How Not to FLP

It is easy to get a false sense of confidence when a technique like the Family Limited Partnership (FLP) marches through the court system like an unassailable champion of taxpayers and racks up one victory after another. These triumphs, transforming larger estates with dramatic last-minute valuation discounts, serve as an open invitation to all who have failed to plan ahead.

Unfortunately, FLPs are not suitable for every estate and they are not without their pitfalls. Here, we focus on several cases which have clearly illustrated how not to accomplish FLP goals. It should be concluded that the last-minute approach to planning with FLPs is not likely to take advantage of the important non-tax benefits that partnership arrangements bring to the family business setting.

Legislative Update

In June, the House of Representatives passed the Permanent Death Tax Repeal Bill of 2002 (H.R. 2143) by a vote of 256-171. The bill would have made the repeal of estate and generation-skipping transfer taxes permanent beginning in 2010. An alternative plan which would have frozen the top rate at 50% with an exemption of $3 million was rejected by 231 to 197.

The Senate vote was 54 to 44 for the bill, but this was six votes short of the 60-vote majority needed to waive the Budget Act under which the sunset provision originates. Two alternatives, including one that would have established an estate tax exemption of $4 million and a top estate tax rate of 45%, were defeated.

In light of the repeal or major modifications of the estate tax, should we continue to care about estate tax reduction techniques such as FLPs? Absolutely. Without any doubt, FLPs are still highly valuable for both tax and non-tax purposes. The estate tax will remain with us for several years. Gift taxes and state death taxes remain thereafter. And what Congress makes permanent today, Congress revises from scratch tomorrow.

An Irresistible Attraction

Like "the face that launched a thousand ships,"¹ the FLP has everything going for it-enormous estate tax savings, bold last-minute rescues of estates, and high-profile court successes. And with a simple formula that is widely applicable, every small business owner in America who seeks out tax advice can have the same mechanism that saved Sam Walton's estate $13.5 billion.² As a result, admirers have launched a flotilla of "partnership" estates seeking FLP triumphs.

The Warrior: Though it was once content to be a technique known mainly to accounting firms, financial planners, and upwardly mobile families, the FLP stood its ground in court and the same bread and butter rationales that made it popular were able to withstand all challenges. This new Champion emerged victorious in case after case, culminating in a series of influential cases during late 2000 and early 2001. Cases such as Harrison, Kerr, Knight, Church, and Strangi,³ have left us with several key points:

Tremendous valuation discounts (such as one transforming $59 million into $26 million in Harrison) are possible.

Partnerships can be valid even though the grantor or transferor has retained 99.9% of control.

Partnerships can be valid despite being formed only in the days before death (such as 62 days in Strangi).

The Warnings: Naysayers were inevitable in the wake of the FLP success story. But these quiet footnotes were not merely raised for the sake of argument. Several potential pitfalls may serve as an Achilles heel for the mighty FLP.⁴

Inappropriate funding using assets that can be valued as annuities without any discount.

Funding which causes the recognition of capital gains that might have been avoided through a stepped up basis.

Costly drafting of FLP arrangements that are overkill as applied to a small estate.

Design defects originating during the technical drafting of the partnership.

Operational defects of otherwise valid arrangements such as the commingling of personal and FLP assets.

The Trojan Horse

An estate that takes the FLP for granted may come to regret it. The FLP may be introduced to the estate with the best of intentions and may appear to be entirely benign. Yet, like the Trojan horse, an FLP can leave an estate with a concealed enemy that will open the gates for all kinds of other problems.⁵

Several recent cases illustrate some of the problems. The estate of Fred Godley appealed the Tax Court valuation of the decedent's 50 percent interest in five general partnerships. Here, factual circumstances undermined the arguments for a minority valuation discount. The Court granted a marketability discount, but since decedent had managerial control over the assets, no minority discount was provided.

In affirming, the Fourth Circuit Court of Appeals noted that options to buy each of the decedent's five partnership interests for $10,000 each did not actually affect decedent's control or entitle the estate to a minority discount. Factually, the partnerships were guaranteed a long-term stream of income that managerial control would not affect and distributions were carefully controlled by contracts.⁶

Respect

Seemingly minor details loom large in context that is intolerant of informality. The IRS has issued a series of attacks on "sham transactions."⁷

In the recent case of Shepherd, the 11th Circuit Court of Appeals affirmed a Tax Court opinion which valued assets without regard to the partnership because of the sequence in which the events took place. The donor formed the FLP and transferred assets to it one day before his two sons signed the partnership agreement. The transfers were deemed an indirect gift to the sons.⁸

Can we make transfers one day before death and then ask courts to grant them the same legal effect as if they had taken place years in advance? And if, in fact, we have serious business or tax purposes, then is it too much to ask that every formality be respected?

Consider the following scenario in which there was not an overwhelming single error but rather, a collective indifference to the sanctity of the arrangement. These informalities made the FLP indistinguishable from the arrangements that preceded it. Eight months before his death, decedent contributed $1.7 million of assets to an FLP. He retained a 99% interest in the property as the sole limited partner while his two children held the remaining 1% as general partners. This sounds like the same premise as many of the FLP success stories, but brace yourself for a surprise ending. The decedent retained economic benefits and commingled assets. Assets ended up being included in the decedent's gross estate by the IRS. The Tax Court analyzed the testimony as follows:

"When [an heir and ostensible partner] was asked on cross-examination to explain this delay between the effective date of the partnership and the formal transfer of assets into the entity, he replied: 'Probably for different reasons, some mechanical delays and who we're dealing with, but generally, there was no rush to do it. We were just doing it in an orderly fashion.'

"Next, in response to a further question asking why there was no rush, he continued: 'There was no rush. I mean, we were just handling the business in an orderly fashion. There wasn't any deadline or urgency to do it and get it done.' The following colloquy then ensued:

Q: "Now let's talk for a moment about the income from the portfolio assets. Before the title to the assets was transferred to the partnership, your father or his trust continued to receive the income from those assets. Isn't that right?

A: "Would you restate that? I'm lost.

Q: "Okay. At a certain point in time the assets were contributed to the partnership, correct?

A: "Yes.

Q: "Okay. Before that happened, your father's trust continued to receive the income from those assets, correct?

A: "Probably.

Q: "Well, why isn't it Yes?

A: "Well, before he contributed it, he was in control of that. Who else would get it? I say probably."

The court was not favorably impressed by this and other testimony, and commented, "we are again met with an example of indifference by those involved toward the formal structure of the partnership arrangement and, as a corollary, toward the degree of separation that the Agreement facially purports to establish.

Beyond Taxation

Shifting our attention away from last minute tax strategies, let us consider those non-tax benefits that may ultimately have the greater influence on planning as the estate tax diminishes in importance and approaches its repeal. Alas, laying a secure foundation with long-term planning basics lacks charisma. But the non-tax benefits of FLPs are indisputable:

ORGANIZATION: Diverse assets can be organized under central administration. Investments thus combined may be more effectively diversified.

CONTROL: The business owner can retain control over the business by serving as general partner.

CONVENIENCE: Transferring FLP interests is simple compared to annual gift transfers of partial real estate interests which require annual deeds.

ASSET PROTECTION: FLPs are effective for asset protection purposes. Creditors of a limited partner are unable to reach partnership assets directly and must settle for claiming those amounts which are distributed to that particular partner. Note that section 703 of the Revised Uniform Limited Partnership Act limits a judgment creditor to a charging order against the FLP interest of an individual partner, not the FLP itself. Further, under Rev. Rul. 77-137, a creditor with a charging order is treated as a substituted limited partner for federal tax purposes. This is not an attractive proposition for a creditor. Note also that the general partner has discretion in accumulating income and decides how much to distribute to limited partners.

EQUAL SHARES: As opposed to a motley assortment of real estate, separate businesses, equipment, securities, etc., which cannot be easily divided, a partnership can be divided into shares that can be distributed equally so that fair shares of the partnership can be transferred to multiple heirs.

INVESTORS: Investors in the family business can have reduced personal liability as limited partners. This facilitates raising capital.

ACCUMULATE ASSETS: As provided for by the partnership agreement, business assets can be accumulated rather than distributed, thereby providing the general partner with great flexibility.

ANCILLARY PROBATE: Partnership interests are generally treated as personal property, so where a business owns property in several states, the transfer of real estate to an FLP can avoid the need for ancillary probate in most states.

Crucial Succession Planning

The ability of a business to sustain a flow of revenues to family members after an owner's death is far more critical than tax issues in many estates. This concern alone will make FLPs a valuable technique that will far outlast the transfer tax system.

* Writing in Trusts & Estates, John Bedosky underscored the importance of planning for business succession. He noted that, according to some estimates, less than 13 percent of family businesses stay within a family for more than 60 years. What's lacking in the family business setting is the application of best business practices, i.e., a performance-based compensation and promotion system.¹⁰

FLPs tie into succession plans in that the general partnership can be shared and then turned over to an heir or other person who is being developed as the successor to the manager. Turning over control of the business prior to death can be advantageous for tax purposes.

Nonparticipating Heirs: An FLP is an ideal devise for enabling a fair share of profits to benefit an heir who is not employed by the family business. This is often a problem in an estate that is dominated by business-related assets that, in the absence of an FLP, would be left to those heirs who are participating. The nonparticipating heir gaining the estate's leftovers typically does not get a value that is equal to the business assets.

But consider how quickly all of these business succession benefits fly out the window when instead of integrating the FLP into a sound plan that is designed years in advance, a last minute FLP is applied as a last minute clean up measure.

The child who is excluded from joining the partnership's management at the last minute ends up in conflict with the child who remains in charge. Telling the owner's child that he or she will not be the designated successor at the last minute limits his or her options and leaves the business without anyone at the helm. In the alternative, naming an unqualified successor can be even more detrimental.

FLP Glory

A family limited partnership remains a thing of beauty in the right setting, i.e., taking a disorganized collection of assets and a variety of heirs and creating an arrangement that will reduce estate taxes and structure a coherent approach that will serve the family well even though there is little time to plan. makes up for many of the sins of not planning ahead. But therein also lies a danger of too little planning too late. And when partnership boundaries are ignored by family members, they may later be disrespected by the IRS and the courts as well.

TECHNICAL REFERENCES

¹ "Was this the face that launched a thousand ships, and burnt the topless towers of Ilium?" These lines were written by playwright Christopher Marlowe in 1604. They refer to Helen, who, in Greek mythology, was the daughter of Zeus and Leda, and the most beautiful of all women. Helen was abducted to Troy by Paris, triggering the Trojan War, but was ultimately returned to her husband, King Menelaus.

² At his death in 1992, Sam Walton, founder of Wal-Mart, had a family business valued at $25 billion. But because it had long since been in a family partnership, his own share was a mere $2.5 billion, which went into a marital trust.

³ Harrison v. Comm'r., 52 TCM 1306 (1987); Kerr v. Comm'r., 113 T.T. 450; Knight v. Comm'r., 115 T.C. 506; Church v. Comm'r., CA-5, 2001-2; and Strangi Estate, 115 T.C. 478. See, Estate planning with FLPs, The Estate Analyst (March, 1999).

⁴ An Achilles' heel for FLPs?, The Estate Analyst (Oct., 2001). Achilles was a legendary Greek warrior of the Trojan War who gained invulnerability when his mother dipped him in the river Styx as an infant. Only the heel by which she held him was left vulnerable. Achilles was ultimately felled when the god Apollo guided an arrow from the Trojan prince Paris into his heel.

⁵ We are admittedly stretching this analogy, but for the record, the Greeks laid siege to Troy for 10 years and then pretended to sail off while leaving behind a gift. The latter was a ruse which enabled them to get past the defensive barricades of Troy. The gift was a giant wooden horse that concealed warriors who opened the city gates and ultimately led to the destruction of Troy. The moral: Beware of giant wooden horses. Also, never let your guard down. Assuming that an FLP, with all its tax and non-tax benefits, is good for whatever ails an estate is very dangerous.

⁶ Estate of Godley v. Comm'r., 2002-1 USTC, 4th Circuit Court of Appeals, (April, 2002).

⁷ TAMs 9719006, 9730004, 9725002, and 9723009.

⁸ Shepherd v. Comm'r., 115 T.C. 376, No. 30 (October, 2000).

⁹ Harper Est., T.C. Memo. 2002-121 (May, 2002).

¹⁰ Planning a successful family business succession, John Bedosky, 141 T&E 4, p. 47 (April, 2002).

© R. Moshman /K.S. Inc. MMII.7