Super-Recognition and the Return-to-Sender Exception: The Federal Income Tax Problems of Liquidating the Family Limited

• Author: Samuel A. Donaldson
• Position: Associate Professor of Law and Director, Graduate Program in Taxation, University of Washington School of Law.
• Pages: 15-58

Page 15

Participants at the Capital University Law School 2006 Tax Conference, Tax & Business Planning for Family Limited Partnerships, offered many helpful comments in the preparation of this manuscript.

Introduction

In John Godfrey Saxe's poem, The Blind Men and the Elephant,¹ six visually impaired men pay a visit to an elephant.² Each of the men touches a different part of the elephant, causing a heated debate among them as to whether the elephant is more like a wall, a snake, a spear, a tree, a fan, or a rope.³ Saxe used the parable to explain differences in world religions,⁴ but it can also be used to explain the different views of the family limited partnership. Estate planning practitioners see the family limited partnership as a common technique for utilizing various valuation discounts in effecting efficient transfers of wealth.⁵ The Internal Revenue Page 16 Service (Service) sees the family limited partnership as an elaborate shell game designed to artificially destroy value and, thus, unfairly reduce the federal gift tax or federal estate tax liability associated with wealth transfers.⁶ Subchapter K of the Internal Revenue Code (Code), however, sees the family limited partnership as just another everyday partnership;⁷and therein lies the problem.

Ask many estate planners about the income tax aspects of a family limited partnership and you are likely to hear some variation of the following: it is a pass-through entity for federal income tax purposes, meaning the partnership's income is taxed directly to the partners and subsequent distributions of such income will be tax-free.⁸ It is tax-free to form and it is tax-free to liquidate.⁹ As two-sentence summaries go, this generally works. But it ignores a host of exceptions, three of which arise when the family limited partnership liquidates. After a short discussion of the federal wealth transfer tax aspects of the family limited partnership, Part I of this Article explains the three roadblocks to tax-free liquidation. These roadblocks appear in sections 704(c)(1)(B),¹⁰ 737,¹¹ and 731(c)¹² of Page 17 the Code.¹³ Very generally, these provisions often require partners to recognize gain or loss for federal income tax purposes upon a distribution of property from the partnership. Application of one or more of these provisions rebukes the conventional wisdom that a family limited partnership may liquidate on a tax-free basis.

Part II of this Article offers a simple hypothetical case study that will both explain the interaction of the applicable rules and expose two problems that merit correction. The first problem concerns the inconsistent treatment of beneficial assignees. Partners that contribute "built-in gain property"-property with a fair market value in excess of its adjusted basis at the time of contribution-are rightly spared from recognizing such builtin gain if the partnership distributes the built-in gain property back to the contributing partner.¹⁴ This relief comes in the form of a "return-to- sender" exception, which is expressly provided in the Code.¹⁵ But where a contributing partner gifts his or her partnership interest to a beneficiary, the partnership's distribution of the built-in gain property to the beneficiary may present problems. Specifically, the beneficiary is excused from gain recognition under section 704(c)(1)(B) due to a provision in the regulations.¹⁶ But the regulations under section 737 are silent, leading some commentators to conclude that a beneficiary must recognize gain under section 737 when the partnership distributes built-in gain property to the beneficiary even though the beneficiary's assignor would not have to recognize such gain.¹⁷ Page 18

There is no reason to insulate beneficial assignees from gain recognition under section 704(c)(1)(B) only to turn around and subject them to gain recognition under section 737, especially since the Code provides that their assignors would not be subject to gain recognition.¹⁸Accordingly, this Article urges the Treasury Department (Treasury) to correct the regulations under section 737 so that assignees can qualify for the return-to-sender exception.

The second problem relates to "loss property"-property with an adjusted basis in excess of its fair market value.¹⁹ When a family limited partnership holds both gain property and loss property, in-kind distributions of gain property to some partners coupled with in-kind distributions of loss property to other partners can result in the problem of "super-recognition"-where a partner will have to recognize more gain than the partner would realize upon a fully taxable disposition of his partnership interest.²⁰ Even though super-recognition initially appears problematic, closer examination reveals that it is the correct result because it is consistent with the results of a sale of gain property by the entity followed by a distribution of the loss property in liquidation of a partner's interest.²¹

But the typical family limited partnership is not formed to engage in disguised sales of assets.²² Super-recognition is an acceptable result only if one accepts the initial premise that the liquidation should be treated the same as a sale of the assets by the partnership to an unrelated party. This Article proposes that the initial premise is flawed and suggests two ways Congress can cure the problem. Page 19

I A Short Primer on the Family Limited Partnership

A The Use of Family Limited Partnerships in Contemporary Estate Planning

The term "family limited partnership" is used to describe an arrangement whereby individuals with substantial estates²³ assign investment assets to an entity that will be taxed as a partnership²⁴ and then transfer ownership interests in the entity to beneficiaries of their choosing.²⁵ To see how the family limited partnership has become such a lightning rod for controversy, it helps to see the device in action. For this purpose, consider a hypothetical married couple, George and Louise, who reside in a city. Among their many assets, they own several unencumbered parcels of farmland worth an aggregate $3 million and they own stocks in various public corporations worth $7 million. George and Louise form a limited liability company that will be taxed as a partnership. They transfer the farmland and the stock to the limited liability company in exchange for all of the ownership interests in the entity. There are no federal income tax consequences associated with this exchange.²⁶

The capital structure of the limited liability company formed by George and Louise consists of one thousand "voting units" and ninety-nine thousand "nonvoting units." Each unit has equal rights with respect to distributions and liquidation of the entity; the only difference between a Page 20 voting unit and a nonvoting unit is that a voting unit also carries the right to vote on managerial matters concerning the limited liability company.²⁷

Following the formation of the limited liability company, George and Louise transfer all or some portion of the nonvoting units to their son, Lionel. Such transfers may be by gift or by sale.²⁸ Following these transfers, Lionel will have an ownership interest in the entity which, in turn, represents an ownership interest in a portion of the farmland and stock.²⁹ For instance, if George and Louise transfer ten thousand nonvoting units to Lionel each year for three consecutive years, Lionel will have a combined thirty thousand nonvoting units, representing a 30% capital interest in the limited liability company by the end of the third year. This effectively represents a 30% interest in the farmland and a 30% interest in the stock.

Estate planners would refer to George and Louise's entity as a "family limited partnership" even though the entity is formally a limited liability company and not a limited partnership.³⁰ In furtherance of their love for acronyms and jargon, many estate planners would simply refer to this arrangement as an "FLP."³¹ In the interest of convenience, this Article will follow suit.

George and Louise could have achieved a similar result by conveying to Lionel an undivided 10% interest in each of the parcels of real estate and in each of the various stocks each year for three years.³² But that would involve substantially more effort, paperwork, and expense.³³ Once the assets have been conveyed to the FLP, George and Louise can make efficient wealth transfers through gifts and sales of nonvoting units instead of gifts and sales by a litany of deed and assignment documents.

Notice, too, that the FLP structure permits George and Louise to convey up to 99% of the total equity in the entity without sacrificing any Page 21 voting control over the entity.³⁴ Were George and Louise to convey an undivided 99% tenancy-in-common interest³⁵ in each parcel of farmland and each share of stock to Lionel, they would effectively lose their ability to control the disposition and everyday management of those assets.³⁶Thus, the FLP offers the additional advantage of retained control to the founders.

But perhaps the most important advantage to the FLP, at least from a tax perspective, relates to valuation. Had George and...