FLP Planning Should Be Reviewed in Light of IRS Attacks
A properly structured and maintained family limited partnership (FLP) or limited liability company (LLC) can be an effective vehicle for passing wealth to succeeding generations at reduced transfer tax costs. A person can transfer assets to the FLP or LLC in exchange for interests in the entity and then gift limited partnership or membership interests, as the case may be, to the younger generation. In determining the value of the gifted interests for gift tax purposes, the transferor will generally be allowed to take minority interest and lack of marketability discounts. These discounts are permitted because the inability to control the entity and the lack of a market for the sale of the interest causes the interest to be worth significantly less than it would otherwise be worth. The corresponding reduction of the gift tax value of the interest allows the transferor to get more leverage out of his or her $1 million gift tax exemption.
In recent years, however, the IRS has been aggressively attacking this technique on various theories. While the IRS has not had great success in the courts with many of these theories, it has been successful in arguing that, where certain circumstances exist, all of the assets transferred to the FLP should be included in the transferor's estate upon his or her death under Internal Revenue Code ("Code") Section 2036, and without any valuation discounts. As a result of these cases, particularly Estate of Strangi v. Comm'r., clients who have an existing FLP or LLC that is being utilized as a wealth transfer technique should consider having the relevant documents reviewed for the possibility that a restructuring or other planning with respect to the entity may be warranted in light of these recent cases.
Code Section 2036 essentially provides that if someone transfers property and retains for himself the possession or enjoyment of the property or the right to income from it, or retains the right to designate others who will possess or enjoy the property or the right to income from it, then these "strings" over the property cause it to be included in the transferor's estate upon his death. As discussed in our March 2003 Update, under Strangi and other cases, the failure to respect the FLP or LLC as a separate entity may be fatal, since the IRS has been successful in arguing in such instances that the transferor had an implied agreement with his family members to use the entity's assets as his own.
As a result, assets of the entity should not be commingled with personal assets of the transferor; personal use assets such as a house or car should not be transferred to the entity; assets being transferred should be promptly retitled in the entity's name and a separate account should be opened for the entity immediately; the transferor should retain enough assets outside of the entity to sustain his standard of living so that he does not need to rely on the entity's assets; distributions should not be made disproportionately in favor of the transferor but should rather be made pro rata among all the partners at the same time; the entity should not make distributions (whether before or after the transferor's death) to pay for the transferor's personal expenses, to satisfy bequests in his will or to pay death taxes imposed on his estate, etc. These factors, and others that indicate there was an implied agreement for the transferor to retain enjoyment of the assets, will cause all of the assets in the entity to be included in the transferor's estate without discount.
More troubling, however, and what many legal practitioners believe to be an incorrect result, is the Strangi case's conclusion that if the transferor can, whether alone or together with the other partners, control distribution decisions or liquidate the entity, then this is sufficient to cause the transferred assets to be included in the transferor's estate under Code Section 2036. This implies that if the transferor owns any interest (not just a controlling interest) in the entity at the time of death, the assets will be included in his estate. As a result of this aspect of the case, it might be advisable for the transferor to gift away his entire interest in the entity more than three years prior to death (transfers made within three years of death will nonetheless be included in the estate). Such a transfer could result in gift tax or accelerated use of the gift tax exemption, however, and also defeats the control that many clients expected when setting up the FLP or LLC. In addition, the transferor or another entity in which the transferor owns an interest, is the general partner in many existing FLPs and LLCs, which may no longer be advisable in light of the Strangi case. It may therefore be advisable to change the general partner or, in the case where an entity in which the transferor owns an interest is the general partner, the transferor might consider gifting away not only his interest in the FLP or LLC, but also his interest in the entity that is the general partner.
We would like to stress that, while the IRS has had some recent success attacking FLPs and LLCs, use of these entities can still be an effective and viable estate planning tool if the arrangement is structured and maintained properly under factual circumstances outside the purview of the cases where the IRS has been successful. Additionally, please note that practitioners still believe that the most troubling aspects of the Strangi decision were improperly decided. The Strangi case is on appeal, and hopefully the decision will be clarified by the appellate courts. In the meantime, clients utilizing these entities for estate planning purposes may wish to consider having their documents and practices revisited to determine what, if any, safeguards should be implemented to produce the most favorable factual scenario in the event of an IRS challenge and increase the likelihood that the entity will accomplish its intended estate and gift tax savings.