As discussed in prior Partner's Perspectives, the family limited partnership or family limited liability company ("FLP") is an estate planning staple. Using an FLP enables a taxpayer to transfer an ownership interest in an asset at a discount from its fair market value, while maintaining certain controls (subject to fiduciary standards) over the asset by means of being the managing party of the FLP. An issue that has concerned many tax professionals is whether this type of planning is effective, if the FLP holds closely held corporation stock. Late last month, the IRS said no in TAM 199938005 (Sept. 27, 1999). This month's Partner's Perspective will examine the IRS's conclusions in the TAM, and offer some alternative structures if one does not want to fight its conclusions.
In the TAM, the decedent taxpayer and his brother owned all the voting and non-voting stock of a corporation. Each of the brothers transferred 55% of each of the classes of stock to an FLP, in which they were equal general partners and limited partners. The decedent then made gifts of limited partner interests to his children. Under the terms of the FLP agreement, the two brothers had the exclusive right to vote the shares of stock of the corporation held by the FLP.
One might ask--Why did the decedent go through all this planning? After all, couldn't he have merely transferred non-voting stock to his children and retained the same voting control? In addition, wouldn't the decedent have been entitled to substantial valuation discounts on the transfer of non-voting stock, without resorting to the FLP?
Reputable appraisers have indicated that 40% valuation discounts are not uncommon for a non-controlling interest in a closely held corporation. Where the same stock is contributed to an FLP, gifts of non-controlling interests may carry an additional discount in the 4%-8% range. However, this additional discount often is not the primary motivating factor in contributing the stock to an FLP prior to its gift. Instead, it's the additional controls provided by the FLP vehicle that often generate the incentive to use the FLP.
For example, it is not considered advisable for a grantor to be the trustee of a trust established for the benefit of the grantor's descendants if the grantor wants to avoid inclusion of the trust's assets in his estate. Consequently, the grantor loses all control over the property transferred to [the] descendants' trust. Sometimes, a grantor may appoint a "cooperative" trustee; however, such a solution is an imperfect one at best, as there are no guarantees as to the actions that may be taken by the trustee, and the trustee has fiduciary obligations to the beneficiaries.
On the other hand, if property is transferred to an FLP in which the grantor has management control, the grantor can continue to control the property. Subject to fiduciary standards, the grantor has the ability to control, among other things, the investment of the FLP's property and the distribution of its assets. And the IRS has privately ruled on numerous occasions that such retained powers, because of associated fiduciary obligations, does not cause estate tax inclusion of the transferred FLP interests pursuant to Code Secs. 2036 or 2038. Unfortunately for the decedent in TAM 199938005, the IRS drew the line on FLP flexibility where the underlying property was voting stock in a closely held corporation. Let's examine the IRS analysis.
In United States v. Byrum, 408 US 125 (1972), a taxpayer had transferred voting stock of a closely held corporation to a trust, but retained the right to vote the stock, to replace the trustee and to control certain transfers of trust assets. Together with stock he retained personally, the taxpayer controlled 71% of the vote of the corporation. The IRS argued that the taxpayer maintained the right under Code Sec. 2036(a)(2) to affect the beneficial enjoyment of the transferred property and that the property should be included in his gross estate. The Supreme Court rejected the IRS's argument.
Congress responded to the IRS's defeat by enacting Code Sec. 2036(b), which provides for estate tax inclusion of transferred voting stock, if the decedent retained the right to vote the stock and possessed (including by attribution) 20% or more of the vote of the corporation at the time of his death or at any time during the three-year period preceding his death. This provision, however, does not statutorily apply to transfers of partnership interests, where the transferor retains management control of the partnership.
Nonetheless, in TAM 199938005, the IRS concluded that the decedent, through his general partner interest, indirectly held the requisite 20% voting control and, therefore, the value of the closely held voting stock transferred to the partnership by the decedent was includible in his gross estate. The IRS noted that the Code Sec. 2036(b) legislative history indicates that "indirect" voting control can cause estate tax inclusion, and that such control exists where the decedent is the trustee of a trust that owns "controlled" corporation stock or where the decedent transfers such stock to a trust and has an arrangement with the trustee to vote the stock as the decedent directs. The IRS bootstrapped this legislative history to conclude that the ability to vote the stock through a general partner interest should also cause estate tax inclusion under Code Sec. 2036(b).
The IRS has had a mixed bag in its application of the "aggregate" theory, as opposed to the "entity" theory, of partnership taxation. However, instead of fighting the IRS theory, in this situation one can easily find a different route to success.
A common approach taken by tax professionals when a substantial interest in the stock of a closely held corporation is to be gifted, but retained control is desired, is to recapitalize the corporation into voting and non-voting stock. For example, where a parent owns 100% of the stock of a C corporation or an S corporation, the parent might recapitalize the corporation into 1% voting stock and 99% non-voting stock, and then gift all or a portion of the non-voting stock. The recapitalization is tax-free, and, from a valuation standpoint, it is clear that the taxpayer has made a gift of a "minority" interest, which qualifies for substantial valuation discounts. (But see Simplot v. Commissioner, 112 TC No. 13 (March 22, 1999), regarding the valuation of the retained interest--discussed in the Partner's Perspective at 69624.) And from an estate tax standpoint, it is clear that one can transfer non-voting stock and retain any amount of voting stock without being subject to the estate tax inclusion rules of Code Sec. 2036(b). See the legislative history to Code Sec. 2036(b) and Rev. Rul. 81-15, 1981-1 CB 457.
So, instead of trying to challenge the IRS's conclusion in TAM 199938005 and risking defeat, it often is simple enough to recapitalize the corporation and transfer non-voting stock to an FLP, followed by gifts of non-managing FLP interests. Besides retaining direct control of the corporation's voting stock, control is also retained (subject to fiduciary standards) over the investment and distributions of any proceeds generated from the stock, whether from dividends or sale proceeds. And there should be an additional small valuation discount, to boot. (Needless to say, the added step of contributing closely held stock to an FLP cannot be done with stock of an S corporation, as a partnership is not an eligible S corporation shareholder.)
Suppose, instead, that a taxpayer owns 20% or more of the stock of a closely held corporation, having a single class of stock, but is not in a position to cause the corporation to recapitalize. Yet, the taxpayer desires to transfer stock to his descendants and maintain control through an FLP. The taxpayer should be able to accomplish most of his goals by creating an FLP in which he holds management control, but providing in the agreement that the non-managing members have the right to vote the stock of the closely held corporation on a pro rata basis. The taxpayer will have lost his voting leverage, but the other aspects of FLP control (e.g., distributions, investment of funds, etc.) will have been retained.