Wrestle Mania

June 2, 2008

Wrestle Mania - By Joseph B. Darby III , Paul McCawley

Some things just set people off: wave a red flag at a bull, or tell a hard-core professional wrestling fan that you think the WWE is a complete fake, or walk into a sports bar in Boston wearing a Yankees hat and start talking serious New York smack to a die-hard Red Sox fan.

Or, if you REALLY want to start a WrestleMania, all you have to do is file an estate or gift tax return with the IRS and claim a discount for an interest in a family limited partnership (FLP).

For the last 15 years, taxpayers and the IRS have been engaged in a kind of Texas Steel Cage Death Match over the gift and estate tax consequences of an FLP. Thus far, it has been a hard-fought and surprisingly even fight. On the one hand, taxpayers have used this popular tax-planning technique to cut estate and gift taxes dramatically, while passing a greater portion of the family wealth on to successor generations. On the other hand, the IRS has pushed back hard, and after an early period of inept and feckless failures, has become increasingly canny and successful in attacking FLPs and limiting their effectiveness.

Conflict, of course, is inevitable. Wealthy taxpayers want to pay as little in taxes as possible, while the IRS would like to collect as much tax as it can. That is not news. What makes the contest fascinating is the amount of money at stake, and the sophisticated skills of the contestants as they face-off in the proverbial ring.

This battle is not going to end anytime soon: Taxpayers can be counted on not to give up a dollar more in taxes than is required; Uncle Sam, meanwhile, has no intention of saying "uncle."

An FLP, even though created for a variety of bona fide business reasons, does have undeniable benefits under tax law. First and foremost, FLP interests can be fragmented and easily transferred, and the value of those interests can be eligible for substantial discounts. The IRS distinguishes limited partnerships that hold securities and other investment assets from a real estate partnership or a partnership that carries on an active business. In the former case, assuming that there is substance to the FLP, that formalities are observed and that administration is meaningful and consistent, the IRS will grudgingly give a discount in the 15% area, while in the case of a more active and meaningful partnership (for example, one engaged in the ownership and management of real estate or the operation of a business), the IRS has accepted discounts of 35% or more on audit.

Potential Benefits Of An FLP

FLPs are used by families and their advisors to accomplish a wide variety of legitimate family objectives, including the following:

1. An FLP allows for a pooling of family resources that lets everyone enjoy investment diversification and economies of scale.
2. It allows for centralized management and control over what can be a diverse portfolio of family assets.
3. As a partnership, it allows flexibility in planning and structure not available through a corporation, trust or other business entity.
4. Assets such as real estate can be held in an FLP (or even reconsolidated in one), so the fractionalization occurs when the interests in the FLP are handed out, and not in the underlying asset. This can preserve the value of large or important assets, particularly real estate.
5. FLPs can provide significant asset protection benefits to the partners.
6. FLPs can ease the burdens of administration and reduce the costs in probating an estate, because there is only a single partnership interest instead of many separate assets in the estate.
7. There are federal estate and gift tax benefits in an FLP, including potential valuation discounts based on lack of control (the "minority interest" discount) and lack of marketability (the "marketability" discount).
Disagreements are the spice of life: In the words of Mark Twain, "It is not best that we should all think alike; it is a difference of opinion that makes horse races."  

At the moment, this particular disagreement makes for one heck of a lot of tax court litigation.

A Brief History Lesson

If the IRS does not like FLPs-and it does not-it has no one to blame but itself. The agency invented the "FLP era" in 1993 when it issued Revenue Ruling 93-12, which ruled that minority discounts could be appropriate even for interests in a family controlled entity. Not surprisingly, taxpayers and their advisors scooped up Revenue Ruling 93-12 and ran with it as far and fast as they could. Taxpayers contributed property to FLPs, then gave away, sold or otherwise transferred the FLP interests, often claiming discounts of 35%, 45% or even 55% or more.
The IRS responded initially by attacking the concept of discounts. However, it was not on solid footing because, almost inherently, a minority interest in an FLP lacks both liquidity and control. In these early cases, the IRS took a repeated body slam to the mat.

In recent years, however, the IRS has started attacking FLPs with different theories, particularly its favorite weapon, Code Section 2036-the brass knuckles in the IRS' arsenal. The IRS developed two distinct arguments under this provision. First, it argued successfully in several cases that FLP assets were properly included in a decedent's estate because, while the ownership of the assets had been transferred to the FLP, the original owner retained the enjoyment of the assets, either directly or through the tacit cooperation of the family. In effect, if mom and dad gave ownership of an FLP to the children, but then continued to use the partnership assets and to receive all the income from the partnership, the property could be included in the estate.

The second IRS argument, successfully asserted in an instantly infamous case called Estate of Strangi v. Commissioner, was that if a transferor of assets retained the ability to control distributions from the FLP (for example, by directly or indirectly controlling the general partner managing the FLP), then the FLP assets could be included in the transferor's estate. This is a far broader and more controversial interpretation of the law than earlier cases.

Taxpayers and their advisors are nervous about the Strangi case, but so far it is the only case on this point. Further litigation is all but certain.

Withstanding An IRS Half Nelson

An FLP is formed under the limited partnership statute of a particular state. People might choose a state for a variety of factors, but they often pick Delaware because it is very favorable on a number of legal issues. However, if asset protection is a principal objective of the FLP, look for a state (such as Florida) that makes a "charging order" the exclusive remedy for a creditor of a partner. (A charging order gives a creditor certain economic rights, notably the right to receive the partner's share of any partnership distributions, but the creditor does not take legal possession of the partnership interest or become a partner in the partnership.)

An FLP is comprised of one or more limited partners who have no right to participate in the management and at least one general partner who has all management power and authority. Structuring the entity that will act as general partner is an interesting and complicated issue, especially after the Strangi case, because many senior family members who are willing to put assets in an FLP and give away the interests nevertheless want to retain control over the assets (and thus the children).

n general, it is considered bad form to have a property transferor retain direct ownership or control over the general partner (which is often an LLC). A "middle" strategy is to make the general partner of the FLP a single-member LLC owned by an irrevocable trust. The transferor can be a trustee of this trust. The argument is that the fiduciary duties imposed on the senior family member as a trustee may help mitigate the IRS's argument that control has been retained. There is case law that may help support this position. However, a more conservative position (and the one we recommend) would be for the trustee to be someone other than the senior family member/transferor. This family member could then be given the right to remove the trustee and appoint an "independent trustee," to allow for at least some degree of retained control over the trust.

A key issue in structuring an FLP is to identify (and document) the nontax purposes for forming the partnership. Recent case law indicates that there must be a "significant and legitimate nontax purpose" in order for the partnership to be respected (and for the discounts to be permitted). (Some of these common non-tax purposes have already been mentioned.)

The following are some further ideas for structuring an FLP to better withstand IRS challenge: (i) Include assets other than marketable securities, particularly real estate or closely held business entities (but note that if S corporation stock is contributed, the S election is terminated because partnerships are not eligible shareholders of S corporations); (ii) Pool the assets of family members other than the senior family member/transferor; and (iii) Maintain sufficient assets outside of the FLP to provide for the daily living expenses of the senior family member/transferor and enough to pay estate taxes following his or her death.

How to Administer an FLP

The IRS has been particularly successful in "taking down" FLPs when the senior family members signed documents transferring FLP interests to children but then went back to "business as usual," with the transferor effectively controlling the partnership and enjoying the benefit of the assets. The key is to operate the FLP in a manner that demonstrates a serious intention to pursue the business purposes identified in the partnership agreement. Regular meetings should be held, distributions should be made in strict conformity with the partnership interests, and far more than lip service should be paid to the intent and spirit of the agreement. Probably the single biggest weakness that the IRS picks on is not the technical structure of the FLP but the actual administration by the family members.

Finding A Victory In The Ring

FLPs can also be combined with other successful estate planning strategies, and the valuation discounts applicable to FLPs can significantly increase the effectiveness of these strategies. For example, interests can be contributed to a grantor retained annuity trust ("GRAT"). Basically, a GRAT is established for a period of years (say five), and during that period the GRAT must pay back to the grantor/creator of the trust a predetermined annuity amount. Any appreciation in the GRAT assets above a statutorily determined interest rate (the so-called "7520 rate") can be passed on to the beneficiaries (such as the children of the grantor) without triggering any gift or estate tax. The 7520 rate for April 2008 is 3.4%, which is extremely low by historical standards.

Another sophisticated alternative is to use FLP interests in connection with an installment sale to an intentionally defective grantor trust (IDGT). FLP interests may be eligible for discounts, and the use of the IDGT may allow a substantial wealth transfer for estate and gift tax purposes. However, because the trust is a type of trust referred to as a "grantor trust," the sale would not be recognized for income tax purposes, and therefore there would be no current income tax consequences on the "sale." The advantages of this technique include the following:

1. The partnership interests may be correctly and fairly valued at a discount to the underlying partnership property.
2. The interest rate that must be charged (the so-called "applicable federal rate") is generally lower than the 7520 rate, allowing enhanced ability to transfer value to successor generations.
3. The "purchase" of the FLP interest has the effect of freezing the value, and any future appreciation above the applicable federal rate will pass to the IDGT and its beneficiaries free of estate and gift taxes.

The more detailed requirements for structuring a GRAT or IDGT are beyond the scope of this article, but the point is that the ability to conveniently fragment and transfer property ownership through FLP interests creates many kinds of planning opportunities, and the potential availability of valuation discounts may significantly enhance the effectiveness of those strategies.

The IRS clearly has antipathy toward FLPs, and when it looks at one, it sees a red flag, a smoking gun, and an obnoxious Yankees fan, all rolled into one. In short, anytime you combine the letters I-R-S and F-L-P in the same sentence, the result is likely to be anything but D-U-L-L.    


Joseph B. "Jay" Darby III ( [email protected]) is a shareholder at the Boston office of Greenberg Traurig LLP, concentrating his practice in the areas of business and partnership law, tax law, and estate planning.
Paul B. McCawley ( [email protected]) is a shareholder at the Fort Lauderdale office of Greenberg Traurig LLP, concentrating his practice in the areas of estate and trust planning, family wealth preservation, and estate and trust administration.