Recent Developments #3

Recent Developments – Estate Planning Issues

Estate Tax Planning with FLP’s

We can expect to achieve excellent estate tax benefits as well as asset protection advantages with a properly designed FLP or LLC structure.

It has been established that many FLP (or LLC) planning techniques, together with a knowledgeable estate planning attorney, can substantially reduce or eliminate estate taxes in a variety of circumstances . The legal discounting of the value of a gift of the limited partnership interests, by as much as 40%, when combined with other available techniques, has clearly taken the bite out of the estate tax. With few exceptions, the IRS has been unsuccessful in its legal attacks against these benefits.

However, since these techniques produce such favorable tax results, the IRS and the courts are creating fairly specific rules to follow in order to achieve the available benefits.  Recent cases demonstrate the anticipated lines of attack from the IRS as well as the suggested structure necessary to preserve a favorable result. The problems usually arise over the issue of whether the creator of the FLP has retained an impermissible level of control over supposedly “gifted” assets.

Annual Exclusion

In Hacki v. Commissioner (18 T.C. No. 14 (March 2002) the Tax Court held that based on the language in the limited partnership agreement, the gift of a limited partnership interest did not qualify for the annual gift tax exclusion. To understand the background, you probably know that you are allowed to make a gift each year of up to $11,000, without creating a gift tax. You can make these gifts to any number of people you wish.  It is a good way to reduce the size of your estate and minimize future estate taxes. FLP’s are a good technique for this because of the discounting applied to the value of the gift.

The caveat to the rule is that in order to qualify for the annual exclusion, the gift has to be a “present interest.” You have to give something that has some value immediately to the donee. A cash gift of $11,000 certainly qualifies since the donee can take that money and spend it. However, if you give your child an interest in an FLP what is he going to do with it?  It can’t be sold and the child has no right to management. Although it may have value in the future, it is not worth much today. Let’s face it. That’s probably why you gave it to him in the first place.

In response to this case, for clients intending to use their FLP for maximum estate tax benefits, we make sure that the language in the Family Limited Partnership Agreement provides the donee child with enough current value to insure that the gift qualifies for the annual exclusion. This is not difficult and doesn’t compromise the control exercised by the client, but the terms of the agreement must satisfy the holding of the case in order to accomplish the intended result.

Disallowed Discount

In the case of Albert Strangi (TC Memo 2003-45 rem’d by 293 F3d 279 (5th Cir. 2002)) the Tax Court disallowed the claimed discount on the grounds that the founder retained too many powers over supposedly ‘gifted’ partnership assets.  The FLP made disproportionately large distributions to the founder and ultimately paid his estate taxes and other expenses, ignoring the legal interests of the limited partners. In spite of the legal format of the structure, the founder continued to treat all assets as his own and to maintain complete power and enjoyment over the “gifted” assets.  The limited partners enjoyed no benefits or protection of their rights under the plan as operated.

When a Family Limited Partnership is intended to serve as a vehicle to avoid substantial estate taxes, several hundred thousand dollars or more, the conservative approach suggests that we include a third party, to protect the rights and interests of the limited partners. Sometimes we use the third party as a trustee of a trust that holds limited partnership interests for other family members. Some financial institutions, trust companies and accounting firms have established specialized “Family Limited Partnership Groups” to handle valuation questions and “control” issues.  The additional fees for these services (ranging from modest to expensive) can be weighed against the amount of available tax savings (and additional asset protection) to determine whether this is a sound economic approach.