A FLP tax-saving strategy.

• Author: Ochsenschlager, Thomas P.
• Position: Family limited partnerships

Letter Ruling 200243001 presents a wealth-transfer strategy for a majority shareholder of a closely held corporation (CHC) that has an employee stock ownership plan (ESOP) as a minority shareholder. The strategy achieves three objectives: it (1) diversifies the majority shareholder's portfolio, (2) allows him or her to discount the value of gifts made to his or her children, for gift and estate planning purposes and (3) achieves these goals in a tax-efficient manner.

In the ruling, the taxpayer transferred CHC stock to a family limited partnership (FLP) for a 99% limited partnership interest. An S corporation controlled by the taxpayer owned the remaining 1% general partner interest, which gave the taxpayer control over partnership elections. The taxpayer gifted FLP interests to his children. The FLP then converted into a limited liability company (LLC) that elected to be treated as a partnership for Federal tax purposes; the taxpayer continued to gift LLC interests.

In the ruling, the taxpayer sought to use a Sec. 1042 election to defer tax on the FLP'S sale of CHC stock to the ESOP. Under Sec. 1042(b), for a sale to an ESOP to qualify for deferral, the ESOP, after the sale, must own at least 30% of either (1) each class of outstanding CHC stock or (2) the total value of all outstanding CHC stock. The seller must also purchase "qualified replacement property" (as defined in Sec. 1042(c)(4)).

Analysis

Sec. 1042(c)(1) will allow for tax deferral on sales of "qualified securities" sold to an ESOP if certain requirements are met. The ruling mainly addresses whether use of a FLP followed by a conversion into an LLC satisfies the three-year holding period, required under Sec. 1042(b)(4) for "qualified property" sold to an ESOP, and whether the disposition of a qualified replacement property (QRP) on a gift of a FLP (or an LLC) interest or on a conversion of a FLP into an LLC triggers Sec. 1042(e) recapture.

According to the ruling, the transfer of the CHC stock to the FLP and the conversion of the FLP into the LLC do not trigger new holding periods. Rather, under Sec. 1223(2), if the basis of property in the transferee's hands is the same as that in the transferor's hands, the transferee takes the transferor's holding period. Thus, under Secs. 723 and 1223 (assuming Sec. 721(b) does not apply), the FLP'S holding period in the CHC stock contributed by the taxpayer will include the period he held the stock. The LLC's holding period...