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Charitable Family Limited Partnerships
Last week, the PGDC published an article by Michael V. Bourland on the traditional and prudent uses of family limited partnerships. This week, Stephen R. Leimberg explores a variation on the family limited partnership -- one with a charitable twist. But is the "charitable" family limited partnership a prudent plan or an evil twin?
"We all seek the Holy Grail-like chalice from which all who drink will be given large and lasting income tax deductions at little or no cost. But that chalice will be hard to find within the Charitable Family Limited Partnership concept!"
Charitable Family Limited Partnerships: The Promises
Imagine a concept that enables you to obtain a large income tax deduction, generate a largely tax-sheltered capital gain on the sale of business and investment assets, create and retain a strong and steady stream of income, and pass on substantial wealth to your family members at little, if any, gift or estate tax cost.
Its promoters tout that it does all these things and is even better than a CRT since the deduction is higher, the stream of income is potentially greater, the gift you make, unlike an outright gift which once made is gone forever, comes back to your family (and is worth more than when you gave it) forever, and within a few short years (unlike the case where a CRT is used) the charity is out of the picture, and it's the client's family who receives the wealth rather than the charity, and all that family wealth is shifted, at little if any gift or estate tax cost.
Step 1: You create a FLP comprised of a general partner's interest and one or more levels of limited partnership interest(s).
Step 2: You put business and other appreciated assets and cash into the FLP.
Step 3: You, as general partner, retain a management fee for operating the partnership. The fee ranges from 3 to 10% of asset value. This enables you to keep all or most of the firm's cash flow, or trickle out a token amount to limited partners at your whim.
You also retain, as General Partner, the right to borrow partnership assets for personal needs at competitive interest rates.
Step 4: You make a gift of (say) 97% of the limited partnership interests to one or more qualified charities. This generates a large current income tax deduction (however, the charitable income tax deduction valuation process considers the fact that even at 97% of all the limited interests in the FLP, the interests conveyed carry limited control and almost no marketability, and must therefore be discounted considerably).
The charitable gifts carry a "put" enabling the charity to force a buy-back of the limited partnership interest, but at a very significant discount from its value when it was received by the charity. For instance, the charity may be given an option to "put" its interest back to the partnership or to the other partners in five to eight years, but at a small fraction of its value.
Step 5: You make a simultaneous gift of the remaining 3% of the FLP's limited partnership interest to your children and/or grandchildren. The gift tax valuation of these interests also takes into account the lack of control and marketability and so a relatively large gift tax valuation discount may be taken.
Step 5A: To fund the deferred buy-out, life insurance on the donor's life is purchased. The partnership itself splits the premium dollars with an irrevocable trust that represents the interests of its beneficiaries, the 3% limited partners. Indirectly, since the charity holds 97% of the partnership's limited interests, the charity is helping to pay insurance premiums. In other words the charity is funding the bulk of the premiums that will be used to buy itself out.
In one variation on the theme, the charity's "put" enables it to sell its interest to the irrevocable life insurance trust (yes, the same ILIT its dollars have been helping to fund the life insurance that will be used to buy out its interest at a discount). The trust would then receive the partnership interest with a stepped-up basis.
Step 5B: If there is a sale of partnership assets during the donor's life and before the charity exercises its right to demand a purchase of its interest, approximately 97% of the gain is attributable to the charitable partner, so the client's family pays tax on only a small fraction of any gain.
Step 6: At the specified "put" date, the charity exercises its option to force a purchase (at pennies on the dollar) of the limited interests the charity was holding. It receives cash in return for the interest, which has been sold back, either (a) to the partnership itself or (b) to the 3% owners. This brings the family business and other holdings of the FLP (together with any appreciation on relatively untaxed capital gains sheltered by the charity's tax free status) back into the control of the family.
What's Wrong With This Picture?
Here we go - again! All the parties to this scheme know from inception that this is not a charitable gift, an action of detached disinterested generosity.
Everyone knows, and intends, that this is yet another re-run of the "Let's Make a Deal" show. Charity, you'll get a "play-along" fee in return for allowing Mr. and Mrs. "Angry Affluent" to receive a large charitable deduction for their "gift" (even though they have relatively little charitable intent here). We all know this arrangement is designed to disproportionately benefit Mr. and Mrs. A and their family and facilitate their personal estate planning objectives.
This is yet another classic example of using a charity to serve a private rather than public purpose. If personal economic goals were not a substantial element, why not merely give the charity an outright gift of the FLP limited partnership interest?
An IRS Blueprint
There are at least three specific roadblocks the IRS will place in the way of a current deduction:
- The intent of the parties from inception is based on the unwritten, but very real, understanding between the parties that after a relatively short period of time, the charity will sell its interest back to the partnership or the other partners, and receive nothing more than pennies on the dollar.
Here's a (simplified) "best case" (from the taxpayer's viewpoint) IRS position:
- Say the interest may have really been worth $1,000,000 and a deduction taken for $700,000 (after a 30% reduction for lack of control and marketability).
- Assume the charity sells it back five years later under the "put" to the partnership or other partners for the pre-specified price of, say $100,000.
- Assume also that each year for the five years, the partnership distributed $10,000 a year to the charity as its share of the FLP's distributions.
The IRS could easily argue that what the charity received at the time of the contribution was the sum of --
the future value of a right to receive the put price of $100,000 in five years at a reasonable discount rate, plus
- the present value of a stream of $10,000 payments for five years at a reasonable discount rate.
No matter what reasonable discount rate is assumed, when you crunch the numbers, the sum of the two real rights the charity is being given fall far below the $700,000 deduction actually taken. Clearly, at best, the difference would be disallowed and appropriate interest and penalties would be imposed.
A more likely IRS approach is that there is no allowable income or gift tax deduction. The IRS will argue that what the "donor" gave here is in reality a possible, but certainly uncertain, stream of dollars over a period of years followed by a "balloon" (remainder) payment.
Since this "partial interest" gift is not in the form allowed by the Code (e.g. not a CRT or remainder interest in a home or farm), there is no Code-based sanction for a deduction. The result of a disallowance of the income tax deduction is obvious. But consider the implications of the disallowance of the gift tax deduction; the entire value of the transfer to the charity, less any allowable annual exclusion, would be taxable!
Although promoters may argue that the "put" is merely an option and that there was never a legal obligation for the charity to sell (and therefore the contribution of the 97% interest in the FLP must be respected), consider the probability that parties, particularly the donor, would never have entered into the transaction had it not been contemplated from inception that the charity would have no practical choice but to exercise its put.
This is just like the CSD concept in that promoters are hoping to obscure the substance of the overall plan with a focus on each step of the form. Yet the IRS and the courts will put the pieces of the puzzle together and view it as a whole, since the taxpayer here would not enter into any portion of the transaction unless it was contemplated that the whole would work. (Again, if the transaction was intended merely to benefit charity, why not a Palmer-like outright "no strings attached gift?")
If the transaction is viewed in its entirety, the intent of the promoters and the client becomes obvious. The combination of the --
generous management fee reserved by the "donor," when added to
the overvalued deduction valuation, on top of
- the underpayment for the partnership interest that was, just five years previous to its intended resale to the "donor's" partnership, valued much higher (and the fact that the "put" in no way is grounded on an objective or reality-based formula) must lead a court (as well as any other intelligent and honest observer) to the conclusion that the transaction was something very different than a contribution solely for the benefit of a public charity.
Certainly, the spirit, if not the letter, of the private inurement and private benefit rules have been violated. This is clearly not a gift for the exclusive benefit of the charity or its intended beneficiaries.
Certainly, under "intermediate sanctions" regulations, if the donor has been a substantial contributor to the charity or he/she or their family is/are for some other reason considered "disqualified persons," that is, persons who by their relationship with the charity, have a direct or indirect power over the decisions of the charity or a position of trust vis a vis its actions, they will be severely penalized for any "excess benefit" transaction. Here, both an unjustifiable management fee and the underpayment to the charity at the time of the put could easily result in harsh excise taxes, in addition to the normal interest and penalties.
The Bottom Line
When promoters use form to obfuscate substance and when the exemptions of a charity are exploited to achieve private objectives, expect problems. I have never known a client who was happy to have his name on a well-known case.
The "I'm Different" Defense
You'll hear, of course, many promoters claiming, just as they did in Charitable Split Dollar, "I'm different." "My variation will work even if other "more greedy" versions will not."
You'll hear about an "I'm different" version where --
- the management fee is lower,
- the FLP's payout to the charity is higher,
- the charity gets a better deal on the sell-back, or
- the charity's money isn't used to finance the buyout of its own interest.
One Last Time
The central issues to focus on are:
Is the arrangement you are examining a transfer representing "detached disinterested generosity" or an incredibly great deal for the charity and a relatively negligible benefit for the donor (deductible), or is it a take-it-or-leave-it deal in which the major beneficiary is the "donor" (nondeductible)?
Is the gift of the right to uncertain income for a period of years followed by a balloon payment (the "put") a partial interest gift (nondeductible)?
- Are both the original transfer to charity and the buy-back from the charity REALLY valued at arms' length (O.K.) or are (or can) valuation games being (be) played? The deduction, if any, will be limited to the real and measurable value of what the charity gets at the date of the original transfer.
The less in it for the donor and the more for the charity, the better the odds.
At the very least, --
it has to be a true charitable gift,
it must be a gift of the donor's entire interest, and
- there must be the total absence of the ability to play games with valuation.
If any one of these elements is missing, you have an invitation to litigation.
And giving the charity "something," a "go along with the deal" fee, is not good enough. It's not enough that the charity ends up with something other than an empty bag. Throwing the charity a bone, in return for a lopsided benefit, was not what Congress had in mind when it created the income tax deduction for gifts to charity.
To paraphrase the brilliant authors (G. Quintiere and G. Needles) of an article entitled, THE EVOLVING EDGE OF THE SPLIT DOLLAR ENVELOPE (Benefits Law Journal, Vol. 9, No. 1, Spring 1996):
"Determining the edge of the Charitable FLP envelope is a lot like the study of geometry; they both start with theorems of pristine simplicity - and gradually progress - to caverns of complexity."