FLP Planners Find a Present Under their Tree

Apparently the IRS did not vacation this year-end, judging by the volume of pronouncements it has issued during and shortly after the holiday season. Just recently, we have seen final regulations addressing basis adjustments after sales of partnership interests, proposed regulations dealing with mergers and divisions of partnerships, a notice discussing the manner of depreciating property received in a like-kind exchange under Code Sec. 1031, Rev. Rul. 99-57 addressing the tax consequences to a partnership and a corporate partner from a taxable exchange of the corporation's stock when the stock was originally contributed by the corporate partner, and proposed regulations addressing the allocation of certain types of nonrecourse liabilities under Code Sec. 752. Future Partner's Perspectives will address many of the issues raised by these pronouncements. This month the Partner's Perspective will discuss Kerr v. Commissioner, 113 TC No. 30 (December 23, 1999), an early Christmas present that estate planners found under their tree this holiday season.

The use of the family limited partnership or family limited liability company (collectively referred to in this column as an "FLP") has been a staple estate planning technique since the IRS acknowledgment in Rev. Rul. 93-12, 1993-1 CB 202 that family control of a business enterprise does not eliminate the availability of valuation discounts on the transfer of ownership interests by family members. The ruling involved an operating business housed in corporate format and, while the IRS indicated that gifts of minority shareholder interests qualified for valuation discounts, the IRS did not indicate the amount of the discount, nor did the IRS provide any indication whether the ruling extended beyond ownership interests in an operating business.

Based on the ruling, however, garden-variety FLP planning has been extended to using an FLP to hold a donor's marketable securities followed by gifts of interests in the enterprise. There are many good business reasons for a donor to structure a gift transaction in this manner, including the ability to continue to control (subject to fiduciary standards) the investment and distribution of the underlying assets, the ability to leverage investments, creditor protection, etc. See Partner's Perspective at 69575.

Notwithstanding these good business reasons, the IRS apparently is not enamored with the concept of discounted gifts or discounted estate tax valuations associated with FLPs holding investment assets. The IRS has issued numerous technical advice memoranda containing a variety of theories as to why valuation discounts should not be available, and President Clinton's last two budget proposals have contained a provision that would eliminate valuation discounts for family FLPs other than those engaged in an operating business.

IRS audit activity in the FLP arena has increased substantially in various districts in the country. However, despite all this activity, the IRS rhetoric and the flurry of FLP planning engaged in by tax professionals, there has been little judicial authority addressing this planning technique. The Kerr case is one of the first of its kind.

Cutting through a lot of facts and summarizing the most relevant of them, in Kerr the taxpayer established a Texas limited partnership that had a term expiring on December 31, 2043 or on the consent of all partners and a provision that precluded the withdrawal by a limited partner. A small gift of a limited partner interest was made to the University of Texas and significant gifts of limited partner interests were made to the Kerr's children and to grantor retained annuity trusts whose remainder beneficiaries were generation skipping trusts. Unanimous consent of all partners was necessary to amend the partnership agreement or to allow the withdrawal of a partner, meaning that the University of Texas was in a position to prevent the withdrawal of a limited partner. In valuing the gifts, minority and lack of marketability discounts were taken.

In its FLP technical advice memoranda the IRS has been positing three different theories for the unavailability of valuation discounts for gifts of FLP interests--(1) sham transaction; (2) Code Sec. 2703; and (3) Code Sec. 2704(b). As a fourth means of attacking discounts, the IRS has asserted that, even if a discount is available, the amount of the discount is a gift on formation of the entity, thereby effectively eliminating any benefits of discounting. See Partner's Perspective at 69619 discussing these theories. In Kerr, the only approach of the four that is discussed in the case is the applicability of Code Sec. 2704(b).

Code Sec. 2704(b) provides that if there is a transfer of an interest in a partnership to a member of the transferor's family, and the transferor and members of his family hold, immediately before the transfer, control of the partnership, any "applicable restriction" is to be disregarded in determining the value of the transferred interest. An "applicable restriction" is a restriction that effectively limits the ability of the partnership to liquidate and, after the transfer, either (1) lapses in whole or in part or (2) the transferor or any member of his family, either alone or collectively, has the right to remove it. However, an applicable restriction does not include one that is no more restrictive than is imposed by state law.

The IRS appears to have approached its Code Sec. 2704(b) argument from two different angles. First, the IRS argued that the agreement provision that states that the partnership will liquidate on the earlier of December 31, 2043 or the consent of all partners is an applicable restriction. The Tax Court rejected this argument "because Texas law provides for the dissolution and liquidation of a limited partnership pursuant to the occurrence of events specified in the partnership agreement or upon the written consent of all the partners, and the restrictions contained in ... the partnership agreement are no more restrictive than the limitations that generally would apply to the partnerships under Texas law."

Interestingly, while not enunciated by the Court, the Court apparently concluded that the selection of a date when the partnership is to liquidate is not an applicable restriction. This issue has been a concern of FLP planners from two standpoints. One--is the selection of a long term, rather than a short term, an applicable restriction, given that the taxpayer is free to select the length of term? And, after all, the longer the term, the greater the valuation discount. Two--is a term, regardless of its length, an applicable restriction given that it is one that lapses with the passage of time? On the other hand, some tax professionals have concluded that, because a term requires a partnership to liquidate rather than it restricts a partnership from liquidating, it does not fall within the penumbra of the applicable restriction definitions.

This area of Code Sec. 2704(b) has been a confusing one and the Kerr case is helpful in blunting the "term" argument. However, the Court's analysis is not well-developed and, after all, it is just one decision. What tax professionals have been doing to avoid this argument, and what this author would continue to recommend notwithstanding the Kerr decision, is to form the FLP in a state that provides for a perpetual term.

A continuing trend in many states (e.g., Delaware, Georgia, Nevada) is not only to permit a LLC to have a perpetual term, but to either prohibit LLC members from withdrawing or allow a withdrawing member only to receive such distributions as would have been received had he/she not withdrawn. Formation in such a state should further blunt IRS arguments under Code Sec. 2704(b). See Partner's Perspective at 69619. However, the Kerr FLP was formed before state statutes of this type were in vogue. The Kerr FLP was formed under Texas law that contained the following provision:

Frankly, the existence of a term in the Kerr FLP probably would have made the Six-Month Withdrawal Right inapplicable. The Six-Month Withdrawal Right is a provision commonly found in LLC and limited partnership statutes of states that are not "FLP progressive," and is designed to allow LLC members and limited partners to receive the "fair value" of their partnership or LLC interest on six months notice, where there is a perpetual term. The Kerr agreement, because it had a term, likely would not have been covered by such a provision, but, nevertheless, the Kerr agreement made sure of its inapplicability by overriding the Six-Month Withdrawal Right and providing that limited partners were not permitted to withdraw.

The IRS jumped on this elimination of a right to withdraw and screamed "applicable restriction." Based on the Tax Court's opinion that the liquidation provision contained in the partnership agreement (i.e., December 31, 2043 or the unanimous agreement of all the partners) was not an applicable restriction, thereby producing a 50-year period during which a limited partner's access to assets was restricted, the additional agreement provision eliminating a partner's right to withdraw was probably not especially significant in the Kerr case. Nevertheless, it is important to analyze this provision for other FLPs that formed in perpetual term states (perhaps because of concerns about the "term" argument noted above) that grant a six-month withdrawal right, which right is overridden by agreement.

The Kerrs had two primary arguments against the IRS assertion that the elimination of the right of a partner to withdraw from the partnership was an applicable restriction. First, the family did not have the ability to remove the withdrawal restriction contained in the partnership agreement, because the consent of the University of Texas, a non-family member, would have been necessary to have been obtained. Unfortunately, the Court did not address this argument--unfortunate because there are many FLPs that have added an unrelated partner with a small interest to blunt IRS Code Sec. 2704(b) arguments, and it would have been interesting to have a court's view on such type of structuring.

The second argument presented by the Kerrs was that the withdrawal provision was not a restriction on liquidation of the partnership. The Court bought into this argument hook, line and sinker. Under state law (including Texas, in this case), LLCs and limited partnerships do not liquidate and dissolve in the event of the withdrawal of a member or limited partner. Therefore, a restriction on the ability of such a person to withdraw has nothing to do with the "applicable restriction" rules because it has nothing to do with the ability of the entity to liquidate. This conclusion by the Tax Court is significant for many FLPs formed in non-progressive FLP states, as many of the IRS arguments contained in its pronouncements have focused on limitations on the right to withdraw.

It will be interesting to watch post-Kerr developments. However, notwithstanding this favorable decision, it is probably still sound advice to form an FLP in a "discount favorable" state and dot ones i's and cross one's t's. In this regard, see the Partner's Perspectives at 9608 and 9619 for structuring recommendations.