Source: http://www.mendellgroup.com/Seminar-Handouts/Advanced-Asset-Protection-Through-Family-Limited-Partnerships.shtml
Timestamp: 2017-01-23 04:18:58
Document Index: 211639498

Matched Legal Cases: ['§2703', '§2703', '§2701', '§2701', '§2701', '§2701', '§25', '§2701', '§2702', '§2702', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2703', '§2704', '§2704', '§2704', '§2704', '§2704', '§2704', '§2704', '§2704', '§25', '§25', '§ 1', '§2704', '§2704', '§2704', '§2704', '§2704', '§2704', '§2704', '§2036', '§2036', '§2036', '§2036', '§2036', '§2036', '§2036', '§2512', '§2036', '§7', '§153', '§7', '§153']

A. Estate and Gift Tax Savings — It is difficult to pass on a very large estate to future generations due to the substantial transfer taxes (estate and gift) imposed. Substantial valuation discounts for estate and gift tax purposes have been obtained for reasons discussed in connection with Sections IV through VIII below. B. Protecting Assets From Future Creditors — If a family member who has transferred most or all of his non-exempt properties to a family limited partnership is unable to satisfy the claim of a future creditor, such a creditor has very limited remedies against the assets held in such family limited partnership, as discussed in Section IX below. This limitation on remedies is what makes the family limited partnership an effective asset protective device. C. Simplified Family Transfers — It is often difficult to transfer undivided interests in multiple assets, such as real properties, securities held in investment accounts, oil and gas interests, etc., among the various children, grandchildren or other donees or devisees of a donor. If these assets are placed in a family limited partnership, the resulting limited partner units can be used as "family money" to conveniently gift or devise the equivalent of undivided interests of all of the assets to family members. If the gifts of limited partnership units qualify for the annual exclusion, the same discount methods of valuation discussed in Section VII below will apply, so that a greater value can be gifted to family members without potentially incurring a gift tax. If the discounted value of the gift exceeds the annual exclusion, the diminishment of the unified credit can be reduced. Similarly, even if the annual exclusion is found not to apply to such gifts, the reduction of the unified credit can still be diminished. However, while once thought that gifts of family limited partnership interests would routinely qualify for the annual gift tax exclusion, relatively recent developments have indicated otherwise. See, e.g., Hackl v. Commissioner
, 118 T.C. 279 (2002), aff'd 335 F.3d 664 (7 th Cir 2003); TAM 9751003; Price v. Commissioner
, T.C. Memo 2010-2 (1/4/10); Fisher v. U.S.
, No 1:08-cv-0908-LJM-TAB (S.D. Ind. 3/11/10); but see, Estate of Wimmer v. Commissioner
, T.C. Memo 2012-187 (6-4-12), where the transfers of limited partner interests qualified, but only because distributions were continuously made to the partners and such distributions could be readily ascertainable. D. Protecting Assets Against Failed Marriages — Many affluent individuals are worried about financial exposure in the event of a divorce involving their children and the possible passage of a substantial portion of the family wealth to a second family. While other protective devices such as prenuptial or postnuptial agreements are often found to be distasteful, the family limited partnership could provide the necessary protection without even raising the issue. If the wealth of a child consists of limited partnership units acquired by gift (before or during marriage) and, thus, constituting separate property of the child, the wealth of the child can be protected from award to a divorced spouse. Even if the divorce court were to award part of the limited partnership units to a divorced spouse, a properly drafted family limited partnership agreement would provide that involuntary transfers are subject to repurchase options, so that retention of family assets can be maintained by the family. E. Revocability — One major disadvantage of the irrevocable trust, which also has substantial asset protection features, is that it cannot generally be lawfully amended or terminated without participation by a court and, possibly, other parties such as a guardian ad litem for minor children or other incapacitated beneficiaries. The family limited partnership agreement may be amended or terminated if the designated vote of the partners (in a family limited partnership, comprised of family members) can be obtained. F. Generation to Generation Retention — Since a well-drafted family limited partnership agreement will contain consent requirements and/or purchase option provisions on the attempted transfer of any partner of his or her partnership units, the assets can be effectually retained in the family for the duration of the partnership. G. Reduction of Investment Portfolio Costs — Families may have many members, as well as trusts set up on their behalf, resulting in costly maintenance of separate investment accounts for multiple family member investors. Consolidation of investment accounts in one partnership can greatly alleviate this problem. Using a different financial or money manager for each family member or trust may be prohibitively expensive. There may be a substantial reduction in financial or money manager fees based on various levels of investment. If multiple family member and trust accounts are consolidated into one investment account in the family limited partnership, managed by one financial or money manager, the realization of a substantial reduction of fees can be obtained. On the other hand, many professionals advise that multiple financial managers are necessary to, among other things, achieve more diversification of the various portions of the family's total investment portfolio, outweighing the benefit of reduced fees and other costs. H. Flexibility in Portfolio Mix — Oftentimes, in the irrevocable trust scenario, the trustee is not allowed to use sound portfolio investment principles because of concern of treating either the income beneficiary or the remainder beneficiary unfairly. An income beneficiary's interest increases if the portfolio contains investments generating larger income, usually in the form of dividend or interest income, while a remainder beneficiary's interest is enhanced through investments that appreciate in value. Thus, the division of interests between the income and remainder beneficiaries may produce an inherent conflict. Since sometimes it is better to invest in appreciating securities and sometimes in income producing securities, or a mixture of the two, an investment vehicle that sidesteps fiduciary duties relating to conflicts among different beneficiary classes is desirable. Placement of the investment portfolio in a family limited partnership provides this flexibility. I. Retention of Younger Generation Initiative — An often-expressed fear of the older generation is that a substantial transfer of wealth too early stifles the initiative of their children to produce through work. Since retention of management, including the power to make distributions to younger generation limited partners, is a fundamental feature of essentially all family limited partnerships, the older generation can completely control the cash flow to their children and encourage productive work habits. III. Structure of Family Limited Partnership
A. Ownership of Units — While differing fact patterns may dictate other structures, this author often creates a Texas limited partnership, now governed under the Texas Business Organizations Code, with 100 partnership units: one general partner unit and 99 limited partner units. The predominant spouse (or a revocable trust with such spouse as trustee) contributes 1 percent of the marital assets going into the family limited partnership in exchange for the one general partner unit. The predominant spouse contributes 49 percent of the marital assets going into the family limited partnership for 49 limited partner units. The non-predominant spouse contributes 50 percent of the marital assets going into the family partnership for 50 limited partner units. Later, pursuant to an annual gift-giving program, or on an intermittent basis as the spouses may determine, both spouses may gift limited partner units to family members as "family money". B. Management of the Family Limited Partnership — Sole and exclusive management control of the family limited partnership will be held by the general partner, who is usually the predominant spouse or a revocable trust, relating to which the predominant spouse is the trustee. In the event of marital estates where each spouse has management control over separate significant portions of such estate (and, sometimes, in other circumstances), dual family limited partnerships, where one spouse is general partner of one family limited partnership and the other spouse is the general partner of the other family limited partnership, can maintain proper spousal control of marital assets subject to each spouse's normal management domain. Crucial to asset protection concerns and the attainment of substantial valuation discounts is the ability of the general partner to limit cash distributions to the partners in the general partner's sole discretion. Additionally, for estate and gift tax planning, it may be desirable to have junior family members own the general partner interests to help bolster the arguments for significant estate or gift tax discounts. C. Transfer Restrictions - Unless there are lack-of-family-harmony concerns, transfers of interests in the family limited partnership should require unanimous or super-majority vote of all of the partners for asset protection reasons. It is this voting control to admit new partners into the partnership, among other things, that provides the difficulty of a creditor in becoming a substituted partner into the family limited partnership. Many practitioners feel that other common restrictions on transferability will meet the "comparability test" under IRC §2703, such as requirement for the consent of only the general partner and/or right of first refusal provisions. Furthermore, many practitioners feel that the normal "permitted transferee" provisions allowing for the admission of related partners upon death or similar events will not cause IRC §2703 concerns. D. Liquidation Rights — For IRC Chapter 14 purposes, no partner should be given the right to unilaterally liquidate the partnership, including the general partner. Common procedures to prevent the risk of dissolution upon the death, incapacity or other withdrawal of a sole individual general partner, which would subject the partnership to a partnership vote to reconstitute and continue the partnership, would be to provide for the appointment of successor general partners or to include multiple general partners. Successor general partners can conveniently be established by making a revocable trust be the general partner, the grantor and trustee of such trust being the individual who would otherwise serve as general partner. Within the trust document, successor trustees could be provided for. IV. Estate and Gift Tax Considerations (General)
A. Estate Tax Credit/Applicable Exclusion Amount - The American Taxpayer Relief Act of 2012 ("ATRA"), signed into law on Jan. 2, 2013, made permanent the basic exclusion amount of $5,000,000 per person ($10,000,000 for a married couple), adjusted for inflation for decedents dying in 2013 and thereafter. With the inflation adjustment, the basic exclusion amount is $5,250,000 for 2013 and $5,340,000 for 2014. Other important features of ATRA include: (i) the generation-skipping transfer ("GST") exclusion is also $5,000,000, adjusted for inflation, (ii) the maximum estate tax and GST tax rate has been set at 40% and (iii) the so-called "portability" provision, where the surviving spouse may utilize the unused portion of the deceased spouse's estate tax exclusion amount, has been made permanent. B. Gift Tax Credit/Applicable Exclusion Amount - Starting for transfers made in 2013, ATRA makes the applicable exclusion amount for transfers by gift equal $5,000,000 for each taxpayer ($10,000,000 for a married couple), adjusted for inflation, the same as the estate tax exclusion amount (under a unified estate/gift tax structure). V. Estate and Gift Tax Considerations (Chapter 14, IRC §§2701 - 2704)
A. Chapter 14, IRC §2701 — IRC §2701 was designed primarily to address the traditional corporate and partnership recapitalizations that seek to "freeze" the value of senior generation interests and shift appreciation to junior generation interests. For example, in the corporate context, the recapitalization was accomplished with preferred stock retained by the senior generation and common stock gifted to the junior generation. IRC §2701 contains special valuation rules that cause certain discretionary distribution rights and liquidation rights (retained through preferred stock, for example, in the corporate context), preserved within the senior "frozen" interests, to be valued at zero so that the transfer value of the junior interest is determined without such considerations and, thus, are assigned a much higher value. However, non-lapsing differences with respect to management and limitations on liability do not create separate classes of interest for this purpose. Treasury Reg. §25.2701(c)(3). Therefore, most practitioners agree that the difference between general and limited partnership interests regarding participation in management and exposure to liability do not create two "classes" of partnership interests for this purpose. In the family limited partnership context, involving so-called "straight up" interests, IRC §2701 should not apply since there are not two classes of interests, with retained special distribution rights or liquidation rights attached to one of such classes. B. Chapter 14, IRC §2702 — IRC §2702 was designed primarily to address retained interests in trusts and is generally not applicable in the family limited partnership context. C. Chapter 14, IRC §2703
1. IRC §2703: In General - In recent years, IRC §2703 is one of the more common mechanisms used by the IRS to attack family limited partnerships. IRC §2703 contains rules governing the tax impact of certain buy-sell agreements and similar arrangements designed to limit or restrict the value of interests in family-controlled partnerships and corporations. Generally, IRC §2703 provides that the value of any property shall be determined without regard to any contractual restrictions on transferability unless such restrictions are (1) a bona fide business arrangement, (2) not a device to transfer the covered property to members of a decedent's family for less than full and adequate consideration and (3) comparable to similar arrangements entered into by unrelated parties. The IRS has taken the position in recent cases that the entire partnership agreement (and, thus, the existence of the partnership) may be disregarded under this code section and, thus, the value of partnership assets attributable to a transferor should be determined without regard to any partnership structure (no discounts). 2. IRC §2703: The Statute - IRC §2703 reads as follows: SUBTITLE B--ESTATE AND GIFT TAXES (Sections 2001 to 2704)
3. IRC §2703: The Lead Case - Estate of Strangi v. Commissioner, 115 T.C. 478 (2000), aff'd in part and rev'd in part on other grounds, 293 F.3d 279 (5th Cir. 2002) (referred to as " Strangi I"). In Strangi I, the Tax Court rejected the IRS argument that "a right or restriction may be implicit in the capital structure of an entity" by stating: "Respondent (IRS) next argues that the term "property" in section 2703(a)(2) means the underlying assets in the partnership and that the partnership form is the restriction that must be disregarded. Unfortunately for respondent's (IRS') position, neither the language of the statute nor the language of the regulation supports respondent's (IRS') interpretation. Absent application of some other provision, the property included in decedent's estate is the limited partnership interest and decedent's interest in Stranco."
"Treating the partnership assets, rather than decedent's interest in the partnership, as the "property" to which section 2703(a) applies in this case would raise anew the difficulties that Congress sought to avoid by repealing section 2036(c) and replacing it with chapter 14. We conclude that Congress did not intend, by the enactment of section 2703, to treat partnership assets as if they were assets of the estate where the legal interest owned by the decedent at the time of death was a limited partnership or corporate interest. See also Estate of Church v. United States, 85 AFTR 2d 2000-804, 2000-1 USTC par. 60,369 (W.D. Tex. 2000). Thus, we need not address whether the partnership agreement satisfies the safe harbor provisions of section 2703(b)." 4. IRC §2703: Conclusions — Many practitioners believe that IRS attacks on validly formed limited partnerships based on IRC §2703 will continue to be fruitless (on the IRS' part) under the Strangi I rationale that the term "property" cannot refer to the partnership assets themselves, since such assets are not part of the transferor's estate (the partnership interests are), thus, rendering IRC §2703(a) non-applicable to the valuation of the partnership interests. Many practitioners also believe that an additional IRC §2703(b) argument (not addressed by the Strangi I court, since its determination under IRC §2703(a) made an analysis of IRC §2703(b) unnecessary) would also be available by relying on state law regarding the non-assignability of interests without the consent of all partners (unless provided otherwise in the partnership agreement). As to whether other restrictions, such as right of first refusal provisions, will trigger IRC §2703 applicability will need to be determined under the subjective "comparability" rule of IRC §2703(b)(3), in the event a court were to find IRC §2703(a) applicable to the partnership interests, themselves (contrary to Strangi I). A recent contrary case, holding that IRC §2703 disallows consideration of transfer restrictions contained in a limited partnership agreement in determining the magnitude of the lack of marketability discount for family limited partnerships holding primarily marketable securities is Holman v. Commissioner, Doc 2010-7656, 105 AFTR2d ¶2010-721 (8 th Cir 4/7/10). While being consistent with earlier cases in affirming that the property transferred is the partnership interest itself, rather than the underlying assets held by the partnership (in this case, publicly traded Dell stock), the majority opinion indicated that typical transfer restriction provisions, such as a right of first refusal, do not meet the bona business arrangement prong of the IRC §2703 test where the partnership essentially holds marketable securities. That is, the majority decision essentially held that "maintaining family control" is a legitimate business purpose for partnership restrictions only when the "control" being preserved is the right to manage an operating business or an actively managed asset. Also, see similarly, Fisher v U.S., 106 AFTR2d ¶2010-6144 (S.D. Ind. 9/1/10), applying the Holman majority rationale to a limited partnership holding lakefront real estate for future appreciation. Also, of note, is the Holman dissent, which contains a good discussion of authorities indicating that, contrary to the majority decision, "maintaining family control" is a legitimate business purpose even for partnerships holding passively managed investment assets. D. Chapter 14, IRC §2704
1. IRC §2704: In General — An additional attack of family limited partnerships by the IRS in recent years is under IRC §2704. IRC §2704 (the anti- Harrison statute) applies to treat a "lapse" of a voting right or liquidation right as a taxable transfer. Thus, if the transferor retained the unilateral power under the partnership agreement to liquidate the partnership or his interest in the partnership, the transferor's partnership interest would be valued at liquidation value (no discounts). Additionally, IRC §2704 provides that certain "applicable restrictions" on a transferor's ability to liquidate the partnership or his interest in the partnership will be disregarded, if, among other things, the "applicable restrictions" are more restrictive than that provided under applicable state law. Thus, if a partnership agreement provides for unanimous vote of all of the partners to liquidate a partnership, but the applicable state's partnership law provides for a 70 percent vote, a transferor's 75 percent partnership interest would be valued as if the partnership agreement's restriction on the ability to liquidate were disregarded, treating the 75 percent partner as if he had the power to liquidate the partnership, notwithstanding the more restrictive provision in the partnership agreement. 2. IRC §2704: The Statute - IRC §2704 reads as follows: SUBTITLE B--ESTATE AND GIFT TAXES (Sections 2001 to 2704)
2704(b)(4) Other Restrictions. -- The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor's family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee. 2704(c) Definitions And Special Rules. -- For purposes of this section --
2704(c)(2)(C) any brother or sister of the individual, and 2704(c)(2)(D) any spouse of any individual described in subparagraph (B) or (C).
3. IRC §2704: The Regulations - Treasury Regulations §25.2704-1 and §25.2704-2 reads as follows: Treasury Regulations
An applicable restriction is a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction.
A restriction is an applicable restriction only to the extent that either the restriction by its terms will lapse at any time after the transfer, or the transferor (or the transferor's estate) and any members of the transferor's family can remove the restriction immediately after the transfer. Ability to remove the restriction is determined by reference to the State law that would apply but for a more restrictive rule in the governing instruments of the entity. See section 25.2704-1(c)(1)(B) for a discussion of the term "State law." An applicable restriction does not include a commercially reasonable restriction on liquidation imposed by an unrelated person providing capital to the entity for the entity's trade or business operations whether in the form of debt or equity. An unrelated person is any person whose relationship to the transferor, the transferee, or any member of the family of either is not described in section 267(b) of the Internal Revenue Code, provided that for purposes of this section the term "fiduciary of a trust" as used in section 267(b) does not include a bank as defined in section 581 of the Internal Revenue Code. A restriction imposed or required to be imposed by Federal or State law is not an applicable restriction. An option, right to use property, or agreement that is subject to section 2703 is not an applicable restriction. [Emphasis added] 25.2704-2(c) Effect of disregarding an applicable restriction. 839525.2704-2
(1) written consent of all partners to the winding up and termination of the limited partnership; and (2) an event of withdrawal of a general partner. [Emphasis added] Acts 2003, 78th Leg., ch. 182, § 1, eff. Jan. 1, 2006.
5. IRC §2704: The Lead Case - Kerr v. Commissioner, 113 T.C. 449 (1999), aff'd on other grounds, 292 F.3d 490 (5th Cir. 2002) (the Tax Court decision referred to as " Kerr I" and the 5 th Circuit decision as " Kerr II"). In Kerr I, the Tax Court held that IRC §2704 did not apply because the provisions of the partnership agreement regarding liquidation and withdrawal were no less restrictive than applicable state law (Texas law). In Kerr II, the 5 th Circuit, in affirming the ruling of the Tax Court, ruled that IRC §2704 did not apply because of the existence of a third party partner (a 501(c)(3) entity-The University of Texas) that could, through its vote, prevent the liquidation of the partnership. As the 5 th Circuit made its determination on such basis, it did not address (or approve or disapprove) the Tax Court's rationale for holding that IRC §2704 did not apply. 6. IRC §2704: Conclusions - Many practitioners believe that IRS attacks under IRC §2704 of validly formed Texas limited partnerships following the Texas statutes on liquidation and partner withdrawal will continue to be fruitless (on the IRS' part) based on the favorable wording of the Texas limited partnership laws. Many practitioners believe that liquidation rights of a general partner provided under state law do not trigger applicability of IRC §2704, or that provision for entity, multiple or successor general partners eliminates this issue. Some practitioners feel that there must be some third party limited partner, such as a charity, to avoid concerns that the family will be treated as one unit for determining liquidation rights, since a partnership may be liquidated under state law by unanimous vote of all partners. Additionally, it appears that the IRS' attention has been shifted to IRC §2036(a) (discussed below) due to a string of recent successes in various recent cases. VI. Estate and Gift Tax Considerations (IRC §2036(a))
A. IRC §2036(a): In General - The primary area in which the IRS has experienced success in connection with challenges to family limited partnerships involved situations where the taxpayers failed to respect the integrity of the entity in various ways. In these cases, the courts have used IRC §2036(a) to bring a value of the partnership assets back into a decedent's estate as a retained life interest. B. IRC §2036(a): The Statute - IRC §2036(a) reads as follows: SUBTITLE B--ESTATE AND GIFT TAXES (Sections 2001 to 2704)
1. " Schauerhamer" : Estate of Schauerhamer v. Commissioner, T.C. Memo 1997-242, 73 T.C.M. 2855 (1997) 2. "Reichardt"
: Estate of Reichardt v. Commissioner, 114 T.C. 144 (2000) 3. "Church"
: Church v. United States, 85 A.F.T.R.2d 804 (W.D. Tex. 2000), aff'd without published opinion, 268 F.3d 1063 (5th Cir. 2001) (per curiam), unpublished opinion available at 88 A.F.T.R.2d 2001-5352 (5th Cir. 2001) 4. "Harper"
: Estate of Harper v. Commissioner, 83 T.C.M. 1641 (2002) 5. "Thompson"
: Estate of Thompson v. Commissioner, 84 T.C.M. 374 (2002), aff'd, Turner, Executrix of the Estate of Thompson v. Commissioner, No. 03-3173 (3rd Cir. 9/1/04) 6. "Strangi II"
: Estate of Strangi v. Commissioner, 85 T.C.M. 1331 (2003) 7. "Stone"
: Estate of Stone v. Commissioner, 86 T.C.M. 551 (2003) 8. "Kimbell"
: Kimbell v. United States, 371 F.3d 257 (5th Cir. 2004), rev'g 244 F.Supp.2d 700 (N.D. Tex 2003) 9. "Abraham"
: Estate of Abraham v. Commissioner, 87 T.C.M. 975 (2004) 10. "Hillgren"
: Estate of Hillgren v. Commissioner, 87 T.C.M. 1008 (2004) 11. "Bongard"
: Estate of Bongard v. Commissioner, 124 T.C. 8 (2005) 12. "Bigelow"
: Estate of Bigelow v. Commissioner, T.C. Memo 2005-65 (3/30/05) 13. "Korby"
: Estate of Korby v. Commissioner, T.C. Memo 2005-102 and 2005-103 (5/10/05) 14. "Disbrow"
: Estate of Disbrow v. Commissioner, T.C. Memo 2006-34 (2/28/06) 15. "Schutt"
: Estate of Schutt v. Commissioner, T.C. Memo 2005-126 (5/26/05) 16. "Rosen"
: Estate of Rosen v. Commissioner, T.C. Memo 2006-115 (6/1/06) 17. "Erickson"
: Estate of Erickson v. Commissioner, T.C. Memo 2007-107 (4/30/07) 18. "Gore"
: Estate of Gore v. Commissioner, T.C. Memo 2007-169 (6/27/07) 19. "Mirowski"
: Estate of Mirowski v. Commissioner, T.C. Memo 2008-74 (3/26/08) 20. "Hurford"
: Estate of Hurford v. Commissioner, T.C. Memo 2008-278 (12/11/08) 21. "Jorgensen"
: Estate of Jorgensen v. Commissioner, T.C. Memo 2009-66 (3/28/09), aff'd, No. 09-73250 (9 th Cir. 5/4/11) 22. "Miller"
: Estate of Miller v. Commissioner, T.C. Memo 2009-119 (5/27/09) 23. "Keller"
: Estate of Keller v. Commissioner, No. V-02-62 (S.D. Tex. 8/20/09) 24. "Shurtz"
: Shurtz Estate v. Commissioner, T.C. Memo 2010-21 (2/3/10) 25. "Jorgensen"
: Jorgensen Estate v. Commissioner, No. 09-73250 (9 th Cir. 5/4/11) 26. "Turner"
: Turner Estate v. Commissioner, T.C. Memo 2011-209 (8-30-11) 27. "Liljestrand"
: Liljestrand Estate v. Commissioner, T.C. Memo 2011-259 (11-2-11) 28. "Stone"
: Stone Estate v. Commissioner, T.C. Memo 2012-48 (2-22-12) 29. "Kelly"
: Kelly Estate v. Commissioner, T.C. Memo 2012-73 (3-19-12) D. IRC §2036(a): The Key Factors From Recent Cases
Reichardt, Thompson, Strangi II, Abraham, Bongard, Bigelow, Korby, Erickson, Miller
In the typical family limited partnership context, a discount for minority interest should also be applicable. A discount for minority interest reflects the holder's lack of control over management and voting and is relevant for valuation purposes, since a minority interest holder cannot influence management, compel distributions or force liquidation. Because of this lack of control, potential purchasers are less willing to buy a minority interest. In the past, the IRS has strongly advocated against applying a minority discount to interests in family-owned entities, using a "unity of ownership" theory. However, the IRS has backed off this position in Rev. Rul. 93-12, IRB 1993-7, February 16, 1993, which holds that the factor of "corporate control" in the family, when a donor transfers shares in a corporation to the donor's children, is not considered in valuing the transferred interests for purposes of IRC §2512. The ruling goes on further to state that the IRS will follow past case law (including Bright
) in not assuming that all voting power held by family members may be aggregated for purposes of determining whether transferred shares should be valued as part of a controlling interest. Perhaps the most important discount applicable in the family limited partnership context is the marketability discount. This discount reflects the absence of a readily available market, in comparison to a publicly traded entity, and the resulting lack of transferability.
In the past, much concern has been expressed about the applicability of discounts with respect to family limited partnerships holding solely, or primarily, marketable securities. See
Dalley Estate v. Commissioner
, T.C. Memo 2001-263 (10/3/01) for a relatively recent taxpayer victory involving a family limited partnership whose assets consisted solely of marketable securities [the Court allowed a 40% discount]. Also, we should note the 1/8/03 comments of Mary Lou Edelstein, national family limited partnership coordinator for IRS appeals. Ms. Edelstein announced the following IRS voluntary settlement positions for valuation discounts for family limited partnerships not constituting "death bed" partnerships: (i) 35% to 40% discounts for family limited partnerships holding "active" assets and (ii) 25% to 30% discounts for family limited partnerships holding "passive" assets. Presumably due to the IRS victories under IRC §2036(a), the IRS has issued updated "Appeals Settlement Guidelines", authored by Ms. Edelstein and dated October 20, 2006, issuing new settlement guidance and guidelines (actual percentages redacted).
A. Limited Exclusive Remedy — The key to the asset protection feature afforded by family limited partnerships is the exclusive remedy of creditors of a partner (but not of the partnership) with respect to collection against the partnership interest of a debtor partner. This remedy is commonly referred to as a "charging order" remedy (as opposed to, for example, a "turnover order" remedy). TRLPA §7.03(c) and TBOC §153.256. A "charging order" gives the judgment creditor only a right to the cash distributions attributable to the partner's interest ( when and to the extent declared by the general partner) and a right to inspect partnership records. The judgment creditor who holds the charging order does not become the owner of the interest or a substitute partner under the properly drafted family limited partnership agreement. TRLPA §7.03(c) and TBOC §153.256 were amended effective Sept. 1, 2007, to clarify that the "charging order" remedy is the sole remedy for a judgment creditor with respect to the limited partnership interest of a debtor partner. Prior law and the amended statutes are provided below.
B. Phantom Income — Although the judgment creditor is not assured of receiving any distributions from the family limited partnership, once he obtains a charging order, he is nonetheless required to pay federal income taxes on the income of the partnership in proportion to the interest encumbered by the charging order. Rev. Rul. 77-137, 1977-1 C.B. 178. Thus, the judgment creditor is immediately exposed to "phantom income," without the ability to force cash distributions to pay for such liabilities. C. Fraudulent Transfers — It must be noted that the "charging order" remedy is only an exclusive remedy if the transfers of property to the family limited partnership are not fraudulent transfers. If such transfers are found to be fraudulent, they may be set aside and subject to the claims of the affected creditors under various remedial laws, including the Uniform Fraudulent Conveyances Act and applicable bankruptcy laws. D. Settlement Leverage — The practical effect of transferring assets into a family limited partnership, not in violation of fraudulent transfer rules, is, at the very least, increased leverage in obtaining a favorable settlement with a judgment creditor. A judgment creditor faced with the uncertainty of being able to obtain the underlying assets of value and, at the same time, incurring "phantom income" increases a debtor's negotiating power tremendously. X. Use of Limited Liability Companies in Texas