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George F. Bearup, J.D. Senior Legal Trust Advisor

26-Oct-20

The ‘Downside’ to Family Limited Partnerships – Part I

Take-Away: Family limited partnerships (FLPs) are popular because they permit valuation discounts for interests that are transferred to family members during lifetime, or the retained interests warrant valuation discounts at the time of the senior family member’s death. However, FLPs come under close scrutiny by both the IRS and the US Tax Court, and if not formed and operated correctly, the value of the FLP’s assets will be included in the senior family member’s taxable estate using one of the string provisions of the Tax Code. Making matters worse, it is possible that the use of a family limited partnership might actually cause more estate taxes to be paid on the senior family member’s death.

Background: Family limited partnerships attract valuation discounts due to the lack of marketability and lack of control of the interest retained by the transferor who forms the FLP or contributes assets to the FLP. One risk with a FLP is the possibility that one of the string provisions of the Tax Code [IRC 2036(a)(1) or (2)] will apply if there was no legitimate non-tax purpose for the transfer of assets to the FLP, or the transfer to the FLP was not for fair and adequate consideration.  If either of those Tax Code sections applies, the result is the value of the FLP’s assets will be included in the transferor’s taxable estate at death.

IRC 2036 Exception: Whether the IRC 2036 string provision applies to a transaction, such as transferring assets to an FLP,  requires a two questions to be answered to determine if the statutory exception to IRC 2036 applies.

  • Full Consideration ‘Test:’ First, was the transfer to the FLP for adequate and full consideration, meaning did the transferor receive partnership interests equivalent in value to the value of what was contributed to the FLP?
  • Non-Tax Purpose “Test:’ Second, was the transfer or ‘sale’ to the FLP bona fide, what basically means, what was the transferor’s motive? This second question is much tougher to answer, as it depends upon the transferor’s intent. In order to satisfy the bona fide ‘test’, there must be objective evidence that establishes that a nontax reason was a significant factor that motivated the FLP’s creation and/or the transfer of property to the FLP. In short, merely ‘wrapping’ assets like marketable securities in an FLP in order to claim valuation discounts will be insufficient.

IRC 2033 and 2036- Double Estate Inclusion: If IRC 2036 applies to the transfer of assets to an FLP, on the transferor’s death arguably there will be double ‘counted’ assets valued in the transferor’s estate. First, the transferor- received consideration, i.e. the FLP interest, when property was transferred to the FLP; presumably the transferor continues to own the FLP interest at the time of his or her death, so the value of the received and retained FLP interest will be included in the transferor’s taxable estate. [IRC 2033.]. Second, the import of IRC 2036 is that the fair market value of the FLP’s assets will also be included in the transferor’s taxable estate. This results in a ‘double inclusion’ of the value of assets subject to estate taxation on the transferor’s death.

IRC 2043 Avoids Double Inclusion: In order to avoid that ‘double inclusion’ of asset values, the Tax Code added IRC 2043. IRC 2043 provides what is, in effect, a mathematical formula used to determine what is to be included in the transferor’s taxable estate when IRC 2036 causes the value of the FLP’s assets to be included in the transferor’s taxable estate. [Note that IRC 2043 also applies to the other two string provisions of the Tax Code, IRC 2037 and IRC 2038.]

  • IRC 2043 Formula: The formula for estate inclusion is: Value (included in estate) = Consideration received (FLP interest’s FMV at death under IRC 2033) + FMV of FLP assets – (initial consideration transferred to FLP under IRC 2036) – value of consideration transferred initially to the FLP.
  • Past Practice: Traditionally, when confronted with gross estate inclusion of an FLP’s assets under IRC 2036, the Tax Court has simply disregarded the existence of the FLP and has instead held that the fair market value of the FLP’s assets themselves, rather than an interest in the FLP, are included in the deceased transferor’s gross estate. Ignoring the FLP interest and taxing the underlying FLP assets avoids this double taxation issue. That changed with the 2017 Powell decision, discussed below.
  • Effect of IRC 2043 Formula: Most FLPs are formed with the intent to shift future asset appreciation away from the transferor’s taxable estate. If, in fact, the assets transferred to the FLP do increase in value after they reside inside the FLP, on the transferor’s subsequent death, if IRC 2036 applies, all that future appreciation in the FLP’s assets will be included in the transferor’s taxable estate. [IRC 2033.] In short, if the FLP interest received and retained by the transferor increases in value over time and prior to his or her death, that post-transfer appreciation in the FLP interest itself will be taxed in the transferor’s estate. Added to that is the value of the FLP’s assets which is also included in the transferor’s taxable estate. [IRC 2036.]
  • Double ‘Counted’ Appreciation: Under the IRC 2043 formula, the post-transfer appreciation in the FLP’s assets is thus included in the transferor’s taxable estate. The offset against this ‘double inclusion of the appreciation in (i) the FLP’s underlying  assets, and the (ii) the transferor’s FLP  interest  is the original fair market value of the assets that were transferred by the transferor to the FLP. The result is that the post-transfer appreciation [both of the FLP interest retained by the transferor and also the assets held in the FLP] is double counted: the increase in the FLP interest held until death, and the increase in the FLP’s assets until the time of the transferor’s death.
  • Observation: If the value of the FLP increases, double ‘counting’ value will result, as the date-of-death value of the FLP’s assets plus the post-contribution appreciation of the FLP interest will be included in the deceased transferor’s taxable estate. IRC 2036 was not meant to be draconian- like all of the string provisions, IRC 2036 is simply meant to ‘undo’ a structure in which the decedent retained impermissible control or access to the transferred property. If the value of the partnership deceases, then the decedent-transferor is in better shape from an estate tax perspective had he or she not entered into the FLP transaction, which is the exact opposite of what IRC 2036 seeks to achieve. In sum, if an FLP is formed, yet IRC 2036 is later applied (with hindsight) to cause inclusion of the FLP’s appreciated assets in the transferor’s taxable estate, the transferor would have been better off, from a transfer tax perspective, never having formed the FLP and transferred assets to it.

Powell Case:  Despite IRC 2043 being in the Tax Code for several years, the Tax Court had not spent much time looking at how to proceed to avoid double inclusion of value in the transferor’s taxable estate,. Usually the Tax Court judge simply ignored the FLP interest held by the decedent and only included the fair market value of the FLP’s assets in the transferor’s gross estate. The Estate of Powell v. Commissioner 148 Tax Court 392 (2017) spent some time in its decision discussing the off-set portion of the IRC 2043 valuation formula. The majority opinion in Powell found that while taxing the underlying FLP’s assets but avoiding double taxation is the correct result, the reason for that end result had gone “unarticulated”, which it then took upon itself to ‘articulate.’  The majority held that the decedent’s gross estate should include (i) the value of the decedent’s interest in the FLP under IRC 2033, which includes any valuation discounts taken; and (ii) the value of the assets transferred to the FLP, less (iii) the value of the partnership interest the decedent had received in return at the time it was received. In Powell, however, the value of the FLP interest was the same at death as the value of the assets transferred initially to the FLP one week prior to the decedent’s death, so the result was in effect, no ‘double counting.’

Moore Case: However, more recently, in Estate of Moore v. Commissioner, Tax Court Memo, 2020-40, where the Tax Court judge adopted the reasoning in Powell, ‘double counting’ did in fact occur, which resulted in a higher estate tax liability than if the transferor had not engaged in the FLP planning to begin with.

Therefore, the traditional approach the Tax Court has taken in the past, to simply ignore the FLP interest held by the decedent (and by implication ignore the formula of IRC 2043) and include in the decedent’s taxable estate the fair market value of the FLP’s assets,  will no longer apply. Now, the fair market value of the FLP interest retained will be included in the decedent’s estate along with the fair market value of the FLP’s underlying assets, only then to be reduced by the ‘old’ value of assets that the transferor had transferred to the FLP. This leads to doubling the appreciation of the transferred assets in the decedent’s gross estate, a result that was supposed to be addressed by IRC 2043.

Random Observations:

  • The more time that passes between the FLP’s formation and the transferor’s death, the greater the probability that the date of death value of the FLP interest and the date of contribution value to the FLP will be different, which will more likely lead to a ‘double counting’ of any asset appreciation.
  • For FLPs that are successful and appreciate in value, the total cost of IRC 2036 inclusion has gone up so that the transferor will be worse off compared to the result if he or she had not done the FLP planning to begin with. The old planning adage that “the transferor will be no worse off for doing FLP planning” is no longer true.
  • With regard to existing FLPs that may have appreciated over time, but have some IRC 2036 exposure, that planning should be revisited in light of how IRC 2043 is now interpreted and implemented by the Tax Court, as the transferor’s death could result in more estate taxes paid than would otherwise be the case if the FLP was sold or gifted by the transferor prior to his or her death.
  • Both Powell and Moore were aggressive deathbed FLPs, formed quite obviously for tax avoidance purposes, each inviting the old saw ‘bad facts make bad law’ and making it probable that IRC 2036 would apply to the funding of the FLP.
  • If discount rates increase from the time of the transfer of the transferor’s property to the FLP until the transferor’s death, then the date of death value of the retained FLP interest will become lower than the value of the property initially transferred to the FLP, which would reduce the value ultimately included in the transferor’s gross estate. Thus, a transferor’s estate could equally argue that IRC 2036 applies against itself for an FLP to which the decedent contributed, to claim a lower value to be included in the transferor’s gross taxable estate.

Conclusion:  Estate planning with FLPs is always risky due to the broad sweep of IRC 2036. It has become even more problematic if the FLP is ‘successful’ in the appreciation of its assets, as there will be some ‘double inclusion’ in the transferor’s gross estate if IRC 2036 and its string provisions ultimately apply. Those who have engaged in FLP planning in the past need to review the FLP documentation and also how well the FLP investments have performed. It may be time for the transferor to relinquish his or her retained interest in the FLP to avoid the inclusion of double appreciation under IRC 2036 and IRC 2043, and also avoid the 3-year look-back rule of IRC 2035 with regard to the taxation of released retained rights under IRC 2036, 2037, 2038 and 2042.