Limited partnerships can be an important component of a family’s comprehensive wealth transfer plan. A number of recent Tax Court cases confirm the continuing viability of the family limited partnership as an estate planning tool but highlight the need to observe the form and function of the entity to insure that it accomplishes its purpose, that is, as a mechanism for managing the family wealth and reducing estate and gift taxes. The following summary of these cases is meant to show what families should and should not do to forestall or overcome a challenge to the family limited partnership.

Jones v. Commissioner

In Jones v. Commissioner, the donor owned the surface rights to two cattle ranches. The donor formed two family limited partnerships, one with his son, and one with his four daughters. In each case, the donor transferred a ranch interest to the family limited partnership in exchange solely for a limited partnership interest, and the children contributed property in exchange for general and limited partnership interests. Immediately after the formation of the partnerships, the donor made gifts of a substantial portion of his limited partnership interests to the other partners. The government argued that the donor made a taxable gift upon the formation of each of the limited partnerships because the fair market value of the limited partnership interest he received was less than the fair market value of the property he contributed to the partnership. The Tax Court rejected the government’s arguments and held that there are no gifts on formation of the family partnerships because the contributions made by the donor were reflected in his capital account for each of the partnerships.

The Internal Revenue Service ("IRS") also challenged the valuation discounts claimed by the taxpayer. Because the limited partnership interest transferred to the son gave him the unilateral right to cause the dissolution of the son’s family partnership, the court allowed only an 8% lack of marketability discount in determining the value of the gift to the son of the limited partnership interest. With respect to the limited partnership interests transferred to the daughters, however, since these interests did not carry with them the ability to dissolve the partnership, the court allowed the 8% lack of marketability discount, followed by a 40% secondary market discount.

Jones teaches that it is important that all capital contributions to a family limited partnership be reflected in the respective capital accounts of the contributing partners. In addition, conferring any unusual power on the limited partners, particularly one that is tantamount to a withdrawal power, will have a substantially negative impact on the valuation discounts available.

Estate Of Strangi v. Commissioner

In Estate of Strangi v. Commissioner, the decedent’s son-in-law, as attorney-in-fact under a durable power of attorney, formed a family limited partnership and transferred the decedent’s property to the partnership in exchange for a 99% limited partnership interest. The decedent also purchased 47% of the corporate general partner. 75% of the assets of the family partnership consisted of cash and securities. The IRS argued strenuously that the family limited partnership should be disregarded as having no business purpose. A number of facts supported this contention. Following the decedent’s death, the family partnership distributed assets to the decedent’s estate to pay estate taxes. The family partnership also distributed assets and extended lines of credit to the beneficiaries of the decedent’s estate.

Although skeptical of the business purposes asserted by the taxpayer, the court nevertheless held that absent persuasive evidence that the partnership agreement would not be enforceable by the parties, it would not disregard the partnership agreement. Like Jones, the Strangi court also held that there was no gift by the decedent on the formation of the family partnership. The estate tax return reported the fair market value for the decedent’s interest in the family partnership based on a 33% discount for lack of marketability and lack of control. The Tax Court permitted combined discounts for minority interest and lack of marketability of 31% for the decedent’s limited partnership interest and 19% for the decedent’s interest in the corporate general partner.

The court suggested that the IRS should have argued estate tax inclusion on the basis of section 2036 of the Internal Revenue Code, but held that the issue was not timely asserted by the government. Section 2036 provides that if a decedent transfers property for less than full and adequate consideration and thereafter retains the right either to the income from the transferred property or the right to designate who will enjoy that income, the transferred property is includable in the decedent’s estate for estate tax purposes. The same facts that support an argument that a family limited partnership lacks business purpose could support a section 2036 argument. To avoid a section 2036 challenge, clients should respect the independent nature of the business entities they form, and avoid even the appearance that they are continuing to treat the property transferred to the entity as their own. Assets such as tangible personal property and personal residences should not be transferred to a family limited partnership unless the client will pay fair market value rent for the continued use of those assets.

Knight v. Commissioner

In Knight v. Commissioner, the taxpayers (husband and wife) formed a family limited partnership to which they transferred a ranch, residential property, municipal bonds, treasury notes, insurance policies and cash. Thereafter, the taxpayers transferred some of their limited partnership interests to two trusts for the benefit of their children. The taxpayers continued to use the partnership ranch property and permitted their children to occupy the partnership residential property without paying rent. The partnership kept no records, prepared no annual reports and had no employees. The partners had no meetings or interaction on any level. Nevertheless, the court held that the family partnership should not be disregarded.

The taxpayers in Knight attempted a formula gift of limited partnership units to the trusts for their children. Thus, the transfer documents stated that the taxpayers were transferring to each of the children’s trusts that number of family partnership units which were equal to $300,000. The taxpayers, however, did not report the transfers as formula gifts on their gift tax returns nor did they consistently treat them as formula gifts. The Tax Court, therefore, also refused to treat the transfers as formula gifts.

The taxpayers’ expert opined that an aggregate discount of 44% for the portfolio, the minority interest and lack of marketability should apply. The court found the expert’s testimony to be wholly unsupported and unconvincing, and permitted only a 15% discount. The court was particularly unimpressed with the expert’s use of noncomparable entities in his data. Apparently, the expert cited numerous restricted stock studies without any showing of how the companies in the studies were comparable to the family limited partnership being evaluated.

Knight therefore is a lesson not only in the factors used by the IRS to determine whether it will challenge the validity of a family partnership, but also in the quality of the appraisal necessary to sustain any valuation discounts claimed by a taxpayer. Taxpayers are well advised to administer their family entities in a manner that is as close as possible to the administration of business entities in which no family relationship exists among the equity owners. With respect to the quality of an appraisal necessary to withstand government challenge, Tax Court judges on the lecture circuit have repeatedly stated that unless the appraisal used by the taxpayer to establish the value of a transfer of an interest in an entity is based upon suitable comparables and accounts for all distinctions that exist between the entity evaluated and the comparables used, the appraisal will not be respected.

Shepherd v. Commissioner

Shepherd v. Commissioner illustrates the importance of ordering the steps in the formation of a family partnership so as to make it clear that the asset transferred to the donee is an interest in the family partnership, rather than a share of the property contributed to the partnership. In Shepherd, the taxpayer transferred to a family limited partnership his fee interest in timberland subject to a long-term lease and shares of stock he owned in three banks. After the taxpayer signed the partnership agreement and transferred the property to the partnership, his two sons signed the partnership agreement and each became owners of 25% of the partnership. The court held that under State law no valid partnership came into existence until the sons signed the partnership agreement. Accordingly, the sons did not receive an interest in the family partnership for gift tax purposes (because the partnership did not exist prior to their signing the partnership agreement), but instead received a fractional interest in the property transferred to the partnership. Therefore, the court permitted only a 15% minority interest discount. The court relied on an analogous gift tax regulation governing contributions to a corporation, which concludes that a gratuitous contribution of property to a corporation results in a pro rata gift to the other shareholders of the property contributed to the corporation.

Recent Litigation

Greenberg Traurig recently served as counsel in the litigation phase of a case involving an IRS challenge of a family limited partnership. The IRS viewed the partnership as a sham even though all of the State law formalities had been followed in establishing the partnership and even though it was funded prior to the 99% limited partner’s death. The clear thrust of the IRS attack was to discredit the family limited partnership by focusing on its operations, particularly those occurring after death. Any irregularities in the partnership operations, such as those present in Knight, were cited as evidence that the partnership had no economic substance for tax purposes. Even after Strangi, Knight and Jones, the IRS refused to entertain any settlement based on these authorities.

From this experience, it is apparent that notwithstanding its losses in Tax Court, the IRS is likely to continue to challenge family limited partnerships using every available argument under the Internal Revenue Code, including those based on positions that already have been discredited in the lower courts. In egregious and borderline cases, the IRS may refuse to settle, hoping that it can achieve a victory on any argument or legal theory that it can convince a court to adopt. The existence of both dissenting and concurring opinions in Strangi and Knight may have fueled the IRS’s zeal in seeking to overturn family limited partnerships as tax avoidance schemes. Thus, where the facts of a case include nonbusiness-like conduct in the formation or administration of a family limited partnership, it can be anticipated that the IRS will seize on the case and pursue it to trial and appeal, hoping for victory in the circuit courts or for a conflict in the circuits, paving the way for U.S. Supreme Court review.

Conclusion

The best protection against an IRS onslaught is in the careful planning and implementation of the family limited partnership from its inception and throughout its life. The taxpayers who have been successful in sustaining a family limited partnership and the associated discounts have, as the Tax Court stated in Strangi, dotted their "i’s" and crossed their "t’s". For those taxpayers, substantial tax benefits continue to be available.

Greenberg Traurig attorneys would be happy to assist you in a review of the administration of your family limited partnership or to discuss with you whether a family limited partnership may be appropriate to implement your family wealth transfer planning.

© 2001 Greenberg Traurig

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.