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Flipping Out Over FLPs

Family Limited Partnerships (FLPs) are the rage these days. You read about them in the press and it seems like estate planners are hawking them at flea markets. Not surprisingly, the IRS grinches have gone ballistic over the huge estate tax savings. They’ve launched a coordinated offensive. While I think they’ll lose the war, the government might get the last laugh due to an obscure income tax rule that gets little publicity.

Much to the IRS’ chagrin, a simple example demonstrates the FLP’s’ primary selling point. How much would you pay to be a 50% limited partner in my partnership which owns $100,000 of publicly-traded securities? If you said, “$50,000,” please apply for a job as an IRS agent. If you said, “Something less than $50,000,” please move to the head of the class.

As a limited partner, you have far less liquidity than if you owned the underlying securities outright. You can’t simply ask your stockbroker to sell your partnership interest at the current trading price.Also, you would have little or no say in the partnership’s investment and operating decisions. Instead, as the general partner, I would have virtually complete control over the partnership and you might be stuck as my partner for the rest of your life. “Way far less than $50,000,” I hear you thinking.

Bingo! Since transfer taxes are based on the partnership interest’s value, a gift or bequest of the limited partnership interest reduces the associated gift or estate tax relative to a transfer of a proportionate share of the partnership’s assets. We could be talking about a 30% - 50%+ discount. No wonder the grinches want to steal Christmas.

Advisors Anticipate Attack

Most advisors thought that an attack on FLPs would center around Section 2704, a complex and vague provision enacted in 1990 as part of a Congressional broadside against estate planning gamesmanship. It can ignore provision which enhance valuation discounts in some agreements.

Suppose a partnership agreement prohibits a partner from unilaterally forcing the partnership to redeem the interest. This restriction reduces marketability and decreases the interest’s value. Although the law is unclear, Sec. 2704 might ignore this restriction. However, rather than leave a void, Sec. 2704 artificially replaces the offensive provision with something less restrictive from state partnership law.

Clever advisors counterattacked by “forum shopping,” meaning forming the partnership in a state with “tougher” restrictions. Some friendly state legislatures have changed their laws to enhance restrictions and help to beat the IRS.

Sneak Attack

Seeing Sec. 2704 disintegrate before its eyes, IRS agents counterattacked with Sec. 2703. Frankly, when I first heard this, I thought the agent had “cut” his training class at the break between 2703 and 2704! Congress enacted Sec. 2703 to neuter buy/sell agreements, intra-family stock options and similar agreements by ignoring their existence for estate tax purposes. There is no clue that Congress meant Sec. 2703 to ignore a partnership’s existence as the IRS now asserts.

Quite the contrary. Congress explicitly said it did not intend to outlaw these “entity” discounts. Since at least a few family partnership discount cases are docketed in the courts, we should learn the answer in the not-too-distant future.

Income Tax Basis Surprise

Unfortunately, winning the transfer tax discount will create a rude surprise for some people. The government may get the last laugh. The explanation lies in the complex income tax basis rules for partnership interests received by either gift or bequest.

Suppose you die owning a partnership interest. You probably know that your heirs receive a new income tax basis equal to the date-of-death value of the interest. But, if your estate sustains a 30% valuation discount, your heirs will get a 30% lower basis. That means more taxable gain (or less deductible loss) when they sell the partnership. The good news is that a 55% estate tax saving outweighs an income tax cost of up to 39.6%, so it’s not the end of the world.

But, let’s look a little closer. Suppose you bequeath the partnership interest to your spouse. Thanks to the marital deduction, there is no estate tax, regardless of the partnership interest’s value. However, your spouse’s income tax basis still is adjusted to the discounted date-of-death value. Although no estate tax savings arise at your death, your spouse potentially incurs an income tax cost. Ouch!

Inside Out Basis Affects Timing

Well, your spouse or kids might not sell the partnership interest for a long time. Maybe the significance of the extra income tax should be discounted.

Unfortunately, the timing of this income tax impact is not that simple. Death affects the “outside” basis, meaning your heirs’ basis in the partnership interest. As I said, this outside basis is important if they sell the partnership interest. It’s also relevant if the partnership liquidates and distributes assets to them.

But, what about the partnership’s basis in its assets? This “inside” basis determines the amount of gain or loss reported to partners when the partnership sells its assets. Partnerships can elect to step-up a deceased partner’s share of the partnership’s inside asset basis. Doing so permits the partnership to report less gain to the heirs when an asset is sold.

However, the partnership cannot increase its inside basis above the discounted value of the partnership interest. Therefore, the income tax impact of the estate tax discount may be felt earlier when partnership assets are sold, rather than when the partnership interest is sold or liquidated.

Lost Gifts

Basis rules applicable to gifts are also complex. Generally, basis carries over from a donor to a donee. However, if the donee later sells the asset (i.e., the partnership interest), the basis for determining a loss is limited to the value at the time of the gift. Again, if the partnership interest was discounted for gift purposes, the loss might be limited.

Family limited partnerships are great for accomplishing a variety of tax and non-tax objectives. But, don’t flip out over the benefits without thoroughly understanding the costs and the status of IRS attacks.

 

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