Family Partnerships Under Fire-Again
Over Christmas, the IRS fired yet another salvo in its continuing efforts to dampen enthusiasm for one of family owned businesses'most prized family wealth planning techniques. The latest attack culminates a year of unparalleled efforts to derail family limited partnerships ("FLPs"), which are used by almost 20% of the respondents to the Arthur Andersen/MassMutual American Family Business Survey '97.
The latest blast was a technical advice memorandum (TAM) in which the IRS denied the $10,000 annual exclusion for gifts of FLP interests. It concluded a year of increased field audits, TAMs and private letter rulings (PLRs) disallowing gift and estate tax valuation discounts for FLP interests (see March 1997 "Professional Insight").
What's a TAM?
Our readers know that I view PLRs and TAMs as just below slime in the food chain of tax authorities. Basically, they are the views of a few IRS National Office personnel who hate certain planning techniques. So, they issue pronouncements asserting sometimes legitimate and sometimes off the wall arguments about why the techniques don't work. See my April through June 1996 columns for details.
PLRs and TAMs can't be completely ignored. The newest TAM is no exception. But, it must be carefully analyzed for the law it purports to interpret and the specific facts it addresses. Advisors who fail to do so will panic and quit recommending the technique, which is exactly the National Office folks'intent.
The recent TAM focused on two partnership agreement provisions that restrict marketability and liquidity. Making these provisions more restrictive increases the general partner's (GP) control over the limited partners (LPs, also known as Athe kids@) and maximizes gift and estate tax valuation discounts. The partnership agreement in the TAM was at the extreme end of the control spectrum, so it's not surprising that the National Office took issue with it.
The first provision stated that "the General Partner shall have complete discretion to retain funds within the partnership for future partnership expenditures OR FOR ANY OTHER REASON WHATSOEVER" (emphasis provided by IRS). The second provision totally prohibited transfers of LP interests. The IRS concluded that the provisions violated the requirements for the $10,000 annual exclusion.
Present Interest Requirement
To qualify for the annual exclusion, a gift must be of a "present interest," which means an unrestricted right to the immediate use or enjoyment of the property. The donee must receive substantial present economic benefit. The regulations elaborate by excluding interests that commence in use, possession or enjoyment at some future date.
Example 1: Gifts of stock to trusts do not qualify as present interests if the trustee has discretion over income distributions. Why? The discretion can delay the donee's present economic enjoyment of the gift.
Example 2: An outright gift of non dividend paying stock qualifies as a present interest. The IRS rationalizes permitting the exclusion by saying that the board of directors determines dividends subject to their fiduciary duties to the shareholders.
But, a trustee's distribution discretion is subject to fiduciary duties to the beneficiary. Why is fiduciary duty a deal killer in Example 1, but perfectly okay in Example 2? Frankly, I think that the IRS rationale in Example 2 blurs the issue. A gift of non dividend paying stock qualifies as a present interest simply because the donee receives immediate possession of the stock. He has substantial economic benefits of ownership despite the lack of current dividends. In the trust example, the donee's enjoyment of the stock is delayed until the trustee chooses to give it to him.
The Plot Thickens
Here the plot thickens. The IRS minions use this fiduciary duty smokescreen to further their anti FLP agenda.
Back when it was friendlier toward FLPs, the IRS issued TAMs allowing annual exclusions even though the GP had discretion to determine the timing and amounts of distributions. Although the distribution discretion gave the GP substantial control, the IRS concluded that the discretion was subject to the fiduciary duty normally imposed by state law upon a GP. Sound familiar?
The recent TAM simply extends the previous ruling posture to the extreme language quoted from the agreement. According to the IRS, that language overrides fiduciary duty. However, they did not bother to analyze state law, which is what imposes fiduciary duty in the first place.
I doubt that many states'laws are clear as to whether any particular language steps over the line. So, many advisors will feel compelled to back off of the desired tight controls over distributions. Voila! Chalk one up for the IRS!
Prohibition against Transfer
The IRS cites two cases for the proposition that the prohibition on transferability violates the present interest requirement. However, the cases are quite different from restrictions on transferability commonly found in partnership agreements.
Both cases involved gifts of non income producing property to trusts. In one case, the court disallowed the exclusion because the trustee had discretion over income distributions. No surprise, but not relevant to the TAM. In the other, the donor claimed annual exclusions for the beneficiaries'income interests in the trust because the trustee was required to distribute all income. The court found that the mandatory distribution provision was illusory because there was no income.
Neither case concerned restrictions on transferability of property given outright to a donee. Exactly how many current rights must a donee receive to be a present interest? The IRS has succeeded in muddying up the waters. So, advisors may begin to loosen up on the otherwise desirable restrictions on transferability. Chalk another one up to the IRS!
What to Do
I don't think we've heard the last of this issue. Subject to future developments, I recommend that you compare your partnership agreement terms to those the IRS found offensive in the TAM. If yours are substantially as restrictive as the TAM's, and you plan to make annual exclusion gifts in the future, talk with your advisors. Consider the magnitude of your gift tax risk if the annual exclusions are disallowed. If that risk scares you, consider amending your agreement to loosen the restrictions. But, don't loosen too far or you begin to lose the controls and discounts which may be important to you. Do not amend pre January 28, 1992 agreements without considering the potential loss of grandfathering under the Chapter 14 regulations.
And, give the IRS National Office credit for creatively protecting the federal fisc.