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The Family Limited Partnership
Need a primer on family limited partnerships? In this edition of Gift Planner's Digest, Ft. Worth attorney Michael Bourland discusses 10 reasons to use family limited partnerships. Topics include valuation discounts -- navigating the Chapter 14 rules -- real and possible IRS challenges -- drafting, formation, and operation -- and how family limited partnerships can be used to facilitate charitable gifts.
by Michael V. Bourland
with Kenneth L. Wenzel, Christina S. Woods, Michelle White
For many years, the family limited partnership has been used as a vehicle to own and manage family property or family business enterprises. In the past few years, the family limited partnership has come under intense scrutiny from the Internal Revenue Service (IRS) as they view the family limited partnership as primarily a discount tool for the estate planning practitioner. Due to the focus by the IRS and practitioners on the discounts in family limited partnerships, many practitioners have not considered the other uses for the partnership, such as to minimize state franchise taxes, to provide management control to the parent generation, to provide limited liability for its partners, and even in some situations, marital property protections. For many practitioners, the partnership has been viewed as an alternative to a trust for holding and managing assets. As outlined below, there are multiple reasons for selecting the family limited partnership as a planning tool, including 10 that we believe are relevant in many family situations.
10) Limitation of Payroll Taxes.
9) Accumulation of Wealth.
8) Family Training in Management and Growth of Assets.
7) State Taxes/Income Tax Flexibility.
6) Valuation Discount.
5) Consolidation of Assets.
4) Asset Protection-Inside & Outside of FLP.
3) Separate Property Maintenance/Pre-Martial Planning.
2) Continuity of Management.
1) Control, Control, Control.
(And you thought Letterman had the corner on Top Ten Lists!)
9) Accumulation of Wealth.
8) Family Training in Management and Growth of Assets.
7) State Taxes/Income Tax Flexibility.
6) Valuation Discount.
5) Consolidation of Assets.
4) Asset Protection-Inside & Outside of FLP.
3) Separate Property Maintenance/Pre-Martial Planning.
2) Continuity of Management.
1) Control, Control, Control.
(And you thought Letterman had the corner on Top Ten Lists!)
Valuation Of The Family Limited Partnership Interests
One of the more appealing aspects of a family limited partnership is a client's ability to make transfers of limited partnership interests (through gifts or otherwise) to his or her descendants on a leveraged basis due to valuation discounts that are customarily associated with transfers of limited partnership interests. Valuation discounts are attributable to a family limited partnership interest because the characteristics of a limited partnership interest generally cause the interest to be less valuable than the value of the underlying assets of the family limited partnership. In many situations, the discounts are consistent with discounts attributable to a minority interest position in a corporation.
The cornerstone test for determining the value of a limited partnership interest, and the percentage of valuation discount to be applied on a transfer of a limited partnership interest, is the amount a willing buyer would pay to a willing seller for the subject property (i.e., the limited partnership interest and not an interest in the underlying asset), where neither the buyer nor the seller is under a compulsion to buy or to sell and both the buyer and the seller have reasonable knowledge of the relevant facts of such transfer. [Treas. Reg. § 20.2031-1(b)] Under the "willing buyer/willing seller" test the proper focus should be on the value of the property transferred rather than on the value of the transferred property in the hands of the transferee following the completion of such transfer.
Valuation Methods. In determining the fair market value of a limited partnership interest, an appraiser must consider both the net asset value of the limited partnership, and the net income/cash flow generated by the assets of the limited partnership. In both the net asset value approach and the income approach, the appraiser would need to take into account the distributions to the partners as allowed by the terms of the limited partnership agreement. The powers of the general partner regarding distributions to the partners of the limited partnership, as well as the history of the actual distributions made to the partners of the limited partnership will be considered in valuing the limited partnership interest under either method.
The income approach to the valuation would take into account the current earnings and cash flow of the limited partnership as well as projected future earnings and cash flow of the limited partnership over a specified period of time. The income and cash flow approach to valuations is normally used where the limited partnership activity is an active, operating business as the value of the limited partnership's business is based more on the income and cash flow generated from the assets of the limited partnership as opposed to the value of the assets held by the limited partnership. It is important to note that the amount of discount that can be taken from the value of a limited partnership interest determined from the income approach may be limited where a partner's return on his or her capital contribution to the limited partnership is significant.
The net asset value approach would involve the determination of the fair market value of all of the assets owned by the limited partnership reduced by the aggregate value of all of the liabilities of the limited partnership. The net asset value approach is normally used where the limited partnership's value is based on the value of its assets (normally passive type assets, i.e., real estate, publicly traded securities, etc.) as opposed to the income generated from those assets owned by the limited partnership.
There are incidences where an appraiser would choose to use both the income approach and the net asset value approach in determining the limited partnership's value (i.e., an oil and gas limited partnership). In such instance, an appraiser would then attribute a reliability factor to the value of each approach (as each approach applies to the specific limited partnership) in order to arrive at the value of the applicable limited partnership interest.
Once the limited partnership's value is determined using one or both of the above two methods, the appraiser could then apply two discounts to the value of the subject limited partnership interest. These discounts are as follows: 1) a "lack of control" or "minority interest" discount, and 2) a "lack of marketability" discount. The IRS has recognized both of the above-referenced discounting principles. As mentioned above, substantial and/or frequent distributions to the partners of the limited partnership, as well as substantial income generated by the assets of the limited partnership, may restrict the amount of discount that can be taken from both the net asset value approach and the income approach in determining the value of the subject limited partnership interest.
The lack of control or minority interest discount is applicable to limited partnership interests due to a limited partner's limited voting rights with respect to the partnership's business and management. Typically, a limited partner would have very limited voting rights within the partnership, and the voting rights the limited partner has are usually reserved to extraordinary items affecting the partnership's business and operations such as: 1) the merger or the dissolution of the partnership; 2) the selling of assets that constitute all or substantially all of the partnership's assets; 3) the removal or admittance of a general partner; 4) the admittance of an additional limited partner; and 5) the amending of the partnership agreement. Summarily, a limited partner would normally have: 1) no voice in the management of the partnership's day to day business; 2) no rights or interests (to partition or otherwise) in the partnership's underlying assets; 3) no power (or a very limited power) to withdraw from the partnership; 4) no power to compel distributions from the partnership; and 5) restrictions placed on the partner's ability to transfer his or her limited partnership interest. These limited voting rights make the limited partnership interest substantially less attractive to a hypothetical willing buyer under the "willing buyer/willing seller" test. The amount of the minority interest discount is dependent upon the amount of distributions made from the limited partnership to its partners, the financial risk associated with the limited partnership's assets, and the terms of the limited partnership agreement.
The lack of marketability discount may apply regardless of whether or not the limited partnership interest transferred actually represents a minority interest in the partnership. The premise for the lack of marketability discount is that the transfer restrictions attributable to the limited partnership interest (whether such restrictions are imposed by the terms and provisions of the partnership agreement or by state and/or federal law) will make the limited partnership interest a less attractive asset than comparative publicly-traded assets under the "willing buyer/willing seller" test. The amount of the lack of marketability discount is determined by comparable sales of restricted stock of publicly traded companies.
Role Of The Appraiser. Due to the recent scrutiny directed by the IRS on transfers of interests in family limited partnership interests, the role of the appraiser in identifying and evaluating the valuation discounts attributable to a limited partnership interest is crucial. It is extremely important that an appraiser be chosen who: 1) is familiar with the nature and structure of the family limited partnership as a family planning tool; 2) routinely appraises family limited partnerships; 3) is familiar with Chapter 14 and state law related to partnerships; and 4) has experience in defending his or her appraisals of the family limited partnership in an IRS audit.
The need for an appraiser should be discussed with the client early on if the client might want to participate in a planned giving program. Also, the appraiser's assistance may be needed in establishing the appropriate values on the assets initially contributed to the partnership in order to substantiate the initial allocation of the limited partnership interest percentages among the initial limited partners. If the appraiser is not qualified or does not specialize in appraising the type of assets contributed to, or owned by the family limited partnership, a separate appraiser may be needed in order to ascertain the value of the underlying assets before the family limited partnership appraisal is prepared.
Timing. There has always been debate among family limited partnership practitioners and appraisers regarding whether time, and if so, how much, should be allowed to pass between the funding of the family limited partnership and when gifts of limited partnership interests are made. In Technical Advice Memorandum (TAM) 97-51-002, issued by the IRS on August 28, 1997, the IRS failed to take issue with the timing of gifts of limited partnership interests. In this instance, an elderly donor made gifts of limited partnership interests on the same day as the funding of the family limited partnership. (The family limited partnership had been created only nine days prior to the funding.) The issue involved in this TAM was whether or not the gifts of limited partnership interests qualified for annual exclusion. It is unclear whether the IRS will ignore the creation of the family limited partnership with respect to gifts of limited partnership interests that are made shortly after the limited partnership is created and attempt to treat the transfers as gifts of undivided interests in the partnership assets. While many family limited partnership practitioners believe that a conservative estimate as to the amount of time that should be allowed to lapse following the family limited partnership's formation and funding until the date transfers of partnership interests are made is three to six months, there is no definitive answer as to the appropriate timing of gifts following the funding of the family limited partnership. An argument can be made that gifts of limited partnership interests can be made within days of the funding of the family limited partnership as many clients would not make gifts of undivided interests in real property or outright ownership of investment assets to their children or grandchildren.
Application Of Chapter 14 To Family Limited Partnerships
Chapter 14 was enacted to provide a more precise set of rules for estate and gift tax purposes for valuing transfers of equity interests in corporations or partnerships between family members. Of the four Sections of Chapter 14 (Sections 2701-2704), only Section 2702 does not have application to the family limited partnership. The application of Section 2701, Special Valuation Rules in Case of Transfer of Certain Interests in Corporations or Partnerships; Section 2703, Certain Rights and Restrictions Disregarded; and Section 2704, Treatment of Certain Lapsing Rights and Restrictions, in the context of transfers of equity interests in family limited partnerships are generally discussed below.
Section 2701. The valuation rules set forth in Section 2701 are a complex set of rules that can entangle the unaware and unwind a carefully drafted estate plan. As such, the summary of the more general rules of Section 2701 outlined below should not be relied upon solely in forming a family limited partnership. Rather, Section 2701 should be carefully reviewed in light of your facts and circumstances to ensure that the formation of the family limited partnership, and subsequent giving of family limited partnership interests does not become another victim of the pitfalls of Section 2701.
Transfers of interests in family limited partnerships that have more than one class of partnership interests (i.e., a senior and a junior partnership interest) may be subject to the special valuation rules of Section 2701. For Section 2701 to apply, the transferor of a partnership interest, or an "applicable family member" of the transferor, must immediately after the transfer hold an "applicable retained interest," in the family limited partnership. An "applicable family member" includes the transferor's spouse, an ancestor of the transferor or transferor's spouse or the spouse of any such ancestor. [IRC § 2701(e)(2)] These rules can apply whether or not the transfer of the interest would otherwise be deemed to be a taxable gift to the family member under Chapter 12 of the Code (i.e., whether or not the transfer is a transfer for full and adequate value). Therefore, a senior family member may not sell a junior preferred interest to a family member in an effort to avoid the application of Section 2701. Additionally, transactions that are not commonly considered transfers of an equity interest, such as contributions to capital or changes in the capital structure of an entity can trigger the special valuation rules of Section 2701. [IRC § 2701(e)(5)] The special valuation rules set forth in Section 2701 do not apply to a transfer of an equity interest if the retained interest is of the same class as the transferred interest, i.e., the interests have identical rights except for non-lapsing rights under state or federal law. [IRC § 2701(a)(2)(B)] Differences in general and limited partnership interests, such as the right to participate in the management of the family limited partnership and limitations on liability of the partners, do not create two classes of partnership interests as such differences are considered non-lapsing rights. [IRC § 2701(a)(2)(B)] Additionally, provisions in the partnership agreement that are necessary to comply with partnership tax allocation requirements under the Code, such as Section 704(b) and Section 704(c), are considered non-lapsing differences as well, and therefore, do not create two separate classes of partnership interests. [Treas. Reg. § 25.2701-1(c)(3)] Based upon the above, the initial question that the practitioner must answer if he/she is considering structuring a family limited partnership with two classes of partnership interests is, "Is the interest that the transferor retains is an 'applicable retained interest' under Section 2701?"
An "applicable retained interest" is any equity interest in an entity with respect to which there is an "extraordinary payment right" or, in the case of a controlled entity, a distribution right other than a "qualified payment right." [Treas. Reg. § 25.2701-2(b)(1)] Thus, if the family member retains a "qualified payment right", Section 2701 will not apply, and there will not be a revaluation of the transferred interest. For purposes of determining the applicability of Section 2701, distribution rights and extraordinary payment rights do not include: 1) mandatory payment rights (that requires the payment be made at a specific time and in a specific amount); 2) liquidation participation rights; 3) guaranteed payments under Section 707(c); or 4) non-lapsing rights. (See Treas. Reg. § 25.2701-2(b) for further explanation of what constitutes an applicable retained interest.) An "extraordinary payment right" is any put, call (that includes any warrant, option, or other right to acquire one or more equity interests), or conversion right, any right to compel liquidation, or any similar right, the exercise or non-exercise of which affects the value of the transferred interest. [Treas. Reg. § 25.2701-2(b)(2)] A "qualified payment right" includes a fixed cumulative dividend on preferred stock payable on a periodic basis, any other fixed cumulative distribution payable on a periodic basis, or any distribution right that the transferor elects to treat as a qualified payment right. [Treas. Reg. § 25.2701-2(b)(6)(i)] Care must be taken to ensure that the distributions that qualify as a "qualified payment right" are actually distributed by the family limited partnership. If a partner dies, or transfers a qualified payment right to another during his/her lifetime, and the qualified payments have not been paid, the taxable estate or taxable gifts of the partner for the year of the transfer will be increased to include such qualified payments that are due and owing plus a sum equal to the hypothetical earnings on such payments. [Treas. Reg. § 25.2701-4]
Valuation Of The Transferred Interest. If Section 2701 is applicable to a transfer of an equity interest in a family limited partnership, the value of the transferred interest is determined by utilizing a subtraction method of valuation more fully described in Treas. Reg. § 25.2701-2. In overly simplified terms, the value of the transferred interest is determined by subtracting the value of any family held applicable retained interests and other non-transferred equity interests from the aggregate value of the family held interests in the partnership. In determining the value of an applicable retained interest under this method, the value of any extraordinary payment right as well as any distribution right (unless such right qualifies as a qualified payment right) is zero. [Treas. Reg. § 25.2701-1(a)(2)] Therefore, if Section 2701 applies to a transfer of an interest in a partnership, the value of the senior interest retained by the transferor is zero and the transferred interest (along with the other non-senior interests held by the transferor and family members) is valued at 100% of the value of the partnership.
Planning Options. The application of the special valuation rules of Section 2701 are avoided by having only one class of partnership interest; however, the formation of a family limited partnership with two classes of partnership interests can serve as a beneficial estate planning tool if structured correctly. Although the intent of Section 2701 is to prevent the use of "estate freeze" partnerships, gifts by the transferor (i.e., parent) of the preferred or senior equity interests to family members (normally children or grandchildren) while retaining the common or junior partnership interests fall outside the application of the Section 2701 valuation rules. The giving of the senior equity interests (with distribution or other extraordinary payment rights) to family members while retaining the junior equity interests provides a possible planning opportunity for "reverse freeze" partnerships. Another planning opportunity in structuring a family limited partnership with two classes of partnership interests is to take advantage of the tax benefits that would arise from giving a portion of the partnership interests to a charity. The family limited partnership could be structured with a senior preferred interest that could be given to a public charity. The preferred payment would provide the charity with cash flow each year, fulfilling the client's charitable inclinations and a fixed principal amount on liquidation (i.e., the charity would not share in the appreciation of the common partnership interest). Additionally, the client would receive a charitable deduction upon the gift of the partnership interest to a charity. Finally, the family limited partnership would also fall outside the application of Section 2704, as there would be non-family members as partners. For a more detailed analysis of the benefits of structuring a family limited partnership with two classes of partnership interests and a charity as a limited partner, see "New & Improved! Drafting Guide to the Family Limited Partnership," Continuing Professional Education and Group Meeting for Estate Tax Attorneys, Baird, Thomas C., March 26-27, 1997.
- Section 2701 does not apply if there is only a single class of limited partnership interests.
- Intent of Section 2701 is to prevent use of estate freeze partnerships or corporations where preferred or senior interest does not have real economic value.
- On gifts by parents to children of junior or common partnership interests, preferred interests must have payments from the partnership that qualify as "qualified payments" in order to avoid the preferred or senior interests being valued at zero, which would result in a higher value on the interests being given to the children.
- Gifts by parents to children of preferred interests while parents retain common interests should not be subject to Section 2701. This provides a possible planning opportunity for "reverse freeze" partnerships.
Section 2703. Section 2703 applies to all transfer restrictions contained within the family limited partnership agreement and has been one of the areas in which the IRS has vigorously pursued the denial of discounts on family limited partnership interests. Section 2703(a) provides that for purposes of the estate, gift, and generation-skipping transfer tax, the value of the property transferred shall be determined without regard to "any restriction on the right to sell or use the property." [IRC § 2703(a)] The right or restriction referred to in Section 2703(a) may be contained within the partnership agreement (that would include any agreement to use, acquire, or sell the property at a price less than full market value) or may be implied in the partnership's capital structure. [Treas. Reg. 25.2703-1(a)(3)] State law restrictions that restrict a partner's ability to withdraw from the partnership, or impede the partner's ability to sell the interest, have been viewed by the IRS as rights or restrictions implied in the partnership capital structure. Section 2703(b) provides a safe harbor from the application of Section 2703(a) by providing that Section 2703(a) shall not apply to any option, agreement, right or restriction that: 1) is a bona fide business arrangement; 2) is not a device to transfer the property for less than full and adequate value to family members; and 3) at the time the right or restriction is created, has terms comparable to similar arrangements entered into by persons in arm's-length transactions. [IRC § 2703(b)] Each right or restriction is tested separately against the three-prong test unless the rights or restrictions are considered integral parts of a single right or restriction. [Treas. Reg. § 25.2703-1(b)(5)] Any restriction that meets the three safe harbor requirements will be considered in determining the value of the applicable partnership interest.
Planning Options. To avoid application of the rules set forth in Section 2703(a), the restrictions on the transfer or use of partnership interests should be structured to be consistent with third-party arrangements. A right or restriction is consistent with third-party arrangements if the terms are arm's length and may have been obtained in a fair bargain between unrelated parties. Certain restrictions such as a right of first refusal, limitations on the ability to pledge partnership interests for third-party debt, and provisions for a buyout of a partner's interest upon a default under the terms of the partnership agreement are consistent with third-party arrangements and have a significant impact upon the valuation of a partnership interest. Additionally, reliance upon state law restrictions on transfers of partnership interests (i.e., assignees' rights) provides an effective means to control the value of the partnership interests.
- Applies to all transfer restrictions in the partnership agreement.
- Designed to prevent the use of buy-sell provisions, options, calls, puts or other transfer restrictions to distort the value of the assets for transfer tax purposes.
Safe harbor for transfer restrictions, if restrictions:
1) are a bona fide business arrangement;
2) are not a device to transfer property to family members for less than full and adequate consideration; and
3) are comparable to similar arrangements entered into in an arm's-length transaction.
- Key in design of the family limited partnership is to use state partnership law restrictions on transfer to control the value of the partnership (assignee rights).
- Other restrictions on transfer or use of ownership interests should be structured to be consistent with third-party arrangements, i.e., right of first refusal, limitation on ability to pledge interest on third-party debt, etc.
Section 2704. Section 2704 is another key provision that should be addressed in forming a family limited partnership. Section 2704 provides that in the case of the transfer of an interest in a partnership to a member of the transferor's family, if the transferor and members of the transferor's family hold control immediately before the transfer then any "applicable restriction" is to be disregarded. [IRC § 2704(a)] An "applicable restriction" is defined to be a restriction that limits the ability of the partnership to liquidate, and such restriction either lapses after a transfer or the transferor and members of his/her family, alone or collectively, have the right to remove the restriction. [Treas. Reg. § 25.2704-2(b)] A restriction is not an applicable restriction if it is not more restrictive than the limitations under state law. [Treas. Reg. § 25.2704-2(b)] Restrictions imposed on the partnership as part of financing or equity participation with an unrelated party are not an applicable restriction for purposes of Section 2704. [Treas. Reg. § 25.2704-2(b)]
Planning Options. One key to obtaining valuation discounts in a partnership is to rely upon the state law restrictions on liquidation and voting rights in the particular state in which you choose to form the family limited partnership. In forming a family limited partnership, the partnership agreement should be structured such that the voting and/or liquidation rights do not lapse upon a transfer of an interest and may not be removed by the transferor or his/her family members. A family limited partnership with individual general partners should have multiple general partners so that the withdrawal of a general partner will not materially impact the voting rights of the partners.
One argument that the IRS has made under Section 2704, and one that the practitioner should be aware of prior to forming a family limited partnership, is that creating a term-of-years partnership creates an applicable restriction under Section 2704. This argument is based upon state law that allows the creation of a family limited partnership with either no set term or a term that is set in the partnership agreement. Pursuant to the law in some states, a limited partner in a family limited partnership with no set term has the right to withdraw from the family limited partnership upon giving six months written notice whereas a term-of-years family limited partnership does not provide the limited partners with any right to withdraw. Therefore, the IRS could argue that the family members, by choosing to form a term-of-years partnership, have removed the limited partners' right to withdraw from the family limited partnership until the end of the term thereby creating an "applicable restriction" that is more restrictive than state law. Recently, several states, including Texas and Delaware, have amended their partnership statutes to remove the limited partners' right to withdraw from a limited partnership whether the partnership is a term-of-years or otherwise. As a result of these amendments, this argument by the IRS is inapplicable to family limited partnerships that are formed under the laws of a state that has removed the ability of a limited partner to withdraw from a family limited partnership, and the practitioner may want to consider forming a family limited partnership under such states' laws to avoid this possible IRS argument.
- Family limited partnership should avoid "lapse" of voting or liquidation rights. Additionally, the partnership should have multiple general partners (if individual general partners) so that the withdrawal of a general partner will not materially impact the voting rights.
- An "applicable restriction" is defined to be a restriction that limits the ability of the partnership to liquidate and such restrictions either lapses after a transfer or the transferor and members of his/her family, alone or collectively, have the right to remove the restriction.
- Restrictions that are more restrictive than state law will be ignored. A restriction imposed by state law is not an "applicable restriction."
- Key in planning a family limited partnership is to rely upon state law restrictions on liquidation and voting rights.
- Restrictions imposed on the partnership as part of financing or equity participation with an unrelated party are not an "applicable restriction."
Real And Possible Challenges To Family Limited Partnerships
The increasing use of family limited partnerships (and the discounts associated with them) as an estate planning tool to transfer family businesses, real estate interests, and investment assets from one generation to succeeding generations has made family limited partnerships of particular concern to the IRS. The IRS, noting what it calls a "rising level of abuse," has made it known that it intends to vigorously pursue valuation issues regarding family limited partnerships. Of particular concern to the IRS are family limited partnerships that are utilized to transfer investment assets to the next generation at a discounted value. The use of the family limited partnership in an investment context, as a means of transferring wealth from one generation to the next has also recently become an issue of concern to the federal government. In a recent series of Technical Advice Memoranda, the IRS has attacked the "death bed" creation of family limited partnerships and disallowed any discounts for the partnership interests under the theory that the formation of the family limited partnership and the disposition of the partnership interests pursuant to the decedent's testamentary plan on his/her death are identical and therefore are treated as a single testamentary transfer. The IRS's position on the "death bed" creation of family limited partnerships to obtain valuation discounts in an estate is not surprising considering the facts of the Technical Advice Memoranda that are described in detail below. What is interesting about this series of Technical Advice Memoranda is that the IRS outlined their attack against the family limited partnerships under Section 2703(a)(2), Section 2703(b), and Section 2704(b)(2) in addition to characterizing the transactions as a single testamentary transaction. Any practitioner involved in an audit with the IRS regarding a family limited partnership should review these Technical Advice Memoranda carefully.
Recent Technical Advice Memoranda
TAM 97-19-006. Two days prior to the decedent's death, her assets, which were held inside two trusts, were transferred into a family limited partnership by her son as trustee of the trusts. The decedent had been removed from life support at the time of the creation of the family limited partnership and the transfer of the assets. The decedent's Will at the time of the transfer, and her subsequent death, divided all of her assets equally between her son and daughter. After the creation of the family limited partnership, one of the trusts sold its limited partnership interests to the son and daughter for cash, and 30-year promissory notes. Upon the death of the individual, the value of the partnership interests in the estate was discounted by 48%.
TAM 97-23-009. The decedent executed a Will leaving all of her assets to her son in November of 1992. In June of 1993, the son had a new estate plan prepared for the decedent that included placing all of the decedent's assets into a family limited partnership; the general partner of which was a corporation that the son controlled. The son transferred the decedent's assets into the family limited partnership in his representative capacity pursuant to a power of attorney. The decedent died two months later and the estate claimed a discount of 46% on the value of the partnership interests owned by the estate.
TAM 97-25-002. In 1990, the decedent became incapacitated due to an auto accident and as a result of his incapacitation, the decedent's son conducted his affairs pursuant to a durable power of attorney and as trustee of a funded revocable trust. Prior to the decedent's incapacitation, he had executed a Will leaving his estate to the revocable trust that allocated a specific bequest of $1,000,000 to his spouse (second wife), and the balance to his two children. In August of 1993, the son formed a family limited partnership and transferred the revocable trust assets into the family limited partnership in exchange for limited partnership interests that were subsequently valued at 62% of the fair market value of the assets upon the decedent's death two months later. The decedent's two children and five grandchildren's trusts were also limited partners of the partnership. The IRS applied the single testamentary transaction argument to this transaction. However, under the decedent's testamentary instruments (his revocable trust), his second wife was to receive a specific bequest of $1,000,000, with the balance of the revocable trust going to his two children. The IRS, in its analysis, referenced that the two children extracted the assets from the revocable trust that they were to receive upon their father's death and conveyed these assets to the newly created family limited partnership. No further explanation was given regarding how the two children were able to only extract the trust assets going to them and the impact of the removal of the assets on the testamentary disposition to the second wife. Additionally, while it was clear that the decedent was incapacitated at the time of the creation of the family limited partnership, there was no discussion regarding whether or not the incapacitation was an imminent terminal condition.
TAM 97-30-004. In this memorandum, the decedent (a widower) entered into a new Will on September 16, 1994, leaving his entire estate to his only son. On September 26, 1994, the decedent was diagnosed with terminal cancer. The decedent and his only child (an attorney who had written an article on the benefits of family limited partnerships) formed a family limited partnership on October 22, 1994, to hold real estate. The general partner of the family limited partnership was a corporation in which the decedent held a 49% interest, the son a 50% interest and a family friend a 1% interest. Decedent was the sole limited partner of the family limited partnership. The partnership agreement vested sole authority to manage the partnership and conduct the partnership business in the general partner. The agreement also provided that a limited partner could not withdraw prior to the termination of the partnership's existence. On October 31, 1994, shortly after the formation of the family limited partnership, the decedent gave several small partnership interests to family members. Decedent died on December 15, 1994, less than two months after he made the gifts. The decedent's estate took a discount of 40% on the value of the partnership interests for lack of control and marketability as the corporation had control of the partnership assets and the decedent could not withdraw from the family limited partnership prior to the termination of its existence. The decedent's estate also took a discount on the decedent's ownership interest in the general partner corporation.
TAM 97-35-003. The decedent had a revocable intervivos trust that held (among other assets) an interest in a liquidating trust containing promissory notes from a partnership that invested primarily in derivative securities. The decedent's son, as trustee of the revocable trust and pursuant to decedent's power of attorney, created a family limited partnership into which he transferred the decedent's assets and a portion of the revocable trust's assets. The partnership agreement provided that the limited partners did not have the right to withdraw from the family limited partnership. However, state law under which the family limited partnership was formed provided the limited partners with the right to withdraw upon six months written notice. The estate of the decedent took a discount of 55% on the value of the family limited partnership interests on the decedent's death. The discount taken by the estate was based upon a comparison with three partnerships engaged in the investment of high-risk equity and debt securities that traded at approximately 45% of their asset value in the secondary market.
TAM 98-04-001. The decedent formed a family limited partnership to which he contributed investment assets and retained general and limited partnership interests. Thereafter, the decedent transferred limited partnership interests to each of his children in trust. The decedent's children also contributed assets to the family limited partnership in exchange for general partnership interests; however, the decedent was named the managing general partner of the family limited partnership. The partnership agreement provided that a general partner could withdraw at any time upon notice to the other partners; however, limited partners did not have the right to withdraw. The partnership agreement also provided that upon a general partner's withdrawal, the general partnership interest of such general partner was to be converted to that of a limited partner if the general partner continued as a partner pursuant to the terms of the partnership agreement. Pursuant to state law, if the general partner withdrew and an event requiring the winding up of the family limited partnership did not occur within a specified time, the withdrawing partner's interest was to be automatically redeemed. The IRS found that the decedent had both a voting right (as the decedent was the managing general partner) and a liquidation right (as the decedent could have withdrawn as a general partner and the partnership would have been forced to redeem his interest or wind up) in the family limited partnership that lapsed upon the decedent's death. The IRS did not address the fact that a general partner's partnership interest was automatically converted to a limited partnership interest under the terms of the partnership agreement. Additionally, the IRS concluded that because of the decedent's right as a general partner to dissolve or withdraw from the family limited partnership, his limited partnership interest had a greater value when held with the general partnership interest than when held alone. The IRS did not address the exact impact the general partner's right to withdraw had on the value of the limited partnership interest. Arguably, the impact on the limited partnership value should be minimal, if any, as the partnership (pursuant to state law) was only required to redeem the general partnership interest not the limited partnership interest.
TAM 97-51-003. A 71-year-old widow (Donor) with no children formed a family limited partnership into which she transferred all of her interest in real property that was jointly owned by her and members of her family. The general partner of the family limited partnership was a corporation that was owned and controlled by the Donor. After formation of the family limited partnership, the Donor made annual exclusion gifts of her partnership interests in varying percentages to her family members. The partnership agreement provided that the general partner had complete discretion regarding the distribution of funds from the family limited partnership, and that the general partner could retain the funds in the partnership "for any?reason whatsoever." Additionally, the partnership agreement restricted the ability of the limited partners (other than the Donor) to transfer their interests in the family limited partnership and restricted the ability of a limited partner (other than Donor) to withdraw from the family limited partnership. The IRS found that the gifts made by the Donor were future interest gifts under the argument that the ability of the general partner to retain funds for any reason whatsoever overrode the general partner's fiduciary duty under state law, and allowed the general partner to withhold income for reasons unrelated to the conduct of the partnership. Additionally, the IRS argued that the restrictions in the partnership agreement that prohibited and restricted the limited partners (other than the Donor) from transferring or assigning their limited partnership interests were further proof that the limited partners lacked the immediate and present benefit of the partnership interests.
IRS Law And Analysis In Technical Advice Memoranda
Single Testamentary Transaction. The IRS disregarded the discounted value placed upon the partnership interests finding that the only discernable purpose for the formation of the family limited partnership was the depression of the value of the assets held by the family limited partnership. In each of the TAMs, the beneficiaries of the assets under the decedent's testamentary instruments were the recipients of the partnership interests. Therefore, as the formation of the family limited partnership and the disposition of the limited partnership interests were consistent with the testamentary documents of the decedent, the IRS ruled that they must be viewed as a single testamentary transfer occurring at the decedent's death. This argument would normally only be applied in the situation where the partnership was created shortly before the death of the transferor.
Lack Of Bona Fide Business Purpose. Section 2703(a)(2) provides that for purposes of the estate, gift, and generation-skipping transfer tax, the value of property shall be determined without regard to "any restriction on the right to sell or use the property." In the TAMs, the IRS interpreted this Section to apply to any restriction regardless of the manner in which the restriction is created, i.e., finding that the right or restriction may be contained in a partnership agreement or implicit in the capital structure.
Section 2703(b) provides that Section 2703(a) shall not apply to any option, agreement, right, or restriction that: 1) is a bona fide business arrangement; 2) is not a device to transfer the property for less than full and adequate value to family members; and 3) has terms comparable to similar arrangements entered into by persons in arm's-length transactions. Therefore, if the restriction satisfies the requirements of Section 2703(b), the restriction is considered in the determination of the value of the partnership interest. In the TAMs in Section V(A)(1) (a)-(g) above, the IRS found that the family limited partnerships were not bona fide business arrangements as the partnership agreements contained restrictions upon the rights of the limited partners to withdraw, transfer their partnership interests, or terminate the partnership's existence. The IRS found it inconceivable that the decedent would have accepted such restrictions upon his partnership interests if he was dealing at arm's length with third parties as such restrictions terminated his complete control over the assets and their income stream. The IRS also found that the family limited partnerships were a device to transfer property for less than full value to family members of the transferor. For this purpose, the IRS (in the TAMs) said a device under Section 2703(b) is "reasonably viewed" as including any restriction that has the effect of artificially reducing the value of the transferred interest for transfer tax purposes without ultimately reducing the value of the interest in the hands of the transferee-family member. Finally, in these TAMs, the IRS found that placing the assets inside the family limited partnership changed nothing of substance regarding the testamentary disposition of the assets as the family members of the decedent received the same interests in the assets they would have received had the family limited partnership not been formed.
"Applicable Restriction" (Section 2704). Section 2704 provides that in the case of the transfer of an interest in a partnership to a member of the transferor's family, if the transferor and members of the transferor's family hold control immediately before the transfer then any "applicable restriction" is to be disregarded. For purposes of Section 2704, an "applicable restriction" is defined as any restriction that effectively limits the ability of the partnership to liquidate, and with respect to which the transferor or any member of the transferor's family has the right, after such transfer, to remove. A restriction is not an "applicable restriction" if it is not more restrictive than the restrictions under state law. The limited partnership agreement in each of the TAMs above restricts the right of the limited partners to withdraw from the family limited partnership. In reviewing these family limited partnerships, the IRS found this restriction upon the right of a limited partner to withdraw to be an "applicable restriction" under Section 2704. In making this determination, the IRS broadened the focus of Section 2704 from restrictions that limit the ability of the partnership to liquidate, to include restrictions that limit the limited partners right to withdraw as a limited partner, and liquidate their respective partnership interest. Interestingly enough, the IRS did not address the fact that these family limited partnerships were term-of-years partnerships and therefore, the limited partners did not have a right to withdraw from the family limited partnership under state law.
Possible IRS Positions
Partnership Business Purpose. One argument that the IRS will raise in its effort to eliminate, or reduce a valuation discount, is that the family limited partnership is a fraud and a sham whose only purpose is that of tax avoidance through the artificial depression of the value of the assets that are placed inside the family limited partnership. Thus, the valuation discounts should be ignored in determining the value of the partnership interests owned by the decedent. To counteract this claim by the IRS, the practitioner should educate his client regarding the non-business reasons for placing his assets inside a family limited partnership. As discussed in the Top 10 List at the beginning of this article, there are multiple business reasons for the family limited partnership structure. Asset protection, marital planning, and the ability to transfer a partnership interest to a family member (rather than a specific investment asset that can be immediately sold and spent, or an undivided interest in real estate that causes difficulty when there are multiple owners and the parties want to sell their real estate) are among the business reasons set forth above. In many situations, once the client understands the control features, the liability protection, and the continuity aspects of the family limited partnership, the additional benefits of a valuation discount become secondary. As a result of these business reasons, the family limited partnership has replaced the use of a trust in many planning situations. As always, the family's argument as to the validity of the family limited partnership as a vehicle to hold the family's assets is weakened if the client does not respect the structure of the family limited partnership and actively utilize the family limited partnership for valid business purposes including educating succeeding generations regarding the management and growth of the family's assets.
Investment Partnership. The most aggressive argument that the IRS will likely make in challenging a valuation discount in a family limited partnership that only holds investment assets is the argument that the use of a family limited partnership as a vehicle for holding liquid assets has no valid business purpose. The IRS takes the position that the contribution of liquid assets to a family limited partnership followed by gifts of limited partnership interests to family members lacks business and investment purpose as the value of the partnership interests received by the transferor is worth less than the assets placed inside the family limited partnership. The basis of the IRS's argument is that the family members are not minority interest holders in any meaningful sense as the entity is controlled by the family group as well as the fact that, to the IRS, it is implausible that an individual would actively reduce the value of his or her estate. Numerous provisions in Subchapter K of the Code reference the investment nature of partnerships and contemplate that a family limited partnership could be set up with the express purpose of holding liquid assets. The use of the family limited partnership to hold liquid assets does serve a valid business purpose in numerous situations in that it allows the client to educate the succeeding, and often spendthrift, generations as to the management and growth of the family wealth. If the family limited partnership consists solely of investment assets, the transferor should be cognizant of the possible application of Section 2703 (i.e., bona fide business arrangement comparable to an arrangement third parties would enter into) when the limited partners do not have any rights to withdraw from the investment partnership. There are many third-party managed investment partnerships across the United States, but very few do not give a limited partner a right to withdraw until the 30- or 40-year-term of the partnership expires. A right to withdraw after a minimal term of years (one to five years), with limitations on the timing and amount of assets that can be withdrawn is more comparable to third-party business investment partnerships, and can aid in providing a long term investment vehicle for family members as it alleviates the fear of the transferor that he/she will not be able to obtain a return of his/her money invested in the partnership.
Section 701 Anti-Abuse Rule. The final regulations for Code Section 701, Anti-Abuse Rule (Rule), were issued on December 29, 1994. The Rule and the subsequent regulations were put in place to ensure compliance with applicable tax law and more specifically in the IRS's view, to stop the use of Subchapter K as a tax avoidance tool. The Rule authorizes the IRS, in certain circumstances, to recast a transaction involving the use of a partnership. The regulation requires that the partnership be bona fide, that the form of partnership transactions be respected, and that the transactions be entered into for a substantial business purpose and properly reflect income. The broad language, together with two examples (Examples 5 and 6 dealing with estate planning) initially led to the understanding that the regulations applied to all federal taxes. On January 23, 1995, however, the IRS stated in Announcement 95-8 that the partnership anti-abuse regulation would be applied only for income tax purposes and would not address the transfer tax implications of partnerships and that Examples 5 and 6 regarding the applicability of the anti-abuse regulations to family partnerships would be deleted. Although at this time, Section 701 is not being utilized by the IRS as a means of challenging valuation discounts, it is always possible that it might be used in future arguments by the IRS regarding family limited partnerships.
Gift Upon Creation. It is clear from the regulations to the Code that a contribution of property in exchange for a pro rata partnership interest in the family limited partnership does not constitute a gift to the other partners upon formation. However, one position that the IRS can take in a case involving family limited partnerships formed by two generations of a particular family, is that the limited partners (typically the succeeding generations) receive a gift upon the contribution of family assets by the mother and father for their interests in the family limited partnership, if the partnership interests received by the family members are not comparable to the value of the contributed property. One way to strengthen the argument that a gift has not been made upon creation of the family limited partnership is for the family limited partnership to only have one class of partnership interests. There may be differences in voting and management rights with respect to the partnership interests (general partnership interest versus limited partnership interests), and to have a consistent method of valuing the assets contributed by each partner to the partnership. Another way to circumvent this argument by the IRS is to form the family limited partnership with the mother and father initially owning all of the limited partnership interests and subsequently making gifts of such interests to the succeeding generations.
Step Transaction Doctrine. The IRS has aggressively pursued the use of the step transaction doctrine to combat what it labels an "abusive use of family limited partnerships." The creation of the family limited partnership and the subsequent gifts of the limited partnership interests are viewed by the IRS as having no effect or purpose other than to reduce transfer taxes and therefore, the transaction should be regarded as a single testamentary transaction. The cases in which the IRS has made this argument have involved unusual fact situations, such as when a family limited partnership is created in the face of the transferor's imminent death, and often times utilizing a power of attorney to transfer the transferor's assets into the family limited partnership. A carefully thought out estate plan that utilizes a family limited partnership as part of the overall plan to transfer family wealth to the succeeding generations in a manner that allows the transferors the ability to educate the succeeding generations regarding the management and growth of the family assets should not be subject to this attack by the IRS.
General Planning/Drafting Considerations
In drafting a family limited partnership agreement, the practitioner should carefully evaluate and address many of the same issues that are faced by the practitioner in the formation of any closely held entity. The major issues to be reviewed with a family are restrictions on transfer, withdrawal/distribution rights, and management powers. Decisions prior to formation need to be made regarding the ability of the owner to give or transfer his/her interests to a third party, including family members, and other buy-sell rights typically contained in a buy-sell agreement for a closely held entity. Additionally, the ability of the owner to withdraw from the entity for full fair market value or receive distributions from the entity are not particular to a family limited partnership, but instead are issues to be addressed in any closely held entity. Finally, the management powers, and allocation of the power among the owners, are issues to be discussed with the family members prior to the formation of the partnership so that the partnership agreement reflects the purposes and intent of the family members. It is important for the practitioner to discuss these issues with the family members and to tailor the partnership agreement to satisfy the business relationship of the family member partners. The fact that these partners are family members, and not third parties, does not change the importance of addressing these issues with the partners as they directly impact the relationship among the family members now and in the future. The family members should understand early on that the partnership is an operational entity structured to satisfy their business goals and purposes for the ownership, management, and operation of assets, and not solely a tool for discounting asset values for gift and estate tax purposes. The following is a discussion of certain provisions of the partnership agreement that should receive careful attention by any practitioner in order to tailor the partnership agreement to the goals and needs of the family members.
Restrictions On Transfer. A key planning issue in all closely held entities is to restrict the ability of a partner to transfer his or her interest outside the group of partners who formed the partnership. All transfer restrictions that impact the value of the partnership interest will be tested against the requirements of Section. One of the general tests of Section 2703 is whether or not the restrictions are commercially reasonable. Therefore, any restrictions on the transfer of a limited partnership interest should be applied against this standard if the practitioner intends for the restriction to impact the partnership interest value. Any restriction that does not satisfy this Section 2703 standard will be ignored for purposes of valuing the partnership interest.
Section 7.02 of the Texas Revised Limited Partnership Act provides that, unless otherwise provided by the partnership agreement, a partnership interest is assignable in whole or in part. Further, Section 7.02 provides that unless the assignee becomes a partner, the assignor partner continues to be a partner, and to have the power to exercise any rights or powers of a partner except to the extent those rights or powers are assigned to the assignee. The assignment of a partnership interest under the Texas Revised Limited Partnership Act does entitle the assignee to be allocated income, gain/loss, deductions, credit, or similar items, and to receive the distributions to which the assignor was entitled, to the extent those items were assigned.
There are normally three general types of restrictions on assignment contained in a partnership agreement:
- an overall restriction on the right to assign the interest;
- a right of first refusal granted to the partnership and/or the other partners to purchase the interest being sold to a third party on the same price and terms of the third party offer; and
- specific buy-out rights to the partnership and/or the other partners upon an event of default by a limited partner in violation of the terms or provisions of the partnership agreement.
It is common for a partnership agreement to provide that a partner cannot transfer his/her interest in the partnership other than as provided in the partnership agreement. This is consistent with the intent of partners in a closely held entity to control who they are partners within a business relationship.
Consistent with the partners' desire to control with whom they are partners, it is normally very common to provide the partnership and/or the other partners a right of first refusal on any attempted sale or transfer of a partnership interest by a partner to a third party. A right of first refusal will normally give the partnership and/or the other partners a right to purchase any interest sold by a partner to a third party on the same price and terms offered by the third party. A properly drafted agreement will normally give the partnership a right, exercised over a 30- or 60-day-period, to step into the shoes of the purchaser and purchase the partnership interest being sold in order to maintain ownership of the partnership interests among the existing partners. If the partnership, or the other partners, do not exercise their option to purchase the partnership interest being sold the selling partner would be entitled to sell his/her interest to the third party and the third party would become an assignee of the partnership interest.
Finally, most partnership agreements require the limited partner to satisfy certain obligations and responsibilities related to his/her ownership of a partnership interest and duties to the partnership. These obligations and responsibilities could include a restriction not to pledge his/her partnership interest to a third party, a requirement that the partner make additional capital contributions to the partnership upon a call by the general partner or a restriction upon the limited partner's ability to transfer or convey his/her interest other than as allowed in the partnership agreement. If a partner violates the terms of the partnership agreement and is in default of his/her obligations or responsibilities under the partnership agreement, the partnership, and/or the other partners, can be granted a right to purchase the defaulting partner's interest, normally at a reduced price. The reduced price could take into account the costs, expenses, and damages suffered by the partnership due to the default of the partner and could also contain a limitation on the value paid by the partnership for the defaulting partner's interest (i.e., a percentage of the fair market value or a price that is based upon the partner's unadjusted capital account). Such restrictions on value should be carefully evaluated by the practitioner to determine whether they are in compliance with the commercially reasonable requirements of Section 2703.
Withdrawal Rights. Again, in Texas, prior to 1997, a limited partner had a right to withdraw from the partnership under Texas law and receive fair market value for his partnership interest unless the partnership was a term of years partnership. This caused most practitioners to structure family limited partnerships as a term of years partnership to limit the limited partner's right to withdraw from the partnership. One argument advanced by the IRS was that the selection by the family members of a term of years partnership was a restriction of a partner's right to withdraw and liquidate his or her interests, and therefore should be ignored in valuing the limited partnership interest under Section 2704. In 1997, Section 6.03 of the Texas Revised Limited Partnership Act was amended to provide that a limited partner may only withdraw from a limited partnership at the time, or on the occurrence of an event, specified in the partnership agreement, and then only as allowed in the partnership agreement. Therefore, if the partnership agreement is silent as to the withdrawal power of a limited partner, the default provisions of Texas state law provide that a limited partner does not have the right to withdraw from the limited partnership; therefore, the state law exception to the application of Section 2704 is applicable and Section 2704 does not apply to the limitation on a limited partner's right to withdraw from the partnership.
Restricting a limited partner's right to withdraw from partnerships containing business or investment assets other than public securities or cash is a common occurrence in order to avoid having to liquidate real estate or other operational assets to purchase a limited partner's interests. However, it is not unusual in investment partnerships (i.e., partnerships with publicly traded securities) to give limited partners limited rights of withdrawal upon the occurrence of certain events or on an annual basis. This limited right of withdrawal is normally provided to a partner in order to allow the partner the ability to recognize a return on his/her investment and opt out of the investment philosophy of the investment partnership. Therefore, in structuring a family investment partnership, the practitioner should consider giving the limited partners a right of withdrawal in certain situations. There are numerous reasons for considering this type of provision. First, a family investment partnership normally involves multiple family members contributing investment assets to a partnership in order to receive the benefit of diversification of assets, professional management of a larger portfolio, shared management costs, and spread of the investment risk. If the limited partner cannot withdraw all or a portion of his/her interest and "cash it in," it can disrupt family harmony if one or more of the family members do not approve of the investment strategy of the managers. Secondly, a limited right of withdrawal can increase the status of an investment partnership as a viable operating entity and not a tool solely used for discounting limited partnership interests for estate and gift tax purposes. This can be helpful in nullifying the IRS arguments regarding the application of Section 2703, as well as the overall business purpose arguments advanced by the IRS, against the family investment limited partnership. Any withdrawal rights should be weighed against the purposes and intent of the family members in setting up the family investment partnership.
In some cases, the partners want a commitment of an initial term of years, whereby the partners will agree to let the managers manage the assets without any right to withdraw and cash in the limited partnership interest. Once an initial period has expired, the limited partners can have a right to withdraw a percentage of their partnership interests on an annual basis, so that over a period of a few years a limited partner would be able to liquidate his/her entire interest.
Of course, only a partner should be entitled to exercise this withdrawal right; an assignee of a partnership interest should not be entitled to exercise any withdrawal rights as to the limited partnership interests received by the assignee. In this manner, a creditor who obtains a partnership interest as an assignee would not be entitled to exercise the withdrawal right. The practitioner should carefully review and discuss these withdrawal rights with the family members to ensure that they are comfortable with the limited partner's right to withdraw assets from the partnership in the selected circumstances, and to ensure that it is consistent with their overall plan for the management and distribution of the investment assets in the partnership.
Distribution Powers. In deciding on the type of distribution powers for a particular partnership, there are multiple issues a practitioner should consider. First, will the general partner be required to distribute part or all of the income of the partnership each year? In certain partnerships it is important to the partners that the general partner be required to make a mandatory distribution equal to the anticipated income taxes on the partnership income (usually based on the highest individual income tax rate). In other partnerships, it is the partners' desire that the income of the partnership be reinvested for growth purposes. There is no right or wrong distribution plan for the partnership; the distribution plan should reflect the desires of the partners. Once the plan is determined, however, there are limits on how broad or strict the distribution powers should be structured.
In TAM 97-51-003, the IRS argued that the general partner's power to withhold distributions was so broad that a gift of limited partnership interests did not qualify for the annual exclusion exception. Pursuant to the partnership agreement, the general partner could retain partnership funds for any reason whatsoever, and the IRS argued that this broad provision overrode the fiduciary duty of the general partner, and did not allow the limited partners to receive the immediate benefit of their partnership interests, i.e., the benefit was a future interest gift due to the broad powers of the general partner to withhold funds. On the other hand, requiring mandatory distributions by the general partner could impact a partnership's ability to fulfill its purposes and also could cause the partnership to lose its creditor protection features.
Whichever distribution plan is selected, there should be limitations on the ability of the general partner to make distributions from the partnership in excess of the income or net cash flow of the partnership. The practitioner should be careful that he/she does not give the general partner such broad distribution powers that the general partner is able to effectively liquidate the partnership over a period of a few years. By granting the general partner such broad distribution powers the practitioner could markedly impact the discounting available for any limited partnership interest owned by the general partner.
Assignee Interests. Family limited partnerships are closely held entities and, as such, restrictions should be placed on the ability of a partner to transfer his or her interest in the partnership. One mechanism to limit the ability of a partner to effectively transfer all of his/her right and interest in a partnership to a third party is to provide that on any transfer of a partnership interest, the transferee is only an assignee.
The partnership agreement should either be silent as to the rights of a transferee of a partnership interest or provide a specific mechanism for a transferee to become a limited partner, and not an assignee. The partnership agreement should not provide that a transferee would automatically become a substituted limited partner because a judgment creditor only has the rights of an assignee of the partnership interests; therefore a judgment creditor will not have the rights of a limited partner. Additionally, for valuation purposes, an assignee limited partnership interest is less valuable than a full partner limited partnership interest.
General Partner Considerations. The selection and structure of the general partner (i.e., individual, solo individual general partner, multiple individual general partners, S corporation, or limited liability company), is probably the most critical issue to address with clients as the decision will impact the control of the partnership during the founders' lifetime and the succession plan for the partnership after death. Additionally, the use of individual general partners can cause complications upon the death of the general partner, and if there is only one general partner, it can cause dissolution of the partnership and impact the valuation of the partnership interests. Forming a partnership with a single individual general partner is not recommended as the death of the individual general partner, with no remaining general partner, will usually cause the dissolution of the partnership under state law unless all of the partners agree to continue the partnership within 90 days of the death of the individual general partner. This can impact the valuation of the limited partnership interest. Additionally, the IRS has attempted, in the past, to argue for smaller discounts on limited partnership interests owned by the general partner under the theory that through control as a general partner, he/she has control over his/her limited partnership interest. When there is only one individual general partner, this argument could gain credibility, especially as to a limited partnership interest in an individual general partner's estate. If the partnership agreement is silent as to the continuation of the partnership after the individual general partner's death, then one theory that could be advanced by the IRS on the death of the general partner, is that any limited partnership interest in the estate should be valued as though the partnership will be liquidated after the death of the general partner as the partnership will dissolve under state law unless all of the remaining partners agree to continue the partnership. Therefore, the estate of the deceased general partner technically has the ability to force the liquidation of the partnership by agreeing not to continue the partnership.
In Texas, having multiple individual general partners alleviates this issue to some extent as the Texas Revised Limited Partnership Act provides in Section 8.01(3)(A) that, if there is one remaining general partner after the death of a general partner, the partnership will continue its business if the partnership agreement permits the business to be carried on, and the remaining general partner agrees to do so. There is still some question as to the impact on the valuation of a limited partnership interest when the partnership agreement provides for the partnership to continue. It is unclear what impact the death of a single individual general partner, or the death of one general partner when there are multiple general partners, will have on the valuation of the partnership interest. These issues will not be answered until there is case law addressing these issues.
One mechanism to avoid the problems related to the death of an individual general partner is to have an entity as the general partner of the partnership, i.e., an S Corporation or limited liability company. A limited liability company is becoming the preferred general partner for family limited partnerships due to the creditor protection features of limited liability companies (i.e., the transferee of a membership interest in a limited liability company is treated similarly to an assignee under partnership law), the favorable tax treatment of limited liability companies versus S Corporations and the ability to name managers to basically a lifetime term (i.e., not restricted by annual elections). The selection of managers for a long term is a feature normally preferred by the senior members of a family and is similar to the selection of a general partner for the partnership (i.e., a manager is selected to serve in that capacity until removed "for cause" or death). Additionally, successor managers can be pre-selected so that there is a set succession plan for management of the limited liability company, and therefore, management of the partnership. In some partnerships, we will provide for each child of the senior generation to be a manager of the limited liability company once the parents are deceased. Thereafter, even after the child's death, the child's family group can select one person from their group to represent the child's family group's interest. In this manner, the limited liability company can serve the interests of the family group through multiple generations, and it can continue to act as general partner of the partnership with a succession plan selected by the senior generation. A well-planned continuity of management scheme for the family limited partnership gives the partnership a chance to survive and continue as a viable entity through the second and third generations of the founder's family.
General Partner Management Fee. It is important that the general partner receive reasonable compensation for the services performed on behalf of the partnership. Section 704(e) of the Internal Revenue Code requires that partners providing services on behalf of the partnership be properly compensated for such services in order to avoid a shifting of income and benefit to the other partners. Additionally, compensating the general partner adequately for his/her services is consistent with the operation of a partnership among non-family members. The practitioner must be careful that the management fees paid to the general partner are reasonable based on third-party standards. Otherwise the partnership could lack the business attributes applicable to a business partnership, and the IRS may argue that a gift has been made to the children (if no or little management fee is charged) or that a partial gift has been made by the children (if a larger than reasonable management fee is charged to the partnership).
Practical Considerations In Forming And Operating A Family Limited Partnership
Partnership Classification/Check-The-Box Proposal. In 1960, the IRS issued Treasury Regulation Section 301.7701-1-4, which sets forth the criteria for the classification of unincorporated organizations as associations, partnerships, or trusts. The regulations were written with a bias against partnerships. They were based on the "corporate resemblance" test of Morrisey v. Commissioner, 296 U.S. 344 (1935). Formerly, the practitioner had to be cognizant in drafting the partnership agreement of the rules regarding classification of the partnership for income tax purposes. In order for the partnership to be classified as a partnership, it was required to have two non-corporate characteristics. The four corporate characteristics that were reviewed in determining this classification issue were: 1) continuity of life; 2) centralization of management; 3) limited liability; and 4) free transferability of interest. On March 29, 1995, the IRS announced that it was considering a proposal to allow all entities, other than state law corporations, to elect whether to be classified as a partnership or as an association taxable as a corporation. [Notice 95-14, 1995-14 I.R.B. 7] Thereafter, on May 10, 1996, the IRS issued Proposed Treasury Regulation Section 301.7701-3 dealing with the check-the-box proposal. The regulations became final on December 17, 1996, and do away with the corporate resemblance classification test of Morrisey. [Treas. Reg. § 301.7701-2 and -3]
Under the check-the-box regulations, an unincorporated organization or other business entity is an "eligible entity" if it: 1) is recognized for federal tax purposes as an entity separate from its owners; 2) is engaged in business; and 3) is not a trust or a per se corporation. [Treas. Reg. § 301.7701-3] An eligible entity with two or more members may be classified and taxed either as a partnership or as an association that is taxable as a corporation. If the entity does not make an affirmative election as to its tax classification, its classification is determined under certain grandfather provisions applying to entities existing on or before January 1, 1997, or certain default provisions for entities formed after December 31, 1996. [Treas. Reg. § 301.7701-3(b)] A pre-1997 entity, which has two or more members (a domestic business entity that is not a trust or per se corporation), remains the same as it was under the prior regulations (if the entity had a reasonable basis for its claimed classification) and need not file an election in order to maintain its tax status. [Treas. Reg. § 301.7701-3(f)(2)] A post-1996 entity, which is a domestic business entity that is not a trust or a per se corporation and that does not make an election, is taxed as a partnership. [Treas. Reg. § 301.7701-3(b)]
Investment Company Partnership. As a general rule, under Section 721(a) no gain or loss will be recognized by a partner on a contribution of property to the partnership in exchange for a partnership interest. [IRC § 721(a)] However, Section 721(b) provides that the non-recognition rules of Section 721(a) do not apply to gain realized upon a contribution of property to a partnership that would be treated as an "investment company" (within the meaning of Section 351) if the partnership was incorporated. (See Treas. Reg. § 1.351-1(c)(1) for the definition of an "investment company.") Prior to the Taxpayer Relief Act of 1997, a partnership would be deemed to be an investment company if, after the partners' contribution, more than 80% of the value of the partnership assets (excluding cash and non-convertible debt obligations) were held for investment and consisted of readily marketable stock or securities or interests in Regulated Investment Companies (RIC) or Real Estate Investment Trusts (REIT). For Section 721(b) to apply, the contribution must result, "directly or indirectly, in the diversification of the transferor's interest." However, Proposed Regulation Section 1.351-1, which was issued on August 10, 1995, provides that a transfer of investment assets to a partnership will not be treated as resulting in diversification of a transferor's interests if each transferor transfers a diversified portfolio of assets within the meaning of Section 368(a)(2)(F)(ii). Pursuant to Section 368(a)(2)(F)(ii), a diversified portfolio of assets exists if not more than 25% of the value of the transferor's total assets is invested in the stock and securities of any one issuer and not more than 50% of the value of the transferor's total assets is invested in stock and securities of five or fewer issues.
The Taxpayer Relief Act of 1997 retained the above-described definition of an investment company, but expanded the definition of what constitutes "property" transferred to an investment company. Money, stock, and other equity interests in a corporation (whether public or private), evidences of indebtedness, options, forward or future contracts, notional principal contracts, and derivatives, metals (unless used in an active trade or business after the contribution), interests in a RIC or REIT, common trust funds or publicly traded partnerships, or other interests convertible into the above listed assets, are all considered property for purposes of applying the 80% investment company test. The IRS has regulatory authority to add other assets to the list. [IRC § 351(e)(1)]
Liabilities Upon Contribution. As a general rule, no gain or loss is recognized either to the partnership or to any of its partners upon a contribution of property, including money, to the partnership in exchange for an interest in the partnership. [IRC § 721(a)] However, if the property being contributed to the partnership is subject to a debt or encumbrance, caution should be used prior to contributing the property to the partnership. If the debt or encumbrance exceeds the adjusted basis of the property, the contributing partner may recognize gain depending on his/her share of the liabilities of the partnership. The regulations under Section 752 set forth complex rules with respect to determining a partner's share of partnership liabilities. The factors for determining a partner's share of partnership liabilities include, but are not limited to: 1) the type of liability, i.e., recourse v. non-recourse; 2) outside risk sharing agreements between the partners and/or partnership; and 3) the type of partnership interest held by the partner (limited or general). Under Section 752, a partner's share of liabilities is determined upon contribution by netting the increase in the partner's share of partnership liabilities with the decrease in such partner's share of partnership liabilities. [Rev. Rul. 79-205, 1979-2 C.B. 255] The adjusted basis of the partner's partnership interest is impacted by the shift of liabilities. An increase in a partner's share of partnership liabilities is treated as a contribution of money to the partnership. However, if such partner's share of liabilities upon contribution has decreased, such reduction shall be treated as a distribution of money to the partner under Section 731. To the extent a distribution of money (or relief of liability) exceeds the adjusted basis of such partner's partnership interest, the partner will recognize gain. Upon the contribution of property by the partners, the partner's basis is adjusted upward by an amount equal to the adjusted basis of the property contributed and the partner's share of partnership liabilities, and adjusted downward by the amount of any debt or encumbrance to which the property is subject.
Caution should also be used in contributing property to a partnership if the liability to which the property is subject is greater than the fair market value of the contributed property as the contribution may be treated as having no economic effect to the contributing partner. The IRS may also re-characterize the transfer of the property to the partnership as a gift of a partnership interest to such partner, a transfer of an interest to the partner as compensation or a deemed sale of the encumbered property by the partner to the partnership under Section 707. Additionally, Section 752(c) will be applicable to the transfer of property to a partnership if the liability to which the property is subject is in excess of its fair market value. Section 752(c) provides that "a liability in which property is subject shall, to the extent of the fair market value of such property, be considered as a liability of the owner of the property." Therefore, for purposes of computing a partner's basis in his/her partnership interest, the partnership liabilities will only be taken into account to the extent of the fair market value of the property contributed to the partnership.
Additionally, before a partner contributes encumbered property to a partnership, the loan documents with respect to the liability should be reviewed by the practitioner to determine the effect of any transfer restriction upon the property. Many loan documents provide that a transfer of the applicable property without first obtaining the consent of the lender will be a "default" under the loan documents.
Income Tax Operation Issues
Partnership Formalities. The IRS, in auditing family limited partnerships, first attempts to determine whether the partnership is a separate entity with a valid business purpose. As part of this review, the IRS would normally review whether the family members have followed partnership formalities. Such formalities would include:
Compliance With State Law Filing Requirements: A limited partnership should file a certificate of limited partnership with the applicable Secretary of State's office prior to commencing business or funding the partnership. Additionally, if the limited partnership is engaged in business in another state, the limited partnership should register as a foreign limited partnership in the applicable state.
Partnership Agreement Among The Partners: The partners should enter into a written limited partnership agreement to govern the terms of their relationship. The limited partnership agreement should contain certain key provisions, including but not limited to, setting forth the partnership interests of the partners (general and limited), the required capital contributions of the partners, the term of the partnership, management, and voting issues with respect to activities of the partnership, transfer and buy/sell restrictions regarding partnership interests, and withdrawal rights of a partner. Each partner should sign the partnership agreement. Additionally, if buy/sell restrictions are to be applicable to a spouse's interest, the applicable spouse should sign a spousal consent.
Bank Accounts/Brokerage Accounts: The general partner should open a checking account in the name of the partnership with the cash contributed to the partnership at the time of its formation. Moreover, the bank account should be used in the partnership's operations to deposit income earned by the partnership and to pay partnership expenses. Additionally, in the event the limited partnership will hold publicly traded securities, the applicable broker should open up a brokerage account, separate from the partners, for the limited partnership to hold the publicly traded securities. It should be noted that if the investment activities of the limited partnership will involve aggressive investments, i.e., zero cost collars, put options, call options, trading on the margin, etc., the brokerage house may require special language in the partnership agreement to permit these types of trading activities.
Following Formalities Of The Partnership Agreement
- All of the partners should contribute their capital when, and in the amount, required under the partnership agreement. As a general rule, a partner's contribution of capital should match up with how the partners are allocated profits and losses under the partnership agreement.
- The general partner should review and abide by the provisions of the partnership agreement concerning management responsibility.
- Prior to taking substantial and unusual actions on behalf of the partnership, the partners should discuss the transaction at a meeting (including the limited partners), and such meeting should be evidenced by partnership meeting minutes. The transaction could involve the borrowing of a substantial amount of money, or the selling of a valuable piece of real estate. Additionally, where a vote of the limited partners is necessary, the general partner should comply with the voting requirements of the partnership agreement.
- An annual informational meeting of all of the partners of the limited partnership is recommended. If the limited partnership has a corporation or a limited liability company that is a general partner, such general partner should have meeting minutes pertaining to acts that it, as a general partner, will perform on behalf of the limited partnership.
- The limited partnership should keep and maintain its records at its principal place of business. Any partner or assignee of a partnership interest may, on written request stating the purpose, examine and copy the applicable records.
- The limited partnership should only acquire assets and/or enter into contracts in the name of the partnership. The general partner should sign the contracts on behalf of the limited partnership in its representative capacity.
- The general partner should carefully follow the terms of the partnership agreement relating to distributions. As a general rule, distributions should be distributed pro-rata. If there are uneven distributions, the capital accounts of the partnership will not match the profit and loss allocations, and the IRS may attempt to re-characterize such transactions as a deemed gift of proceeds from one partner to another.
Tax And Bookkeeping Compliance
- A federal tax identification number for the partnership must be obtained upon formation by filling IRS Form SS-4.
- The partnership must provide to each partner an IRS Form K-1 to each partner.
- A partnership tax return (IRS Form 1065) must be completed and filed every year by the partnership on, or before, the 15th day of the fourth month following the date its tax year ends.
- As a general rule in a family limited partnership, the income should be allocated in accordance with partnership capital. In the event there is a special allocation in the partnership agreement, the allocation should be reviewed carefully by the accountant and/or practitioner for the partnership. Section 704(e)(2) applies to family partnerships where a gift of limited partnership interests has taken place and provides that the amount of the individual's distributive share of the partnership income is subject to two restrictions: 1) the donee's share must be determined by the allowance of reasonable compensation for the donor's services rendered to the partnership; and 2) the share of the income allocated to the donee must not be proportionately greater than the share of the donor attributable to the donor's capital. The effect of this rule is to limit income allocated to the donee to that earned by his/her share of the capital. Thus, the partnership's total income should first be reduced by reasonable compensation for the donor partner, if applicable, and then the remaining income can be allocated among the partners in proportion to their capital accounts.
- Partnership accounting records must be kept on behalf of the partnership. Depending on the size of the partnership, financial statements should be prepared at least annually and in many situations, quarterly. Additionally, the partnership's accountant should keep track of each partner's capital accounts, distributions of capital and allocation of profits.
- The partners should avoid commingling of personal assets with partnership assets. See Estate of Dorothy M. Schauerhamer v. Comm'r., 73 TCM 2855 (1997) where assets and income were managed by the decedent exactly as they had been managed in the past when the decedent individually owned the assets. The partners should not borrow money from the partnership or loan money to the partnership without signing a promissory note and complying with the terms of the partnership agreement and state law.
- The partnership should not guarantee or pledge business assets of the partnership for personal obligations of the partners. However, if a guarantee or pledging of partnership assets on behalf of a partner is undertaken, all of the partners should consent to such action taken by the partnership. Furthermore, the partnership should receive a fee (i.e., a guarantee fee) from the applicable partner for such partnership services.
- If a partner is transferring real estate subject to a lease to a partnership, the lease must be amended or assigned so as to reflect the partnership as the lessor. Furthermore, a partnership that receives a contribution of real estate from its partner(s) should properly document such transfer by executing warranty deeds, and filing the deeds in the deeds records of the applicable county clerk's office.
- Partnership stationary (reflecting the partnership's legal name) should be prepared and used in the business operations of the partnership.
- In the event the partnership is operating under an assumed name, the partnership should file an assumed name certificate with the Secretary of State's office and with the county clerk of the county in which the partnership's principal office is located.
- If the property contributed to the partnership is agricultural-use property and has previously received an agricultural-use exemption, a new agricultural-use exemption application needs to be filed by the partnership. The new application must be filed by the partnership prior to May 1st of the year following the year the partnership received the property. The application must be filed with the chief appraiser for the appraisal district where the property is located.
Gifts Of Partnership Interest/Proper Documentation. After the formation and the initial funding of the limited partnership, consideration should be given by senior members of the family to making gifts of limited partnership interests, directly or indirectly (through a trust), to the younger generation. Please note, however, as set forth above in Section III(D), it is preferable to wait a few months after the initial funding of the limited partnership before the gifts of limited partnership interest are made by partners. When making gifts, consideration should be given as to the amount of the gift, whether such gift should be an annual exclusion gift or a unified credit gift, and as to whether a valuation expert will need to be hired to substantiate the value placed on the limited partnership interest to be transferred by gift.
The documents that should be prepared to reflect the gifts of limited partnership interest by the limited partners are as follows:
- An assignment document to reflect the amount of limited partnership interest being assigned by the donor to the applicable family members. Such assignment document should be dated and signed by the applicable donor.
- An acknowledgment signed by the donee accepting the limited partnership interest and agreeing to accept and abide by the terms of the applicable partnership agreement.
- In the event the applicable partners of the partnership agree to admit the assignee as a substituted limited partner, the applicable consenting partners should sign an acknowledgment to that effect.
- The partnership agreement should be amended to reflect the new limited partners and the partnership interest adjustments resulting from the gift of a limited partnership interest. One method to simplify amending an agreement when partnership interests change by reason of gifts, etc., is to provide in the partnership agreement that an exhibit will be prepared and signed by all of the partners if the partnership interests change.
Death Of An Individual General Partner. Upon the death of an individual general partner of a family limited partnership, certain issues must be reviewed and dealt with by the practitioner. The following discusses how some of these issues are addressed in Texas:
Does the death of an individual general partner cause the dissolution of the limited partnership under state law?
Section 8.01(3)(A) of the Texas Revised Limited Partnership Act provides that if upon an event of withdrawal of a general partner (i.e., death), there remains at least one general partner and the partnership agreement provides that the business of the limited partnership shall be carried on by the remaining general partner(s), the partnership shall continue. In the event after the death of an individual general partner, there is no remaining general partner, or the partnership agreement does not provide for the continuation of the partnership after the death of an individual general partner, all of the remaining partners (or the percentage specified in the partnership agreement) may agree in writing to continue the business of the partnership. Additionally, if there is no remaining general partner, the remaining partners must agree to the appointment of a new general partner(s). Such reconstitution must be done within 90 days after the event of withdrawal, i.e., death of the individual general partner. In the event there is no remaining general partner after the death of the general partner, or the partnership agreement does not provide for the continuation of the business of the partnership after the death of the general partner, the partnership should be reconstituted so that proper discounting may be taken regarding the valuation of limited partnership interest that is attributable to the deceased partner. Partnership meeting minutes should be prepared to evidence the reconstitution of the partnership and the appointment of the new general partners, if applicable, and the partners whose consents are needed to reconstitute the partnership should sign the minutes. If there are several general partners, the family partnership agreement should provide for an automatic reconstitution.
Upon the death of a general partner, what happens to the deceased partner's general partnership interest? For simplification purposes, the agreement should provide that such deceased partner's general partnership interest should be converted to a limited partnership interest. If the partnership agreement does not provide for such result, Section 6.02(b) of the Texas Revised Limited Partnership Act provides that the remaining general partner(s), or if there are no remaining general partners then the limited partners, may at the option of a majority in interest of the limited partners in a vote that excludes any limited partner's interest held by the withdrawing of the general partner:
- convert the general partner's interest to that of a limited partner; or
- pay the withdrawn general partner in cash, or a secured bond approved by the court, the value of the deceased general partner's partnership interest.
If the partners vote to convert such general partnership interest to a limited partnership interest pursuant to the Texas Revised Limited Partnership Act, or the partnership agreement provides that the general partner's partnership interest converts to a limited partnership interest, certain documents will need to be prepared. The first document is an amendment to the partnership agreement reflecting the conversion of the general partnership interest to a limited partnership interest. The second document is an amendment to the certificate of limited partnership that will need to be filed with the applicable Secretary of State's office to reflect the general partners of the limited partnership after the death of the general partner.
If a new general partner is appointed by vote of the partners or is named as a successor general partner in the partnership agreement, how is the new general partner going to acquire his general partnership interest?
In the event the new general partner is an existing limited partner, such partner could convert a portion of his or her limited partnership interest (i.e., 1%) to a general partnership interest. Another method to acquire the general partnership interest is by a direct contribution of capital to the partnership equal to 1% of the value of the underlying assets of the partnership. In either situation, the partnership agreement would need to be amended to reflect the new general partner in the manner outlined above. The new general partner should also evidence his/her agreement to abide by the terms and conditions of the partnership agreement in the amendment. Finally, as mentioned above, any change in the general partners of a partnership requires the certificate of limited partnership to be amended and filed with the applicable Secretary of State's office. If a new general partner is needed, consideration should be given to adding a corporation or a limited liability company as a general partner for continuity purposes. Furthermore, in the event an individual general partner dies and there remains only one individual general partner, consideration should also be given to adding a new general partner (preferably an entity) so that the partnership may continue if the remaining general partner dies.
How is partnership income allocated to the deceased general partner?
Section 706(c)(2)(A) provides that the taxable year of the partnership will close with respect to a partner whose interest in the partnership terminates by reason of his or her death. The effect of this rule is that the deceased partner's distributive share of partnership income or loss for the short partnership year that ends at his/her death is included on the partner's final income tax return.
Method Of Accounting. As a general rule, the partnership may elect to use the cash method of accounting, the accrual method of accounting or a combination of both methods, so long as the method clearly reflects income. [IRC § 446(c)] However, Section 448 places certain restrictions on the use of a cash method of accounting by the partnership. A partnership that has a C Corporation as a partner may not use the cash method of accounting [Section 448(a)(2)], unless the partnership has average gross receipts for a three-year-period that do not exceed $5,000,000, or the partnership is engaged in a farming business. [Section 448(b)(1)] It should be noted, however, that other statutory provisions might preclude a farming partnership from using the cash method of accounting.
Furthermore, Section 448(a)(3) provides that if the partnership is classified as a "tax shelter," it will not be able to use the cash method of accounting. Section 448(d)(3) broadly defines a tax shelter so that any limited partnership reporting a taxable loss will most likely be required to use the accrual method of accounting. Additionally, Section 461(i)(3)(b) provides that a "syndicate" will be treated as a tax shelter. A "syndicate" is defined to be any partnership where more than 35% of partnership losses during any taxable year are allocated to limited partners or investors who do not actively participate in the management of the partnership. [IRC § 1256(e)(3)(B)]
It should be noted that other principles under tax law might limit the use of the cash method of accounting by a partnership, such as if the partnership purchases and sells inventory. Section 448 may require the partnership to use the accrual method of accounting.
Section 2036(a); Section 2036(b); Section 2038(a). One issue that the IRS and practitioners have raised with respect to family limited partnerships is whether by remaining a general partner following a transfer of limited partnership interests, a senior member partner retains certain ownership rights in limited partnership interests that he/she has given to his or her descendants or trusts for their benefit. This issue has been considered by the IRS under Sections 2036(a)(1) and 2038(a).
Section 2036(a)(1) provides that the value of the decedent's gross estate includes the value of all property the decedent has transferred by trust or otherwise and then has retained for life, for any period not ascertainable without reference to the decedent's death, or for any period that does not in fact end before the decedent's death either: 1) the possession or enjoyment of, or the right to income from, the property; or 2) the right to designate the persons who shall enjoy the property or the income therefrom. [IRC § 2036(a)] In United States v. Byrum, 408 U.S. 125 (1972), the Supreme Court addressed the issue of including the value of stock in the decedent's estate where the descendant transferred stock in trust and retained the right to vote the transferred shares, the right to veto the sale or acquisition of trust property, and the right to replace the trustee. The Court concluded that, because of the fiduciary constraints imposed on corporate directors and controlling shareholders, the decedent "did not have an unconstrained de facto power to regulate the flow of dividends, much less the right to designate who was to enjoy the income." Congress, however, responded to the Supreme Court by enacting Section 2036(b)(1) that provides that the direct or indirect retention of voting rights in transferred stock of a controlled corporation shall be considered to be a retention of the enjoyment of the transferred property.
Additionally, with respect to the retention of interest by the general partner, Section 2038(a)(1) may be applicable, and it provides that the gross estate includes the value of property to the extent that the decedent has transferred such property without receiving adequate and full consideration in money or money's worth, and if at the decedent's death, the enjoyment of the interest is subject to change through the exercise of a power by the descendant alone, or by the decedent in connection with any other person, to alter, amend, revoke, or terminate, or where any such power is relinquished during the three-year-period ending on the date of the decedent's death.
The IRS has, in several Private Letter Rulings, held that a limited partnership interest given by the general partner to his or her descendants, etc., would not be included in the gross estate of the general partner. The IRS stated that the general partner has a fiduciary duty and duty of loyalty to the other partners that prohibits him or her from acting out of self-interest to the detriment of the partnership. Therefore, acting as a general partner is not a retention of limited partnership interest under Sections 2036(a) and 2038(a). [See, PLR 9546007; PLR 9546006; PLR 9310039] It should be noted that the limited partnership interest described in the Private Letter Rulings referenced above were consistent with interests normally found in limited partnerships between unrelated third parties, i.e., rights to profits, losses, distributions, and at least minimal voting rights.
Another issue under Section 2036 that arises when a limited partnership holds closely held corporation stock of a business is whether the retention of voting control by the general partner, who is the senior member of the family, causes inclusion in his/her estate of the value of 100% of the stock for purposes of Section 2036(b). The IRS to date has not published any rulings addressing this question. One might consider giving the voting rights of the stock to the limited partners or only contributing nonvoting stock of closely held corporations.
Marketable Securities Distribution. Beginning December 8, 1994, Section 731 was amended to treat certain distributions of marketable securities as cash distributions. For purposes of determining the amount of gain that a partner recognizes upon a distribution of marketable securities by a partnership, the fair market value of securities is treated as money. Thus, under Section 731, and subject to satisfying one of the exceptions below, a partner will recognize gain to the extent that the sum of the fair market value of marketable securities and money received by the partner exceeds the basis in his/her partnership interest. The value of marketable securities is its fair market value on the date of distribution.
- Partnerships formed for the purposes of holding marketable securities for investment or sale to customers is not subject to the above marketable securities distribution rule. An investment partnership is a partnership that: 1) has never been engaged in a trade or business; and 2) substantially all of its assets consist of specified investment type assets. Please note, however, if the investment partnership owns a partnership interest in a lower tier partnership and such interest is equal to or greater than 20% (capital and profits interest), or such investment partnership participates in the management of the lower tier partnership in which it owns an interest, such lower tier partnership's business operations will be treated as the operations of the upper tier investment partnership. Thus, the upper tier partnership may not meet the investment partnership exception because it would be deemed to be engaged in a trade or business. [Treas. Reg. § 1.731-2(e)(4)]
- The marketable security distribution rule generally does not apply to the distribution of a marketable security to a partner if the partner contributed the security to the partnership.
- The marketable securities distribution rule permits a partner to receive a distribution of marketable securities without recognizing the gain that is attributable to his or her share of the partnership's net appreciation with respect to securities of the type distributed.
- The securities in such partnership were not originally actively traded.
Section 704(e). Section 704(e) sets forth certain criteria designated to ensure that in a partnership where capital is a material income-producing factor that the income of a partnership is taxed to the person who earns it through his/her own labor or the utilization of his/her own capital. [Treas. Reg. § 1.704-1(e)(l)(i)] If capital is a material income-producing factor in the family partnership, the transfer of a partnership interest may be accomplished by gift or by purchase so long as the recipient family member owns a capital interest. IRC § 704(e)(1) Section 704(e)(2) requires that: 1) the services rendered to the partnership by a donor be adequately compensated; and 2) in the event of a transfer of a family partnership interest that has been funded with donated capital, the donor and donee receive income from the partnership allocable to those interests in proportion to the contributed capital. The gift of a limited partnership interest to the donee must be a legally effective gift under state law, and the donee must be the real owner of the limited partnership interest. Each family partnership should satisfy these requirements as long as income and distributions are made pro rata and each family member who does work for the family partnership is adequately compensated. It should be noted where capital is not a material income producing factor (i.e., where partnership's income is derived primarily from fees or commissions for personal services), the partnership interest and the allocation of income and loss may still be recognized under the facts and circumstances test of Comm'r. v. Culbertson, 337 U.S. 733 (1949). The test under Culbertson is whether the parties acted in good faith, and whether they acted with a business purpose to join together as partners. This test, however, has been strictly construed by the IRS in recent years, and it is likely that the IRS will not respect a partner who has an interest in a service partnership, unless the family member provides substantial or vital services to the partnership or the partner purchased the partnership interest with his/her own funds in order to be a bona fide partner who is taxed on his/her share of the income. If the family member fails to qualify as a partner holding a valid partnership interest, assignment of income rules come into play.
Dispositions Of Interests In Partnership Holding Installment Obligations. In Rev. Rul. 60-352, 1960-2 CB 208, the IRS has taken the position that a charitable contribution of a partnership interest where the partnership held installment obligations constituted a "disposition" of the installment obligations held by the partnership. The logic of the ruling of the IRS in not recognizing the partnership as a separate entity for installment obligations is open to debate. However, if the IRS ruling is correct, any charitable contribution, gifts, and other transfers of partnership interest would trigger a disposition as to all of the installment obligations held by the partnership at the time of the applicable transfer, and therefore, gain would be recognized by its applicable partners.
Income Tax Basis Step Up. If a partnership files a Section 754 election, the basis of partnership property will be adjusted ("stepped up" or "stepped down") as to the applicable partner's share of the partnership assets in the following cases:
- Sale or exchange of partnership interest or on the death of a partner. Such adjustments are made in the manner provided in Section 743 and its Regulations. Note: Section 754 adjustments do not apply to income in respect of decedent items.
- Distribution of property in the manner provided in Section 734.
In the case of a transfer of an interest in a partnership, either by sale or exchange or as a result of the death of a partner, a partnership that has a Section 754 election in effect shall:
- increase the adjusted basis of partnership property by the excess of the transferee's basis for his/her partnership interest over his/her share of the adjusted basis of the partnership property; or
- decrease the adjusted basis of his/her share of the partnership property by the excess of the transferee partner's share of the adjusted basis of all partnership property over his/her basis for his/her partnership interest.
For purposes of depreciation, depletion, gain or loss, and distribution, the transferee partner will have an adjusted basis in the underlying assets of the partnership equal to his/her outside basis.
In the case of a distribution under Section 734, if a Section 754 election is in effect, the basis of the partnership's remaining assets after a distribution must be decreased or increased depending on the effect of the distribution to the liquidating partner.
It should be noted that where a partner has a community property interest in a limited partnership, not only are all of his/her estate's interest in the inside assets of the partnership adjusted if there is a Section 754 election in place, but the deceased partner's spouse's interest in such assets is adjusted also. [Rev. Rul. 79-124, 1979-1 C.B. 224]
Liabilities. Section 752 and the regulations thereunder, as set forth above, outline the sharing of liabilities among partners in a partnership. Additionally, Section 752 sets forth when a partner may have an increase or decrease in his/her share of partnership liabilities. If a partner shares in the liability of a partnership, it will be treated as a contribution to capital and will have the effect of increasing the basis in his/her partnership interest. [IRC § 752(a)] The partner's increase in a partner's basis is important for two reasons: 1) a partner may receive nontaxable distributions of money from a partnership only to the extent that the distribution does not exceed the adjusted basis in his/her partnership interest [Section 731(a)(1)]; and 2) a partner's distributive share of partnership losses is deductible only to the extent of the partner's adjusted basis for his/her partnership interest at the end of the tax year. [Section 704(d)]
A decrease in a partner's share of liabilities is treated as a deemed distribution of money by the partnership and decreases the distributee's basis (but not below zero). However, to the extent the deemed distribution of money exceeds the partner's basis in his/her partnership interest, gain recognition will result. [IRC §§ 731(a)(1) and 752(b)]
The regulations under Section 752 provide for different sharing rules with respect to recourse and non-recourse liabilities of a partnership depending on whether the partnership is a general partnership or limited partnership.
Key Provisions Of The Family Limited Partnership Agreement
The family limited partnership agreement typically contains the following provisions:
- The partnership has a set term of years. Currently, many family limited partnerships have 40- to 50-year-terms. The trend in the future could be to go to shorter terms (i.e., 20- to 25-year-term) in order to address IRS arguments under Section 2703.
- There is more than one general partner (or the sole general partner is an entity).
- The limited partner cannot demand his or her capital or withdraw before the end of the specified term. However, a practitioner should consider giving the partners a partial right to withdraw from an investment partnership in order for the family limited partnership to be comparable to third-party investment partnerships.
- The managing general partner has the discretion to retain earnings of the partnership to meet the partnership's reasonable business needs.
- There are restrictions on the transferability of limited partnership interests, and the partnership has a "right of first refusal" to purchase a limited partnership interest being sold to a third party.
- The general partner should retain the authority to approve the admittance of a new or substituted partner.
- There should be restrictions on the general partners' ability to unilaterally liquidate the partnership.
- All partners must consent if they desire to dissolve the partnership before the end of the stated term.
Ethical/Legal Malpractice Considerations: Representation In The Context Of A Family Limited Partnership
In the context of a family limited partnership, oftentimes, each of the family members regards the lawyer as his or her personal attorney. In other words, the family views the lawyer, not only as the attorney for the family limited partnership (i.e., the entity), but as their individual attorney as well. This situation can put the lawyer "between a rock and a hard place." On the one hand, it may be very difficult for the lawyer to selectively represent only the family limited partnership or the family limited partnership and certain family members to the exclusion of everyone else. On the other hand, representation of each of the family members, along with the family limited partnership itself, may give rise to conflicts of interest that impede the lawyer's ability to effectively represent and advise each family member and the family limited partnership. So, what is the family limited partnership practitioner to do? Should the lawyer take the position that the lawyer is solely representing the family limited partnership itself, and not any of the family members, and therefore, require each family member to hire his or her own legal counsel in connection with the family limited partnership transaction? Although a lawyer may be able to take this position in selected transactions, practically, the lawyer would run into resistance from family members in most situations. Therefore, should the lawyer blindly proceed with representing all of the family members and the family limited partnership, and hope that he/she has been lucky enough to be hired by the Brady Bunch?
The following are three fundamental steps that a lawyer should take in any family limited partnership representation matter in order to help protect the family members, as well as the lawyer:
- Perform A Conflicts Analysis. The first thing the lawyer should do is perform a conflicts of interest analysis to determine whether the lawyer's joint representation of family members and the family limited partnership is appropriate in the first place. This conflicts analysis may lead the lawyer to conclude any one of the following: 1) there is no conflict at all; 2) there is a conflict, but the conflict is a type that can be "cured" by disclosure to, and consent of, all of the family members; or 3) there is a conflict, and the conflict is a type that cannot be "cured" (even with disclosure to, and the consent of, all of the family members); therefore, the joint representation of the family members and the family limited partnership is inappropriate. The very nature of a family limited partnership, having two distinct classes of partners, general and limited partners, can lead a lawyer to conclude that the joint representation of all partners involves a conflict-though a type of conflict that can be cured by disclosure and consent. In particular, the fact that limited partners do not have any real control over the management and operations of the family limited partnership, including distribution decisions, may be a ripe area of conflict where, for example, a family limited partnership will have the parents as general partners and the children as limited partners. This should be discussed with all of the family members and an appropriate engagement, conflict, and consent letter should be prepared.
- Prepare Engagement/Conflict/Consent Letter. Assuming the lawyer, after performing the conflicts analysis, determines that the joint representation of the family members and the family limited partnership does not present a conflict, or presents a conflict that can be "cured" (i.e., waived) by disclosure and consent. At that point, the lawyer should send to each of the family members a written letter that sets forth: 1) the persons and entities who the lawyer will be representing; 2) the nature and scope of the legal services to be performed; 3) the manner of calculating the lawyer's legal fee; 4) the conflict disclosure matters; and 5) a request for each person's consent to the representation. In addition, the practitioner should inform all of the family members that the joint representation will be conducted as an "open relationship" among all of the family members. In other words, any communications from a family member to the lawyer regarding the family limited partnership matter will not be confidential, but shall be disclosed by the lawyer to all of the other family members if relevant to their decision making. The lawyer should be sure to have each family member and the general partner of the family limited partnership return to the lawyer an executed original of the letter evidencing their consent to the joint representation.
- Remain Alert For New Or Escalating Conflicts. Even if the lawyer obtains the consent to the joint representation as outlined above, the lawyer cannot assume that joint representation will be appropriate forever. Rather, the lawyer must remain on the lookout for new conflicts arising in the future or the escalation of existing conflicts that might cause the ongoing joint representation to be inappropriate or require additional disclosures and consents from the family members. Furthermore, in the event a dispute among two or more of the family members (or a family member and the family limited partnership) arises in connection with the family limited partnership matter, absent the consent of the family members (unlikely), the lawyer cannot take sides in the matter and represent one family member against the other. Each would need to retain different legal counsel.