Published in NH Society of CPA's Connections Newsletter and NH Bar News (3/21/2019)
One of the most appealing strategies for reducing estate taxes is creating and funding a family limited partnership ("FLP") (or a family limited liability company – FLLC). Under this strategy, limited partnership interests are transferred by senior family members (usually in trust) to children at a discount. Senior family members thereby utilize less of their federal exemption amount and "freeze "the value of their estates by causing appreciation of the transferred interests to occur in the trusts, escaping taxation at their estate level.
Lessons to learn from recent cases
Wealth transfers using interests in FLPs have long aggrieved the IRS which has spent decades pushing back against what it considers to be unwarranted valuation discounts and overly aggressive tax planning. Recent case law showcases the IRS success in challenging such planning. For example, in Powell v. Commissioner, 148 T.C. 18 (2017), the Tax Court ruled that limited partnership interests should be included in the decedent's taxable estate, following aggressive entity planning using a power of attorney.
Last year in Estate of Frank D. Streigtoff v. Commissioner, T.C. Memo 2018-178 (2018), the IRS disputed the taxpayer's characterization of the estate's interest in certain business assets. The Tax Court agreed with the IRS that the interest represented a limited partnership interest, refuted the claim that the interest owned by the decedent represented a lack of control, and adopted the IRS expert's analysis of an 18% overall discount for lack of marketability (as opposed to the taxpayer's assertion that a 27% discount was warranted for lack of marketability), resulting in significant additional taxes.
Most of the FLP disputes with the IRS center on the nature of the interests transferred, as well as the proper application of valuation principles to these interests given their inherent lack of marketability and the new owners' lack of control over partnership distributions, investments and liquidations. Especially with near death planning, the IRS is quick to allege that the planning lacked substance and was abusive.
Advantages of FLP planning
Notwithstanding this landscape, the family limited partnership as a planning strategy remains viable and offers many benefits. These advantages include centralized asset management, inclusion of next generation family members in the management of family assets; asset protection; avoidance of fractional ownership, especially of real estate; senior generational control of partnership distribution policy and tax planning.
To attain these benefits and obtain the leverage of valuation discounts on the transfer of partnership interests, careful planning is essential, including ensuring that the taxpayer respects that the ownership and governance of the assets has changed due to the provisions of the partnership agreement. It is vital that partnership formalities are observed, which includes regular meetings documenting the non-tax reasons for forming the partnership, such as collective asset management, investment policy development and implementation and distribution goal setting and tracking. Once gifts of interests are made, reporting such interests on a federal gift tax return (Form 709) is an important step to start the three-year statute of limitations running on the value of the gift as well its characterization. To ensure that the statute of limitations runs, IRS rules require that the gifts be "adequately disclosed" which requires a qualified appraisal. In short, recent cases suggest that the valuation discounts for lack of control and lack of marketability may be more limited than in the past, but transferring interests into a family limited partnership continues to be a valuable planning tool for reducing potential estate taxes.
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.