Family Limited Partnership Formation: Dueling Dicta

• Author: Mitchell M. Gans/Jonathan G. Blattmachr
• Position: Professor of Law at Hofstra University School of Law in Hempstead/Partner in Milbank, Tweed
• Pages: 1-14

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The authors recently co-authored, along with Damien Rios, THE CIRCULAR 230 DESKBOOK (PLI 2006).

Introduction

In attempting to limit the use of family limited partnerships as a transfer-tax strategy, the Internal Revenue Service (IRS) has advanced several arguments.¹ The courts, however, have not been entirely receptive. For example, the IRS has not had any success with the argument that a partnership formed without a sufficient business purpose must automatically be disregarded for transfer-tax purposes.² As a result, partnerships formed for tax-driven reasons remain a viable estate-planning strategy. Nonetheless, the IRS has enjoyed some important successes with two arguments.

The first argument, a gift-tax argument, stems from the indirect gift regulation.³ Under the regulation, the contribution of an asset to an entity is treated as an indirect gift of the asset to those who own an interest in the Page 2 entity.⁴ When the regulation applies, the value of the gift is determined on an "undiscounted" basis: the existence of the entity is disregarded for purposes of valuing the gift.⁵

The second argument, an estate-tax argument, derives from I.R.C. section 2036.⁶ Under section 2036, if the decedent retains access to or control over the assets contributed to the partnership, the entity may be disregarded for estate tax purposes.⁷ This argument, however, is subject to a critical exception: if the estate can demonstrate that the decedent had a sufficient non-tax purpose for forming the entity, then the entity is not disregarded, despite the decedent's retention of access or control (provided the decedent had received full consideration in contributing the assets to the entity).⁸

Even though taxpayers may be able to defeat both of these arguments with careful planning,⁹ the section 2036 argument presents planners with a Page 3 more difficult challenge and, therefore, is the more potent of the two. Indeed, taxpayers aware of the indirect-gift argument may easily defeat it, even though the Eighth Circuit's recent decision in Senda v. Commissioner strengthened the argument. Because we have previously written about the section 2036 argument,¹⁰ this Article focuses on the indirect-gift argument-specifically, how Senda has reshaped it, and how taxpayers may alter the entity-formation process to defeat it.

Until the Eighth Circuit's recent decision in Senda, the IRS had not been very successful in the courts with its gift-tax approach to family limited partnerships.¹¹ Even though the IRS prevailed in the Eleventh Page 4 Circuit in Shepherd v. Commissioner¹² and in the Tax Court in Senda,¹³taxpayers could easily navigate these IRS victories through proper planning.¹⁴ Dicta in the Eighth Circuit's decision in Senda, which ironically conflicts with dicta in the Eleventh Circuit's decision in Shepherd,¹⁵ has added a new wrinkle that will force taxpayers to rethink the partnership-formation process. The Senda dicta may make the formation process somewhat more complicated, but it likely will not make the IRS's gift-tax arguments any more effective against savvy taxpayers.

IRS'S GIFT-TAX ARGUMENTS

The IRS's gift-tax approach with respect to family limited partnerships has had two strands: a gift-on-formation argument and an indirect-gift argument. Under the gift-on-formation theory, the IRS claims that when a contribution of assets is made to a limited partnership in exchange for a limited unit, the person making the contribution depletes his estate by an amount equal to the discount inherent in the limited partnership unit received in the exchange; the taxable gift is equal to the amount of the depletion.¹⁶ To illustrate, if a taxpayer contributes $10,000,000 to a partnership and, in return, receives a limited partnership interest having a lesser value of, say, $7,000,000 because of lack of control, lack of marketability, or other discounts, a taxable gift of $3,000,000 is deemed to occur under the gift-on-formation theory.¹⁷ Page 5

Originally conceived in the corporate context,¹⁸ the gift-on-formation theory has not fared well in the partnership setting. The Tax Court,¹⁹ the Fifth Circuit,²⁰ and the Third Circuit²¹ (in dicta) have rejected it. On the rationale that a shift in wealth does not occur where a taxpayer makes a contribution to a partnership that is credited to her own capital account, the courts have thus far uniformly refused to apply the theory in the case of a partnership.²² Aware of this developing consensus in the courts, many Page 6 practitioners have concluded that there is little, if any, need for continuing concern about the gift-on-formation theory in connection with partnership formation.²³

A Indirect-Gift Argument

Courts, however, have been receptive to the indirect-gift theory.²⁴ In Shepherd, the parent contributed assets to the family partnership.²⁵ Half of the contribution was credited to the children's capital accounts.²⁶ Invoking Treasury Regulation section 25.2511-1(h)(1) (the indirect gift regulation),²⁷the IRS maintained that the parent made an indirect gift in the amount credited to the children's capital accounts.²⁸ In other words, based on the regulation, the parent is treated as if he made the gift directly to the children, effectively ignoring the existence of the partnership for gift tax purposes.²⁹ The Tax Court embraced the argument,³⁰ and the Eleventh Circuit affirmed.³¹ Ominously for the IRS, both the Tax Court and the Eleventh Circuit suggested in dicta that the result would have been different (i.e., a partnership-level discount would have been allowed) had the contribution been credited to the parent's capital account before the gift of the partnership interest to the children was made.³² The dissenting opinion also endorsed this notion.³³ Page 7

The Shepherd dicta threatened to undermine significantly the value of the court's holding to the IRS. If, for example, the documentation established that the contribution to the partnership occurred days or perhaps hours before the gift of limited units, then discount would presumably be permitted, according to the dicta.³⁴ As a result, Shepherd quickly came to be seen as a somewhat aberrational case in which a planning failure resulted in the taxpayer's defeat. Had the contribution to the partnership occurred immediately before the gift of the limited units, instead of immediately after the gift, the taxpayer would have prevailed.³⁵Shepherd was thus perceived as nothing more than a cautionary tale about the need to sequence and document the contribution and gift properly.

This perception of Shepherd was borne out in Estate of Jones v. Commissioner.³⁶ In Jones, the father made a contribution to a limited partnership in exchange for limited partnership units.³⁷ Even though he made a gift of his limited units to his children immediately after contributing to the partnership,³⁸ the court upheld the discount and rejected the IRS's indirect-gift argument as well as its gift-on-formation argument.³⁹ The court distinguished Shepherd, emphasizing that, unlike Shepherd, the contribution had been credited to the father's capital account.⁴⁰ Jones in effect expanded the Shepherd dicta into a holding: proper sequencing (even if the parent makes the gift of the partnership interest immediately after the contribution to the partnership) precludes the IRS from invoking the indirect-gift argument as long as the partnership first credits the contribution to the contributing partner's capital account.⁴¹ Page 8

B The Indirect-Gift Argument and the Eighth Circuit's Dicta in Senda

In Senda, the Tax Court left intact this understanding of the Shepherd dicta and the decision in Jones.⁴² In Senda, as in Jones, the contribution of assets to the partnership and the gift of limited units to the children occurred at approximately the same time.⁴³ The taxpayer relied on Jones, claiming that the contribution was properly reflected in his capital account, and therefore, the gift of the limited units should qualify for a discount.⁴⁴The Tax Court, however, distinguished Jones and applied Shepherd,⁴⁵denying a discount in computing the value of the gifted limited units.⁴⁶According to the court, unlike Jones, Senda involved a sequencing failure: the taxpayer failed to prove that the contribution had been made to the partnership before the gift of the limited units.⁴⁷ In such circumstances, the gift and contribution "were integrated . . . and, in effect, simultaneous."⁴⁸The taxpayer, in other words, could not establish, as the Shepherd dicta required, that the contribution had preceded the gift.

The court also found that the taxpayer failed to prove that his contribution was properly credited to his capital account.⁴⁹ The implication is that, had the taxpayer carried his burden of proof on this factual issue, the court would have permitted a discount, despite the sequencing failure.⁵⁰ The implication is consistent with the notion in Shepherd that a contribution of assets that is credited to the contributing partner's capital account cannot be viewed as a gift of those assets.

On the taxpayer's appeal in Senda, the IRS sought to undo the Shepherd dicta, the Jones holding, and the Senda implication.⁵¹ In its Eighth Circuit brief, the IRS made two critical arguments. First, it argued that the Shepherd dicta was just that-dicta-and should not be followed.⁵²Second, it argued that the step-transaction doctrine was neither raised nor Page 9 considered by the court in Jones.⁵³ Focusing on the word "integrated" in the Tax Court opinion in Senda, the IRS argued that, unlike the decision in Jones, the Senda decision had applied the step-transaction doctrine.⁵⁴ In short, the IRS did not merely seek an affirmance in the Eighth Circuit on the narrow...