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TAX AND ESTATE PLANNING WITHFAMILY LIMITED PARTNERSHIPS

George L. Cushing, Esq.Amiel Z. Weinstock, Esq.

K&L Gates, LLPBoston, Massachusetts

I. General Attributes of Family Limited Partnerships

A. What is a Family Limited Partnership?

A Family Limited Partnership (“FLP”) is a limited partnership, validly established understate law, through which a group of individuals, generally members of the same family,voluntarily combine to pool their business and/or investment resources in order to achieve longterm financial goals. These goals often include providing centralized management and costeffective administration of family wealth, through economies of scale, as well as limiting therights of individual family members to gain access to, and potentially dissipate, the underlyinginvestment assets held in the partnership.

There are two classes of partners involved with an FLP. The partnership is controlled byone or more “General Partners,” who may be individuals or entities (such as a Limited LiabilityCompany (“LLC”) or Corporation); the other family members who participate in the FLP are the“Limited Partners”.

The General Partner (a) is authorized to manage the partnership assets and can decidewhat distributions, if any, are to be made to the partners; (b) has full power to act on behalf of thepartnership and is personally liable for actions taken; and (c) has fiduciary duties to the otherPartners and to the partnership and must act accordingly in his/its administration of thepartnership.

The Limited Partners own an interest in the partnership which reflects their percentageownership interest in the underlying partnership assets. In addition, the Limited Partners havecertain legal rights with respect to the ongoing administration and future liquidation of thepartnership. However, limited partners do not have any powers with respect to the managementof the partnership or the investment of its assets; by the same token, as “passive investors” theirpotential liability to creditors of the FLP is limited to their investment in the partnership (i.e.,their proportionate interest in the underlying partnership assets, as reflected by their respectivepartnership interests).

B. Alternative Family Wealth Management Structures.

In recent years, legislation authorizing the formation of Limited Liability Companies(“LLCs”) has been adopted in every state. LLCs offer operational and tax planning benefitssimilar to those offered by FLPs, although there are some significant legal differences. Adetailed discussion of the different uses of LLCs, as compared to FLPs, is beyond the scope ofthis outline.

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Some families utilize corporations and/or trusts to accomplish similar financial,management and investment goals. Trusts may offer comparable opportunities for centralizedmanagement and long term investment prospects; however, the standard of care applied inevaluating the performance of trustees may be higher than that applied to mangers of businessentities, including FLPs. In addition, trusts do not offer the opportunity for making discountedgifts, which will be described further, below.

Like FLPs, corporations also offer opportunities for centralized management and formaking discounted gifts; however, in certain circumstances, corporations may be taxeddisadvantageously as compared to partnerships and trusts. Such differences will be explained ingreater detail, below.

C. Non-tax planning.

FLPs can be used for a variety of goals that are not tax related:

1. Instilling family values without creating “trust fund” children.

FLPs may be utilized for teaching younger generation family members (i.e., childrenand grandchildren) to invest and spend with responsibility while permitting the oldergeneration family members (i.e., the patriarch and/or matriarch) to maintain controlover the partnership, either directly or indirectly.

2. Teaching younger generation family members about the family’s investmentstrategies and philanthropic goals.

3. Spreading the expense of asset management among a larger pool of investable assetsand potentially achieving a greater degree of investment diversification, both as toasset classes and through the employment of multiple money managers.

4. Making it easier for older generation family members to make gifts of partnershipinterests (which can be transferred by a simple “Assignment”) as opposed to giftinginterests in property which may be hard to value and/or cumbersome to transfer (suchas real estate or an unincorporated business).

NOTE: An FLP is a voluntary contractual arrangement among family memberswhich often permits the family to retain ownership of the partnershipinterests (and therefore the underlying assets) through restrictive buy-sellprovisions set forth in the Partnership Agreement. Typically, thePartnership Agreement will include a requirement that all partners mustagree to admit an assignee of any transferred partnership interest as apartner before that assignee will acquire the rights of a partner (if notadmitted as a partner, the assignee will only have a right to his/her shareof the income from the partnership).

5. Protection from future creditors.

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a. The creditors of a limited partner may be limited to the partner’s share ofpartnership distributions; if no distributions occur, those creditors will receivenothing.

b. The Partnership Agreement may include a provision requiring the partnership tobuy-back the interest of any limited partner upon whose partnership interest acreditor has tried to levy; the Partnership Agreement may set a formula price topay the creditor, which price may be substantially less than the value of theunderlying assets allocable to that partnership interest (this also protects the otherpartners from including a creditor as a partner).

c. The Partnership Agreement may prohibit the pledging of the partnership interestsby the partners to secure personal loans.

6. Protection against divorce of children.

a. The Partnership Agreement may provide for “Buy-Sell” provisions which aretriggered by the divorce of a limited partner similar to those which apply in theevent of levy by a judgment creditor of a limited partner.

b. It is also relatively easy to provide, via a prenuptial agreement, that a partnershipinterest will be treated as the “separate property” of the limited partner/spousewhich will not be subject to equitable division in the event of a divorce.

7. Flexibility of Partnership Agreement.

a. Since a partnership is a voluntary arrangement, the terms of the PartnershipAgreement may be modified by the agreement of the partners as may benecessary or desirable from time to time.

b. Irrevocable trusts, by comparison, can never be modified by the trust’s Grantor.Some trusts permit the terms of the trust to be amended by the Trustees or by anindividual or committee acting as the “Trust Protector.” Such amendments are,however, quite limited in scope and purpose.

8. “Business Judgment”.

Applicability of the “business judgment” rule to partnerships (as opposed to the“prudent man” rule which applies in the case of trusts) offers more latitude ininvestment decision-making for the managers of the FLP than for Trustees ofirrevocable trusts.

9. Potential for mandatory arbitration or mediation.

Because an FLP is a voluntary arrangement, the Partnership Agreement can requirethat any disputes which arise relating to the management or administration of thePartnership be submitted to arbitration or mediation instead of resorting to costlylitigation.

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10. Costs of controversy.

As a contractual arrangement, the Partnership Agreement can mandate that the“English” rule apply with respect to the costs of any dispute (i.e., that anunsuccessful “litigant” pays all of the costs of all parties to the dispute).

11. Avoiding ancillary probate and state taxes.

To the extent that the partnership owns real property located outside the state ofresidence of the partner, such ownership will not require ancillary probateadministration upon the death of the partner since interests in a partnership owningreal property are nonetheless considered to be “intangible personal property” forprobate and state estate tax purposes (as opposed to the outright ownership of theunderlying real property by the decedent).

In addition, for clients who are current or prospective residents of Florida, the use ofan FLP to hold marketable securities may avoid the Florida intangible personalproperty tax (FSA 199.185 exempts from the tax any “interest as a partner in apartnership, either general or limited”).

12. Investment flexibility with respect to the “beneficiaries”.

The General Partner of an FLP may make distributions to the Limited Partners basedon the partnership’s current financial return and does not need to limit distributions tothe “income” of the partnership.

Moreover, where the partnership interests are owned by a trust or trusts, thepartnership distributions are all considered to be “income” for trust accountingpurposes, regardless of the actual source of the funds from which those distributionswere derived.

13. One level of income tax.

A partnership is a “pass through” entity, which means that all partnership income andlosses are “passed through” to the partners for each taxable year, regardless of theactual amounts distributed to the partners from the a partnership. The amountstaxable to the partners are proportionate to their interests in the partnership

II. Estate and Gift Tax Aspects of Family Limited Partnerships

A. The U.S. transfer tax system imposes an excise tax on the transfer of property, either bygift or at death.

1. “It is a tax on the privilege of passing on property, not a tax on the privilege ofreceiving property”1

1 Ahmanson Foundation v. United States, 674 F.2d 761, 768 (9th Cir. 1981)

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2. In order to be subject to the transfer tax system at death, the decedent must own theproperty immediately before death, and the property must be transferable.

B. The determination of the value of the transferred asset for estate tax purposes reflects thenature of the asset upon its distribution from the estate (e.g., if, upon death, the decedentcan only transfer an assignee interest in the partnership, the value will not be the same asthe value of his general partnership interest immediately prior to death).

C. The relationship between the transferor and the transferee is irrelevant for valuationpurposes.

In Revenue Ruling 93-12, 1993-1 C.B. 202, in which a father transferred all of his stockin a closely held business in five equal (20%) shares to his children, the IRS ruled thateach of the gifts of the separate 20% interests in the business were entitled to a minorityinterest discount in valuing the transferred shares, even though, before the transfer, thetransferor had owned 100% of the value of the enterprise (and thus, the business wouldhave been included in his estate at 100% of its value had he retained the ownership untildeath).

D. The identity of the remaining partners is relevant for valuation purposes in measuring thevalue of the transferred interest.

1. Under the laws of most states, which govern the undefined terms of a limitedpartnership, a transferee takes only as an assignee, and has no management rights,unless approved as a partner by the remaining partners.

2. If the transferee will be the only non-family “outsider” in an FLP controlled byfamily members, it is not likely that they will vote to approve his admission as alimited partner so that he will only have the rights of an “assignee”.

3. For valuation purposes, the hypothetical “willing buyer” must therefore assesswhether the remaining partners will admit him as a partner in the partnership, and, ifnot, should offer a lower purchase price for the partnership interest.

4. There may be a right to withdraw as a partner under state law and, in such case, toreceive “fair value” for the partnership interest within a reasonable period of time.However, this right may be limited by the terms of the Partnership Agreement or maynot exist unless provided by that agreement.

NOTE: “Fair value” does not generally mean liquidation value. Under the laws ofmost states, “fair value” means the present value of the expected cashdistributions from the partnership - that is, the discounted cash flow.

E. The value of the partnership interest to the willing buyer more closely approximates thevalue of the interest in an ongoing business (i.e., the present value of the expected futurecash distributions from the partnership) and not the liquidation value of the assets (sincehe will likely have no control over liquidation).

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F. State law determines the nature of the property interest; federal law determines how suchproperty interest will be taxed.

1. In valuing a partnership interest, the appraiser must take into account the rights of thepartner under the terms of the Partnership Agreement and state law and thendetermine what a “willing buyer” would pay for those rights in light of the nature andvalue of the underlying assets of the partnership, the history of partnershipdistributions and the identity of the other partners.

2. Historically, the IRS has sought to value partnership interests on the basis of the netvalue of the underlying assets (i.e., “liquidation value”), while taxpayers have arguedin favor of the “capitalization” approach (i.e., the “going concern value”). Courtshave sought valuation opinions based on both approaches and then weighed theappropriateness of each approach in arriving at a determination of “fair market value”of a partnership interest in specific cases.

G. Valuation discounts.

1. Valuation discounts are appropriate in valuing limited partnership interests becausethe holder of a limited partnership interest has no right to control the management ofthe partnership assets, cannot compel the liquidation of the partnership, and owns aproperty right which is not readily marketable.

2. Discounts are recognized by the public securities markets in pricing interests inpublicly traded entities similar to partnerships, such as real estate investment trusts,closed end investment companies and similar investments.

3. The discounts recognized in valuing interests in non-public entities, such as an FLP,should logically be more pronounced than in syndicated partnerships, since:

a. The FLP generally will have a less experienced general partner;b. The FLP is not professionally managed;c. The FLP offers a less diversified investment portfolio, therefore subjecting the

investor to higher risk;d. There is less certainty of cash flow/distributions; ande. There is no secondary market for the sale of interests in the FLP.

H. Discount for built-in capital gains costs.

1. A “willing buyer” should also be entitled to take into account the costs which willlikely be incurred in the event that partnership assets are liquidated by the generalpartner, generating capital gains which each partner must report in proportion to hispartnership interests.

2. Even if the buyer has proportionately greater “outside basis” in the liquidatedpartnership assets (through the purchase price he has paid for his partnership interest)

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than the “inside” cost basis of the partnership assets, he cannot offset his outsidebasis against his share of the capital gains realized at the partnership level unless hedisposes of his partnership interest within the same taxable year as the partnershipgains are realized or unless the partnership is liquidated in that same year.

3. While he may be entitled to an offsetting loss in a future year, it is uncertain whetherthat loss will be fully usable in that year and the timing costs of the earlierrecognition of capital gains (and payment of capital gains taxes) could be significant.

I. Annual exclusion for gift of limited partnership interest.

1. Requirement of a “present interest.”

IRC §2503(b) establishes the availability of an annual exclusion for gifts other thangifts of future interests in property (emphasis added). “Future interest” is defined inthe Regulations as an interest in property “limited to commence in use, possession orenjoyment at some future date or time.” Any postponement of the donee’s right topresent possession or enjoyment, however brief, makes the gift a gift of a futureinterest. See, e.g., Estate of Jardell v. Commissioner, 24 T.C. 652 (1955) (outrightgifts of mineral royalty interests in October 1949 effective for productioncommencing January 1, 1950 held not to qualify for annual exclusion).

The annual exclusion is generally available with respect to outright transfers ofproperty, even property that is not currently productive of income; the annualexclusion should be available so long as there is no restriction on the donee’s right topossession or enjoyment of the property. For example, the transfer of the ownershipof a life insurance policy to the donee and the subsequent payment of premiums bythe donor qualify for the present interest exclusion. See Treas. Reg. §25.2503-3(c),Example 6. A different result follows if the policy is owned by a trust and thedonee’s rights in the trust income are postponed until the owner’s death. See Treas.Reg. §25.2503-3(c), Example 2.

Future interests are commonly, but not exclusively, associated with transfers in trust.However, where the trust confers an enforceable right on one or more beneficiarieswhich is presently exercisable, a present interest sufficient to support a presentinterest exclusion may be established.

For example, the transfer of property to a trust which grants the right to income to thebeneficiary (a so-called “§2503(b) Trust”) is eligible for a present interest exclusionto the extent of the value of the income interest, determined in accordance with theactuarial principles governing valuation of income and remainder interests set forthin Treas. Reg. §§25.2512-5 and 20.2031-7.

Where the property is not producing income at the time of the gift in trust, theService has sought to challenge the availability of an annual exclusion for the valueof the income interest, even though a right to receive income is conferred by the trust.The Service’s theory is that the income interest cannot be valued or has no value.

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See, Berzon v. Commissioner, 534 F.2d 528 (2d Cir. 1976). Thus, although actuarialcomputation based on the value of the transferred property, rather than the discountedcash flow from the transferred property, is the valuation method prescribed by theTreasury Regulations, the Service may seek to disallow an annual exclusion for anincome interest in non-income producing property.

2. Annual Exclusion for transferred interests in business.

The requirement that the donee have the right to “substantial, present economicbenefit” has given rise to litigation in the context of transfers of interests in familybusinesses, particularly FLPs, due to the nature and extent of the restrictions on therights of the donees of limited partnership interests to receive distributions from thepartnership or to transfer their interests to a third party.

So long as (1) the donee of a limited partnership interest has the right to receivedistributions from the partnership, (2) the general partner has a fiduciary duty withrespect to the management of the partnership and can only withhold distributions forbusiness reasons; and (3) the donee can assign the donated interest to a third party(subject to “acceptable restrictions” on the right of an assignee to become asubstituted limited partner), annual exclusions should be allowable. See, e.g. TAM9131006, PLR 9415007. See also PLR 9710021 (donees granted right to sell donatedFLP interests within 90 days after receipt). But see TAM 9751003 (partnershipprovision granted general partner so much discretion that it “obviated” the normalfiduciary duties and annual exclusions disallowed.)

The most recent judicial pronouncement regarding the allowance of annualexclusions in connection with gifts of interests in a closely-held business is Hackl v.Commissioner, 118 T.C. 279 (3/27/02) (Nims, J.). This case involved transfers ofvoting and non-voting interests in an LLC controlled by the donor, Mr. Hackl, to thedonor’s eight children, their spouses and an irrevocable trust for the benefit of his 25grandchildren for the year 1996. Gift splitting was elected with respect to all of thegifts. The Service challenged the annual exclusions for the 1996 gifts (similar giftswere made by the taxpayer in 1995 but the availability of the annual exclusions for1995 was not challenged).

The Court noted that the LLC was engaged in tree farming and, in order to achieveMr. Hackl’s investment goals of long-term growth, the LLC invested in tree farmproperty which contained no merchantable timber. From the outset, the LLC wasexpected to experience losses through the year 2000, and the LLC had not yetproduced net profits at the time of trial in 2001.

Due to restrictions on the rights of the holders of the LLC interests to transfer theirinterests, the Court concluded that the annual exclusions should not be allowed forthe gifts of the LLC interests, since the donees lacked the “substantial economicbenefit of the type necessary for the annual exclusion.”

Those restrictions included:

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a. The Manager, Mr. Hackl, had sole control over distributions; moreover, he wasmanager for life and could appoint his successor, both during life and at death byhis will.

b. Members of the LLC had no right to withdraw capital or to demand distributions,except as approved by the Manager and had no right to have the LLC propertypartitioned.

c. Members who wished to withdraw could offer their units for sale to the company,which the Manager had exclusive authority to accept or reject.

d. A Member’s interests were not assignable except with the prior written consentof the Manager which could be given or withheld in the Manager’s solediscretion.

Nonetheless, in spite of the express provision of the LLC operating agreementdescribed in (d) above, the Tax Court noted that if a transfer were made in violationof the LLC operating agreement, the transferee, while not permitted to participate inthe business affairs of the LLC (or to become a Member) would be entitled to receivethe share of profits and distributions which would otherwise have inured to thetransferor. Thus, in fact the donees could assign their LLC interests without themanager’s consent and such a transfer would confer rights on the transfereecomparable to the rights held by the assignee of a limited partnership interest, whichhave been held in the past to be adequate to support the present interest exclusion.See e.g. TAM 199944003, involving a family limited partnership, in which transfersof limited partnership interests were held to qualify for the annual exclusion.

The Tax Court opinion creates confusion about the operative standard for qualifyingfor the gift tax annual exclusion. One element, the receipt of accounting income, wasclearly lacking; however, it appears that the donees did have the ability to sell theirinterests, an alternate basis for allowing the annual exclusion.

Due to the Hackl precedent, which was affirmed by the Court of Appeals without anyre-examination of the underlying issues (335 F.3rd 664, 7th Cir. 2003), donors whoplan to make gifts of LP interests in an FLP (or membership interests in an LLC)should make sure that the restrictions on transfer imposed by the Partnership (orOperating/Management) Agreement do not limit the limited partner’s interests in theunderlying partnership to such an extent that the annual exclusion could be lost.

Specifically, the restrictions should provide either:

a. A right of first refusal which gives the other partners the right to purchase the LPinterests of any limited partner who wishes to transfer the interest, on specifiedadvance notice of any proposed transfer; or

b. A “Crummey” type withdrawal power, exercisable within a specified period oftime after the partnership interest is transferred to the limited partner, within

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which the partner could elect to withdraw assets from the partnership equal to the“value” of the partnership interest.

J. Valuation issues on transfers involving partnerships.

1. Gift on formation.

a. The IRS has asserted in a number of litigated cases that, by establishing apartnership in which the partnership interests received by the transferor inexchange for the assets contributed to the partnerships have a lower value thanthe underlying assets themselves, the transferor has made a taxable gift to theother partners to the extent of the valuation differential.

b. This argument has been successful in circumstances in which the IRS has beenable to establish that property was added to a partnership or other business entity,resulting in the augmentation of the interests of the other partners. See, e.g. J.C.Shepard v. Comm’r, 115 T.C. 376 (2000), Aff’d 283 F.3d 1258 (11th Cir. 2002);Kincaid v. U.S., 682 F.2d 1220 (5th Cir. 1982).

c. However, where the transferred property is an LP interest in the partnership andthe partnership is determined to be a valid legal entity under state law, no “gift onformation” can be argued and the taxpayer is entitled to value the gifts ofinterests at “the price at which such property would change hands between awilling buyer and a willing seller, neither being under any compulsion to buy orto sell and both having reasonable knowledge of relevant facts.” Reg.§§25.2512-1 and 20.2031-1(b), as quoted in Ina F. Knight v. Comm’r 115 T.C.506 (2000).

d. In the recent case of Estate of Albert Strangi v. Commissioner, 115 T.C. 478(2000), aff’d in part and rev’d and remanded in part, 89 AFTR 2d 2977, 293F.3d 279 (CA-5, 2002), (“Strangi I”) the “gift on formation” argument wasrejected by the Tax Court. In Strangi I, an FLP was created through a power ofattorney through which Mr. Strangi, the transferor, contributed almost$10,000,000 of property (representing 98% of his assets) to the partnership; Mr.Strangi, who was advanced in years, died two months after the formation of thepartnership. In exchange for his contribution, Mr. Strangi took back a 99% LPinterest. A corporate general partner owned the remaining 1% interest in theFLP, of which Mr. Strangi owned 47% of the equity and his four children ownedthe rest (the four children subsequently transferred a 1% interest in the corporategeneral partner to a charitable foundation). The estate claimed a significantdiscount for the LP interests owned by Mr. Strangi’s estate on Mr. Strangi’sestate tax return.

e. The Tax Court pointed out that Mr. Strangi had not given up control over theassets; his beneficial interest in the partnership exceeded 99% and hiscontribution was allocated to his own capital account. The Tax Court concluded

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that Mr. Strangi had not “transferred” the value which was “lost” in theconveyance of his assets to the partnership.

f. The underlying legal basis for the Tax Court’s decision in Strangi I was asfollows:

i. Since the partnership was a valid partnership under state law, the transfer tothe partnership was a bona-fide, arm’s length transaction free from donativeintent:

1. IRC §2512(b) provides that “where property is transferred for less thanan adequate and full consideration in money or money’s worth, then theamount by which the value of the property exceeded the value of theconsideration shall be deemed a gift”.

2. Likewise, Treas. Reg. §25.2512-8 provides as follows: “Transfersreached by the gift tax are not confined to those only which, beingwithout a valuable consideration, accord with the common law concept ofgifts, but embrace as well sales, exchanges, and other dispositions ofproperty for a consideration to the extent that the value of the propertytransferred by the donor exceeds the value in money or money’s worth ofthe consideration given therefore. However, a sale, exchange, or othertransfer of property made in the ordinary course of business (a transactionwhich is bona fide, at arm’s length, and free from any donative intent),will be considered as made for an adequate and full consideration inmoney or money’s worth.”

3. Because a pro rata partnership is generally a bona fide arrangement, itscreation should not be treated as a gift, even if a hypothetical willingbuyer would not pay the same consideration to an original partner that thepartner contributed to the partnership on formation.

4. The “willing-buyer/willing-seller” test applies in determining the value ofthe gift, not in determining whether a gift was made under §2512(b).

ii. There was no increase in the net worth of the transferee.

1. Just because there is a decline in the net worth of the transferor does notmean that the value shifted to another person. With the creation of a prorata partnership, there is no shift in value to any of the other partners as aresult of the transaction.

2. There is no such thing as a transfer to the partnership, as an entity, forpurposes of determining whether there has been a gift; there can only be agift to an individual donee, not an entity.

iii. The decline in value of the decedent’s property resulted from the businessdecision to utilize a partnership for the ongoing management of this property.The Court noted that: “Realistically, the disparity between the value of the

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assets in the hands of the decedent and the alleged value of his partnershipinterest reflects on the credibility of the claimed discount applicable to thepartnership interest. It does not reflect a taxable gift.”

K. Application of Chapter 14 of the Code to ignore the partnership agreement, or some of itsterms, in valuing a gift of a partnership interest.

Chapter 14 consists of four code sections designed to deal with estate tax freezetechniques which had become popular in the 1980s. However, since its enactment in1990, the IRS has been largely unsuccessful in using Chapter 14 to combat the use and/orabuse of an FLP. The rules apply only to entities with junior and senior equity interests,which is not the case with a with respect to a partnership in which all of the partners haveproportionate fractional interests (a “pro-rata” partnership).

Estate of Church v. United States, 85 AFTR 2d 804 (2000): Held generally that apartnership created two days prior to the death of decedent should be recognized forestate tax purposes and that §2703 did not apply, as a matter of law, and factually. As aconsequence, the government’s arguments that (1) the term “property” as used in thefederal estate tax law was to be applied to the underlying assets transferred to thepartnership, rather than the partnership interests owned by the decedent’s estate at thetime of the decedent’s death; and, in the alternative, (2) the restrictive terms of thepartnership should be disregarded in valuing the partnership interest, were rejected. “Theestate tax is imposed on that which a decedent transfers at death without regard to thenature of the property interest before or after death…Term restrictions, or those on thesale or assignment of a partnership interest that preclude partnership status for a buyer,are part and parcel of the property interest created by section 2703.”

Strangi I: In discussing the applicability of §2703, the court concluded, after makingreference to Kerr v. Commissioner, 113 T.C. 449 (1999) (which dealt with a similar issuewith respect to the interpretation of §2704), “that Congress did not intend, by theenactment of section 2703, to treat partnership assets as if they were assets of the estatewhere the legal interest owned by the decedent at the time of death was a limitedpartnership or corporate interest.”

Section 2704 applies (and makes the transfer subject to gift or estate taxes) if a lapseoccurs in the assignee’s voting or liquidation rights. This is rarely a problem with FLPsbecause assignees of a general or limited partnership interest never have voting orliquidation rights. Consequently, unless there is an unusual provision in the partnershipagreement, the transfer value of a general or limited partnership interest will be the samebefore and after death.

In general, a lapse of a voting or liquidation right occurs when a presently exercisableright is restricted or eliminated as a result of the occurrence of an event (such as the deathof the partner); however, there is no lapse when a controlling partner transfers away aminority interest that eliminates his control.

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Section 2704 should not apply where a partnership has reconstitution or continuanceprovisions because the owners of the partnership interests have greater (or at least thesame) liquidation rights after the lapse. In addition, Section 2704 should not apply whennon-family owners of the partnership own enough interest to block liquidation efforts bythe family owners.

Kerr v. Commissioner, 113 T.C. 449 (1999): Court held that §2704(b) did not affect thevaluation of limited partnership interests transferred by the taxpayers because therestrictions on liquidation in the partnership agreements at issue were not “applicablerestrictions” under §2704(b). As defined therein, an “applicable restriction” is one whichplaces a limitation on the ability to liquidate that is more restrictive than the defaultlimitations under the applicable state law, and which restriction either lapses after thetransfer or may be removed after the transfer by the transferor or any member of his orher family.

L. Is the partnership a sham?

1. This is the substance over form argument. The IRS argues that there has been nochange in the ownership of the underlying assets and that the partnership’s existenceshould therefore be disregarded.

a. In Reichardt v. Commissioner, 114 T.C. 144 (2000) the court agreed with the IRSthat the form of the partnership had not in fact changed the substance of theownership of the assets. Despite the formation of the partnership, Mr. Reichardtcontinued to manage the property in the same manner as he had before thepartnership was established; he commingled the partnership funds with his personalfunds, he made use of the personal residence that was now an asset of the partnershipwithout payment of rent, and he was solely responsible for the operation of thepartnership.

2. The courts may recognize the intent of the transferor in certain situations, as seen inChurch. In Church there was no “substance” as the partnership papers had not yetbeen filed with the Secretary of State at the time of Mrs. Church’s death. In addition,the LLC that was to be the corporate general partner had not yet been formed.Despite these shortcomings, the court held that, under Texas law, “ownership ofproperty intended to be partnership property is not determined by legal title, butrather by the intention of the parties.”

3. The partnership should not be the alter ego of the initial donor. The transferor(s)should take all appropriate steps to formally establish the partnership and all relatedentities as required by the laws of the state in which the partnership is formed.

a. Establish and maintain a separate partnership bank account – use it only forpartnership expenses, not personal;

b. Partnership distributions should follow the terms of the partnership agreement(e.g., a pro rata partnership should only make pro rata distributions);

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c. The partnership agreement should include language that obligates all partnerswith normal fiduciary duties; and

d. The partnership agreement should be clear that there is an “ascertainable”standard for distributions based on a standard of reasonableness.

M. Does an “investment partnership” lack substance?

1. As long as there is a valid business, investment or financial purpose for using apartnership form, it should not matter that a primary purpose (or benefit) is thereduction of estate tax liability.

2. Section 7701(a)(2) defines the term “partnership” to include “a syndicate, group,pool, joint venture, or other unincorporated organization, through or by means ofwhich any business, financial operation, or venture is carried on”. Based on this codesection, the IRS has recognized “passive investment clubs”. See Rev. Rul. 75-523,1975-1 C.B. 257 and Rev. Rul. 75-525, 1975-1 C.B. 350.

3. These are additional tax rules that apply to partnerships holding passive investmentassets:

a. Section 721: contributions of appreciated property to a partnership can result inrecognition of capital gains by the contributing partner if the partnership is an“investment company” unless each partner’s contributed stock portfolio issubstantially diversified;

b. Section 731(c)(3)(A)(iii): favorable tax treatment is accorded to distributions ofmarketable securities made to partners of “investment” partnerships;

c. Treas. Reg. §1.704-3(e)(3): special aggregation rule for “securities” partnerships;and

d. Treas. Reg. §1.761-2(a): unless a contrary election is made, an investmentpartnership will be treated as a partnership under subchapter K.

N. Application of the “step-transaction” doctrine.

1. The step-transaction doctrine is a judicially developed concept which treats formallyseparate steps as a single transaction if such steps are “in substance integrated,interdependent and focused toward a particular end result.”2 At bottom, it is a subsetof the substance over form doctrine.

2. The step-transaction doctrine should not generally be applied in transfer tax cases; itis primarily an income tax doctrine. Nevertheless, even if it does apply, the case lawindicates that as long as the first step in the transaction is not a sham and hasindependent significance, the steps cannot be collapsed.

2 Rev. Rul. 79-250, 1979-2 C.B. 156, modified by Rev. Rul. 96-29, 1996-1 C.B. 50.

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3. The IRS argued for the application of the step-transaction doctrine in Strangi I. Thethree steps were: (1) creation of the partnership shortly before death, (2) transfer ofthe partnership interest at death, and (3) termination of the partnership at death.However, because the formation of the partnership was recognized under state law,the first step had independent significance, nullifying application of the step-transaction doctrine.

O. Preservation of Valuation Discounts after Death of Founder

1. If the partnership will not continue after the death of the founding partner, the IRSmay claim that the partnership should be ignored and the decedent’s partnershipinterests valued at liquidation value (i.e., without discounts).

2. To achieve valuation discounts on LP interests of a deceased partner, the remainingpartners must show an intention to continue, as well as the actual continuation of, thepartnership’s business/investment operations. This can be built into the partnership’sstructure by having the founding general partner place his GP interest into an entitysuch as an LLC or corporate general partner so that the partnership is notautomatically dissolved upon the general partner’s death.

P. IRC §2036(a)(1).

1. IRC §2036(a)(1) causes the inclusion in the decedent’s taxable estate of propertywhich has been transferred, other than in a bona fide sale for adequate consideration,subject to a retained right of “beneficial enjoyment.”

2. The IRS has asserted that partnership assets should be included in the estate of thedeceased transferor where it appears from all the facts and circumstances that therewas an implied agreement that the transferor would continue to enjoy the economicbenefit of the property transferred to the FLP. This argument has been accepted inseveral cases, including Estate of Albert Strangi, 85 T.C.M. 1331 (T.C. 2003)(“Strangi II”); Estate of Thompson 84 T.C.M. 374, and Estate of Harper v. Comm’r,83 T.C.M. 1641.

3. The Tax Court concluded in these cases that, “when a family partnership is only avehicle for changing the form in which the decedent held his property – a mere‘recycling of value’ – the decedent’s receipt of a partnership interest in exchange forhis testamentary assets” does not qualify as a bona fide sale for adequate and fullconsideration and thus the transferred assets are bought back into the transferor’sestate at full market value with no discount for the fact that those assets were subjectto the terms of a partnership agreement. Estate of Thompson.

4. In Kimbell v. U.S., 371 F.3d 257 (5th Cir. 2004), the U.S. Court of Appeals for theFifth Circuit addressed the asserted application of §2036(a) to a transfer by the 96-year old Mrs. Kimbell to an FLP in which she owned a 99% LP interest and a 50%interest in an LLC which owned a 1% GP interest shortly before her death. Only15% of the partnership assets were oil and gas interests.

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In spite of the advanced age of the transferor, the Court of Appeals concluded that thetransfers to the partnership and LLC were bona fide sales and “not a disguised gift orsham transaction.” The Appeals Court found that those were legitimate businessreasons to have established the partnership, pointing to the need for activemanagement of oil and gas interests.

i. Adequacy of Consideration

Although transactions between family members are subject to “heightenedscrutiny,” such transactions are not automatically to be considered entered intofor less than adequate consideration. The Appeals Court then noted thatunrelated parties commonly exchange assets which are owned outright and areunrestricted for “transfer restricted, non-managerial” interests in a partnership inwhich there are financial considerations other than immediate financial gain at100 cents on the dollar (such as management expertise, security, capitalappreciation, and avoidance of personal liability). So the mere fact that theexchange involves a decline in value of the transferor’s property does not preventadequate consideration from having been exchanged. The Court of Appealsstated that the “proper focus” is on whether the interests credited to the partnersare proportionate to the assets each partner contributed to the partnership;whether the assets so contributed were credited to the respective capital accountsof each partner; and whether on termination or dissolution, the partners wereentitled to distributions from the partnership equal to their capital accounts.

ii. Bona Fide Sale

The Court of Appeals analyzed the record and determined that the decedent’stransfer of assts to the partnership was a “bona fide sale”. The decedent hadretained sufficient assets outside the partnership for her support, and there was nocommingling of partnership and personal assets after the transfer. Thepartnership was established with proper formalities and the assets were placed inthe name of the partnership. The assets included working oil and gas interestswhich required active management. There were a number of non-tax reasons forusing the partnership, including protection from creditors’ claims, includingenvironmental claims arising from the oil and gas interests; reducingadministrative costs; and preserving the family’s capital in a single pool whichwould be enhanced over time for the benefit of the decedents’ descendents. Inspite of the de minimis contributions to the partnership by other parties, the Courtconcluded that a bona fide sale had occurred.

The Court of Appeals ruled that §2036(a) was inapplicable to the decedent’spartnership interests and remanded the case to the District Court for adetermination of the proper value at which to include those interests in her estatefor estate tax purposes.

Q. IRC Section 2036(a)(2).

IRC §2036(a)(2) requires the inclusion in the decedent’s gross estate of all propertywhich the decedent has transferred during his lifetime (except in the case of a bona fide

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sale for adequate and full consideration) subject to the retention of the “right, either aloneor in conjunction with any person, to designate the persons who shall possess or enjoythe property or the income therefrom.”

As a general proposition, §2036(a)(2) precludes the retention by a transferor of rightswhich enable the transferor to control the management of and distributions from propertyafter the transfer has occurred, for example, as trustee of a trust to which the property hasbeen transferred. The retention of the powers as trustee does not preclude the completionof a taxable gift; however, the retention of trustee powers may result in estate taxinclusion of the trust assets, depending on the scope of the retained powers.

In a number of estate tax cases and rulings, if the transferor’s retained powers to controldistributions was limited by a so-called “ascertainable standard,” the fiduciary dutiesrequiring the transferor to exercise the powers only in accordance with the distributionstandards (such as “support in reasonable comfort,” “health,” “education,” “reasonablemaintenance,” etc.) have been considered sufficiently restrictive on the transferor’sretained powers to preclude estate tax inclusion. See, e.g. Revenue Ruling 73-143, 1973-1C.B. 407; Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947); Hurd v. Comm’r, 160 F.2d610 (1st Cir. 1947); Estate of Walter E. Frew, 8 T.C. 1240 (1947), acq. 1947-2 C.B.

1. In United States v. Byrum the Supreme Court rejected the arguments of the IRS thatSection 2036(a)(2) caused transferred assets (namely, stock in a business corporationtransferred to an irrevocable trust as to which Mr. Byrum had retained the power tovote) to be included in the decedent’s estate, holding that §2036(a)(2) should not beapplied to the retained voting power even though that power gave Mr. Byrum someability to affect the income received by the trust beneficiaries. (In fact, Mr. Byrumowned or controlled the vote on 71% of the corporate stock.)

The Supreme Court held that the power to manage assets that may affect atransferee, including assets transferred to a trust, is not subject to §2036(a)(2),citing Reinecke v. Northern Trust Co., 278 U.S. 339 (1929), a case whichpredated the enactment of §2036, and Estate of King v. Commissioner, 37 T.C.973 (1962).

The IRS argued that Mr. Byrum had “the power to use his majority position andinfluence over the corporate directors to ‘regulate the flow of dividends’ [fromthe corporation] to the trust”. However, “[a] majority shareholder has a fiduciaryduty not to misuse his power by promoting his personal interests at the expenseof corporate interests. Moreover, the directors also have a fiduciary duty topromote the interests of the corporation. However great Mr. Byrum’s influencemay have been with the corporate directors, their responsibilities were to allstockholders and were enforceable according to legal standards entirely unrelatedto the needs of the trust or to Mr. Byrum’s desires with respect thereto.”

The Supreme Court also pointed out that Mr. Byrum had no real “control” overdividend distributions made to the trust because of the business and economicpracticalities involved. So, in Byrum, the Supreme Court held that the rights

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retained by Mr. Byrum do not amount to a “retained right” as contemplated by§2036(a)(2).

2. The same principles that applied to a corporate structure in Byrum should also applyto a partnership. However, in Strangi II, after remand from the Fifth Circuit, the TaxCourt distinguished Byrum by finding that the management rights retained by Mr.Strangi exceeded the administrative powers in Byrum and that the management inStrangi did not owe fiduciary duties to the limited partners sufficient to avoid theapplication of the statute.

a. In Strangi, the corporate general partner, 47% of which was owned by decedent,had the power to distribute the assets of the partnership “in the sole and absolutediscretion of the managing general partner.” On remand, in Strangi II, JudgeCohen found that the decedent, in conjunction with other individuals, “had thepower to accumulate partnership income for the benefit of each partner, ratherthan disperse that income, which in turn constituted a ‘right to designate’ undersection 2036(a)(2).”

3. Moreover, the fiduciary duties owed to the holders of the LP interests were illusory,since the decedent owned a 99% LP interest and thus the duties were owed tohimself, rather than to third parties.

4. Drafting to avoid application of §2036(a)(2).

a. Affirm normal partnership fiduciary duties in the agreement;

b. Provide for arbitration for partner disagreements with management;

c. Liability for management only to the extent the decision is outside the businessjudgment rule;

d. English rule on costs of the arbitration;

e. Partners must respect the terms and form of the partnership;

f. Limit the distribution power of the managing partner to an ascertainable standard;and

g. General partner should only make transfers that are for full and adequateconsideration (perhaps using a defined value formula).

R. Section 2036(b).

In response to Byrum, Congress provided that the retention of the right to vote shares ofclosely held stock (whether directly or indirectly) will result in the inclusion of thetransferred shares in the decedent’s estate. This is potentially relevant where thetransferor transfers closely held stock to the partnership.

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S. Section 2038.

The retention of the right to alter or amend a partnership agreement will cause inclusionof any transferred partnership interests in the estate of the transferor. Therefore, thepartnership agreement should contain a provision that the partnership cannot be amendedexcept by the unanimous consent of the partners.

IV. Avoiding Income Tax Problems

A. Only one level of tax for a partnership under the “check the box” regulations.

B. Avoid being considered an “investment company” under §351 which would trigger gainon the contribution of appreciated property to the partnership (as opposed to the generalnonrecognition treatment offered under §721(a)). The general intent of the rule is toprevent individuals who are not diversified from achieving a tax-free diversificationsimply by forming a partnership.

When planning for an FLP, it is important to be aware of the diversification rules whichmay inadvertently trigger gain on the contribution of the various partners. As initiallypromulgated in letter rulings, and later in the regulations, there is no diversificationproblem if the assets contributed by each party:

1. Do not include as more than 25% of such assets the stock or securities of one issuer,and

2. Do not include as more than 50% of such assets the stock or securities of five orfewer issuers.

The Regulations under §351 provide further that “a transfer of stock and securities willnot be treated as resulting in a diversification of the transferor’s interests if eachtransferor transfers a diversified portfolio of stocks and securities [Reg. §1.351-3-1(b)(6)(i)].

C. Be aware of potential gain or loss on the distribution of assets in kind to a partner.

1. Disguised sales under §707(a)(2)(B): Applies when a partner makes a contribution,either directly or indirectly, to the partnership and the partnership transfers money orother property to that partner or any other partner. The regulations provide thefollowing rebuttable presumption for transfers occurring within a two-year period:“If within a two-year period a partner transfers property to a partnership and thepartnership transfers money or other consideration to the partner (without regard tothe order of the transfers), the transfers are presumed to be a sale of the property tothe partnership unless the facts and circumstances clearly establish that the transfersdo not constitute a sale.” Treas. Reg. §1.707-3(c). Additionally, the regulationsestablish the converse of that presumption for transactions that are made more thantwo years apart; that is, such transactions are presumed not to be a sale unlessotherwise indicated by the facts and circumstances. Treas. Reg. §1.707-3(d).

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2. Section §704(c) requires the recognition of gain or loss to a partner who contributesappreciated or depreciated property to a partnership if the partnership distributes thatproperty to another partner within five years of the initial contribution.

3. Section 737 requires the partner who contributes appreciated property to apartnership to include in income the built-in-gain if the partner receives a distributionin excess of his adjusted basis in his partnership interest within five years of thecontribution of the property to the partnership.

D. Section 704(e) applies to FLPs to guard against the shifting of income between familymembers through gifts of partnership interests where the income is based on personalservices.

This is nothing more than a specific rule instructing the partners to respect the form ofthe partnership as a true and legitimate entity and not as a device to shift assets toindividuals with a lower income tax bracket or smaller estate.

Where a partner’s share of the partnership is acquired by gift, or purchased from anotherfamily member, §704(e)(2) provides that “the distributive share of the donee under thepartnership agreement shall be includible in his gross income, except to the extent thatsuch share is determined without allowance of reasonable compensation for servicesrendered to the partnership by the donor, and except to the extent that the portion of suchshare attributable to donated capital is proportionately greater than the share of the donorattributable to the donor’s capital.”

E. If a partner makes a gift of a partnership interest which reduces his liabilities, the donorpartner will be treated as having received a cash distribution under §752(b), unless theunderlying liabilities are recourse to the donor.

V. Disadvantages of Creating and Utilizing a Family Limited Partnership

A. Short-term loss of value (because of the valuation discounts). These discounts are real,not merely an argument to justify a reduction in estate or gift taxes.

B. Transaction costs.

C. The assets of the partnership may not be available in the event of need, and anydistribution must be made on a pro rata basis to all partners.

D. Growth in the value of the partnership assets will be included in the gross estate of theowner.

E. Congress could revisit the current status of discounts as they relate to family attributionrules (Congress tried to do this in 1988 but was unable to do so politically).

F. Owning an interest in an FLP will raise a “red flag” for IRS scrutiny on audit of adecedent’s estate tax return because it is a so-called “hard-to-value” asset. To reduce thislikelihood, perhaps consider using a defined value clause in the partnership which should

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include the following language somewhere in the formula clause: “as finally determinedfor Federal gift tax purposes”.

VI. Drafting the FLP

A. Notwithstanding the materials in the foregoing outline, it is important to note that thelandscape in this area is changing constantly. In all likelihood, a partnership agreementdrafted today will not come under scrutiny until several (perhaps many) years havepassed, at which point the law in this area may be drastically different. As practitionersand advisors, we must be educators to our clients, and we must plan and draft with anunderstanding of the general principles being applied by the IRS today.

B. The case law suggests that the IRS commonly directs its focus on the issue of thepartnership’s “business purpose. Business purpose can be achieved quite simply byincluding factors such as (1) the consolidation and preservation of assets, and (2)centralized management of assets. Susan A. Beveridge, Esq., in a recent article in theEstate Planning Journal3, suggested that the following sample clause be used in thepartnership agreement:

The purpose of the Partnership is to acquire, own, operate, finance, refinance,and hold those assets described on Exhibit “A” hereto and any other assets thePartnership may acquire, for long-term investment, and to conduct any otheractivities related or incidental to the acquisition, ownership, operation,financing, refinancing, maintenance or transfer of all or any portion of thePartnership assets. In addition, the Partnership entity is intended to consolidatethe various properties and businesses of BROTHER and SISTER, to provideliability protection to the limited partners, to maintain family ownership of thePartnership assets through transfer restrictions, to provide for efficientcentralized management of the property, to provide capital for futureacquisitions, to preserve the property’s viability as an operating businessdespite its fractionalized ownership by preventing partition or demands forliquidation, to provide a business succession plan for the eventual retirement ofBROTHER and SISTER, and to provide for the harmonious co-ownership ofthe property by their respective descendants following their deaths.

VII. Operating the FLP.

A. If you have already established, or plan to establish, an FLP 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 reasonablelife expectancy.

a. The entity must be properly established under state law and run like a business.

3 Susan A. Beveridge, Practical Strategies for Building a Better Family Limited Partnership,Estate Planning Journal, June 2004.

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b. It should have its own taxpayer identification number and bank account.

c. It should timely file tax returns and such period reports as may be required in itsstate of organization.

d. There should be an annual meeting with a financial report of the prior year’soperations to the holders of the interests in the entity.

e. The purposes for forming the entity should be documented (such as to provideprotection from creditors, permit centralized management of assets, permit pooledinvestment in more aggressive investment vehicles, etc.).

f. Special provisions in the governing documents which give the founder specialprivileges, reduce or waive fiduciary duties of the manager, or which preventtransfer of interests in the entity without the founder’s consent should be avoided.

2. Only business or investment assets (real estate, marketable entities, stock options,private family business interests, venture capital interests, etc.) should be transferredinto the entity.

3. “Personal” assets (such as primary residences or vacation homes, or tangible propertysuch as furniture or artwork) should not be placed in the entity, nor should thefounder transfer substantially all of his assets to the entity but should retain sufficientasset to provide for his support, maintenance and medical care without reliance onfuture distributions from the entity. If possible, have other parties contribute funds orproperty to the entity at its formation, or transfer interests in the entity to others asgifts once the entity has been established.

4. Any distribution made from the entity must be made proportionately to all personsholding an interest in the entity (although reasonable compensation may be paid topersons rendering services to the entity).

5. If possible, the founding partner should relinquish control of the partnership’soperations before death, either by giving away control of the General Partnershipinterest or by selling that interest on “arm’s length” terms.

B. While following the foregoing ground rules won’t guarantee that an FLP is immune fromany IRS attack, it will significantly reduce the risk of a challenge, as well as improve thetaxpayer’s likelihood of success if a challenge is made.