Sec. 2036 and FLPs.

• Author: Lerman, Jerry L.
• Position: Family limited partnerships

At the University of Miami's Heckerling Institute's annual conference on estate planning, held earlier this year, Mary Lou Edelstein, the IRS National Coordinator for Family Limited Partnership Appeals, emphasized that the IRS has coordinated all family limited partnership (FLP) discount cases at the Office of Appeals level and will actively seek to determine whether a FLP's underlying assets are includible in a transferor's estate under Sec. 2036(a), without a discount. Ms. Edelstein noted some red flags, including whether (1) the parties respected the technical formalities of a FLP in its creation and operation, (2) the transferor used personal assets (e.g., his or her residence) to fund the FLP and (3) the transferor retained sufficient assets to maintain a reasonable standard of living, without having to rely on the FLP'S assets.

Valuation Discounts

FLPs are a mainstay of estate and succession planning, to manage and preserve wealth within a family and to pass family assets to a younger generation at reduced values for transfer tax purposes. Typically, in such arrangements, wealthy individuals contribute various assets (e.g., businesses, real estate and marketable securities) to a partnership formed with their children and receive partnership interests in exchange. Later, the parents often gift some or all of the limited partner (LP) interests to their children, while retaining the general partner (GP) interests (which frequently can be as low as 1%).

Although the children may end up with a majority (or greater) interest in the FLP, control over the FLP's assets remains in the parents' hands because the parents retain the GP interests. In gifting LP interests rather than the underlying assets, the parents take advantage of valuation discounts (historically 30%-40%), which, in effect, enable them to transfer their assets from their estate to their children at significantly reduced values for gift tax purposes. The parents gain because the value of the LP interest may be less than its proportionate share of the underlying partnership assets. This is based on the LP'S lack of control and marketability, because of its inability to reach the FLP'S capital and profits and the inability to unilaterally sell such an interest.

The IRS, in seeking to eliminate (or at least reduce) valuation discounts claimed on gifts of LP interests, has put forth various arguments. Some are based on general tax concepts like the business-purpose doctrine...