This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal adviser.
This Article is a technical analysis, aimed at professionals with a high level of expertise. Click here for a more general article. A Family Limited Partnership ("FLP") [or a Family Limited Liability Company ("FLLC")] is a tool to transfer wealth to selected heirs, usually without impairing the client's liquidity. This tool is ideal for a client who expects his assets to exceed the tax free amount at his death.
The FLP/FLLC allows a client to transfer wealth to his family tax free (by annual gifting). The value of the gift is reduced for tax purposes (by limitations imposed on the gift), allowing the client to give each donee about $15,000, yet claim that it is worth only $10,000 after IRS allowed discounts. Even after making the gift, the client retains control over the gifted assets. Future earnings are taxed to the donee, and future growth stays out of the donor's estate.
In a typical FLP, a client will transfer investment real estate [although other assets (including a liquid investment stock account) work just as well] to an FLP, receiving 1% General Partner ("GP") shares and 99% Limited Partner ("LP") shares. The client then gives away to each of his descendants $15,000 of LP shares each year, claiming a one-third discount to have the gift fall within the annual $10,000 tax free gift rule.
After several years, the client has given away substantial wealth tax free, yet he still controls the Partnership operations, investments, and cash flow, since he is the GP. As GP, he is paid a reasonable fee (taxable, and subject to Self-Employment Tax). Any distributions (beside the GP's fee) of funds in excess of reserves established by the GP are made pro rata.
The reasons why many people do not make maximum annual gifts are that they cannot afford to give away large sums, and they do not want their money squandered. Shares in an FLP (whether it owns a building or an investment portfolio) cannot be sold or spent.
One drawback of making lifetime gifts is that there is no step-up in basis at the death of the client for gifts made during his lifetime.
There are 2 types of discounts involved: a discount for lack of control (Minority Discount) and one for lack of marketability. Conceptually the issue is: What must the owner of an entity share do legally to force conversion of his share to cash? Can he compel cash distributions, or termination and liquidation of the FLP (i.e. distribution of its assets to its owners)?
Since no Partner has any right to any partnership asset, and no right of liquidation or partition exists, a discount is allowed to reflect the difficulty of converting those shares into cash.
The law is simple: Fair Market Value (FMV) is what a willing buyer is willing to pay for the FLP/FLLC share, subject to the restrictions (allowed by the IRS) imposed by the Partnership Agreement or LLC Operating Agreement.
For years, the IRS refused to recognize discounts on transfers between family members, in effect attributing between family members the shares held by the entire family. Since the family had control before and after the gift, no discount was allowed. [Rev. Rul. 81-253, 1981-2 C.B. 187]
Several cases starting in 1987 turned the tide. [Estate of Watts 823 F.2d 483 (11th Cir. 1987) and Estate of Harrison 52 T.C.M 1306]. Then the IRS gave up (at least partially) by issuing Revenue Ruling 93-12 which revoked Revenue Ruling 81-253, and stated that family attribution would not be applied and that minority discounts were allowable, even in the family context.
In Revenue Ruling 93-12, Father gave 20% of his closely held stock to each of 5 children. Here, IRS ruled that a minority discount was appropriate.
Despite the seeming capitulation by IRS, the Service has retreated somewhat. See TAM 9436005, in which Dad owned 100% of the stock. If in year 1, he gives 30% to Son and in year 2 he gives 30% to Daughter, IRS asserts that although the gift to Son may receive an initial discount, the subsequent gift to Daughter causes an indirect gift to Son, as Son and Daughter (their relationship is not relevant) could thereafter band together and obtain control. A control premium may apply.
1. Minority Discount
Typically, the Limited Partner ("LP") and LLC Member have non-voting shares.
The General Partners of a Partnership or the Managers of an LLC control distributions from the entity. They control the business operations. The LPs and LLC Members merely have the right to sit back and wait for the Managers to cause a monetary distribution. This lack of control by the minority (or non-voting) LPs and LLC members causes their interests to be worth less than "face value."
Retained control by the donor as Managing General Partner is allowed in an FLP/FLLC without causing an improper retained interest by the donor.
Therefore, the FLP Agreement and the LLC Operating Agreement will usually allow transfers, subject to a right of first refusal on the part of the other Partners.
A right of first refusal has a severe chilling effect on potential buyers. Analyzing a potential business acquisition is too much work just to find out that the other Owners might match his offer. The mere existence of a right of first refusal is usually sufficient to eliminate most buyers from consideration of the purchase.
These discounts usually cause a one-third discount, but an appraisal should be obtained.
Internal Revenue Code Analysis of Discounts
In 1990, Congress passed IRC Chapter 14 (§§2701 - 2704) which affects FLP/FLLC planning.
IRC §2704(b) requires ignoring certain attributes of a business in computing valuation. Although such attributes may be legally binding, they are ignored for valuation purposes.
Under §2704(b) restrictions or rights more restrictive than those imposed by state law are ignored for valuation purposes. Put simply, this means that if an entity under general state law may be dissolved by a majority vote, but the client's entity may be dissolved only by unanimous vote, such restriction is valid but will be ignored by IRS for valuation purposes. State law is generally referred to as the "state default provision."
IRC §2701, passed in 1990, applies to certain gifts of corporation and partnership shares (other than publicly traded securities) to a member of the transferror's family. §2701 does NOT apply if the donor gives away a "vertical slice" of corporate or partnership shares. If a donee of a 2% share has 2% of every right in the entity (i.e. no special allocations; profits, capital, etc are all pro rata), §2701 does not apply.
To provide other than a pro-rata vertical slice and still avoid adverse application of §2701 requires such extreme care that it usually makes little sense even to try.
DISCOUNT ON RETAINED SHARES
Assume the client dies before giving away all of his LP shares. Do those shares get a discount in the client's taxable estate?
IRC §2704(a) requires valuation of a decedent's voting and non-voting shares as a block. §25.2704-1(f), Example 5. If the decedent is the GP, very little discount will be appropriate, since as GP he could have forced liquidation of the Partnership, thereby causing conversion of his LP shares into cash. However, if someone else (or a corporation owned less than 50% by the decedent) is the GP, the client's retained LP shares will receive a significant discount since he personally has no voting control as GP.
An ideal structure is a corporate GP owned 49% by Dad, 49% by Mom, and 1% by each child. No one person has control of the GP, and a discount should apply to all LP shares (those given during life, as well as those retained at death), even though Mom and Dad together have control.
Dad dies, owning a minority of the corporate GP, allowing his retained LP shares to be discounted. At Dad's death, his shares in the corporate GP pass not to Mom (because Mom would then have direct control over the GP), but to the children. Mom then has indirect control if she can get 1 child to vote with her.
This lack of direct control eliminates the §2704(a) liquidation right problem since neither Dad nor Mom owns voting shares or control over the corporate GP. Thus, their LP shares are entitled to a discount.
PUBLICLY TRADED STOCKS
If an FLP/FLLC owns publicly traded stock brokerage accounts, do similar discounts apply? Yes, the discount is caused by the LP's inability to convert his share to cash. Even if the underlying asset is liquid, the LP cannot compel cash distributions, or termination and liquidation of the FLP/FLLC.
But does an investment partnership qualify as a partnership. Under California law, a Partnership must "carry on as co-owners a business for a profit." (Corp. Code §15006) That business may be any business other than banking, insurance or trust. (Corp. Code §15616) It appears that holding a portfolio of publicly traded stocks in a partnership format qualifies as a permissible business purpose under California law.
Even if a business is a partnership for state law purposes, will Federal tax law respect that classification?
In 1997, IRS initiated an attack of FLP discounts. In each case, the fact situations all looked abusive.
In TAM 9719006, the Decedent, after having life support disconnected, acting through her son, as authorized by a durable power of attorney, formed an FLP. Immediately thereafter, the Decedent sold LP shares to her children at a discount, with the purchase price payable over 30 years at 5.06% interest. The Decedent died 2 days later.
In Schauerhamer Est. v Comr. T.C. Memo 1997-242 (5/28/97), after being diagnosed with cancer, Decedent executed FLP documents but did not maintain any separate business records or checking accounts; instead, she commingled funds (including FLP rental income) and paid personal expenses from the FLP funds. The Court had little difficulty deciding that an implied agreement existed among the Partners that Mom had retained full ownership under §2036.
In TAM 9723009, 54 days before his death, Decedent, acting by her Son through a durable power of attorney, formed an FLP but failed to file necessary forms with the State or have Son contribute funds as required by the documents. Personal expenses were claimed by the FLP.
In TAM 9725002, 2 months before his death, Decedent, acting by his Son through a durable power of attorney, formed an FLP.
The IRS used 3 alternative arguments in most of these rulings:
FLP v FLLC
Assuming a standard situation wherein Mom and Dad want to retain control as long as either is alive, and then pass control to their children, and make gifts to their children and grandchildren (some grandchildren are over 18, some under), the analysis in choosing between the FLP and FLLC focuses mainly on discounts: which entity will give the biggest discount?
The deciding factor may be based on the difficulty of dissolution: since under the California default provision an LLC is dissolved on the death of any Manager, while an FLP is dissolved only if the sole remaining General Partner dies, the FLP has a slight edge in terms of discount.
With all of these benefits of the FLP/FLLC structure, what else can be achieved? Asset protection!
Usually, a creditor (including a spouse in the event of divorce) may only obtain a charging order [Corp. Code §§15028, 15673, 17302, 17001(n)] entitling him to all rights of an assignee of an LP's or LLC Member's shares. This causes the creditor to receive the economic interest of the "assignor" entitling him only to any distributions payable to that LP or Member. Typically, an assignee will have no voting rights.
In the FLP/FLLC context, assume that Dad is the managing General Partner. A judgment is imposed against Son, a 25% LP, for something unrelated to the FLP. The FLP owns an apartment building with a positive cash flow.
The creditor serves Dad with a charging order, compelling Dad to send the creditor any distributions otherwise payable to Son. Although the creditor has the right to get Son's distributions, the creditor has no right to vote Son's shares.
In past years, the General Partner (Dad) has caused substantial distributions to be made pro-rata to each Partner. Now, Dad decides that distributions are inappropriate; instead greater cash reserves are necessary to provide for anticipated capital expenditures which will be needed for the Partnership. Until such reserves have been accumulated, the extra cash balances will be invested in the stock market.
While this decision stops the cash distributions to the entire family, Son's creditor gets nothing.
More interestingly, as the creditor is now effectively the involuntary assignee of Son, the creditor gets Son's K-1 and must pay income tax on the tax allocations previously borne by Son. Rev. Rul. 77-137, 1977-1 C.B. 178. [As a Partnership is a `pass through entity' in which the Partners pay tax on their allocable share of Partnership income and expenses even if nothing is distributed to them, a Partner (or creditor with a charging order) may have income tax liability without any cash distribution.]
Further, if the Partnership Agreement calls for potential future capital contributions by LPs, the General Partner (in conformance with the Partnership Agreement) may request capital contributions from all LPs, including the creditor.
These powerful rights of the General Partner (to determine distributions and request capital contributions) may cause creditors to stay away from FLPs.
Occasionally, a creditor (including a spouse in the event of divorce) of an LP might be allowed to foreclose on an FLP/LLC share and receive actual ownership of FLP/FLLC shares. However, he is still an assignee with no right to vote, but, unlike a charging order which is temporary (like a garnishment it is effective until the debt is paid), this creates permanent ownership.
In Hellman v Anderson (1991) 233 Cal.App.3d 840 the Court held that a judgment debtor's interest in a General Partnership could be foreclosed upon and sold, even over objection by the remaining partners, if such a sale did not unduly interfere with the partnership business.
In Crocker Nat. Bank v. Perroton (1989) 208 Cal.App.3d 1 the Court held that with permission of the other Partner, a judgment debtor Partner's interest could be sold.
However, if an LP (or LLC Member) files for Bankruptcy, the Judge may impose any requirement for discharge of the LP's debts. This might include (1) requiring that the debtor assign his shares to the creditor; or (2) requiring that the debtor buy the shares back from the Bankruptcy estate for a specified price.
CALIFORNIA REAL PROPERTY TAX LAW
If California real property is to be owned by an FLP/FLLC, we must be especially careful about triggering a `change in ownership.' The following is not a complete analysis; extremely careful study is required to avoid unnecessary reassessment (i.e. malpractice).
In general, real property taxes are reassessed only when a property has a change in ownership. The statutes grant to certain specific transfers an exemption from being changes in ownership. It is vital to understand several of these exemptions for FLP/FLLC planning.
While I cannot protect my own assets easily, if someone makes a gift to me in Trust, of assets which were never mine, asset protection can be achieved easily.
Assume Mom wants to give Marc $100,000. She can write a check to Marc who is then the owner of the funds. As the owner, Marc can spend it as he desires, invest it, convert it to community property (deliberately or inadvertently), and leave it to whomever he desires.
Instead, Mom forms a Trust for Marc. Marc is the Trustee (manager); Marc, his wife and Mom's descendants are beneficiaries.
Marc has full rights to invest and spend for himself and his family. However, Marc does not own the assets in the Trust.
There are 4 benefits of Trust ownership:
Dad dies, leaving his assets in a Trust for Bobby, age 3. Uncle Tom is named Trustee to manage the assets. Tom has investment and spending control, but can only spend for Bobby's benefit.
Uncle Tom is sued for a car accident unrelated to the Trust. Are the assets at risk? Clearly, the answer is, "No!" The assets are not Tom's and regardless of Tom's personal problems, they are not at risk. [If Tom gets divorced, can his wife claim a share of these assets? No, the Trust may be managed by Tom, but the assets are not at any more risk than if Tom were a store manager for K-Mart and Tom's personal creditor wanted to attach store merchandise for Tom's personal debts.]
One day, Bobby bites the ear off of a child in pre-school (the tuition of which is paid by the Trust). Bobby is sued for millions. Bobby loses.
Are the Trust assets at risk? Not as long as the assets are in Trust. Bobby is the beneficiary, but not the owner, of those assets as long as they stay inside the Trust.
Once assets come out of the Trust's protective shield, to or for Bobby, the creditor can intercept those assets if he has obtained a "charging order" and served it upon Tom. But once Tom is served with the charging order, he will be smart enough not to spend any more money on Bobby until he can resolve the creditor's claims.
Once Bobby grows up, the Dynasty Trust allows Bobby to become his own Trustee (manager) once he has reached age 30, or whatever age requirement Dad imposes when establishing the Trust, and just as when he was 3 years old, the assets are protected.
The Dynasty Trust is something we like to use in a variety of circumstances, especially in Living Trusts or for lifetime gifts.
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