I spent the third week of January in Orlando at the University of Miami’s Heckerling Estate Planning Conference. This is a top national conference covering estate planning topics, where you will find many eminent attorneys both lecturing and attending. Topics include what’s new in the tax laws, IRS challenges and court cases, and what planning techniques might be used to limit clients’ income, gift and estate tax bills.
Over the next several weeks I’ll be covering subjects that were discussed at this conference. Today I’m going to review recent IRS challenges to family limited partnerships. When I mention partnerships in this article I am also referring to other family business entities, such as limited liability companies (LLCs). Family limited partnerships have been used for several years to centralize the management and control of family assets, and to create a comprehensive estate plan that benefits multiple generations of a family.
Family partnerships are commonly used to own real estate, although they are used to own a variety of different kinds of assets. Typically the senior family members contribute the assets to the family limited partnership, and then the senior family members will gift partnership units to their children and grandchildren.
Estate attorneys and accountants typically then report those gifts at a discounted value from what would have been the value of an undivided interest in the asset itself. The theory behind the discount is that the private partnership units cannot be sold on the open market, as the partnership agreement usually restricts the sale of the partnership units, that the partnership units transferred to the children and grandchildren lack majority control, and that their voting rights are typically restricted.
The IRS frequently challenges the validity of the valuation discounts, sometimes even challenging the validity of the partnership itself. The reason, of course, is to collect more gift or estate tax from the senior family members. Sometimes the IRS challenges the gifts at the time that they are made, but sometimes the challenge doesn’t occur until the senior family member dies. This is why it is important to know what the IRS looks for to limit your family’s exposure. While I cannot, in a short column, highlight all of the issues, there are some common threads appearing in the Court cases:
The partnership agreement is not a “boilerplate” document. There are many choices that must be considered when drafting and implementing a partnership document. Further, the laws are constantly changing, meriting frequent reviews of the partnership document’s provisions as well as the operation of the family partnership. If you have a family partnership or family LLC that hasn’t been reviewed in quite some time, you should consult with competent estate planning counsel to ensure that the agreement is current and that the family is not operating the partnership in a manner that would invite IRS examination.
The IRS will disregard the gifts to the family members and tax the entire value of the partnership assets in the senior family member’s estate if the senior family member(s) continue to exercise dominion and control over the assets as if they were not in the partnership. It is important to follow the formalities of a partnership. An example of family not properly following formalities would include the instance where a senior family member has contributed real estate into a family partnership, but the senior family member continues to reside or otherwise enjoy the real estate as if it were still owned in his individual name.
Death bed transfers of assets into partnerships and subsequent gifts of partnership interests are suspect. There are famous cases that IRS agents like to cite where partnership interests were formed and transfers were made days before the senior family member’s death, and the IRS claimed that the “sole motive” for the transaction was to obtain estate and gift tax discounts. Courts have agreed with this analysis on many occasions. In order to bolster a strong argument that gift and estate tax discounts are proper, the formation and creation of the partnership should achieve a valid business purpose other than reduction of taxes. For this reason it is important to note that family partnerships that contain nothing other than marketable securities are suspect in the eyes of the IRS, and invite scrutiny.
The IRS mostly disregards family agreements establishing a below market fixed price for a partnership unit or for the value of the asset. Many families have learned the hard way that they cannot arbitrarily set a below market price for assets and have that price determinative for federal tax purposes. Internal Revenue Code sections deal with this issue on point, and the IRS successfully challenges such arrangements.
Too much control by the senior family member often sinks family partnerships. In many family partnership arrangements, the senior family member controls the partnership assets, and the children and grandchildren usually just own nonvoting or limited voting partnership units. The IRS has successfully argued to the Tax Court that where the senior family member can “do what he wants” then he still owns the partnership assets for federal tax purposes. In many cases agreements can be redrafted to address this problem.
Even if the partnership was set up properly, its improper operation could lead to problems. In many cases the partnership agreements were drafted properly and the attorneys advised their clients how to properly operate the partnerships. When family members disregard the partnership entity, fail to record partnership meetings and transactions, comingle personal assets with partnership assets, and make distributions outside of the partnership agreement, then the IRS has a good chance of challenging the partnership.
Disproportionate distributions to senior family members can sink a partnership. Some of the cases won recently by the IRS include facts where the senior family members contributed most of their assets into a family partnership, and the partnership made disproportionate distributions to those senior family members often so that the senior family member will have sufficient resources to pay their everyday expenses. Sometimes, in a rather transparent effort to conceal the distributions, the family or their advisors would engage in creative accounting booking the distributions as “loans”. Needless to say, that doesn’t often work.
These are just a few of the major points addressed in some of the sessions. If you have a family partnership, meet every so often with competent estate planning counsel to ensure that your family entity is up to date and that you are operating it in a way that will not encourage IRS scrutiny.