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Recent case law trend suggests a balance
Much to
the dismay of taxpayers and their attorneys, the IRS has finally managed to
score some courtroom victories against family limited partnerships (FLPs).
FLPs will, however, continue to offer taxpayers numerous benefits — including
sizable valuation discounts — for years to come if taxpayers and their
advisors learn the lessons taught by these recent legal battles.
Too good to be true
FLPs gained popularity in the 1990s for the numerous benefits they offer
wealthy individuals. With an FLP, a donor can transfer a substantial chunk of
his or her wealth to heirs, charitable organizations or both at a discount
from the partnership’s net asset value. As an added bonus, donors don’t have
to relinquish complete control to their heirs, as long as they retain a small
general partner interest in the FLP. The major downside is the FLPs’
administrative hassle and expense.
Generally, to maximize an FLP’s minority interest and marketability
discounts, an attorney drafts the partnership agreement to maximize general
partner control and minimize limited partners’ rights. Then, when justifying
his or her valuation discounts, the valuation expert cites the FLP’s numerous
restrictive provisions.
Several recent cases, however, suggest that attorneys can take this strategy
too far. In fact, restrictive provisions in which a donor retains control or
enjoyment of the underlying assets could prove to be his or her undoing —
serving to eliminate valuation discounts altogether.
Taxpayer rudely awakened
After repeatedly failing to defeat FLPs using Chapter 14-based claims, the
IRS revised its modus operandi. Under its new attack plan, the IRS challenges
FLPs under Section 2036(a) of the Internal Revenue Code covering situations
in which the donor explicitly or implicitly retains control of, and an
ongoing benefit from, the partnership’s assets.
In a number of highly publicized cases — including Strangi, Harper and
Thompson — the IRS has made significant inroads against the steep discounts
from which FLPs have historically benefited.
Estate of Albert Strangi v. Commissioner (T.C. Memo 2003-145). The
IRS scored a substantial victory against FLPs last spring when the Fifth
Circuit remanded Strangi to the lower court for consideration of the IRS’s
last-minute Section 2036(a) contention. On remand, the Tax Court ruled in the
IRS’s favor, leaving the estate to pay tax on the partnership’s net asset
value of $11 million, rather than the discounted value of approximately $6.6
million claimed on the estate’s tax return.
Even though the Strangi estate apparently tried to abide by the rules set
forth in its partnership agreement, the decedent died within a year of the
FLP’s creation, which raised a red flag with the IRS. Other signs that
Strangi’s partnership blatantly violated Section 2036(a) include the
decedent’s use of a personal residence owned by the FLP and the contribution
of 98% of his assets to the partnership, which left him without enough cash
to support himself.
The Tax Court concluded that “the crucial characteristic
[in Strangi] is that virtually nothing beyond formal title changed in decedent’s
relationship to his assets.”
Estate of Morton B. Harper v. Commissioner (T.C. Memo 2002-121).
The IRS not only attacked valuation discounts taken on Harper’s estate tax
return but also on gifts the decedent made to his children prior to his
death. This case sets forth an insightful list of factors the judge
considered when deciding to disallow the FLP valuation discounts under
Section 2036(a).
Admittedly, Harper’s partnership committed some blatant abuses of the
Internal Revenue Code, such as disproportionate distributions and commingled
personal and partnership assets and expenses. The FLP also committed less
obvious indiscretions, including distributions that corresponded to the
decedent’s living expenses and gifts, as well as the decedent’s unilateral
control of the partnership.
Estate of Theodore Thompson v. Commissioner (T.C. Memo 2002-246).
Once again, the Tax Court disallowed valuation discounts in the Estate of
Thompson. Not only had the donor transferred the bulk of his assets to
the estate’s FLP, but the partnership also paid Thompson distributions to
fund his assisted living expenses and annual gifts. The court dubbed
Thompson’s transfers to the FLP “a mere recycling of value.”
When creating partnership agreements, these recent cases suggest a fine line
between restricting limited partners’ rights and retaining donors’ control
and economic benefits from the partnerships. While these restrictions may
serve to support above-average FLP valuation discounts, if taken too far they
can negate the effect of any discounts whatsoever.
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