have been. It is not unusual for the FLP interests to be included in the parent’s estate at a 35% or greater discount from the value of the contributed assets. Thus, property that would have an estate tax value of $100,000 if owned by the parent directly might be exchanged for limited partnership interest worth only $65,000. There should ordinarily be no gift on the formation of the FLP as typically the parent receives a capital account credit equal to the full value of what she contributed. If there was a liquidation of the FLP, the parent would normally be entitled to be paid her capital account balance. Further, the children commonly contribute their own funds in exchange for the controlling interest. Thus, normally on formation, no value has been shifted to others that could trigger a gift and the consequent gift tax.
Additionally, the parent could, but often does not, make gifts of the FLP interests to her children (and possibly pay a resulting gift tax). To the extent the children lack control and cannot readily sell their interests, the lack of control and lack of marketability discounts will apply to the gifted interests. The lack of control discount is reduced if the limited partnership interests are gifted to a child who is a general partner, as general partners control the operation of the limited partnership. A general partner may, however, share that control with others if there is more than one general partner. Further, a general partner has fiduciary duties to the limited partners to protect their interests, which keeps the general partner’s control from being unfettered. The lack of control discount, therefore, would still not be zero.
If unqualifiedly allowed, this technique would be an estate tax bonanza. With a bit of slight of hand, the value of an estate could be dramatically reduced with perhaps little change in the underlying beneficial ownership or use of the assets. Tax advisors and their clients loved it. The Service did not. The Service understandably did not think a decedent should so easily reduce the estate taxes owed. At the time of the 2001 article, the focus of the Service’s efforts was on FLLEs formed shortly before death. The Service had issued a number of technical advice memoranda and there were a few cases on point. Since then, the number of cases has grown dramatically and are not limited to FLLEs formed shortly before death, but also include FLLEs that meaningfully predate the decedent’s death and until recently might have been thought by many to be “safe.” As noted below, the Tax Court has taken a tough line, usually applying section 2036 to ignore the FLLE and include the contributed assets in the decedent’s estate. The Third and Fifth Circuits (and to a lesser extent the First Circuit) have had something to say on the subject as well. They have not been particularly taxpayer-friendly either. The Fifth Circuit seems to be somewhat more generously inclined, but in the final analysis its approach may not lead to different outcomes.
Section 2036 includes in the decedent’s estate assets transferred during life. If the decedent retains the right to income, possession, or enjoyment, or the right to say who can receive income, possession, or enjoyment. The purpose of section 2036 is to prevent decedents from excluding assets from their estates by transferring legal title but maintaining substantial rights.Given the plethora of new cases, in particular recent pronouncements of the Fifth Circuit in Kimbell v. United States, the Third Circuit in Estate of Thompson v. Commissioner and the Tax Court in Estate of Bongard v. Commissioner, and the tack those cases have taken, the area is worthy of a fresh look. Ultimately, the Article concludes that a modified version of the original proposal, which would generally bring property transfers to FLLEs back into the decedent’s estate if made within three years of death, could successfully address the principal concerns this area raises.