HOT TOPICS
UNDER THE 2001 TAX ACT AND TRANSFER PLANNING
MAINTAINING/OPERATING
THE FAMILY
LIMITED PARTNERSHIP
by Michael V. Bourland
P. Michelle Eaton
Stephanie M. Bourland
A
Professional Corporation
Attorneys
and Counselors
City
Center Tower II
(817)
877-1088
(817)
429-3945 (metro)
(817)
810-0463 (facsimile)
mbourland@bwwlaw.com
(Email)
Presented to
Eleventh Annual Advanced
ALI-ABA Course of Study
ESTATE PLANNING FOR THE
FAMILY BUSINESS OWNER
Thursday – Saturday
©
100100
BIOGRAPHICAL INFORMATION
MICHAEL V. BOURLAND
EDUCATION
B.A.,
J.D.,
LL.M. in Taxation,
PROFESSIONAL
ACTIVITIES
Founding Shareholder - Bourland,
Wall &Wenzel, P.C.
Board Certified (Estate Planning
and Probate Law) –
Fellow,
Former Member, Real Estate, Probate and Trust Law Council (State Bar of
ACADEMIC APPOINTMENT AND HONORS
Guest Lecturer in
Estate Planning at
The
Center for American and International Law
University
of
KENNETH L. WENZEL
EDUCATION
B.S., Southwestern University in
J.D.,
PROFESSIONAL
ACTIVITIES
Shareholder – Bourland, Wall
& Wenzel, P.C.
Board Certified (Tax Law) –
P.
MICHELLE EATON
EDUCATION
B.A.,
J.D.,
PROFESSIONAL ACTIVITIES, ACADEMIC APPOINTMENT AND
HONORS
Associate
Attorney - Bourland, Wall & Wenzel, P.C.
STEPHANIE
M. BOURLAND
EDUCATION
B.A.,
J.D.,
M.B.A.,
PROFESSIONAL ACTIVITIES, ACADEMIC APPOINTMENT AND
HONORS
Associate Attorney
– Bourland, Wall & Wenzel, P.C.
TABLE OF CONTENTS
I. INTRODUCTION..................................................................................................... 5
II. TOP
TEN LIST......................................................................................................... 5
III. VALUATION
OF FAMILY LIMITED PARTNERSHIP INTERESTS....................... 6
A. General.......................................................................................................... 6
B. Valuation....................................................................................................... 6
1. Methods........................................................................................................ 6
C. Role of the Appraiser..................................................................................... 8
D. Timing........................................................................................................... 8
IV. APPLICATION
OF CHAPTER 14 TO FAMILY LIMITED PARTNERSHIPS........ 11
A. Overview..................................................................................................... 11
B. Section 2701................................................................................................. 11
C. Section 2703................................................................................................. 14
D. Section 2704................................................................................................. 15
V. REAL
AND POSSIBLE CHALLENGES TO FAMILY LIMITED PARTNERSHIPS. 17
A. Initial IRS Position (1997 –
2000)................................................................... 17
1. Facts of Memoranda......................................................................... 17
2. IRS Law and Analysis (1997 –
2000)................................................. 20
B. Current Case Law and Other
Developments.................................................. 22
1. Partnership Business Purpose;
Lack of Economic Substance; and Corporate Formalities. 22
2. Gift Upon Creation........................................................................... 25
3. Applicable Restriction....................................................................... 26
4. Step Transaction Doctrine................................................................. 27
5. Transfer of Assignee Interests.......................................................... 27
6. Annual Exclusion Gift....................................................................... 28
VI. GENERAL
PLANNING/DRAFTING CONSIDERATIONS..................................... 28
A. Overall Considerations.................................................................................. 28
B. Restrictions on Transfer................................................................................ 29
C. Withdrawal Rights........................................................................................ 30
D. Distribution Powers...................................................................................... 31
E. Assignee Interests........................................................................................ 32
F. General Partner Considerations..................................................................... 32
G. General Partner Management Fee................................................................. 34
VII. PRACTICAL
CONSIDERATIONS IN FORMING AND OPERATING A FAMILY LIMITED PARTNERSHIP.................................................................................................................. 34
A. Income Tax Formation Issues........................................................................ 34
B. Income Tax Operation Issues........................................................................ 36
C. Gifts of Partnership
Interest/Proper Documentation........................................ 40
D. Death of an Individual General
Partner.......................................................... 41
E. Method of Accounting.................................................................................. 43
F. IRS Questions on Audit................................................................................. 43
VIII. Other
Concerns.............................................................................................. 43
A. Section 2036(a); Section 2036(b);
Section 2038(a).......................................... 43
B. Section 701 Anti-Abuse Rule......................................................................... 45
C. Marketable Securities
Distribution.................................................................. 45
D. Section 704(e).............................................................................................. 46
E. Dispositions of Interests in
Partnership Holding Installment Obligations............ 47
F. Income Tax Basis Step Up............................................................................ 47
G. Liabilities...................................................................................................... 48
IX. KEY
PROVISIONS OF THE FAMILY LIMITED PARTNERSHIP AGREEMENT. 48
X. ETHICAL/LEGAL MALPRACTICE
CONSIDERATIONS: REPRESENTATION IN THE CONTEXT OF A FAMILY LIMITED PARTNERSHIP............................................................................... 49
XI. FORMS
DISCLAIMER........................................................................................... 51
ATTACHMENTS
#1 Summary of Key Partnership Provisions of Founder Family
Investments, L.P.
#2 Limited Partnership Agreement of Founder Family Investments,
L.P.
(INTENTIONALLY NOT INCLUDED)
#3 Spousal Consent (INTENTIONALLY NOT INCLUDED)
#4 Excerpts From Manager’s Minutes for Founder Management, LLC
#5 Assignment of Limited Partnership Interest
#6 Acceptance of Limited Partnership Terms and Conditions
#7 Consent to Admission of Substituted Limited Partners
#8 Exhibit “C” to the Partnership Agreement for Founder Family
Investments, L.P.
#9 First Amendment to the Limited Partnership Agreement of
Founder Family Investments, L.P.
#10 Sample IRS Questions
#11 Engagement Letter
The authors gratefully acknowledge
THE FAMILY LIMITED PARTNERSHIP
For many years, the family limited partnership has been used as a vehicle to own and manage family property or family business enterprises in a custom designed entity to fulfill the family’s desires. In the past few years, the family limited partnership has come under intense scrutiny from the IRS as they view the family limited partnership as primarily a discount tool for the estate planning practitioner. Due to the focus by the IRS and practitioners on the discounts in family limited partnerships, many practitioners have not considered the other uses for the partnership such as to minimize state franchise taxes, to provide management control to the parent generation, to provide limited liability for its partners, and even in some situations, marital property protections. For many practitioners, the partnership has been viewed as an alternative to a trust for holding and managing assets. As outlined below, there are multiple reasons for selecting the family limited partnership as a planning tool, including ten which we believe are relevant in many family situations.
TOP TEN REASONS TO USE FAMILY LIMITED PARTNERSHIP
10. Limitation
of Payroll Taxes
9. Accumulation
of Wealth
8. Family Training in Management and Growth of Assets
7. State
Taxes/Income Tax Flexibility
6. Valuation
Discount
5. Consolidation
of Assets
4. Asset
Protection-Inside & Outside of FLP
3. Separate Property Maintenance/Pre-Martial Planning
2. Continuity
of Management
1. Control,
Control, Control
(And you thought Letterman had the corner on Top Ten Lists!)
One of the more appealing aspects of a family limited partnership is a client’s ability to make transfers of limited partnership interests (through gifts or otherwise) to his or her descendants on a leveraged basis due to valuation discounts which are customarily associated with transfers of limited partnership interests. Valuation discounts are attributable to a family limited partnership interest because the characteristics of a limited partnership interest generally cause the interest to be less valuable than the value of the underlying assets of the family limited partnership. In many situations, the discounts are consistent with discounts attributable to a minority interest position in a corporation.
The cornerstone test for determining the value of a limited partnership interest, and the percentage of valuation discount to be applied on a transfer of a limited partnership interest, is the amount a willing buyer would pay to a willing seller for the subject property (i.e. the limited partnership interest and not an interest in the underlying asset), where neither the buyer nor the seller is under a compulsion to buy or to sell and both the buyer and the seller have reasonable knowledge of the relevant facts of such transfer. Treas. Reg. § 20.2031-1(b). Under the “willing buyer/willing seller” test the proper focus should be on the value of the property transferred rather than on the value of the transferred property in the hands of the transferee following the completion of such transfer.
In determining the fair market value of a limited partnership interest, an appraiser must consider both the net asset value of the limited partnership and the net income/cash flow generated by the assets of the limited partnership. In both the net asset value approach and the income approach, the appraiser would need to take into account the distributions to the partners as allowed by the terms of the limited partnership agreement. The powers of the general partner regarding distributions to the partners of the limited partnership, as well as the history of the actual distributions made to the partners of the limited partnership, will be considered in valuing the limited partnership interest under either method.
The income approach to the valuation would take into account the current earnings and cash flow of the limited partnership as well as projected future earnings and cash flow of the limited partnership over a specified period of time. The income and cash flow approach to valuations is normally used where the limited partnership activity is an active, operating business as the value of the limited partnership’s business is based more on the income and cash flow generated from the assets of the limited partnership as opposed to the value of the assets held by the limited partnership. It is important to note that the amount of discount (as identified and discussed below) that can be taken from the value of a limited partnership interest determined from the income approach may be limited where a partner’s return on his or her capital contribution to the limited partnership is significant.
The net asset value approach would involve the determination of the fair market value of all of the assets owned by the limited partnership reduced by the aggregate value of all of the liabilities of the limited partnership. The net asset value approach is normally used where the limited partnership’s value is based on the value of its assets (normally passive type assets, i.e. real estate, publicly-traded securities, etc.) as opposed to the income generated from those assets owned by the limited partnership.
There are incidences where an appraiser would choose to use both the income approach and the net asset value approach in determining the limited partnership’s value (i.e. an oil and gas limited partnership). In such instance, an appraiser would then attribute a reliability factor to the value of each approach (as each approach applies to the specific limited partnership) in order to arrive at the value of the applicable limited partnership interest.
2. Discounts.
Once the limited partnership’s value is determined using one or both of the above two (2) methods, the appraiser could then apply two (2) discounts to the value of the subject limited partnership interest. These discounts are as follows: (i) a “lack of control” or “minority interest” discount, and (ii) a “lack of marketability” discount. Both of the above-referenced discounting principles have been recognized by the Internal Revenue Service. As mentioned above, substantial and/or frequent distributions to the partners of the limited partnership, as well as substantial income generated by the assets of the limited partnership, may restrict the amount of discount that can be taken from both the net asset value approach and the income approach in determining the value of the subject limited partnership interest.
The lack of control or minority interest discount is applicable to limited partnership interests due to a limited partner’s limited voting rights with respect to the partnership’s business and management. Typically, a limited partner would have very limited voting rights within the partnership, and the voting rights the limited partner has are usually reserved to extraordinary items affecting the partnership’s business and operations such as (i) the merger or the dissolution of the partnership, (ii) the selling of assets which constitute all or substantially all of the partnership’s assets, (iii) the removal or admittance of a general partner, (iv) the admittance of an additional limited partner, and (v) the amending of the partnership agreement. Summarily, a limited partner would normally have (i) no voice in the management of the partnership’s day to day business, (ii) no rights or interests (to partition or otherwise) in the partnership’s underlying assets, (iii) no power (or a very limited power) to withdraw from the partnership, (iv) no power to compel distributions from the partnership, and (v) restrictions placed on the partner’s ability to transfer his or her limited partnership interest. These limited voting rights make the limited partnership interest substantially less attractive to a hypothetical willing buyer under the “willing buyer/willing seller” test. The amount of the minority interest discount is dependent upon the amount of distributions made from the limited partnership to its partners, the financial risk associated with the limited partnership’s assets, and the terms of the limited partnership agreement.
The lack of marketability discount may apply regardless of whether or not the limited partnership interest transferred actually represents a minority interest in the partnership. The premise for the lack of marketability discount is that the transfer restrictions attributable to the limited partnership interest (whether such restrictions are imposed by the terms and provisions of the partnership agreement or by state and/or federal law) will make the limited partnership interest a less attractive asset than comparative publicly-traded assets under the “willing buyer/willing seller” test. The amount of the lack of marketability discount is determined by comparable sales of restricted stock of publicly traded companies.
Due to the recent scrutiny directed by the Internal Revenue Service on transfers of interests in family limited partnership interests, the role of the appraiser in identifying and evaluating the valuation discounts attributable to a limited partnership interest is crucial. It is extremely important that an appraiser be chosen who (i) is familiar with the nature and structure of the family limited partnership as a family planning tool, (ii) routinely appraises family limited partnerships, (iii) is familiar with Chapter 14 and state law related to partnerships, and (iv) has experience in defending his or her appraisals of the family limited partnership in an Internal Revenue Service audit.
The need for an appraiser should be discussed with the client early on if the client might want to participate in a gifting program. Also, the appraiser’s assistance may be needed in establishing the appropriate values on the assets initially contributed to the partnership in order to substantiate the initial allocation of the limited partnership interest percentages among the initial limited partners.[1] If the appraiser is not qualified or does not specialize in appraising the type of assets contributed to or owned by the family limited partnership, a separate appraiser may be needed in order to ascertain the value of the underlying assets before the family limited partnership appraisal is prepared.
There has always been debate among family
limited partnership practitioners and appraisers regarding whether time, and if
so, how much, should be allowed to pass between the funding of the family
limited partnership and when gifts of limited partnership interests are
made. In Technical Advice Memorandum
97-51-002, issued by the Internal Revenue Service on
E. Recent Cases.
1. High Discount Cases.
Dailey
v. Commissioner, 82 T.C.M.
(CCH) 710 (October 2001) allowed a 40% combined minority interest and lack of
marketability discount. In Dailey, a
Another
Strangi and Knight
(discussed later) are similar cases in that while the partnerships were
properly formed their existences were ignored by the parties involved and the
properties were seemingly owned and operated as if the partnerships were not in
existence. Other than attempting to
achieve discounts, there appeared to be little business purpose for the
partnerships.
The Tax Court has also applied discount rates
to partnerships in excess of the 40% rate seen in Daily. In Weinberg v. Commissioner, 79 T.C.M. 1507
(February 2000), the Tax Court applied an overall discount of approximately 50%
to the valuation of the limited partnership interest in a real estate venture
which owned and operated an apartment complex in Pennsylvania. In this case, the Tax Court and the valuation
experts applied the minority discount to the initial valuation of the estate’s partnership
interest rather than taking it off after the valuation had been completed. On top of this amount, the Tax Court applied
an additional marketability discount of 20%.
Comparing the agreed value of the real property to the Tax Court’s final
value, the overall discount afforded by the Tax Court was just over 50%. In Hoffman
v. Commissioner, 81 T.C.M. 1588 (May 2001), the Tax Court allowed a
combined discount rate of 46.7% on a 27.5% interest in a partnership holding
lakefront property ready for development.
Interestingly, the valuation accepted by the Tax Court, which attributed
a 46.7% discount rate, was proposed by the appraiser hired by the IRS.
The Church case (Churc