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Family limited partnerships (FLP) and limited liability companies (LLC) are routinely used for wealth preservation through asset protection and estate planning. FLPs can be an especially attractive planning option in that substantial valuation discounts such as discounts for lack of marketability and discounts for lack of control are common. This reduces the gross value of the estate for tax purposes, supporting wealth preservation and transfer tax savings.

The Internal Revenue Service continues to aggressively scrutinize these “pass-through entities” to differentiate between those that are legitimate, for business or investment purposes, and those that are formed for the sole purpose of obtaining the benefits of these valuation discounts and, thus, for tax purposes alone. Six recent cases from the tax courts themselves are giving guidance to the correct formation and use of FLPs and LLCs and may serve as a roadmap for achieving successful results.

• In Wandry v. Commissioner of Internal Revenue, T.C. Memo. 2012-88 (TC Memo 2012-88), taxpayers executed gift documents transferring membership units of an LLC to their heirs. The documents specified the dollar value of each gift based on the applicable exclusions and exemptions at the time but left the number of units gifted to be based on the fair market value of the LLC as determined by the IRS or a court of law.

  The Tax Court allowed the taxpayers to use a formula clause to determine the value of a business interest for gift tax purposes. Wandry is distinct in that it is the first case to approve of a defined value clause and was untroubled when no charitable donee was a party in the transaction.

  Defined value clauses are unique, in that they diffuse the IRS's position that these clauses are against “public policy” arguments (Christiansen v. Commissioner, Petter v. Commissioner). Thus, an IRS audit won’t result in any additional gift tax owed, providing a disincentive to the IRS to audit.

  Dissatisfied, the IRS announced its nonacquiescence to the Wandry decision (IRB 2012-46) in November 2012. Therefore, expect the IRS to continue to challenge the use of so-called “Wandry” formulas or clauses in business valuations.

  Yet as the Tax Court confirms, so long as the dollar amount passing to the donee is fixed by formula, it is immaterial that the percentage interests allocated to the donee may change as a result of IRS revaluation; “the threat is neither severe nor immediate.”

• For those considering charitable contributions, the case of the Estate of Anne Petter v. Commissioner (upheld by the Ninth Circuit Court of Appeals) is worth studying. According to the Petter case, formula units would be reassigned to a charity rather than reverting back to the donor, providing an even greater disincentive for the IRS to audit. Not only will no additional tax be due, but any units transferred to charity would qualify for a charitable contribution deduction.

  The Tax Court rejected public policy concerns and held that the formula allocation provision does not violate public policy (as noted in Procter) and allowed a gift tax charitable deduction in the year of the original transfer for the full value that ultimately passed to charity based on values as finally determined for gift tax purposes.

  The IRS attacks hard to value assets such as FLP, either as an entity itself or at its level of discounts, such as for lack of marketability or lack of control, by using Internal Revenue Code (IRC) § 2036. If the requirements of IRC § 2036 are met, the full value of the transferred property is included in the value of the decedent's gross estate. But the bona fide sale exception applies when there is an actual business enterprise or business motive for the partnership.

• In the Estate of Stone v. Commissioner, T.C. Memo. 2012-48, after settlement of certain issues, the sole issue remaining for decision was whether the value of real property transferred by Joanne Stone (decedent) to a family limited partnership, for a nominal fee, should be included in the value of her gross estate pursuant to § 2036(a).

  The Tax Court agreed that the decedent’s objectives to create a family asset (later developed and sold by the family) and to protect against partition of the property were “legitimate and significant” nontax purposes sufficient to make the transfer of the Tennessee lakefront property, valued at $1.6 million, to the family limited partnership a bona fide sale for adequate and full consideration, for purposes of § 2036(a) of the IRC. The Tax Court held that the value of the property transferred should not be included in the value of the decedents’ gross estate and that a bona fide sale did occur.

• Contrasted with Stone above, the Estate of Turner v. Commissioner also involves the application of § 2036(a) of the Internal Revenue Code, 26 U.S.C. § 2036(a), to assets transferred inter vivos to FLPs.

  Theodore R. Thompson transferred $2.8 million in securities and other assets to two family limited partnerships in exchange for pro rata partnership interests. Upon his death, Thompson’s estate filed a federal estate tax return that applied a 40% discount to the value of decedent’s partnership interests for lack of control and marketability.

  The Commissioner of Internal Revenue filed a notice of estate tax deficiency in the amount of $707,054 , applying § 2036(a) to return to the gross estate the full date-of-death value of the transferred assets. The Tax Court sustained application of § 2036(a) after finding the decedent retained lifetime control and enjoyment of the transferred assets and concluding the transfer of assets was not a bona fide sale for adequate and full consideration.

  So although there was a transfer in the Turner case, the court concluded the transfer was not a bona fide sale for adequate and full consideration because: (1) the taxpayer stood on both sides of the transaction, (2) the taxpayer commingled personal and partnership funds, and (3) the taxpayer did not complete the transfer of assets to the partnership for at least eight months after the partnership’s formation.

  The court next considered whether the taxpayer enjoyed possession, enjoyment, or income from the property transferred to the partnership. The descendent had failed to retain sufficient assets outside the partnership. Furthermore, the taxpayer depended on the transferred assets, the taxpayer enjoyed disproportionate distributions from the partnership, and the taxpayer commingled assets and use of partnership funds with personal expenses.

  Finally, the court considered whether the taxpayer had the right, either alone or in conjunction with any other person, to designate those who shall possess or enjoy the property or its income. The court found the taxpayer was the sole general partner, had broad authority to manage property and amend the partnership agreement, and had sole and absolute discretion to make pro rata distributions of partnership income. The partnership conducted no legitimate business operations, nor did it provide the decedent with any potential nontax benefit from the transfers. Consequently, IRC § 2036 applied and, thus, included the value of the transferred property in the taxpayer’s estate.

• In the Estate of Kelly v. Commissioner, the decedent transferred assets to four limited partnerships and retained over $1,100,000 in her own name. The decedent gave limited partnership interests in three of the four partnerships to her children and their heirs. A corporate general partner managed and paid the expenses of the limited partnerships, for which the general partner received a management fee.

  The IRS determined that, pursuant to I.R.C. § 2036(a), the decedent retained an interest in the transferred assets including the FLPs, the transfers were not bona fide sales for adequate consideration, and the value of the transferred assets was includable in decedent’s gross estate. The IRS asserted a deficiency of over $2.2 million.

  The petitioner held that the decedent’s transfer of assets to the limited partnerships was a bona fide sale for full and adequate consideration, thus the value of the transferred assets was not includable in the decedent’s gross estate pursuant to I.R.C. § 2036(a). The petitioner held, further, that the management fee paid to the general partner was not retention of income by the decedent, thus the value of the gifted partnership interests was not includable in the decedent’s gross estate.

  The Tax Court found, “The decedent’s primary motives were to ensure effective property management and equal distributions among the children—not minimization of tax consequences.”

  Furthermore, the nature of the assets in this case “would lead any prudent person to manage them in the form of an entity.”

  Furthermore, the Tax Court found that the decedent did not retain an income stream from the partnership interests. On the contrary, the decedent’s implementation of the plan changed the decedent’s rights to, and relationship with, the transferred property. In the resulting entity, the decedent indeed had an income interest, but this interest did not trigger the applicability of § 2036. The partnership agreements, which were respected by the parties, called for a payment of income to a corporation (the general partner), not to the decedent. In essence, the IRS was requesting that the court disregard the corporation’s existence, the general partner’s fiduciary duty, and the partnership agreements. The Tax Court did not do so. The decedent did not retain an interest in the transferred FLP interests. Accordingly, the value of these FLP interests was not included in the decedent’s gross estate.

• In the Estate of Keller v. United States of America, Maude Williams passed away in May 2000, leaving behind both a substantial fortune and incomplete estate planning documents. Although an FLP was formed, there was a failure to fund it with $250 million in corporate bonds. Originally believing this omission precluded transfer of the relevant estate property to a limited partnership, her estate paid over $147 million in federal taxes. The estate lacked sufficient liquid assets to pay estate taxes and obtained a retroactive loan from the FLP.

  The estate later discovered Texas state authorities who supported that Williams sufficiently capitalized the limited partnership before her death, entitling the estate to a substantial refund. In this refund suit, the estate claimed a further substantial interest deduction ($30 million) on the initial payment, which it retroactively characterized as a loan from the limited partnership to the estate for payment of estate taxes.

  As the parties’ dispute reveals, a substantial valuation discount hinges on whether the community property bonds were transferred effectively to the FLP. The question here is whether title to property passed to the FLP contemporaneous with its formation. As the estate points out, at least one federal district court has applied Texas law to resolve a formation-stage problem in an FLP in a similar way, Church v. United States. The district court correctly concluded that Maude’s intent in forming the FLP was sufficient under Texas law to transfer ownership of the community property bonds to the FLP. Accordingly, the court upheld the combined 47.5% discounts on the value of the FLP assets.

  The district court also correctly concluded that the post hoc restructuring of the transfer as a loan from the FLP back to the estate for tax purposes was a necessarily incurred administrative expense; the estate retained substantial illiquid land and mineral assets that justified the loan, and the loan did not constitute an “indirect use” of the community property bonds. The district court upheld both of the estate’s contentions, entitling the estate to a corresponding deduction for the interest on the loan. The district court therefore granted the estate a refund of $115,375,591.

Successfully Navigating FLPs

Taxpayers look for certainty with respect to gift tax implications and transfer taxes. One must ask why a donor who wants to make a gift of cash, for example, should be in a better position of avoiding gift taxes than a donor who wants to make a gift of a harder-to-value asset such as a fixed dollar amount (not a percentage interest) in a family limited partnership. Both intend to make a gift of a specific dollar value and thus assess the resulting gift tax implications. Why should the donor bear the brunt of the gift tax if the value of the hard- to-value asset changes?

As the cases above demonstrate, the use of defined value clauses and the appropriate purpose, formation, documentation, implementation, and operation of hard-to-value family limited partnerships and their interests, in addition to obtaining the best available valuation appraisals, can provide taxpayers with the tools they can use to limit the fight over value and transfer taxes.