Refuting IRS challenges to the use of FLPs.

• Author: Strobel, George L., II
• Position: Family limited partnerships

EXECUTIVE SUMMARY

* The Service has effectively made a policy decision to challenge the validity of closely held partnerships for transfer tax purposes.

* The enactment of Secs. 2701-2704 was not intended to affect the availability of minority or other discounts.

* The Service has attempted to dissuade attempted to dissuade only the most versed and skilled planners from using FLPs for their clients.

The IRS has become increasingly aggressive in attacking the use of family limited partnerships, denying valuation discounts and including the partnership assets in estates. This article argues why the Service's position on this issue may not be valid.

This article highlights the AICPA's position on the legitimate use of family limited partnerships (FLPs). In particular, the AICPA takes exception to the IRS's refusal to recognize for transfer tax purposes the validity of many FLPs under examination. This article examines the development of the FLP and the major cases and laws that have focused on its transfer tax ramifications. It will then discuss the Service's current position, when it is appropriate and how it is being used to discourage practitioners from using the FLP structure. Finally, this article rebuts the technical basis for the Service's blanket challenge to FLPs and suggests guidelines for structuring them to minimize the potential for IRS challenge.

Overview

The use of family partnerships started in the mid-1960s, but became popular in the mid-1970s. Before then, business and investment assets were held largely in corporations, rather than partnerships, for two main reasons. First, the law governing the formation and operation of corporations as compared to partnerships was far better understood by most attorneys. (To a limited extent, this remains true today.) Thus, absent other compelling reasons, attorneys typically urged the formation of corporations rather than partnerships. Second, the corporate income tax rates were significantly lower than the individual rates, making the corporate structure the preferred structure for income tax deferral.

Beginning in 1976, the spread between individual and corporate income tax rates narrowed markedly, making partnerships and single-level taxation far more attractive. Of equal significance, the Tax Reform Act of 1986 (TRA '86) brought the repeal of the General Utilities doctrine and eliminated the ability to liquidate a corporation tax-free and avoid double-level taxation. After the TRA '86, the preferred choice of entity for holding a business or investment became the limited partnership, because of income tax considerations.

The adoption of the Uniform Limited Partnership Act (ULPA) by most states made the laws governing limited partnerships doing business in multiple states relatively similar and understandable. In addition to single-level income taxation, limited partnerships are attractive because:

1. There is bruited liability for most partners (particularly if the sole general partner is a corporation).

2. Equity structure can be very flexible.

3. Both formation and liquidation are largely tax-free.

4. Individual owners can be redeemed largely tax-free.

5. Partnership terms and provisions are flexible and can be changed by the partners as circumstances warrant.

6. They can serve as trust substitutes.

7. They provide significant creditor protection. Limited partnership interests are seldom attached; they provide creditors only the bruited rights of an assignee.

8. Limited partnership interests are attractive assets to gift, because they are generally excluded from consideration in marital settlements and can be easily transferred.

9. Their use avoids multistate probate if real estate is owned in more than one jurisdiction.

10. They avoid division of assets on the death of the partnership interest holder.

11. They allow synergies in the management of the partnership's assets that are achievable only by consolidating financial wealth into one vehicle.

12. They maintain family control of assets held by the partnership.

13. They have minimal capital requirements.

14. They are generally not subject to state franchise taxes.

There are numerous other reasons for combining and holding business and investment assets in a limited partnership.

Valuation Discounts

One offsetting feature of a limited partnership to its holders is that the fair market value (FMV) of the underlying assets may be greater than the FMV of the corresponding partnership interests. This is a drawback to holding assets in partnership solution, particularly if an individual must rely on his personal balance to obtain credit. However, from a transfer tax perspective, the dampening of value is advantageous. There is nothing wrong with holding assets in a partnership rather than owning them directly, even though the former will, in almost every instance, produce a lower transfer tax value. The reduction in the value of FLP interests is due to the existence of marketability and minority interest discounts when a limited partnership interest is valued in the marketplace. Generally, the standard for valuing property for both gift and estate tax purposes is the value at which it would be sold between an arm's-length buyer and seller, neither being under a compulsion to sell or buy, and both with a reasonable knowledge of the underlying facts. For transfer tax purposes, FMV is the price at which property would be sold to a hypothetical third party, not a strategic buyer or an individual who would gain voting control by the acquisition of the transferred interest. In addition to income and transfer tax considerations, partnerships possess numerous other nontax characteristics that make them ideal structures for holding wealth (whether active or passive) and for transferring partial interests in such wealth to others.

Government opposition: Over the years, the Service and Treasury have challenged the existence of large discounts in valuing limited partnership interests in the context of transfers between family members. Throughout the 1970s and 1980s, this opposition was focused on disallowing minority interest discounts on all transfers between family members if the family possessed effective control of the underlying FLP. The government's theory was that all members of the family would act in concert; thus, each member would be deemed to have the benefit of voting control of the underlying FLP, thereby making each family transferor or transferee a controlling partner. The government denied most minority discounts on the transfer of closely held FLP interests.

This theory has been extensively litigated; among the cases dealing with this issue are Bright,(1) Andrews,(2) Ward,(3) Propstra(4) and Lee.(5) After repeatedly losing this argument, the Service, in Rev. Rul. 93-12,(6) acquiesced with the courts' conclusion that both minority and marketability discounts were applicable to transfers of FLP interests. Having conceded the existence of a minority discount in the context of an intrafamily transfer, the Service was left with litigating the magnitude of such discount.

Concurrent with these valuation challenges, the Service also attacked two uses of FLPs tailored to limit or reduce the transfer tax of the senior generation. In Boykin,(7) the Service attempted to challenge the classic estate freeze(8) by arguing that the retention of a deferred income interest equals the retention of a proportionate share of corporate income, thereby requiring inclusion of the entire business in the estate of the holder of the preferred interest. (This technique was available to both partnerships and corporations.) The Tax Court ruled for the taxpayer, noting that the right to receive dividends is established by the corporate documents that govern share rights under applicable state law. Shareholders were not entitled to dividends except to the extent the company's board of directors approved their payment. Because the decedent did not have voting control, the corporation's underlying value was not includible in his estate. The principle is equally applicable to FLPs.

In Snyder,(9) the Service challenged the taxpayer's failure to exercise a conversion right from a noncumulative, relatively low-yielding preferred to a common stock interest. The taxpayer had created a freeze structure with a noncumulative preferred interest convertible into common stock. While the corporation generated little cashflow, its underlying assets appreciated significantly. The government asserted that the taxpayer should have exercised her conversion rights and exchanged the preferred stock for common stock; it imputed a gift to the extent that having done so would have enhanced the value of the senior generation's equity position.

However, the court refused to extend Dickman(10) and equate the failure to convert a noncurrently yielding preferred interest to a common equity interest when the children held common equity interests to the failure to charge interest on family loans. The court rightly refused to substitute its judgment concerning whether to exercise a conversion right for the taxpayer's sound business judgment.

In Harrison,(11) in addition to attacking the freeze transaction, the Service also attempted to attack the use of lapsing liquidation rights. It challenged a valuation of a FLP interest, because at death, such interest was illiquid, nonmarketable and could not be put back to the partnership. The taxpayer possessed a very large limited partnership interest and a small general partnership interest in a FLP formed a few months before his death. While the taxpayer was alive, he could liquidate the partnership; however, under state law, at death, the taxpayer ceased to be a general partner and could require only his general partnership interest to be redeemed. While the taxpayer was alive, he could control the liquidation of both the general and limited partnership interests; however, at death, only the very small general...