Family Limited Partnerships

Family Limited Partnerships By Robert J. Kiggins, Esq. of McCarthy Fingar, White Plains, NY Presented on June 10, 2005

INTRODUCTION • How does FLP work as wealth transfer planning mechanism • Primarily a discounting mechanism for transfers of property interests • Example client has 100,000 shares of Microsoft and wants to gift 10,000 shares to a junior family member (e.g. son) • At $25 per share this would be a $250,000 gift • However, if client gifts the MSFT to Family LLP or LLC and son has only 10% interest in the LLP the value of the gift may well be less than $250,000 on account of minority interest discounts. • Example client owns 100,000 shares of auto dealership (“Auto’) worth $2.5 M and wants to transfer these at death to son at discounted value for estate tax • Pre-death sets up LLP • Transfers 99,000 Auto to LLP for 99% capital interest • 1,000 Auto sold to son for FMV of $25K and son puts them into LLP for 1% capital interest • Son Runs LLP as GP • At death, client’s 99% LLP interest (assume $25 per share) will be valued at less than $2,475,000 (99,000 x $25) • Reason: lack of control discounts

What Else Does FLP Accomplish • It May be A Way to Prevent Family Business from Breakup through Splintering • It may also provide some protection from creditors (limited liability) • May offer economies of scale • May be a way of dealing with family disputes • However, the discounting effect is the one that we will focus on today

Rationale for Discounts • Minority or Lack of Control Discounts: • Business ownership is a bundle of rights. • A controlling co-owner may obligate other owners. • Elements of control may include • appointment of management and determination of compensation; • deciding articles, bylaws and policy making/changing acts; • acquire and liquidate assets; selection and termination of business relationships; • liquidate, dissolve, sell out or re-capitalize company; sell or acquire treasury shares; • register for a public offering • and declare and pay dividends

Rationale for Discounts • The distinguishing characteristic of a partial interest is co-ownership. • This co-ownership can diminish benefits • due to lack of control and liquidity • may eventually entail disputes among owners, which may only be resolved through the expensive process of litigation. • Once any of these rights are encumbered, it is likely to have an impact on value. • Unless there are special laws in place • a controlling partnership interest is worth much more than a non-controlling one; • especially, an assignee interest with no voting rights. • In the absence of such control, a discount is often taken for the inability to unilaterally influence the business or its investment performance. • This is often referred to as a non-controlling or minority discount. • Also these interests tend to be unattractive and difficult to market • These discounts can be significant and are supported by various market studies and case precedent

IRS Attacks • IRS attacks are currently being made under §2036(a) • which pulls back into decedent’s estate transfers: • where decedent retained income interests (Sec 2036 (a) (1)), or • where decedent retains right to direct beneficial enjoyment of income of transferred property (Sec 2036 (a)(2) • In a series of cases courts held that decedent in connection with FLP’s had retained an income interest in the transferred assets • Also some of these cases held decedent had right to direct beneficial enjoyment

IRS Attacks • Estate of Strangi v. Commissioner, 115 TC 478 (2000), aff’d in part and rev’d and remanded in part, 293 F.3d 279 (5th Cir. 2002) (known as Strangi I) and Estate of Strangi v. Commissioner, T.C. Memo. 2003-145 (May 20, 2003) (known as Strangi II). • Facts • Decedent’s son-in-law, an estate planning attorney who also held the decedent’s power of attorney, formed an FLP two months before decedent’s death. • After formation, the son-in-law transferred about $2 million of decedent’s assets to the FLP in exchange for decedent’s receipt of a 99% limited partnership interest. • Decedent also received a 47% interest in the corporate general partner, which owned 1% of the partnership,. • Decedent’s children received 53% the corporation’s shares • But then gave a 1% share to a charitable foundation. • The partnership agreement gave the general partner the sole discretion to determine distributions. • Decedent used partnership assets to pay for personal expenses, including nursing care. • At his death, decedent’s FLP interests comprised more than 96% of his estate. • Decedent’s estate tax return included the 99% limited partnership interest, but with a 43.75% discount for lack of marketability and minority interest.

IRS Attacks • The IRS determined a deficiency in estate and gift tax • Largely on the basis that the decedent’s interest in the FLP should have been increased for estate and gift tax purposes. • The Partnership itself was a restriction under Section 2703 which should be disregarded • The IRS claimed, in part, that Code Sec. 2036(a) ought to apply: • to assets the decedent had transferred to the FLP • due to his retained interest in, and control of those assets. • The Tax Court in Strangi I as to Sec. 2703 held that the FLP was valid under state law: • because the entity complied with all necessary formalities, and • because the partnership had sufficient substance to be recognized for tax purposes. • However, the Tax Court did note that it was skeptical of the non-tax avoidance reasons for formation of the FLP. • The Tax Court refused to consider the Code Sec. 2036(a) issue because the IRS had asserted the issue too close to the trial date. • The Fifth Circuit upheld the majority of the Tax Court’s findings, but remanded on the 2036(a) issue.

IRS Attacks • On remand, in Strangi II, the Tax Court: • held that Code Sec. 2036(a) applied to assets transferred by decedent to the FLP • because decedent implicitly retained economic benefit from the transferred property - 2036(a)(1), • including the right to receive the income therefrom. • Also decedent impliedly kept right to designate persons who would enjoy beneficial use of the property – Sec 2036(a)(2) • Thus, the decedent’s entire 99% limited partnership interest and 47% interest in the corporate GP was included in his estate without discount • Crucial to the court’s decision under 2036(a) (1) were the following facts: • Decedent died two months after the FLP was created; • Decedent transferred substantially all of his assets to the FLP; • Decedent’s attorney-in-fact controlled the FLP; • FLP assets were used for decedent’s personal expenses; and • No other partner had a meaningful economic interest in the FLP. • Decedent, through his attorney-in-fact, retained the right to determine who would benefit from the assets and the income generated therefrom. • Implied agreement existed among the partners of the FLP to allow the decedent to retain the use and enjoyment of, or the income from, the underlying assets.

IRS Attacks • Crucial to the court’s decision under 2036(a) (2) were the following facts: • The decedent acting with others could have the partnership liquidated • If all the LP’s and the GP agreed • GP could consent to a P/P liquidation if all shareholders voted for it • Decedent acting with co-shareholders could control P/P Distributions

IRS Attacks • Note: full inclusion of all P/P assets was required under Sec. 2036(a)(2) • CF: under Sec 2036(a)(1) only pro-rata inclusion would normally be required • Example - if a trust is created by X, and X retains the right to received 2% of the trusts income, then, only 2% of the trust corpus is included in X’s gross estate under 2036(a)(1)

Stone Case - Bona Fide Sale • Estate of Stone v. Commissioner, TCM 2003-309 • FACTS • The Estate of Stone examined five family limited partnerships • formed just two months prior to the death of Mr. Stone and six months prior to the death of Mr. Stone's wife. • At the time of Mr. Stone's death, he held the majority of the general partner and limited partner interests in each of the family limited partnerships as follows: FLP #1 - 69.973% (inclusive of a 1.001% general partner interest) FLP #2 - 94.877% (inclusive of a 1.003% general partner interest) FLP #3 - 94.485% (inclusive of a 1.002% general partner interest) FLP #4 - 95.300% (inclusive of a 1.003% general partner interest) FLP #5 - 91.144% (inclusive of a 1.003% general partner interest)

Stone Case - Bona Fide Sale • The day prior to the formation of the partnerships, small undivided interest gifts were made to each of the Stone's children. • Each partnership held different real properties and other assets, including some preferred stock in the family operating company. • On the date of formation, each of the Stone children received, in return for their respective contributions, small general partner interests. • In each case, just enough general partner interest was provided to Mr. Stone such that he held a simple majority of the general partner interests. Ms. Stone held only limited partner interests. • The estate tax returns were filed claiming, in aggregate, 43-percent lack of control and lack of marketability discounts on Mr. Stone's interests. • Moreover, four of the five partnerships made non-pro rata distributions to the estate for the direct purpose of paying Mr. Stone's estate tax. • It took the IRS only three months from the estate tax filing to pick up the estate of Stone's §706 for audit.

Stone Case - Bona Fide Sale • Issue • both parties agreed a transfer took place, • the Court's decision hinged on whether or not • the transfer qualified under the bona fide sale exception to §2036, a • if not did the decedent retain possession or enjoyment of, or the right to income from, the property transferred

Stone Case - Bona Fide Sale • Bona Fide Sale Exception The IRS asked the Court to rule there was not a bona fide sale, in part, because: • ..a transfer is a sale for adequate and full consideration only if that received in exchange is "an adequate and full equivalent reducible to money value." Treas. Reg. §20.2036-1(a) (cross-referencing Treas. Reg. §20.2043-1(a)) • The average 43-percent valuations discounts claimed on estate tax returns, and the stipulated discounts to be applied in valuing Decedents' limited partner interests in the event the Court concluded that section 2036(a)(1) was not applicable • show that Stones admittedly do not consider interests in the Stone LPs to be the "full equivalent reducible to a money value” of the proportionate amount of the underlying assets Decedents contributed to the partnerships • Court rejected to the IRS argument: • Mr. Stone and Ms. Stone received respective partnership interests in each of the Five Partnerships the value of which, taking into account appropriate discounts, was less than the value of the respective assets that they transferred to each such partnership, they did not receive adequate and full consideration for the assets transferred.

Stone Case - Bona Fide Sale • IRS argument in effect read out of section 2036(a) the exception for "a bona fide sale for an adequate and full consideration in money or money's worth" in any case • where there is a bona fide, arm's- length transfer of property to a business entity (e.g., a partnership or a corporation) • for which the transferor receives an interest in such entity (e.g., a partnership interest or stock) that is proportionate to the fair market value of the property transferred to such entity and • the determination of the value of such an interest takes into account appropriate discounts. • In reaching its decision, the Tax Court explicitly considered the following facts: • Each member of the Stone family was represented by his or her own independent counsel • Each member had input into the decision-making as to how each of the Five Partnerships was to be structured and operated and what property was to be transferred to each such partnership. • The Stone family understood that Mr. Stone and Ms. Stone would not be bound by any agreements that the children were able to reach as a result of the children's negotiations and that Mr. Stone and Ms. Stone would make the ultimate decision as to which, if any, of their respective assets to transfer to each of the Five Partnerships (i.e. the kids weren’t running the show)

Stone Case - Bona Fide Sale • - The Stones did not transfer "all their respective assets to such partnerships. Instead, they retained sufficient assets to enable them to maintain their respective accustomed standards of living." • - the respective transfers at issue did not constitute gifts by Mr. Stone and Ms. Stone...." (i.e., the transfers in exchange were pro-rata) • All partners of each of the Five Partnerships held respective partnership interests in each such partnership that were proportionate to the fair market value of the assets that such partners respectively transferred to each such partnership; • the respective assets that the partners of each such partnership transferred to each such partnership were properly credited to the respective capital accounts of such partners; and • upon the termination or dissolution of each of the Five Partnerships, the partners of each such partnership were entitled to distributions from each such partnership in amounts equal to their respective capital accounts. • The transfers were motivated primarily by investment and business concerns relating to the management of certain assets of Mr. Stone and Ms. Stone during their lives • the Five Partnerships had economic substance and operated as joint enterprises for profit through which the children actively participated in the management and development of the respective assets • there was a genuine pooling of property and services

Stone Case - Bona Fide Sale • the partnerships were formed such that it was "contemplated and intended that each such partnership operate as a joint enterprise for profit for the management of its assets and the children contribute services in providing such management. • after the funding of [the partnerships, the respective children] actively participated in the management of the assets of such partnerships.“ • Court concluded • the respective transfers of assets by Mr. Stone and Ms. Stone to each of the Five Partnerships were for adequate and full consideration in money or money's worth. • Moreover, "we find, that unlike the transfers involved in Estate of Harper and other cases factually similar to that case, the respective transfers at issue by Mr. Stone and Ms. Stone did not constitute 'circuitous 'recycling' of value.'" • Retention of Possession or Enjoyment Finally, because the transfers met the bona fide sale exception to §2036, it was not necessary for the Tax Court to consider whether the decedents retained the right to "possession or enjoyment of, or right to income from, the transferred property" under §2036(a)(1).

Estate of Bongard v. Commissioner, 124 T.C. No. 8 (2005) • Facts • Decedent created an irrevocable trust in 1986 • Funded with some stock in his closely-held company, Empak. • The trust made several distributions of stock to its beneficiaries between 1991 and 1994. • Empak redeemed the stock as it was distributed, so that the beneficiaries would have cash • As part of a plan to make Empak attractive for outside capital (a “corporate liquidity event”), the decedent formed a LLC on December 28, 1996. • The decedent and the trust transferred all of their stock in Empak to the LLC holding company. • The LLC had Class A units and Class B units. • There were Governing and Financial classes of the Class A and Class B units, • Only the Class A units had voting rights. • Decedent’s son was chief manager subject to a “Member Control Agreement”

Bongard – Cont’d • Member Control Agreement • Chief Manager was not granted sole decision making power over allocation of distributions • Chief Manager power over accounting decisions limited if Class A disagreed • 2 Days later (on 12-30-96) Empak Directors were Changed • Chief Manager did not vote on this although LLC was sole Empak shareholder • Decedent and Trustee of the 1986 Trust voted on this • The next day (on 12-29-96), the decedent formed an FLP, • Transferred all of his Class B units in the LLC to it in exchange for a 99% limited partnership interest. • The 1980 irrevocable trust transferred some of its Class B units in the LLC to the FLP in exchange for a 1% general partnership interest. • This was part of decedent’s estate plan and not a necessary step in the business plan • A gifting mechanism to family but without deterring them from working hard and becoming educated • Protection of estate from creditors • Greater flexibility than trusts

Bongard – Cont’d • The decedent created a Children’s Trust and Grandchildren’s Trusts in late December 1996. • He subsequently transferred enough of his Class A units in the LLC to those trusts so • He held only a minority of the Class A units of the LLC. • About one year later (on 12-10-97), the decedent gave a 7.72% limited partnership interest in the FLP to his wife. • Less than one year later than that (on 11-6-98), the decedent died unexpectedly on a combined hunting/business trip to Austria. • IRS on ET Return Audit • $52M deficiency • EMPAK stock transferred to LLC included in D’s estate because D had retained rights in the stock

Bongard – Cont’d • Court Holdings • Bona Fide Sale Exception Applies To Formation Of LLC. • Decedent’s transfer of his Empak stock to the LLC satisfied the bona fide sale exception to §2036 • the decedent possessed a legitimate and significant nontax reason for the transfer (i.e. part of the plan for the “liquidity event”) • because he received LLC interests proportionate to the value of the property transferred to it. • Bona Fide Sale Exception Does Not Apply To Formation Of FLP. • Decedent’s transfer of his LLC Class B units to the FLP did not satisfy the bona fide sale exception. • No significant non-tax motive • No real continued gifting plan • Holding company already provided protection from creditors • No evidence that holding LP interest provided extra flexibility than holding LLC ouright • Implied Agreement For Retained Enjoyment Cause §2036(A)(1) Inclusion ForFLP Assets. • An implied agreement existed whereby the decedent retained the benefit of the LLC Stock transferred to the FLP

Bongard – Cont’d • Court found Decedent kept control: • Decdnt controlled whether FLP could transform LLC stock into cash • Decdnt as CEO and sole director of Empak controlled timing of stock redemptions for cash • He didn’t cause underlying Empak stock to be redeemed thereby assuring that FLP would not engage in asset management • Dissent’s Attack on Section 2036(a)(1) Analysis. • A separate opinion points out alleged weaknesses of the majority’s §2036(a)(1) analysis. • The opinion concurs as to the LLC issue, but dissents as to the FLP issue. • Only 3 of the 17 judges agree with dissent view • it will tough in the future to defend against a §2036(a)(1) claim in the Tax Court if the bona fide sale for full consideration exception does not apply. • Seems like the case had good facts to defend against a §2036(a)(1) attack. • The court found an implied agreement giving the decedent continued enjoyment of the FLP assets • despite the fact that the decedent never received ANY benefits whatsoever from the FLP for the balance of his lifetime, • indeed the court acknowledged that the decedent did not need the FLP assets to maintain his standard of living. • The only factored to support the existence of an implied understanding was the purported ability of the decedent to control cash flow to the entity. • Control over cash flow to the FLP does not logically lead to the existence of an implied understanding as to how the cash would be used once it reached the FLP

Bongard – Cont’d • Application of Discounts. • The court’s decision that §2036 does not apply to the creation of the LLC, and the refusal to bring back the underlying LLC assets (i.e., the Empak stock) into the estate means that discounts attributable to the LLC were allowed. • The parties stipulated that if §2036 did not apply to the transfers to the LLC, • a 13% lack of control discount • and a 17.5% lack of marketability discount (or a seriatim discount of 28.23%) would apply to the Class A units owned by the decedent, • and an additional 5 % lack of voting rights discount (for a total seriatim discount of 31.82%) applied to decedent’s ownership of the Class B units in the LLC, that were directly owned or that were included in decedent’s estate under §2036 as to the FLP. • The LLC discounts generated a total reduction of the gross estate by almost $42.6 million.

FLP Planning Considerations • Existing FLP’s – It is likely crucial for existing entities to consider restructuring • Eliminate right of potential decedent to vote on liquidations and distributions • Inter Vivos Gift • But potential gift tax • Also Sec 2035 would disregard if made within 3 years of death • Reclassification • Two classes • One has all vote and liquidation rights • Other class has no such rights

FLP Planning Considerations (Cont’d) • Amendment not produce gift because potential decedent owns all limited partnership interests and still possesses all pre- amendment voting rights • If the interest carrying voting rights was small (e.g. .5% of FLP) then likely no gift tax will be produced • Incomplete Gift Trust • Transfer the voting and liquidation rights to a trust under which potential decedent has right to change beneficiaries • The theory is that retained modification would mean no gift • However, as Trustee now has the rights potential decedent avoids inclusion of those rights • Property in trust still in estate – but subject to discount

FLP Planning Considerations (Cont’d) • Section 2035 will generally defeat any of these strategies if they occur within 3 year of death • But in case of sale for full consideration Section 2035 bona fide sale exception might be useable • On account of valuation rules (i.e. the sale needs to be for the value of corpus not just life estate which inflates the estate of the selling partner) this likely only works in context of sale to spouse • Example • Ptr with 98% LP interest and virtually all of GP with each carrying voting rights that would trigger no-discount rules of Strangi and Bongard • Assume P/P Assets worth $20M but have a discounted value of $15M.

FLP Planning Considerations (Cont’d) • Partner sells interests for discounted value of $15M (no gift) • However, doesn’t work if death w/n 3 years as case law requires sale be for full $20M for full consideration exception to Sec. 2035 • So, to meet the full consideration requirement of Sec 2035 Partner would have to inflate his estate by $5M and receive a taxable gift of $5M from his purchaser • If however, in the $20M scenario the purchaser is the spouse of the partner there is no taxable gift, and no Sec 2035 inclusion • The selling partner’s estate is still inflated by $5 M but the spouse estate is at the same time reduced by $5M which offsets and preserves the discount of the couple.

FLP Planning Considerations (Cont’d) • Formation • For “Pooling of Interests” Bona Fide Sale Exception to Sec. 2036 • All family members contribute property to FLP • Each receives a P/P interest equal in value to contribution • Keep in Mind • Case law requires a “business purpose” • Each contributing partner needs to use independent wealth (otherwise step transaction will be asserted by IRS) • Some concern that not all of potential decedent’s contribution would be deemed by IRS as included in his/her capital account – thus there is risk of a gift

FLP Planning Considerations (Cont’d) • Restriction on Voting Rights • The essential idea is for the potential decedent to not have voting rights re liquidations and distributions • This avoids Sec. 2035 as well • Issues: • Gift on Formation – reduces value of what potential decedent receives back for his/stock • Some clients will balk at this lack of control • Variations • Transfer of Control to Spouse • Use of Incomplete Gift Trust

FLP Planning Considerations (Cont’d) • Other Considerations • Eliminate distributions to the contributing potential decedent partner • Contributing potential decedent partner needs to maintain sufficient assets to live on outside of the FLP • Personal use assets should not be contributed (residences, cars) • Formalities must be observed – no conmingling of assets

Parting Thoughts • In FLP’s one size does not fit all – careful tailoring is required • This is a dynamic area legally – cases not totally consistent – many may still be appealed - stay alert • If when all is said and done, taxes seem to be the only reason for the FLP, the Courts will strain to “do equity” and disallow the discount

Thank You! • If You Have Further Questions Contact: Robert J. Kiggins, Esq. McCarthy Fingar Tel 914-946-3817 Ext. 251 Email rkiggins@mfdds.com

Family Limited Partnerships