Revisiting the Family Limited Partnership

Revisiting the Family Limited Partnership

Seven years ago, the United States Tax Court issued an opinion that represented one of the most significant changes in the law that dictates the estate and gift taxation of a family limited partnerships or “FLP” (Estate of Powell v. Commissioner, 148 T.C. 392 (2017)).  Notwithstanding the fact that all 17 judges joined in that ruling’s most significant pronouncements, what followed was a systematic downplay by a certain segment of the estate planning community premised in large part by the adage that bad facts make bad law.  But no appellate court has swept in to overrule the Tax Court, which is the only venue available for taxpayers to seek judicial relief from an IRS assessment without having to first pay any additional tax.  In fact, various judges of the Tax Court have since issued opinions that cite Powell in a manner that shows no retreat from its controversial positions.

Tax Benefits of the Family Limited Partnership

To illustrate both the tax benefits of the FLP and the effects of the Powell decision, suppose that a parent establishes a limited liability company (LLC), as its sole member, contributing capital in the amount of $11,000 cash.  Immediately thereafter, the parent forms an FLP, with the LLC contributing $10,000 cash for a 0.1% interest as sole general partner and the parent contributing $9.99 million of her own investment assets for a 99.9% interest as sole limited partner.  Under the standard governing documents of the FLP, the general partner is vested with most of the management powers over the FLP, and the limited partners are relegated to holding an economic interest and the collective right to consent to significant actions and transactions.  A few weeks later, the parent gifts a 49.95% limited partnership interest to an irrevocable trust for the benefit of her descendants.  Assuming that the value of the FLP’s assets have not changed, the proportionate asset value of that 49.95% limited partnership interest—and the amount of the parent’s lifetime exclusion from the estate and gift tax spent to make the gift—is reduced by a 20% discount for lack of marketability and a 10% discount for lack of control.  As a result of these transactions, the parent has effectively removed from her estate and gift tax base both the amount of valuation discounts attributable to the gifted interest ($1,498,500) and the amount of valuation discounts that will apply to the 49.95% limited partnership interest that will pass through her taxable estate at death.  To the extent that the FLP is funded with growth assets, the parent will also achieve an “estate freeze” – i.e., 49.95% of any post-gift appreciation will pass through the trust free from estate or gift tax.  And as icing on the cake (or perhaps a necessary condition for the parent to part with ownership of the underlying assets), the parent maintains control over the FLP by acting as manager of the LLC general partner.

Effects of the Powell Case

The Powell case focused on the application of Internal Revenue Code §2036(a)(2) to an FLP established under similar facts.  Section 2036(a)(2) provides that the date-of-death value of any assets transferred by a decedent during his or her lifetime—other than by “a bona fide sale for adequate and full consideration in money or money’s worth”—will be included in the taxable estate of the decedent if the decedent “retained for his life … the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.”  The judges in Powell did not agree on the nuances of determining the amount included in the taxable estate as a result of the application of section 2036(a)(2); but as a practical matter, if that statute applies to the transfer of assets that capitalized the FLP, then much of the economic benefit derived from the valuation discounts and estate freeze may be lost.

The most controversial part of the Powell opinion (albeit consistent with the court’s previous pronouncements) was the holding that section 2036(a)(2) may apply if the decedent retained the right to join in the decision to terminate and liquidate the partnership – even as a limited partner.  The less discussed aspect of the opinion, which also happens to undermine one of the primary selling points of FLP planning, states that section 2036(a)(2) could also apply if the decedent retained any right to control partnership distributions through management of the general partner – alone or in conjunction with others.  Much to the dismay of prominent commentators, the Powell court rejected the argument, based on the U.S. Supreme Court’s reasoning in U.S. v. Byrum, 408 U.S. 125 (1972), that partners in an FLP are subject to fiduciary duties in the exercise of such powers that render section 2036(a)(2) inapplicable.  That is, any legal duties of one partner to the others will be considered “illusory” if, in contrast with the circumstances in Byrum, the entire entity is effectively owned by the same person (or members of the same family) at the time of the transfer.

As noted above, section 2036(a)(2) will not apply if the decedent’s transfer of assets to fund the FLP was a bona fide sale for an adequate and full consideration.  However, the term “bona fide sale” requires the existence of a legitimate and significant non-tax reason for creating the FLP, an aspect of the case law often taken for granted by estate planners.  Practically speaking, the case law suggests that if an FLP does not actually operate an active business or hold particularly risky investments and no other partners actually participated in the formation of the FLP to consolidate management of a pooling of assets, then reliance upon this statutory exception is, at best, a roll of the dice.  And cleverly drafted recitals of the FLP’s non-tax purposes within the governing documents will be worth little more than the paper they are written on if the circumstances that existed at the time the FLP was funded do not support them.

Strategies to Consider

If the formation of an FLP does not fall squarely within the case law conception of a bona fide sale, then a “de-controlling” of the FLP may be in order.  In continuation of the illustration above, the parent should consider the following strategies:

  • The partners could dissolve the FLP and the LLC entirely or redeem the partnership interests of the parent and the LLC by distributing a proportionate share of the assets and replace the general partner. While this might be the simplest and cleanest approach to addressing the issues raised by Powell, the parent’s estate would lose the benefits of the valuation discounts attributable to her own limited partnership interest.
  • The parent could relinquish her role as manager of the LLC and sell her limited partnership interest in the FLP and membership interest in the LLC to the irrevocable trust or other beneficiaries of her estate. To satisfy the adequate-and-full-consideration exception, the purchase price should be established by a qualified appraisal of the interests; and if the buyer does not have sufficient cash, any promissory note provided in the exchange should bear a sufficient rate of interest, and if appropriate, should be collateralized.  In any case, financing such an exchange with a debt instrument offers far more flexibility, in terms of deferring repayments, than gifting the interests to a grantor retained annuity trust (“GRAT”).
  • The partners could restructure the FLP—or add another entity into the mix—whereby the parent could continue to manage any underlying business and investments of the FLP, but another party would have the authority make distributions, terminate the FLP, and amend the governing documents. That said, such measures must be carefully planned because a “lapse” of certain rights could, in and of itself, result in a taxable gift by the parent under Internal Revenue Code section 2704.

With these strategies in mind, this article concludes with two caveats.  Any remedial actions to de-control an FLP should be taken sooner rather than later because Internal Revenue Code section 2035(a) provides that if a section 2036(a)(2) right is not relinquished or terminated within three years prior to the decedent’s death, the value of the subject property will still be included in the taxable estate.  Secondly, if the facts indicate that there was an implied arrangement for the decedent to retain control over FLP distributions or liquidations after such remedial actions are taken (e.g., emails to the managers directing decision making), section 2036(a)(2) will be applied as if the decedent had retained formal legal control.

It is crucial to understand the estate and gift taxation laws for a family-limited partnership. Our tax professionals are here to provide guidance and support. Should you require assistance or have any questions regarding this topic, please contact us.

Article written by Steven Baker, CPA, Esq.

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2024-03-06T19:07:02+00:00March 6th, 2024|Estates and Trusts|

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