Family Ltd Partnerships - Or Loans, A Comparison

Table of Contents

Tax Cost Containment *

The mission of the plan *

Why loans may not meet your objective *

What do you want to accomplish? *

Introduction *

A Possible Solution for this mission *

Trusts can be a part of the plan *

Advantages of a Family Limited Partnership *

1. Estate Tax Planning - Valuation Discounts *

2. Protecting Assets From Creditors *

3. Gift Tax Planning *

Detailed and Technical Discussion - Family Limited Partnership *

OVERVIEW *

EXPLANATION *

Introduction *

Step 1 - Identify Assets Meeting Logical Criteria For Transfer to A FLP *

Step 2 Formation Must Meet Reasoning Other Than Tax Savings *

Income Tax Considerations *

1. Transferring Appreciated Property *

2. Installment Sales of Family Limited Partnership Interests *

Family Limited Partnership Revived in the 1990's *

Updated Internal Revenue Service Position Letter *

Overview of the estate tax and gift tax system *

Bird's Eye View *

General Explanation *

How is the tax computed? *

Samples of items the tax will be charged on *

How BAD Can The Tax Be? *

Please List Your Needs *

Please Reply To The Longboat Key Office

July 21, 1998

 

Document Transmitted Via:

: ___________________

In order to assist with what you can do to reduce the tax on gifts and estates I am writing this presentation to cover the following:

Introduction

Advantages of a "Family Limited Partnership"

Detailed and Technical Discussion (and analysis)

Not one of us enjoys spending our hard earned money - and certainly not for taxes. The family can use it, the kids or the grandchildren can use it. It would seem that keeping as much of the money as possible will always provide for those necessary emergencies. A point to ponder might be to pre-define what a necessary emergency is. While pondering the point, each of us must consider that the payment for a necessary emergency today will mean that we will not have the same money available for the necessary emergency next week or next month.

I have furnished a simple organizer to assist you with writing your own mission statement for guiding me on what you want to accomplish. Please write a few short sentences or words in the blanks provided.

The mission of the plan

The following presentation is focused on a goal to accomplish these objectives:

You have expressed that your primary objective is to eliminate the gift tax and reduce future estate tax burdens. It is this objective that I am confronting for you herein. As you recall, you and I have discussed this approach for many years. Since tax laws and circumstances change quite frequently, I am reporting to you the alternatives and some ideas that might appeal to you.

In "short - to the point syntax", the following problems arise:

Income can be given to an individual, however the original recipient must pay the income tax on it, and the gift of the income must be included in taxable gifts (gift tax is owed). Two categories of "property" (here the term is used with a very broad meaning) are income producing property and all other property (which will not produce income on a continuing basis). The only method which will function appropriately, to meet your objectives, is to give away the income producing property. We have discussed, in the past, transferring partial ownership of income producing property. Income producing property will be rental real estate, mineral interests, etc.

All of us must confront issues with both types of property. If you are not the only owner of the property, we must get permission from the other owner(s) or discover what your rights and obligations are in agreements regarding transfer of your ownership interest(s).

I am changing my recommendations on the use of loans because your circumstances and those circumstances of the loan have changed. The following will explain to you why at this time the loan becomes more of a vulnerable position and why that solution will be only temporary in nature.

Prior Loans Are Not Being Repaid

There have been loans made from you to an heir in the past. There has been no significant, routine payments of principal and interest, and the amount of the loans are not decreasing (to the contrary are getting larger). One of the essential elements to place you in the position of a creditor - debtor relationship for the debt is for the debt to be reduced significantly over a long term and continuing basis. A bank would not loan money to an individual who did not repay the loan or the interest. If the loan balance at the bank were to continue to grow larger without the debt reduction, the bank would eventually balk at the loaning of more money.

You Have Consumed Virtually The Entire Gift Tax Credit

Memorandum: The credit is increasing up through 2006, however the bulk of the increase is loaded to the end of the term.

You will have only a small portion (in relation to the amount of gifts you have been making) of the credit each year available to you.

A Loan Is A Temporary Solution - NOT a Permanent Tax Savings

If you make a loan (to a beneficiary) and the loan is not repaid, the Internal Revenue Service will reclassify the loan as a gift if it is interest free or if it is not repaid to you. Therefore, the loan will be taxable under any condition.

If the loan is repaid to you, the cash will be in the estate and when the estate is created, will be taxable in the estate.

In other words, if the loan is not repaid it is taxable - it the loan is repaid it is taxable.

There may or may not be adequate credits at the date the estate is created to reduce any potential tax to a significant amount.

Warning!

It may be that you do not care what the potential for estate tax is. Under present law a surviving spouse will owe no tax on the assets transferring to the surviving spouse. If either of you name the other to receive all the assets of the other, then there will be no tax due. ("Period" - end of statement)

However - any assets passing to children or grandchildren will have tax due.

Furthermore - assuming the entire credit is eventually used, the second spouse to pass on may or may not owe a significant amount of estate tax.

In the case that you are not concerned about estate tax, then we should focus our planning efforts only on the current year to year tax issues. The long term (estate tax) issues then should be ignored. However - you must tell me that you want to ignore the estate tax issues.

 

Please ponder about what you want to accomplish.

What do you want to prevent?

What do you want to provide for?

Who do you want to provide for?

What about TOM - What about Dorothy?

I ask that you be very open with me in this planning. If you want facts, circumstances, ownership data, etc. confidential - even from children, then please inform me of this desire. If you want to protect the assets for your own living expenses, please let me know. If you want to protect the children from over-spending - please let me know.

Here are some very typical desires and attitudes that I hear from my clients:

This letter is in response to your inquiry concerning how to reduce the gift taxes being charged against your helping your kids. The family limited partnership is one method available as a vehicle for both gift tax planning and estate planning. A potential problem with the use of this planning vehicle is the process is usually a long term process. The process cannot accomplish a great deal in a year or two. Which might be a reason to start it immediately.

A Possible Solution for this mission

The family limited partnership can assist with providing for:

You have indicated that you hold a large amount of appreciated assets and would like to begin transferring these assets to your children.

Family limited partnerships are being used to achieve significant tax savings in the area of transfer taxes (i.e., estate and gift taxes). The partnership is used as a mechanism to divide family assets among family members to take advantage of rules permitting reduced valuation of the amount being transferred for transfer tax purposes. The reduced valuation is the result of a discount applied to partnership interests because of the limited partner's lack of control over the partnership and the resulting lack of marketability of that interest. Generally, because limited partners have no right to participate in the partnership's management, a buyer will pay less for a non-controlling interest in a partnership than for outright ownership and control of the underlying assets. As a result, the value of the limited partner's interest is reduced accordingly.

While family limited partnerships have historically been used to hold family real estate and operating businesses, a 1993 IRS ruling and a subsequent technical advice memorandum have indicated that the IRS will allow a minority discount for a transfer of an ownership interest in an entity to a family member even where the aggregate ownership interests of all family members provide them with control of the entity at the time of the transfer. In your case, the assets could be transferred to a limited partnership and small percentages of the limited partnership interests can be gifted to your children each year free of gift tax. You and your wife (or another family member) would remain the general partners, thereby assuring your control over the partnership and its assets.

For example, assume you and your wife wish to begin gifting assets to your children. The annual exclusion and spousal gift-splitting permits an annual gift of $20,000 to each child and the child's spouse, or an aggregate of $80,000 of assets each year without gift tax consequences. Instead of gifting the assets outright, you would contribute them to a limited partnership and each take back a 1% general partner interest and a 49% limited partner interest. Each year, your wife and you could gift a limited partnership percentage to each child. Each year we will assist in the determination of the value of the family limited partnership units. A percentage would be gifted, annually, to each child and the child's spouse. The percentage would be computed to be within the annual gift tax exclusion amount. The child and the child's spouse will be receiving limited partnership units - that do not permit the child or the child's spouse to manage the assets, or decide how much is distributed. You and Dorothy decide annually the amount of the cash distributions. Each general partner and limited partner will receive the allocated share of income or loss and will be required to individually pay income tax on the earnings. No gift tax is required to be paid on the transfers that fall within the annual limits. No repayment of distributions of cash is required - unless the partner cash distributions exceed the amount of the balance in the child's capital account. This also, of course, removes these assets from your estate so that they will not be subject to estate tax when you die.

Family limited partnerships may also be used as a means of protecting assets from creditors. If the transfer of assets to a family limited partnership does not violate applicable fraudulent conveyance rules, the creditors or bankruptcy trustees generally can not reach the assets transferred. Even though a creditor could seek a "charging order" against a limited partnership interest, the creditor may risk being treated as the taxpayer with respect to profits and losses allocated to the partnership interest. In such cases, the creditor may be taxed on "phantom" income with no assurances as to when distributions of cash would be made to cover the taxes due on such income. A creditor may instead wish to engage in negotiations which result in a favorable settlement to the debtor.

Because each family situation is different, I would like to explain to you the various options that may be available and appropriate in your circumstance.

Trusts can be a part of the plan

In many instances trusts are established as a part of the asset protection portion of the plan. Trusts may be established to hold a portion of the family limted partnership.

The use of trusts may not be necessary in your circumstances - just be aware, that the use of a family limited partnership does not preclude the use of trusts for John and Sue.

1. Estate Tax Planning - Valuation Discounts

2. Protecting Assets From Creditors

3. Gift Tax Planning

 

1. Estate Tax Planning - Valuation Discounts

a. In General

One of the main incentives for creating a family limited partnership is the discount that is available on the underlying assets for estate tax purposes. This discount is generally for the limited partner's lack of control over the partnership and the resulting lack of marketability of that interest. Generally, limited partners have no right to participate in the partnership's management. A buyer pays less for a non-controlling interest in an entity than for outright ownership and control of the underlying assets, so the value of the limited partner's interests should be reduced accordingly.

A partial interest in a family-controlled entity can be extremely difficult, if not impossible, to liquidate. This lack of marketability must be factored in when determining the transfer tax value of a transferred limited partner interest.

The market discounts on family limited partnerships holding marketable securities could be in the range of 20-30%. 15 This means that a taxpayer is essentially gifting, for example, IBM stock at 70% of its current value.

/Footnote/ 15 See Rev. Rul. 59-60, 1959-1 C.B. 237, Rev. Rul. 65-193, 1965-2 C.B. 370, Rev. Rul. 77-287, 1977-2 C.B. 319, and Rev. Rul. 80-213, 1980-2 C.B. 102, for a discussion of the factors affecting the valuation of closely held stock. See also ¶6290.

The following characteristics of an family limited partnership should be considered in assessing the amount of the discount claimed for lack of control and lack of marketability: 16

• The history and uniqueness of the partnership to be valued. The history will show the degree of stability, direction, rate of growth, and diversity of operations. From this analysis, an opinion of the level of risk of future operations can be formulated. An appraiser should look at gross and net income, dividend history, sales records, products and services, assets, nature of the business, and significant events that have affected the partnership.

• The economic outlook in general and in the specific industry. The appraiser should look closely at the partnership's position in the industry and its ability to compete with current and potential competitors.

• The loss of a key partner/manager. If the decedent was a key partner/manager, this should be considered in valuing the partnership.

• Ability to generate a profit and make distributions.

• Trades of stock of competing corporations. The IRS Valuation Guide states that: "Comparability is a question of degree. Generally, the most important factors to be considered in selecting your comparables are company sales and lines of business."

• Asset values, both current and book.

• The extent of control. If the decedent's holdings are a minority interest, there may be an argument for a substantial discount, even if the decedent's family owns sufficient shares to control the corporation.

• A binding bona fide buy-sell agreement. Such an agreement may override all other valuation considerations. 17

• Any other restrictive agreements concerning the partnership interest.

/Footnote/ 16 See Rev. Rul. 93-12, 1993-7 I.R.B. 13; Rev. Rul. 59-60, 1959-1 C.B. 237; Rev. Rul. 65-193, 1965-2 C.B. 370; Rev. Rul. 77-287, 1977-2 C.B. 319; and Rev. Rul. 80-213, 1980-2 C.B. 102. Although these rulings deal with stock of a closely held corporation, the rules should be equally applicable to family limited partnerships.

/Footnote/ 17 If a post-October 8, 1990, agreement is to be used for valuation purposes, it must: (1) be a bona fide business arrangement; (2) not be a device to transfer property to family members for less than adequate consideration; and (3) have terms which are comparable to those of an arms'-length agreement. §2703.

In measuring the discount, one of the restrictive agreements concerning a partner's interest that needs to be considered is the limited partner's inability to withdraw from the partnership. Both state law and limited partnership agreements often restrict a limited partner's ability to withdraw from the partnership. Such restrictions would clearly reduce the purchase price of a limited partner interest sold in an arm's-length transaction. However, in the context of a family-controlled entity, certain restrictions on transferring an interest imposed by the partnership agreement must be disregarded for gift and or estate tax valuation purposes unless they are no more restrictive than those that would otherwise apply under state law. 18

/Footnote/ 18 §2704(b).

Several approaches are available to avoid the consequences of this rule and, thus, maximize the lack-of-marketability discount. For example, the limited partnership can be formed in a state with favorable statutory provisions. 19 The general rule of the Revised Uniform Limited Partnership Act (RULPA) is that, in the absence of any provision in the partnership agreement to the contrary, a limited partner may withdraw from the partnership on not less than six months' written notice and receive the FMV of the right to share in partnership distributions. 20 For family limited partnerships formed in a state that has adopted the general rule, any limitation in the partnership agreement on a limited partner's ability to liquidate such interest is more restrictive than state law, and therefore would be disregarded.

/Footnote/ 19 A restriction imposed, or required to be imposed, by federal or state law is not, pursuant to §2704(b)(3)(B), an applicable restriction.

/Footnote/ 20 RULPA §603.

Georgia provides a favorable alternative to the RULPA general rule. A limited partner may withdraw from a limited partnership at the time, or on the occurrence, of events specified in writing in the partnership agreement, but the statute does not expressly allow a limited partner to withdraw in the absence of a restriction in the partnership agreement. 21 Therefore, limitations on the ability of a limited partner to withdraw that are in a partnership agreement would appear to be no more restrictive than Georgia law. As a result, the rule that partnership restrictions are disregarded apparently would not apply and a larger discount would be available for limited partner interests in Georgia family limited partnerships.

/Footnote/ 21 See Ga. Code Ann. §14603.

Observation: In some states, RULPA provides that a limited partner does not have a statutory right to withdraw if the partnership agreement specifies a definite time for partnership dissolution. 22 It can be argued that in those states, requiring the certificate to indicate a dissolution date, and the insertion of such date in the partnership agreement, would eliminate the effect of disregarding the restriction. For example, the partnership agreement could indicate that the partnership will dissolve in 50 years. Thus, under this provision, a limited partner has no withdrawal right and is locked into the partnership for its duration. 23

/Footnote/ 22 See RULPA §201(a)(4).

/Footnote/ 23 See Nave, "The Triple Double of Estate Planning: The Family Limited Partnership," 38 Tax Mgmt. Memo., Spec. Ed. 1997-3: Corp. Tax and Bus. Plan. Rev. S-59 (3/17/97).

Comment: It may also be possible to assign economic rights to the children. The general rule is that assignment of a partnership interest does not entitle the assignee to become or to exercise any rights of a partner. An assignee becomes a limited partner only as provided in the partnership agreement or upon written consent of all partners. If the assignee is not a partner, the assignee has no statutory right to withdraw from the partnership. Limitations in a partnership agreement on an assignee's right to withdraw from the limited partnership, thus, would not be more restrictive than those under state law (because, under RULPA, an assignee is not given a right to withdraw). 24

/Footnote/ 24 Id. See also RULPA §§301 and 704.

b. Multiple Discounts

If interests in a closely held entity are transferred to a family limited partnership and family limited partnership interests then are transferred for estate planning purposes, a double discount may be available. The first discount would apply when measuring the value of the underlying family limited partnership assets (i.e., an interest in a closely held entity), and the second discount when measuring the value of the transferred family limited partnership interest. For example, if a couple transfers their interest in the limited partnership, there would be a discount on these interests and a second discount through the family limited partnership. 25

/Footnote/ 25 There are some commentators who believe this approach is very aggressive. See Covey, "Family Limited Partnerships," Practical Drafting, 3780 (October 1994).

c. Lack of Control

As noted in ¶4095.A., above, the IRS issued a ruling in which it agreed that a minority discount is available on an interest in a closely held corporation even though family members as a unit control the entity. 26 Moreover, in a technical advice memorandum following that ruling, the IRS indicated that the ruling applies for estate tax purposes as well as gift tax purposes. 27 Therefore, an individual's lack of control is an important factor in determining valuation discounts.

/Footnote/ 26 Rev. Rul. 93-12, 1993-1 C.B. 202.

/Footnote/ 27 TAM 9432001.

d. Lack of Marketability

As noted above, a partial interest in a family controlled entity can be extremely difficult, if not impossible, to liquidate. This lack of marketability must be factored in when determining the gift tax value of a transferred limited partner interest. The lack-of-marketability discount has two components. The first is absence of a ready market for selling limited partner interests to third-party buyers. The second is the limited partner's inability to withdraw from the partnership (i.e., a "locked-in" discount). The second may be affected by certain rules which essentially provide that certain restrictions on transferring an interest imposed by the partnership agreement must be disregarded for gift or estate tax valuation purposes unless they are more restrictive than those that would otherwise apply under state law. 28

/Footnote/ 28 See §2704(b). The family limited partnership should be structured to minimize the impact of §2704(b). However, even if §2704(b) applies, the minority discount and general lack of marketability discount should still remain available.

e. Range of Discounts

Although many of the typical valuation cases involve closely held corporations, the reasoning used in those cases should be applicable to family limited partnerships as well. For example, in a 1985 Tax Court case, 29 the decedent owned a 15% interest in an operating business conducted by a partnership. The partnership interest was discounted by 35% to reflect the minority status and lack of marketability of the interest. Another Tax Court case involved gifts of minority interests in a real estate general partnership. 30 Focusing on the various restrictions imposed on the transferee partners, the court allowed a combined minority and lack-of-marketability discount of 35%. For valuation purposes, the Tax Court disregarded differences between minority corporate interests and minority partnership interests, stating that the critical factor is lack of control, be it as a minority partner or as a minority shareholder. Other cases have allowed a 50% discount on a limited partner interest 31 and a 30% discount. 32

/Footnote/ 29 Watts Est. v. Comr., T.C. Memo 1985-595.

/Footnote/ 30 Moore v. Comr., T.C. Memo 1991-546.

/Footnote/ 31 Howard v. Comr., 82 T.C. 239 (1984), aff'd, 786 F.2d 1174 (9th Cir. 1986), cert. denied, 479 U.S. 1007 (1986).

/Footnote/ 32 Knott v. Comr., T.C. Memo 1988-120. For an extensive discussion of valuation issues, see Covey, "Valuation Update, Including Marketability Discount and a Discussion of Discounted Cash Flow," Practical Drafting 4125 (October 1995).

Observation: To strengthen the case for a sizable valuation discount, the partnership agreement should place maximum restrictions on the transferee limited partner. 33

/Footnote/ 33 Of course, this should be done with §2704(b) in mind.

2. Protecting Assets From Creditors

Where a problem develops with creditors, an interest in a family limited partnership is relatively protected. If the transfer of assets to a family limited partnership does not violate applicable fraudulent conveyance rules, the creditors or bankruptcy trustees should not be able to reach the assets transferred.

A fraudulent transfer can be defined as a transfer made, or obligation incurred, by a debtor, with actual intent to hinder, delay, or defraud a creditor, whether or not the creditor's claim arose before the transfer was made or the obligation was incurred. If the debtor made a transfer, or incurred the obligation, without receiving reasonable equivalent value in exchange for the transfer or obligation, it was an act of fraud.

It is possible that property transferred to a family limited partnership may be set aside as a fraudulent transfer. However the creditor would have the burden and expense of proving the fraudulent transfer. 34 Moreover, the creditor may be unwilling or unable to pursue the claim or may be willing to settle the claim for a fraction of the original amount.

/Footnote/ 34 For the leading case in this area, Comr. v. Culburtson, 337 U.S. 733 (1949).

A creditor could seek a "charging order" against a limited partnership interest. Under the "charging order," the creditor receives the right to receive distributions with respect to the partnership interest. 35

/Footnote/ 35 RULPA §703.

However, a person's status as a limited partner and his lack of control over the general partner make him unable to demand distributions from the partnership. The general partner could simply choose not to make distributions. 36

/Footnote/ 36 For a more extensive discussion of these issues, see Henkel and Turner, "Family Limited Partnership Can Play a Major Role in Asset Protection Planning," 11 J. of Partnership Tax'n 216 (Fall 1994).

Moreover, the creditor may also risk being treated as the taxpayer with respect to profits and losses allocated to the partnership interest. Such treatment is generally accorded to an assignee of a partnership interest. 37 In that event, the judgment creditor of a profit generating partnership would recognize "phantom" income while the charging order was in place, with no assurance as to when distributions of cash would be made. As a result of many of these rules, it may be possible for the debtor to negotiate a favorable settlement of his obligation.

/Footnote/ 37 Rev. Rul. 77-137, 1977-1 C.B. 178.

3. Gift Tax Planning

Limited partner interests usually are given to younger members of the family. In valuing those interests for gift tax purposes, discounts are generally available for lack of control (because a limited partner is not entitled to participate in management) and lack of marketability. These discounts usually range from 20% to 50% and create the leverage that allows the family limited partnership technique to produce significant gift tax savings.

Example: A couple wants to gift $2 million of marketable securities to each of their two children. The annual exclusion and spousal gift-splitting would permit an annual gift of $20,000 38 to each child or an aggregate of $40,000 of stock each year without gift tax consequences. Instead, the couple contributes the marketable securities to a family limited partnership (initially established with each spouse owning a 1% general partner interest and a 49% limited partner interest) and give the children limited partner interests. The gift is converted from one of stock with a readily determinable value into closely held business interests that can be discounted, thus allowing more marketable securities to be transferred to the children tax free. If a valuation discount of one-third can be justified for the limited partner interest gifts, a 1.5% limited partnership interest can be given to each child each year. An interest allocable to $30,000 of family limited partnership assets (1.5% of $2 million) would have a $20,000 gift tax value. Thus, gifts of interests allocable to $60,000 (rather than $40,000) of stock could be transferred, fully covered, by the gift tax annual exclusion.

/Footnote/ 38 §2503(b). This amount is adjusted for inflation, starting in 1999.

The IRS has ruled on several occasions that, despite the broad control retained by parents as general partners, gifts of limited partner interests satisfy the present interest requirement and qualify for the annual exclusion. 39 The IRS relied on the general partners being under a fiduciary duty to act in the best interests of the partnership and its partners, and distinguished the general partner's control from a trustee's discretionary power to distribute or withhold trust income or principal. 40

/Footnote/ 39 TAM 9131006 and PLRs 9710021 and 9415007.

/Footnote/ 40 See Byrum v. U.S., 408 U.S. 125 (1972).

The leveraging effect of using a family limited partnership is even more dramatic when the $600,000 exemption equivalent is used.

Example: Assume the same facts as the above example, except each spouse transfers interests allocable to $900,000 of family limited partnership assets to the two children without paying a gift tax. Thus, the couple could reduce their estates by a total of $1.8 million by using their $600,000 exemption equivalents.

Observation: As with other gift techniques, all future appreciation on a gift of a limited partner interest is removed from the estate, eliminating estate tax liability on the appreciation. Furthermore, the income attributable to the limited partner interests given as gifts does not become part of a couple's estate, which also reduces the ultimate estate tax liability.

 

 

Bob Parrish

Voice: FL 941/387-0926; TX 915/367-3465; 1-800/535-3960; 915/580-4553

Fax: FL 941/387-0823

E-Mail: BMSarasota@Home.net

{Last date letter read} 09/14/98 Last Read By: Last Date Saved: 07/23/98 1:57 PM Last Saved By:

 

OVERVIEW

A family limited partnership is created under, and governed by, the limited partnership laws of a particular state. These statutes generally are versions of the Revised Uniform Limited Partnership Act (RULPA). A family limited partnership may be used to achieve significant tax savings in the area of transfer taxes (i.e., estate and gift taxes). The family limited partnership is a mechanism used to divide assets among family members to take advantage of rules permitting reduced valuation of the amount being transferred for transfer tax purposes. The particular benefits of the family limited partnership are (1) by reason of the ownership format, the value for transfer tax purposes can be significantly reduced; (2) the senior family member can often control the partnership; (3) the interests transferred to younger family members will not be includible in the estate of the older transferor upon the transferor's death; and (4) the protection of family assets from creditors.

EXPLANATION

Introduction

Historically, family limited partnerships have been used to hold family real estate and as an operating vehicle for family businesses. 1 A 1993 IRS ruling, however, sparked increased interest in using family limited partnerships for estate and gift tax planning purposes. 2 In the ruling, an individual, who owned all of the stock of a corporation, transferred 20% of the stock to each of his five children, thereby disposing of his entire interest in the corporation. Prior to the ruling, the IRS had taken the position that a minority discount 3 should not be allowed for a transfer of an ownership interest in an entity to a family member if the aggregate ownership interests of all family members provide them with control of the entity at the time of the transfer. 4 This position was discarded by the IRS in the 1993 ruling, in which it ruled that the transfer of each 20% ownership interest was the transfer of a minority interest in the corporation for which a minority discount was appropriate. 5 Although the ruling involved a corporation and was limited to the gift tax, the principles of the ruling should be equally applicable to limited partner interests in family limited partnerships and to the estate tax.

/Footnote/ 1 See Brier and Darby, III, "Family Limited Partnerships: Decanting Family Investment Assets into New Bottles," 49 Tax Lawyer 127 (Fall 1995).

/Footnote/ 2 Rev. Rul. 93-12, 1993-1 C.B. 202.

/Footnote/ 3 See ¶4095.C.2, below, for a discussion of valuation discounts. See also, ¶6290 for an in-depth discussion of minority discounts.

/Footnote/ 4 Rev. Rul. 81-253, 1981-2 C.B. 187, revoked by Rev. Rul. 93-12, 1993-1 C.B. 202. See also Ahmanson Foundation v. U.S., 674 F.2d 761 (9th Cir. 1981).

/Footnote/ 5 See also TAM 9432001 (where a corporation was wholly owned by a decedent and his son, a block of the stock, which was includible in the decedent's gross estate and was bequeathed to his son, is valued without reference to the stock the son owned before the bequest).

Observation: By utilizing a family limited partnership, taxpayers can reduce asset values used in calculating transfer taxes on those assets while allowing benefactors to maintain full control over the assets while they are alive.

Step 1 - Identify Assets Meeting Logical Criteria For Transfer to A FLP

The first step in the formation of a family limited partnership is the transfer of assets (typically those with significant appreciation potential or a relatively high rate of return) to a newly created partnership. 6 For example, married taxpayers with a large portfolio of marketable securities could contribute all of their marketable securities to the family limited partnership. In exchange, they would generally receive both a general and limited partnership interest in the family limited partnership.

/Footnote/ 6 Personal assets such as automobiles and the taxpayer's personal residence should not be placed in the family limited partnership.

Where property encumbered with liabilities is transferred to the family limited partnership, the transferor may recognize gain. This is because the transferor is deemed to receive a cash distribution to the extent that he is relieved of liabilities. 7 To the extent this deemed distribution exceeds his basis in the property, gain is recognized. 8 The following are some planning techniques which may be used in such a situation: 9

• Have the transferor personally guarantee the debt or indemnify the family limited partnership, to ensure there is no reduction in the transferor's liability upon the transfer;

• Shift the debt security from the property that will be transferred to the family limited partnership to other assets owned by the transferor;

• Reduce the amount of the debt prior to transferring the property to the family limited partnership.

/Footnote/ 7 §752(b).

/Footnote/ 8 §731(a).

/Footnote/ 9 Tucker and Mancini, "Family Limited Partnerships and Asset Protection," 23 J. of Real Est. Tax'n 183 (Spring 1996).

Observation: Local and state law should be reviewed to determine if the property transfer is subject to transfer and recordation taxes. 10

/Footnote/ 10 See Scott v. Clerk of the Circuit Court for Frederick County, Md. Ct. Spec. App., No. 235 (11/8/96) (Because there is no statutory exemption for a partner-to-partnership conveyance of real property for estate-planning purposes, transfers of real estate to a family limited partnership where limited partner interests were going to be gifted to family members were subject to recordation and transfer taxes).

It is important that the entity be classified as a partnership. However, under the "check-the-box" regulations, this should be relatively easy to achieve. The regulations have a default mechanism that provides that a newly formed domestic entity with two or more members is deemed to be a partnership unless corporation status is elected. 11

/Footnote/ 11 Regs. §301.7701-1 through Regs. §301.7701-4. For a more extensive discussion of the "check-the-box" regulations, see ¶4020.

Where a married couple owns a general partner interest, they have control over the family limited partnership (i.e., power to make management decisions, sell assets, and determine the time and amount of distributions to partners) regardless of the overall ownership percentage reflected by that interest. The general partner interest is usually small (e.g., 1%) because the objective is to transfer value to younger generations. This transfer occurs when limited partner interests are gifted to the next generation.

Comment: The death of a sole general partner causes a dissolution of a limited partnership. In turn, that dissolution causes a loss of any discount with respect to any interest held by the general partner at death. To avoid this result, the partnership should be arranged so that one individual never holds the entire general partnership interest.

Observation: In order to limit personal liability, a transferor may want to consider using a corporation or LLC as a general partner.

Step 2 Formation Must Meet Reasoning Other Than Tax Savings

The family limited partnership should be organized as a bona fide business arrangement and the purposes for which it is organized should be documented. In a 1997 technical advice memorandum, the National Office determined that a transfer of assets to a family limited partnership was not a bona fide business arrangement, but instead was a device to transfer property to family members for less than adequate consideration. 12 The National Office determined that the family limited partnership should be disregarded for estate tax valuation purposes and no discount allowed for the marketable securities represented by the partnership interest.

/Footnote/ 12 TAM 9719006. For full text of the TAM, see 16 Tax Mgmt. Wkly Rep. 434 (3/17/97). The National Office advised that the formation of the partnership and transfer of associated assets two days before the death of the decedent should be viewed as a single testamentary transfer because nothing of substance changed as a result of the series of transactions.

The Tax Court has found the following factors relevant for determining whether an intra-family transaction should be considered a bona fide business transaction: 13

• Family control;

• The parties' business experience;

• Independent appraisals;

• Independent counsel;

• Court supervision;

• Conflicting roles;

• Presence of negotiations;

• Transfers to avoid litigation;

• Transfers to remove grantor from business; and

• Form and adequacy of consideration.

/Footnote/ 13 See Saltzman v. Comr., T.C. Memo 1994-641.

A family limited partnership created to conduct a family's business or non-business financial affairs should generally be considered a bona fide business arrangement. 14

/Footnote/ 14 See PLR 9547004 (An entity to which the taxpayers only contributed securities and cash had associates and a business purpose and, thus, was classified as a partnership and not a trust).

Bob Parrish CPA-----------------

Income Tax Considerations

1. Transferring Appreciated Property

In general, assets can be transferred into the family limited partnership tax free. 41 However, gain is recognized if appreciated securities are transferred to an investment company, (i.e., if (1) the transfer results, directly or indirectly, in diversification of the transferors' interests and (2) more than 80% of the value of the transferee's assets are held for investment and are readily marketable stocks, securities, cash, notes, precious metals, options, or interests in RICs or REITs). 42

/Footnote/ 41 §721(a).

/Footnote/ 42 §721(b), §351(e). See also Regs. §1.351-1(c), which does not reflect the amendment of §351(e) by the Taxpayer Relief Act of 1997.

Conceptually, gain should not be recognized upon the transfer of appreciated securities to a limited partnership if spouses are the only partners. This is because gain or loss is not recognized on a transfer of property between spouses. 43 Thus, spouses may diversify their respective holdings through exchanges between one another without recognizing gain.

/Footnote/ 43 §1041.

Observation: Since spouses are able to diversify without recognition of gain when not using a partnership, it seems illogical for them to be subject to tax when they are the only persons transferring assets to a partnership. 44

/Footnote/ 44 See Weiner and Leipzig, "Family Limited Partnerships Can Leverage the Annual Exclusion and Unified Credit," 82 J. of Tax'n 164 (March 1995).

Recommendation: Because there is no authority for the proposition that the rule relating to transfers of appreciated property to a partnership which would be treated as an investment company if it were incorporated is inapplicable when spouses are the only persons contributing assets to the partnership, it is recommended that each spouse contribute identical securities. The simplest method for accomplishing this is for each spouse to transfer the securities to a tenancy-in-common account and have the securities transferred from that account to the family limited partnership account. 45 Another approach would be to contribute enough other assets (such as real estate) so that the 80% threshold for securities and other investment property is not reached. Second homes and investment real estate could be contributed.

/Footnote/ 45 See PLR 9012024 (No gain or loss is recognized, and §721(b) does not apply, where a husband and wife individually owned significant investment assets in the form of stocks and bonds, exchanged ownership of these assets so that each owned an interest in each asset, and then transferred the stocks and bonds to a partnership, in which each became a partner).

In 1996, the IRS issued regulations which provide that the transfer of stocks and securities is not considered to result in diversification of the transferors' interests if each transfers a diversified portfolio of stocks and securities. 46 A portfolio of stocks and securities is diversified for this purpose if it satisfies certain tests. Those tests are met if not more than 25% of the total assets transferred by each transferor consists of stocks and securities of a single issuer, and not more than 50% of the value of the total assets transferred by each transferor consists of stock and securities of five or fewer issuers. 47

/Footnote/ 46 Regs. §1.351-1(c)(6).

/Footnote/ 47 §368(a)(2)(F)(ii).

Another factor to consider in contributing appreciated property to a family limited partnership is that such property has built-in gain. For example, assume the fair market value of the property contributed to the family limited partnership is $10,000,000, but its basis is $1,000,000. There is a built-in gain on contribution equal to $9,000,000. The regulations provide that if a contributing partner transfers a partnership interest, built-in gain or loss must be allocated to the transferee partner as it would have been allocated to the transferor partner. 48 If the contributing partner transfers a portion of the partnership interest, the share of built-in gain or loss proportionate to the interest transferred must be allocated to the transferee partner. 49

/Footnote/ 48 Regs. §1.704-3(a)(7).

/Footnote/ 49 Id.

Example: A family limited partnership holds property worth $10,000,000 which has a basis of $1,000,000. X, a partner in the partnership, transfers a 10% limited partnership interest to his son Y. The discount factor used is 30%. Therefore, the value of the limited partnership interest transferred is $700,000 (70% x $1,000,000). Y's basis within the family limited partnership is $100,000. Assume an asset which has a basis of $100,000 is sold by the family limited partnership for $1,000,000. It appears that 10% of the $900,000 gain would be allocated to Y even though the value of the partnership interest initially received by Y was $700,000. 50

/Footnote/ 50 See Nave, "The Triple Double of Estate Planning: The Family Limited Partnership," 38 Tax Mgmt. Memo., Spec. Ed. 1997-3: Corp. Tax and Bus. Plan. Rev. S-59 (3/17/97).

2. Installment Sales of Family Limited Partnership Interests

Under certain circumstances, it may be beneficial to sell a limited partner interest to family members. An installment sale could be used if the seller wants to continue receiving an income stream from the property. This produces transfer tax savings because the limited partner interest would be sold for a note equal to its discounted value.

Example: Assume that a 25% interest in a family limited partnership with assets valued at $2 million is sold in an installment sale for $350,000 ($2 million x 25% x a discount factor of 30%). In this manner, $150,000 of value would pass free of transfer tax.

Comment: There is a potential income tax concern to the transaction in the example above because marketable securities cannot be sold on an installment basis. 51 Since the underlying assets are marketable securities, it is unclear whether the sale of the limited partner interest would trigger full recognition of gain. 52

/Footnote/ 51 §453(k)(2)(A).

/Footnote/ 52 The legislative history of §453(k)(2) states that the sale of an interest in a partnership that owns such assets should be denied installment sale treatment only if the seller of the interest could have caused the partnership to sell the stocks or securities directly. S. Rep. No. 313, 99th Cong., 2d Sess. 131 (1986).

Family Limited Partnership Revived in the 1990's

You asked me to provide you with some information on the use of family limited partnerships in estate planning. Family limited partnerships are currently a popular topic in the estate planning field, and I have had a number of such requests from other clients.

Family partnerships have long been used as a tax reduction device by astute tax planners. In the pre-Reagan era of high marginal income tax rates, family partnerships were often used to shift income from family members in a high tax bracket (i.e., the parents) to those in a lower bracket (the children). In a typical case, a parent who owned an income-generating business or piece of real estate would transfer it to a partnership and then make gifts of limited partnership interests to his children. A portion of the income from the business or real estate could then be directed to the children, who would usually be subject to a much lower tax rate than their parent.

The use of family partnerships tapered off after the 1986 Tax Reform Act for two reasons. First, the lowering of the top income tax rates reduced the incentive to shift income to family members in lower brackets. The second reason was the enactment of the "kiddie tax," which subjected passive income received by children to the same tax rate that was paid by their parents. As a result, there was no longer a strong income tax incentive to creating a family partnership.

In the early 1990s, however, family limited partnerships were revived as an estate tax planning tool. The critical stimulus was the IRS's 1993 publication of Revenue Ruling 93-12, in which it abandoned its discredited "family attribution" theory. Before this ruling, the IRS had taken the position that the interests of all family members must be considered when valuing a gift of an interest in a family-controlled entity. For example, if Father, who owned 100% of a family corporation, made a gift of 10% of the stock to each of his three children, it was the IRS position that none of the gifts qualified for a minority interest discount since the family still owned 100% of the corporation.

After consistently losing on this issue in court, the IRS reversed itself in Rev. Rul. 93-12 and said that it would no longer apply family attribution. As a result, in the example above Father was now allowed to discount the value of each of the gifts to his children, thereby reducing the gift tax that he paid on the transfers.

Smart tax practitioners soon realized that the family limited partnership was an ideal vehicle for taking advantage of the discounts that became available with Rev. Rul. 93-12. Unlike the pre-1986 family partnerships, these new partnerships were used to reduce transfer taxes, i.e., the gift, estate, and generation-skipping taxes, rather than income taxes. The new family partnerships were no longer funded solely with businesses and real estate. Since the income from the property was no longer relevant to the decision to create a partnership, the new type of family limited partnership could be funded with a variety of assets, including investment assets and assets that produced little or no income.

Under current practice, a parent (or grandparent) creates a family limited partnership, naming himself as the general partner. The parent will generally contribute most of the assets to the partnership. Typically, he will receive a 1% general partnership interest (to ensure his control) and the rest as a limited partnership interest. His children (or grandchildren) will make modest contributions to the partnership in return for relatively small limited partnership interests. The parent will then begin to make gifts of his limited partnership interests to the children. These gifts will be subject to large discounts, sometimes of up to 70%, depending upon the size of the transfer and the restrictive features of the partnership agreement.

An example is the best way of demonstrating the tax savings that are inherent in family limited partnerships. Assume that Father contributes $980,000 in stocks and bonds to a family limited partnership in return for a 1% general partnership interest and a 97% limited partnership interest. At the same time, his two children each contribute $10,000 in cash to the partnership in exchange for a 1% limited partnership interest.

Several months later, Father decides to make a gift of a 10% limited partnership interest to each of the children. Each 10% interest represents $100,000 in partnership assets, but Father claims that the 10% partnership interest, because of restrictions imposed by the partnership agreement, is worth only $50,000. In addition, each gift qualifies for the $10,000 annual exclusion, reducing the taxable gift to only $40,000. By using the partnership, Father is able to transfer $100,000 of assets to each child, while treating it as a $40,000 gift for tax purposes. Over time, Father can transfer his entire 97% limited partnership interest to the children at a significantly reduced gift tax cost, while still maintaining control over the partnership through his 1% general partner interest. If the partnership works properly, only that 1% interest will be taxed in his estate at death.

Needless to say, the IRS has not been happy with the potential loss of tax revenue. As a result, it has instituted a number of audits of family limited partnerships. These audits, as well as related litigation, are still in a preliminary stage and it remains unclear whether the IRS will forced to allow significant discounts for gifts of family limited partnership interests. Before entering into any family limited partnership, you should be aware that there is an audit risk, especially if the partnership is funded with nonoperating assets.

Family limited partnerships remain a popular, albeit risky, tax planning device. You may wish to consider creating one as part of your estate plan. We will continue to monitor the IRS position in this area, and will prepare a plan that best meets your family's needs while still acknowledging the IRS' concerns. If you need any further information about this subject, please do not hesitate to contact me.

Updated Internal Revenue Service Position Letter

 

Bird's Eye View

The gift tax and the estate tax use the same system. The same tax table is used, the same credit is used. Furthermore, when the estate tax return is prepared, the gifts (not qualifying for the annual exclusion) are included on the estate tax return. The tax is computed based upon the total of the lifetime transfers (not qualifying for the annual exclusion) and the items in the name of the decedent at the date of demise. I shall cover some examples of items the tax is charged on after a few more words of general explanation.

General Explanation

You have indicated that you are interested in a gift plan and an estate plan and you want to understand the basics of the federal estate tax system. This letter responds to that request.

At the time of death, a federal estate tax is imposed on property transferred by a decedent. This tax is imposed on the transfer of wealth. The measure of the amount of tax is the net value of those property rights which are transferred.

Property transferred at death includes the property which the decedent will directly own at the time of her death. This might include, for example, the family residence, stocks, bonds and bank certificates of deposit which are in his/her name. Also included are items of personal property such as household furnishings and jewelry. However, property that is not owned directly at the time of death may also be subject to tax for federal estate tax purposes.

The purpose of the federal estate tax is to impose tax on the transfer of wealth at death, without regard to how that property transfer is accomplished. For example, if beneficiaries, other than a spouse, will succeed to property ownership at the time of a person's demise by reason of the property being held as joint tenants with the right of survivorship, and the decedent purchased that property, the estate tax will apply. Similarly, if the decedent holds "incidents of ownership" (for example, the right to designate the beneficiary) of an insurance policy on his/her life, the proceeds will be includible in his/her gross estate. Also includible will be property that s/he has previously transferred in trust but over which s/he has retained certain rights and powers under the trust instrument. Some limited types of property will be included even where s/he has given up all his/her rights in property, if the termination of such property rights occurs within three years of death. As you can see, the scope of the estate tax is broad. Careful planning is necessary to assure that these tax traps are avoided.

Under current law, a spouse has the right to pass all property in the name of the decedent to the surviving spouse free of taxation. However, at the demise of the surviving spouse the entire estate will be taxed (and furthermore, usually the basis of the property will be more than at the first spouse's demise). It is imperative that the first spouse to pass on provide for the credit (in 1998 it is $625,000 be fully utilized by passing the property up to that limit to the beneficiaries other than the surviving spouse).

How is the tax computed?

The estate tax is imposed on a net estate basis. Thus, after identifying all the assets includible in the gross estate, certain deductions are available to offset that gross amount. These include funeral expenses, administration expenses, claims, and other debts and mortgages.

Additionally, in 1997 the first $600,000 of assets is protected from estate taxation. This is accomplished through the availability of a "unified credit," also known as the "applicable credit amount." This tax credit is also available during lifetime and, accordingly, may have been partially or completely used during life. If completely used during life, it would not be available to protect assets transferred at death from the application of the federal estate tax. The amount protected from estate tax (known as the "applicable exclusion amount") will increase from $600,000 to $625,000 in 1998. The exclusion amount will continue to increase until it reaches $1 million in 2006, allowing more and more property to escape the estate tax.

Assets which are not protected from tax by the unified credit (or otherwise) will be taxed at rates ranging up to 55%. A state death or inheritance tax will also often be due, but this tax can offset the federal estate tax through the use of a credit.

Samples of items the tax will be charged on

Your home

Your checking account

Your savings

Your real estate

Your investments

Your personal property

Your collectibles - rugs, art work, jewlry, etc.

Mineral interests - your share of oil wells, etc.

Partnerships

Any property your name is on

Sometimes - life insurance

How BAD Can The Tax Be?

If the first spouse to pass on makes a will to provide that the credit be fully utilized under the phase in rules then some items owned can be transferred to the heirs other than the surviving spouse. If the surviving spouse is to receive the remainder of the asset, then the tax owing at the demise of the first spouse is held to zero.

The problem will then be exacerbated at the demise of the second spouse.

For illustrative, worst case scenario I shall set the remainder of the credit as zero.

We shall make the following scenario:

In order to make a point I shall make the scenario computations assuming that there is no credit remaining for the remainder of the estate.

In this scenario, we see there is little cash available for paying the estate tax and the final expenses. The estate tax will be approximately $320,000.

This leaves a deficit in the estate of $320,000. Furthermore, there is no liquidity to pay for the court costs and legal fees. This forces either a request for a payout of the tax which will incur added costs of interest and administration or of a liquidation of one or more of the estate's assets. I shall ignore any income tax on the sale of estate assets under the assumption the sale would be structured to close before the expiration of six months after the date of demise. If that were not the case, then there would be an income tax implication. Whether it would be a gain or loss is not known and cannot be forecasted.

With some planning for cash accumulations and for lifetime transfers qualifying for the exclusion, this amount can be reduced. Such tools as the commuity property laws, ownership as joint tenants, the living trust and other itmes must be used in the plan and considered. It is not too late to start.

Laws will change and circumstances will change. The actual results will change.

The lesson is - planning is important. The plan must be monitored. The plan must be revised from time to time.

I hope that this explanation is sufficient for your purposes. Please inform me if I can be of further assistance.

LTR 9751003

Section 2503 -- Taxable Gifts

UIL Number(s) 2503.03-00

Summary

Gifts of Limited Partnership Interests Not Eligible for Annual Exclusion

The Service has ruled in technical advice that gifts of limited partnership interests are gifts of future interests and do not qualify for the annual gift tax exclusion.

The donor is a widow with no children who owned several acres of land with a leased industrial building. She formed a limited partnership and transferred a 95 percent interest in the building to the partnership for a limited partnership interest. She also transferred the remaining 5 percent interest in the building to an S corporation in which she was the sole shareholder. The corporation then transferred its interest in the building to the partnership in exchange for a general partnership interest. Over a period of a couple of years, the donor gifted limited partnership interests to 35 family members and trusts for the benefit of family members who were minors.

The partnership agreement provides for income to be distributed to the limited partners in the complete discretion of the general partner and allows the general partner to retain income "for any reason whatsoever." As a result, said the IRS, it was uncertain at the time of the gifts whether any income would be distributed to the limited partners. For this reason, said the Service, the income component of the limited partnership interests is not a present interest for section 2503(b).

The partnership agreement also contains restrictions that prohibit the limited partners (other than the donor) from taking various actions. For instance, they cannot transfer or assign the gifted interests, nor can they withdraw from the partnership or receive a return of capital contributions until the year 2022. Also, no person can become a substituted limited partner without approval by 50 percent of the partnership interests together with the approval of the donor. An economic right requiring joint action with others, said the Service, is a contingent right regarded as a future interest.

The Service concluded that although title is vested in the donees, the limited partnership interests lack the tangible and immediate economic benefit required under section 2503(b) for a present interest in property and ruled the gifts are gifts of future interests that do not qualify for the annual exclusion.

Full Text

 

Date: august 28, 1997

 

Control No.: TAM-100711-97

 

Taxpayer's Name:

Taxpayer's Address:

Date of gift:

Conferences held:

(by telephone)

 

LEGEND:

Donor = * * *

Limited Partnership = * * *

Corporation = * * *

Building 1 = * * *

Building 2 = * * *

State = * * *

 

ISSUE

[1] Do the gifts of limited partnership interests made by the Donor qualify for the annual exclusion provided for in section 2503(b) of the Internal Revenue Code?

FACTS

[2] Donor is a widow with no children. Prior to the transactions described below, she owned several acres of land with a leased industrial building (Building 1), valued at approximately $2.4 million, and a second building (Building 2), valued at approximately $110,000.

[3] On December 30, 1991, when she was 71 years old, Donor gifted a one-eleventh interest in Building 2 to each of 11 family members. On January 1, 1992, the 11 family members reallocated their interests in Building 2 so that each of the four "family units" representing Donor's 4 siblings (one was deceased), owned a one- quarter interest in Building 2.

[4] On September 24, 1992, Donor set up an S corporation (Corporation) to which she transferred $9,800 in cash. Donor was the sole shareholder of Corporation. On September 25, 1992, Donor created 7 trusts, one each for the benefit of her 7 grandnieces and grandnephews who were minors. The initial corpus of each trust was $10.

[5] On December 22, 1992, the Donor formed the Limited Partnership under State's revised limited partnership act. On December 31, 1992, all of the following occurred:

[6] Donor transferred a 94.77-percent interest in Building 1 to the Limited Partnership and received a 90.6-percent limited partnership interest. Donor transferred the remaining 5.23-percent interest in Building 1 to the Corporation. The Corporation transferred its 5.23-percent interest in Building 1 to the Limited Partnership and received a 5-percent general partnership interest. The 11 members of Donor's family who owned Building 2 transferred their 100-percent interest in Building 2 to the Limited Partnership and received, as a group, a 4.4-percent limited partnership interest.

On the same day, Donor gifted a 29-percent limited partnership interest, in varying percentages, to 35 family members and trusts for the benefit of family members who were minors. Each of the four family units was given a total 7.25-percent interest. On the same day, five donees from one family unit, which consisted of 10 donees, assigned a part or all of their gifted partnership interests to three other donees of the family unit -- one adult and two trusts for minors.

[7] On March 10, 1993, the following occurred: The partners consented to the intra-family assignments of December 31, 1992. Donor gifted a 42-percent limited partnership interest, in varying percentages, to the same 35 family members and trusts for the benefit of family members who were minors. Each of the four family units was given a total 10.50-percent interest. Donor valued each 1-percent limited partnership interest at $9,900. The same five donees from the one family unit assigned a part or all of their gifted partnership interests to the same three donees within the family unit.

[8] In November 1993, Donor and Corporation made capital contributions to the Limited Partnership in the amounts of $283,027 and $14,896, respectively. The purpose of these contributions was to enable the Limited Partnership to purchase a tract of land. As a result of the contribution, Donor's limited partnership interest increased to 27.6 percent. Corporation remained the 5-percent general partner.

[9] On January 1, 1994, the following occurred: The partners consented to the intra-family assignments of March 10, 1993. Donor gifted her remaining 27.6-percent limited partnership interest, in varying percentages, to the 35 family members and trusts for the benefit of minor family members. Each of the four family units was given a total 6.90-percent interest. Donor valued each 1-percent limited partnership interest at $12,300. The same five donees from the one family unit assigned a part or all of their gifted partnership interests to the same three donees within the family unit.

[10] Following these transfers, members of Donor's family owned a 95-percent limited partnership interest and Donor's wholly owned Corporation owned a 5-percent general partnership interest.

[11] The Limited Partnership agreement contains the following provisions with respect to the limited partnership interests:

 

(1) CONCERNING DISTRIBUTIONS OF INCOME

 

Section 5.1: the General Partner may distribute funds of the

partnership to the partners at such times and in such amounts as

the General Partner, in its sole discretion, determines to be

appropriate. Without limiting the generality of the foregoing,

the General Partner shall have complete discretion to retain

funds within the partnership for future partnership expenditures

OR FOR ANY OTHER REASON WHATSOEVER. [Emphasis supplied.]

 

(2) CONCERNING WITHDRAWAL/RETURN OF CAPITAL CONTRIBUTIONS

 

Section 3.2: [No right to withdraw or receive capital unless

otherwise specified in the agreement.]

 

Section 7.4: No Limited Partner shall be entitled to . . . the

return of its Capital Contributions except to the extent, if

any, that distributions made pursuant to the express terms of

this Agreement may be considered as such by law or upon

dissolution and liquidation of the Partnership, and then only to

the extent expressly provided for in the Agreement and as

permitted by law.

 

Section 7.4: No Limited Partner shall be entitled to . . .

withdraw from the Partnership except upon the assignment by it

of all of its Partnership Interest IN ACCORDANCE WITH SECTION

10.2. [Emphasis supplied.]

 

(3) CONCERNING TRANSFERS OF THE INTERESTS

 

Section 10.2: Except as provided in this Article to the

contrary, no Limited Partner's interest in the Partnership shall

be assigned, mortgaged, pledged, subjected to a security

interest or otherwise encumbered, in whole or in part, and any

attempt by any Limited Partner to assign or otherwise encumber

its interest shall be void ab initio. Notwithstanding the

preceding sentence, [Donor] may, at any time and from time to

time . . . transfer and assign her interest in the partnership

by written instrument . . .

 

(4) CONCERNING SUBSTITUTION OF LIMITED PARTNERS

 

Section 10.3. No person may become a Substituted Limited Partner

except an assignee who complies with this Section 10.3. No

assignee of a Partnership Interest of a Limited Partner or any

portion thereof shall have the right to become a Substituted

Limited Partner unless all of the following conditions are

satisfied:

 

(a) the assignor executes a written instrument of

assignment together with such other instruments as the

General Partner may deem necessary to effect the admission

of the assignee as a Substituted Partner;

 

(b) such instrument has been delivered to, received and

approved in writing by the General Partner; and

 

(c) the Super Majority Vote of the Partners (which must

also include the vote of the General Partner) to such

substitution has been obtained, the granting or denial of

which shall be within the sole discretion of each Partner.

 

[12] A Super Majority Vote of the partners means (i) so long as Donor or her estate is a limited partner, a vote of Donor, or her estate, together with the vote of the partners holding at least 50 percent of the partnership interests held by partners other than Donor or her estate, or (ii) if neither Donor nor her estate is a limited partner, a vote of the partners holding at least 67 percent of the partnerships interests.

[13] At issue are the Donor's gift tax returns for the 1993 and 1994 tax years. In each year, Donor claimed an annual exclusion for each of the gifts of limited partnership interests made to the family members and trusts for the benefit of minor family members.

LAW

[14] Section 2501 provides that a tax is imposed on the transfer of property by gift.

[15] Section 2503(a) provides that the term "taxable gifts" means the total amount of gifts made during the calendar year.

[16] Section 2503(b) provides that in the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of such gifts to such person shall not, for purposes of subsection (a), be included in the total amount of gifts made during such year.

[17] Section 25.2503-3(a) of the Gift Tax Regulations provides that no part of the value of the gift of a future interest may be excluded in determining the total amount of gifts made during the "calendar period." "Future interest" is a legal term, and includes reversions, remainders, and other interests or estates, whether vested or contingent, which are limited to commence in use, possession or enjoyment at some future date or time.

[18] Section 25.2503-3(b) provides that an unrestricted right to the immediate use, possession, or enjoyment of property, or the income from property is a present interest.

[19] Under State law applicable in this case, a limited partnership interest is assignable in whole or in part, unless otherwise provided in the partnership agreement. A limited partner may withdraw only at the time specified in the agreement. Ordinarily, a general partner is a fiduciary with respect to the limited partners. See McLendon v. McLendon, 862 S.W.2d 662 (1993).

ANALYSIS

[20] The issue presented is whether the limited partnership interests gifted by Donor are gifts of a present interest in property. As stated by the Supreme Court, "[t]he question is of time, not when title vests, but when enjoyment begins." Fondren v. Commissioner, 324 U.S. 18, 20 (1945). It is not enough that the donee has vested rights; he must also have the present right to use, possess or enjoy the property. In other words, the donee must have the right to a substantial present economic benefit. Id; see also Commissioner v. Estate of Holmes, 326 U.S. 480 (1946).

[21] For purposes of section 2503(b), a gift may be separated into its component parts, one of which may qualify as a present interest, others of which may not. Thus, if the component comprising the capital or corpus of the gift does not satisfy the present interest requirements, but the element comprising the income rights does, an annual exclusion may be allowed for the gift of the income rights. Fondren v. Commissioner, supra at 21; Commissioner v. Disston, 325 U.S. 442 (1945). Nevertheless, a right to income is a present interest only if, at the time of the gift, there is a requirement for a steady and ascertainable flow of income to the donee. Commissioner v. Disston, supra at 449; Maryland National Bank v. United States, 609 F.2d 1078 (4th Cir. 1980); Calder v. Commissioner, 85 T.C. 713 (1985).

[22] In this case, the partnership agreement provides for income to be distributed to the limited partners in the "complete discretion" of the general partner. The general partner may retain funds within the partnership for future partnership expenditure. Further, the general partner may retain funds FOR ANY REASON WHATSOEVER. This provision for the general partner's retention of income "for any reason whatsoever" is extraordinary and outside of the scope of a business purpose restriction. The provision effectively obviates the fiduciary duty ordinarily imposed upon a general partner, and clothes the general partner with the authority to withhold income for reasons unrelated to the conduct of the partnership.

[23] Consequently, it was uncertain, at the time of the gifts, whether any income would be distributed to the limited partners. For this reason, the income component of the limited partnership interests failed to require, at the time of the gifts, that there be a steady and ascertainable flow of income to a donee/limited partner. Because the income component of the limited partnership interests did not entitle the donees to the immediate use, possession or enjoyment of the income, the income component was not a present interest for purposes of section 2503(b).

[24] The limited partnership interests also were subject to restrictions, contained in the limited partnership agreement, that prohibited certain actions that might otherwise be taken by limited partners. For example, under the agreement, the donees could not transfer or assign the gifted interests; nor could they withdraw from the partnership or receive a return of capital contributions until the year 2022. Section 7.4 of the agreement provides that a Limited Partner may assign its partnership interest only in accordance with section 10.2. It is clear from section 10.2 that only the Donor could assign limited partnership interests. This being the case, section 10.3 must be read to apply only to assignees of the Donor. The fact that all partners consented to the intra-family assignments of December 31, 1992, and March 10, 1993, does not void this provision of the partnership agreement.

[25] Moreover, an economic right requiring joint action with others is a contingent right regarded as a future interest. Ryerson v. United States, 312 U.S. 405 (1941); Blasdel v. Commissioner, 478 F.2d 226 (5th Cir. 1973); Chanin v. United States, 393 F.2d 972 (Ct. CI. 1968). Thus, the right of a limited partner to join with other partners to liquidate the partnership does not change the character of the interest as a future interest.

[26] In the present case, although title vested in the donees, the limited partnership interests lacked the tangible and immediate economic benefit required under section 2503(b) for a present interest in property. See e.g., Hamilton v. United States, 553 F.2d 1216 (9th Cir. 1977); Berzon v. Commissioner, 534 F.2d 528 (2d Cir. 1976).

[27] Thus, regardless of whether the components of the gifted limited partnership interests are considered separately or together, the gifts failed to confer on the donees the substantial present economic enjoyment required under section 2503(b) for a present interest.

CONCLUSION

[28] The gifts of limited partnership interests are gifts of future interests and, therefore, do not qualify for the annual exclusion under section 2503(b).

[29] A copy of this Technical Advice Memorandum should be given to the taxpayer. Section 6110(j) provides that it may not be used or cited as precedent.

LTR 9710021

Section 2701 -- Transfers of Interests in Businesses

UIL Number(s) 2701.00-00, 2503.03-00, 2704.00-00, 2704.02-01,

2036.02-00, 2038.01-00, 2642.03-00

Summary

STOCK TRANSFER NOT SUBJECT TO SPECIAL VALUATION RULES.

The Service has ruled that a transfer of an interest in a business trust to family members will not be subject to section 2701 even if the transferor retains other business trust interests.

A couple created a business trust, classified as a partnership, that has Class A, Class B, and Class C ownership interests. Holders of Class A interests manage the trust's business and affairs. Distributions of trust income and distributions on dissolution are made to each owner, pro-rata. No owner may demand a distribution or return of his capital account. An owner may sell his interest to a third party subject to a right of first refusal granted to other owners.

In many cases, a transfer of a Class B or Class C interest must be made with the consent of each Class A owner. However, transferees of Class B interests by gift have the right to gift or sell the Class B interest within 90 days after receipt, without the consent of the Class A owners. The trust also provides that if a Class A owner withdraws from the trust, the Class A interest will convert to a Class B interest representing an equivalent economic interest in the trust.

The trust will terminate in 2045 but may be extended until 2055 with unanimous consent. The trust will terminate earlier if a Class A owner withdraws. An owner is deemed to withdraw upon an assignment for the benefit of creditors or a bankruptcy filing. State law, however, provides that a business trust will have perpetual existence and that the death or bankruptcy of an owner will not terminate a trust.

Section 2.3 of the trust provides that any person may make a payment to the trust for a designated owner's benefit. The designated owner will have the right to withdraw the funds for 60 days. On expiration of that period, the amount will be added to the recipient's account.

The Service concluded that a transfer of a Class B or Class C interest will not be subject to section 2701 even if the transferor retains a Class A interest. The three classes of stock are all the same class of interest for purposes of section 2701, the Service explained. Further, the Service said that the couples' gifts of Class B interests will qualify for the annual exclusion because, for 90 days after receipt, the transferee will have the right to gift or sell the interest without the consent of the Class A owners.

The Service also said that the Class A owners are the equivalent of general partners and that Class B and Class C owners are like limited partners. The Class A owners occupy a fiduciary position and cannot distribute or withhold distributions for purposes unrelated to the conduct of business, however, the Service said. Accordingly, the Service concluded that the value of a Class B or Class C interest transferred by the couple will not be included in the transferor's gross estate under section 2036(a) or 2038 by reason of individual's general partner status.

The Service also concluded that a conversion of a Class A interest into a Class B interest on the withdrawal of a Class A owner from the trust will cause a lapse of voting rights. If family members control the entity before and after the lapse, the lapse will be a transfer to which section 2704(a) applies, the Service said.

The Service also said that trust provisions on the ability of owners to liquidate the trust are not more restrictive than the provisions that would apply under state law, so the trust provisions are not applicable restrictions under section 2702(b)(2) and reg. section 25.2704-2(b).

The Service further concluded that transfers made to the trust for the benefit of a specific owner, under section 2.3 of the trust, will be gifts of present interests that will qualify for the section 2503(b) annual exclusion. Transfers pursuant to this provision will not be considered transfer to a trust that is subject to section 2642(c)(2). The transfers will be subject to section 2501, though, and could be direct skips. The Service added, though, that to the extent a gift qualifies for the annual exclusion, the inclusion ratio will be zero.

Full Text

 

Date: December 6, 1996

 

Refer Reply to: CC:DOM:P&SI:Br.4/PLR-81038-95

Re: * * *

 

LEGEND

 

Taxpayer = * * *

Spouse = * * *

State = * * *

Business Trust = * * *

 

Dear * * *

[1] This is in response to a letter dated December 5, 1995, submitted on your behalf by your authorized representative, requesting a ruling on the transfer tax consequences of a proposed transaction.

[2] Taxpayer and Spouse created a State business trust (Business Trust) by an agreement dated November 27, 1995. Business Trust has been classified as a partnership for Federal income tax purposes. Taxpayer and Spouse each made an initial contribution in the amount of $500 to the Business Trust.

[3] Section 2.1(a) of the Agreement provides that each owner shall make an initial contribution to the capital of the Business Trust and in return the owner shall receive the percentage of ownership interests, consisting of Class A ownership interests, Class B ownership interests and/or Class C ownership interests. Ownership interests of all classes shall represent equivalent economic interests in Business Trust. Notwithstanding the equivalence in economic interests among the classes of ownership interests, the Class A owners shall have the exclusive right to manage the business and affairs of Business Trust.

[4] Section 2.1(b) provides that the Class A interests shall not be less than one percent (1%) of the aggregate outstanding ownership interests of Business Trust at any time during the term of Business Trust and the Class C interests shall not be less than twenty-one percent (21%) of the aggregate outstanding ownership interests of Business Trust at any time during the term of Business Trust.

[5] Section 2.3 provides that, subject to section 2.1(b), any person may make a payment to Business Trust (an "Escrow Payment") in such amounts and at such times as the Class A owners and such person may agree for the benefit of the owner designated by the person. Upon the receipt of an escrow payment, the Trustee shall hold the amount in a separate account and shall notify the designated owner of the receipt of the amount. If, within 60 days, a recipient requests that the Trustee distribute the amount, the Trustee shall promptly distribute the amount to the recipient. Upon the expiration of the 60-day period, the Trustee shall add the amount to the recipient's account and adjust the ownership interests to properly reflect the addition. Unless otherwise designated by the donor, the amount shall be deemed to be made with respect to each class of ownership interest held by the recipient in the proportion each class bears to the aggregate ownership interests of the recipient.

[6] Section 2.5 provides that, if a Class A owner withdraws from Business Trust, the Class A interest shall convert to a Class B interest representing an equivalent beneficial economic interest in Business Trust.

[7] Section 4.1 provides that any realized income of Business Trust may be distributed to the owners, in the discretion of the Class A Owners, acting unanimously if more than one. The distributions of income shall be made to each owner, pro rata, according to the percentage of ownership interests owned by each owner, determined at the end of the operations period.

[8] Section 4.2 provides that, upon the termination and winding up of Business Trust, the property shall be distributed, subject to certain restrictions, to pay Business Trust's debts, liabilities and wind-up expenses including unpaid fees of the Trustee and then to establish a reserve for liabilities. Any remaining property shall be distributed in accordance with the capital accounts of the owners.

[9] Section 5.1(a) provides that, except as otherwise provided, no Class A owner may directly or indirectly sell, exchange, assign, pledge, hypothecate or otherwise transfer or dispose of all or any portion of its Class A interest in the Business Trust to any person without the consent of each other Class A owner and each Class B and Class C owner. The consent may be given or withheld in the sole and absolute discretion of the owners.

[10] Section 5.1(b) provides that, except as otherwise provided, no transfer of a Class B or Class C interest may be made without the consent of each Class A owner. Further, no transfer of a Class B or Class C interest may be made by a sole Class A owner without the consent of a majority in interest of all other owners or, if none, the Trustee. In each case, the consent may be given or withheld in the sole and absolute discretion of the person or persons whose consent is required.

[11] Section 5.2 provides that certain transfers may be made without regard to section 5.1 of the agreement:

 

(a) A transfer of an ownership interest (other than a

transfer by the sole Class A owner of the Class A owner's entire

Class A interest) by one owner to a person who, immediately

prior to the transfer, is an owner.

 

(b) A lifetime transfer of a Class A interest (other than a

transfer by the sole Class A owner of such Class A owner's

entire Class A interest) to:

 

(i) the spouse of the transferring Class A owner,

 

(ii) a descendant of such Class A owner who at the time of

the transfer has reached the age of majority or

 

(iii) a trust of which the sole beneficiaries are any of

 

(A) the Class A owner,

 

(B) the spouse and descendants (and spouses of the

descendants) of the Class A owner,

 

(C) the descendants (and spouses of the descendants)

of the parents of the Class A owner and of the Class A

owner's spouse and

 

(D) qualified charitable organizations.

 

(c) A testamentary transfer of a Class A interest to a

Permitted Class A Transferee of the deceased Class A owner,

provided that if the Class A interest is subject to

administration in the hands of the owner's personal

representative prior to distribution to the Permitted Class A

Transferee, the personal representative shall also be deemed to

be a Permitted Class A Transferee and shall become a substitute

Class A Owner during the period of administration.

 

(d) A Transfer of a Class B interest by any person who

received such Class B interest in a transfer that was a gift for

purposes of Chapter 12 of the Internal Revenue Code, provided

that any direct or indirect sale of such Class B interest shall

be made in accordance with section 5.4 of the agreement and

provided further that any transfer under this section shall be

made during the period ending on the later of:

 

(i) the ninetieth (90th) day after the date of the gift or

 

(ii) in the event of a sale pursuant to section 5.4 with

respect to a bona fide written offer received within ninety

(90) days of the date of the gift, the thirtieth (30th) day

after the close of the offer period.

 

Any individual described in clauses (b)(i) and (b)(ii) or a trust described in clause (b)(iii) is referred to as a "Permitted Class A Transferee". A qualified charitable organization is an organization described in section 170(c) (without regard to section 170(c)(2)(A)) and section 2055(a) of the Internal Revenue Code at the time any property is to be distributed to such organization.

[12] Section 5.4 provides no person shall directly or indirectly sell a Class B interest pursuant to section 5.2(d) unless the person first offers to sell the Class B interest pursuant to the terms of section 5.4.

[13] Section 5.4(a) provides that no sale of a Class B interest may be made unless the seller has received (within ninety (90) days of the date of the gift of the Class B interest) a bona fide offer from a person to purchase the interest for a specified purchase price.

[14] Section 5.4(b) provides that, before transferring the interest, the seller shall give to each other owner and the Trustee written notice that must include the purchase offer and an offer to sell the interest to the owners and Business Trust for the offer price.

[15] Section 5.6 provides an owner may withdraw from Business Trust prior to its termination only with the consent of all other owners. If an owner is permitted to withdraw, he shall be entitled to receive the net equity of his ownership interest as described in section 4.2.

[16] Section 6.1(a) provides that the management and control of Business Trust is vested exclusively in the Trustee and the Class A owners. The Class B owners and Class C owners shall have no part in the management or control of Business Trust and shall have no authority or right to act on behalf of Business Trust in connection with any matter.

[17] Section 7.1(a) provides that Business Trust shall terminate upon the occurrence of any of the following, whichever shall first occur:

 

(i) December 31, 2045, provided, however, that the term of

Business Trust may be extended to December 31, 2055, by the

unanimous consent of the owners;

 

(ii) the withdrawal of a Class A owner, as defined in section

7.1(b), unless:

 

(A) at the time of the withdrawal, there is at least one

other Class A owner (including a successor Class A owner

pursuant to the provisions of section 5.2(c)) who carries

on the business of Business Trust or

 

(B) the remaining owners within 90 days after the

withdrawal unanimously agree to continue Business Trust and

agree on the terms of admission of a new Class A owner or

owners; and

 

(iii) the unanimous approval or written consent of the owners to

terminate Business Trust.

 

Section 7.1(b)(i) provides that a withdrawal event of a Class A

owner occurs upon the happening of any of the following:

 

(i) the Class A owner:

 

(A) makes an assignment for the benefit of creditors;

 

(B) files a voluntary petition in bankruptcy;

 

(C) is adjudged bankrupt or insolvent, or has entered

against the Class A owner an order for relief in any

bankruptcy or insolvency proceeding;

 

(D) files a petition or answer seeking a reorganization,

arrangement, composition, readjustment, liquidation,

dissolution or similar relief under any statute, law or

regulation;

 

(E) files an answer or other pleading admitting or failing

to contest the material allegations of a petition filed

against the Class A owner in any proceedings of this

nature; or

 

(F) seeks, consents to or acquiesces in the appointment of

a Trustee, receiver or liquidator of such Class A owner or

of all or any substantial part of such Class A owner's

properties;

 

(ii) 120 days after the commencement of any proceeding against

the Class A owner seeking reorganization, arrangement,

composition, readjustment, liquidation, dissolution or similar

relief under any statute, law or regulation if the proceeding

has not been dismissed, or if within 90 days after the

appointment without the Class A owner's consent or acquiescence

of a Trustee, receiver or liquidator of the Class A owner or of

all or any substantial part of such Class A owner's properties,

the appointment is not vacated or stayed, or if within 90 days

after the expiration of any such stay, the appointment is not

vacated;

 

(iii) in the case of a Class A owner who is a natural person:

 

(A) the Class A owner's death; or

 

(B) the entry by a court of competent jurisdiction

adjudicating such Class A owner incompetent to manage the

Class A owner's person or property;

 

(iv) in the case of a Class A owner who is acting as a Class A

owner by virtue of being a Trustee of a trust, the termination

of the trust (but not merely the substitution of a new trustee);

 

(v) in the case of a Class A owner that is a partnership, the

dissolution and commencement of winding up of such partnership;

 

(vi) in the case of a Class A owner that is a corporation, the

filing of a certificate of dissolution, or its equivalent, for

the corporation or the revocation of its charter and the

expiration of 90 days after the date of notice to the

corporation of revocation without a reinstatement of its

charter;

 

(vii) in the case of a Class A owner that is an estate, the

distribution by the fiduciary of the estate's entire interest in

the Business Trust; or

 

(viii) in the case of a Class A owner that is not a natural

person, partnership, corporation, trust or estate, the

termination of the Class A owner.

 

[18] Section 3808(a) of the State Code provides that, unless the governing instrument states otherwise, a business trust shall have perpetual existence, and a business trust may not be terminated or revoked by a beneficial owner or other person except in accordance with the terms of its governing instrument.

[19] Section 3808(b) of the State Code provides that, unless the governing instrument states otherwise, the death, incapacity, dissolution, termination or bankruptcy of a beneficial owner shall not result in the termination or dissolution of a business trust.

[20] Section 3809 of the State Code provides that, unless the governing instrument states otherwise, State laws pertaining to trusts are hereby made applicable to business trusts; provided however, that for tax purposes a business-trust shall be classified as a corporation, an association, a partnership, a trust or otherwise, as shall be determined under the Internal Revenue Code.

[21] Taxpayer and Spouse have requested the following rulings:

 

1) The transfer of Class B and Class C interests to other family

members will not be subject to section 2701 because the Class A,

Class B, and Class C interests are interests within the same class

within the meaning of section 25.2701-1(c)(3) of the Gift Tax

Regulations.

 

2) The transfer of a Class B interest by gift will qualify (to

the extent of applicable dollar limitations) for the Federal gift tax

annual exclusion under section 2503(b).

 

3) Neither the provisions of Business Trust regarding the

termination of Business Trust nor the inability of an owner to

withdraw from the Business Trust prior to its termination without

consent of all of the other owners will be an "applicable

restriction" within the meaning of section 2704.

 

4) Class B or Class C interests transferred by Taxpayer or

Spouse will not be included in the Federal gross estate of either

individual under sections 2036(a) or 2038 by reason of the management

rights (including the power in conjunction with other Class A owners

to control distributions from Business Trust) held by the individuals

as Class A owners at death.

 

5) A transfer of property pursuant to section 2.3 of the

Agreement by either Taxpayer or Spouse to a designated owner will

qualify for the annual exclusion under section 2503(b).

 

6) A transfer of property pursuant to section 2.3 of the

Agreement by Taxpayer or Spouse to a designated owner who is a skip

person with respect to the Taxpayer or Spouse will be a direct skip

to the designated owner and, to the extent the gift qualifies for the

gift tax annual exclusion under section 2503(b), will have an

inclusion ratio of zero pursuant to section 2642(c).

 

ISSUE 1

[22] Section 2701(a)(1) provides that solely for purposes of determining whether a transfer of an interest in a corporation or partnership to (or for the benefit of) a member of the transferor's family is a gift (and the value of the transfer), the value of any right --

 

(A) that is described in section 2701(b)(l)(A) or (B), and

 

(B) that is with respect to any applicable retained interest

that is held by the transferor or an applicable family member

immediately after the transfer,

 

shall be determined under section 2701(a)(3).

 

Section 2701(b)(1) provides that the term "applicable retained

interest" means any interest in an entity with respect to which there

is --

 

(A) a distribution right, but only, if immediately before the

transfer described in section 2701(a)(1), the transferor and

applicable family members hold (after application of section

2701(e)(3)) control of the entity, or

 

(B) a liquidation, put, call, or conversion right.

 

[23] Section 2701(b)(2)(B) provides that, in the case of a partnership, the term "control" means (i) the holding of at least 50 percent of the capital or profits interests in the partnership, or (ii) in the case of a limited partnership, the holding of any interest as a general partner.

[24] Section 2701(c)(1)(A)(ii) provides that the term "distribution right" with respect to a partnership means a right to distributions from a partnership with respect to a partner's interest in the partnership.

[25] Section 2701(c)(2)(A) provides that the term "liquidation, put, call, or conversion right" means any liquidation, put, call, or conversion right, or any similar right, the exercise or nonexercise of which affects the value of the transferred interest.

[26] Section 2701(e)(1) provides that the term "member of the family" means, with respect to any transferor -- (A) the transferor's spouse, (B) lineal descendant of the transferor or the transferor's spouse, and (C) the spouse of any such descendant.

[27] Section 2701(e)(2) provides the term "applicable family member" means, with respect to any transferor -- (A) the transferor's spouse, (B) an ancestor of the transferor or the transferor's spouse, (C) the spouse of any such ancestor.

[28] Section 25.2701-1(b)(2) provides that, for purposes of section 2701, a transfer includes a contribution to the capital of a new or existing entity.

[29] Section 25.2701-2(b)(3)(i) provides that a "distribution right" does not include any right to receive distributions with respect to an interest that is of the same class as the transferred interest.

[30] Section 25.2701-1(c)(3) provides that section 2701 does not apply if the retained interest is of the same class of equity as the transferred interest or if the retained interest is of a class that is proportional to the class of the transferred interest. A class is the same class as is (or is proportional to the class of) the transferred interest if the rights are identical (or proportional) to the rights of the transferred interest, except for non-lapsing differences in voting rights (or, for a partnership, non- lapsing differences with respect to management and limitations on liability). For purposes of this section, non-lapsing provisions necessary to comply with partnership allocation requirements of the Internal Revenue Code (e.g., section 704(b)) are non-lapsing differences with respect to limitations on liability. A right that lapses by reason of Federal or State law is treated as a non-lapsing right unless the Secretary determines, by regulation or by published revenue ruling, that it is necessary to treat the right as a lapsing right to accomplish the purpose of section 2701. An interest in a partnership is not an interest in the same class as the transferred interest if the transferor or applicable family members have the right to alter the liability of the transferee.

[31] In this case, the Business Trust agreement provides that distributions of income shall be made to each owner, pro rata, according to the percentage of ownership interests owned by each owner. During the term of the agreement, no owner is entitled to demand a distribution or a return of his capital account. An owner, however, has the right to sell his interest to third parties, subject to the right of first refusal granted to the other owners. In addition, when Business Trust is dissolved, the assets will be distributed to the owners on a pro rata basis in accordance with their respective ownership interests. For purposes of section 2701, the Class A, Class B, and Class C interests are all the same class of interests. Consequently, the transfer of a Class B or Class C interest by Taxpayer or Spouse who retains a Class A interest will not be subject to section 2701.

ISSUE 2

[32] Section 2501(a)(1) imposes a tax on the transfer of property by gift. Section 2511(a) provides that the tax imposed by section 2501 shall apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.

[33] Section 2503(b) provides that in the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of the gifts to the person shall not, for purposes of section 2503(a), be included in the total amount of gifts made during the year.

[34] Section 25.2503-3(a) provides that a "future interest" is a legal term, and includes reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time.

[35] In this case, the Taxpayer and Spouse intend to make gifts of Class B interests. They represent that Business Trust is a partnership for Federal tax purposes. As holders of the Class A interests, they have the power to manage the Business Trust and, therefore, they are the equivalent of a general partner. As such, they have the power to control Business Trust's distributions. A general partner, however, must exercise such powers in a fiduciary capacity and is held to a high standard of conduct toward limited partners. See generally, In re USACAfes, L.P. Litigation, 600 A.2d 43 (Del. Ch. 1991). Thus, the general partner's powers are not the equivalent of a trustee's discretionary authority to distribute or withhold trust income or property (i.e., a power that generally results in the characterization of a gift to such a trust as a gift of a future interest).

[36] Further, each transferee of a Class B interest will have immediate use and possession of the interest. The transferee will have the right to gift the interest without the consent of the Class A owners for a period of 90 days after receipt to the interest. Further, during a limited period, a transferee may also sell the interest, subject to a right of first refusal, without obtaining the consent of the Class A owners. Accordingly, we rule that transfers of Class B interests by Taxpayer or Spouse are transfers of present interests and will qualify (to the extent of applicable dollar limitations) for the Federal gift tax annual exclusion under section 2503(b).

ISSUE 3

[37] Section 2704(a)(1) provides that, for the purpose of Subtitle B, if --

 

(A) there is a lapse of any voting or liquidation right in a

corporation or partnership, and

 

(B) the individual holding the right immediately before the

lapse and members of the individual's family hold, both before

and after the lapse, control of the entity,

 

the lapse shall be treated as a transfer by the individual by gift,

or a transfer which is includible in the gross estate of the

decedent, whichever is applicable, in the amount determined under

section 2704(a)(2).

 

[38] Section 25.2704-1(a)(1) provides that the lapse of a voting right or liquidation right in a corporation or partnership (an "entity") is a transfer by the individual directly or indirectly holding the right immediately prior to its lapse (the "holder") to the extent provided in sections 25.2704-1(b) and (c). Section 25.2704-1(a) applies only if the entity is controlled by the holder and members of the holder's family immediately before and after the lapse. The amount of the transfer is determined under section 25.2704-1(d). If the lapse of a voting right occurs during the holder's lifetime, the lapse is a transfer by gift. If the lapse occurs at the holder's death, the lapse is a transfer includible in the holder's gross estate.

[39] Section 25.2704-1(a)(2)(i) provides that control has the same meaning as that provided in section 25.2701-2(b)(5).

[40] Section 25.2701-2(b)(5) provides that, for purposes of section 2701, a controlled entity is a corporation or partnership controlled, immediately before a transfer, by the transferor, applicable family members, and any lineal descendants of the parents of the transferor or the transferor's spouse.

[41] Section 25.2704-1(a)(2)(ii) provides that members of the family has the meaning given it in section 25.2702-2(a)(l).

[42] Section 25.2702-2(a)(1) provides that, with respect to any individual, member of the family means the individual's spouse, any ancestor or lineal descendant of the individual or the individual's spouse, any brother or sister of the individual, and any spouse of the foregoing.

[43] Section 25.2704-1(a)(2)(iv) provides that voting right means a right to vote with respect to any matter of the entity. In the case of a partnership, the right of a general partner to participate in partnership management is a voting right. The right to compel an entity to acquire all or a portion of the holder's equity interest in the entity by reason of aggregate voting power is treated as a liquidation right and is not treated as a voting right.

[44] In this case, section 2.5 of the agreement provides that, if a Class A owner withdraws from Business Trust, the Class A interest shall convert to a Class B interest representing an equivalent beneficial economic interest in Business Trust. The conversion of a Class A interest, which has the right to manage Business Trust, to a Class B interest will cause a lapse in the voting rights associated with the Class A interest. Accordingly, if the requirements of sections 25.2704-1(a)(1) are met at the time of the lapse (i.e. family members control the entity before and after the lapse), the lapse would be a transfer to which section 2704(a) applies.

[45] Section 2704(b)(1) provides that for purposes of Subtitle B, if --

 

(A) there is a transfer of an interest in a corporation or

partnership to (or for the benefit of) a member of a

transferor's family, and

 

(B) the transferor and members of the transferor's family hold,

immediately before the transfer, control the entity,

 

any applicable restriction shall be disregarded in determining the

value of the transferred interest.

 

Section 2704(b)(2) provides that the term "applicable

restriction" means any restriction -- (A) that effectively limits the

ability of the corporation or partnership to liquidate, and (B) with

respect to which either of the following applies:

 

(i) The restriction lapses, in whole or in part, after the

transfer referred to in section 2704(b)(1).

 

(ii) The transferor or any member of the transferor's family,

either alone or collectively, has the right after such transfer

to remove, in whole or in part, the restriction.

 

[46] Section 25.2704-2(b) provides that an applicable restriction is a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under State law generally applicable to the entity in the absence of the restriction. A restriction is an applicable restriction only to the extent that either the restriction by its terms will lapse at any time after the transfer, or the transferor (or the transferor's estate) and any members of the transferor's family can remove the restriction immediately after the transfer. Ability to remove the restriction is determined by reference to the State law that would apply but for a more restrictive rule in the governing instruments of the entity.

[47] Section 25.2704-2(d), EXAMPLE 1, provides an illustration of an applicable restriction that limits the ability of a partner to liquidate a partnership. In the example, D owns a 76 percent interest and each of D's children, A and B, owns a 12 percent interest in General Partnership X. The partnership agreement requires the consent of all the partners to liquidate the partnership. Under state law that would apply in absence of the partnership agreement, the consent of partners owning 70 percent of the total partnership interests would be required to liquidate the partnership. On D's death, the partnership interest passes to D's child, C. The requirement that all the partners consent to the liquidation is an applicable restriction. Because A, B, and C (all members of D's family), acting together after the transfer, can remove the restriction on liquidation, D's interest is valued without regard to the restriction, i.e. as though D's interest is sufficient to liquidate the partnership.

[48] In this case, Section 3808(a) of State law provides that a business trust shall have perpetual existence. However, section 7.1(a)(i) of the Business Trust agreement specifies that Business Trust will terminate December 31, 2045, or December 31, 2055. This provision is not more restrictive than state law. Under state law, an owner of an interest in a business trust may never receive the liquidation value of his interest in the business trust because the entity has perpetual existence. Under the agreement, the owner will receive the value of his interest in 2045, and therefore, the Business Trust agreement is less restrictive with respect to the owner receiving his liquidated value of his business trust interest.

[49] Further, under Section 3808(b) of State law, the death, incapacity, dissolution, termination or bankruptcy of a beneficial owner shall not result in the termination or dissolution of a business trust. Section 7.1(a)(ii) of the agreement provides that Business Trust will terminate upon the withdrawal of a Class A owner. Withdrawal events are described in section 7.1(b) of the agreement and include, among other things, an assignment for creditors and the filing of a petition for bankruptcy.

[50] The provisions in Section 7 of the agreement are not more restrictive in a manner that limits the ability of an owner to liquidate Business Trust than the provisions that would apply under state law. Accordingly, they are not applicable restrictions within the meaning of section 2704(b)(2) and section 25.2704-2(b).

ISSUE 4

[51] Section 2036(a) provides that a decedent's gross estate includes the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth) by trust or otherwise, under which he has retained, for his life or for any period not ascertainable without reference to his death or any period that does not in fact end before his death, (1) the possession or enjoyment of, or the right to the income, from the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

[52] Section 2036(b) provides that, for purposes of section 2036(a)(1), the retention of the right to vote, directly or indirectly, shares of stock of a controlled corporation shall be considered a retention of the enjoyment of the transferred property.

[53] In United States v. Byrum, 408 U.S. 125 (1972), the decedent was a controlling shareholder and a member of the board of directors of a closely-held corporation. The Court held that stock in the corporation transferred by the decedent to an irrevocable trust was not included in his gross estate under section 2036 even though the decedent expressly retained the right to vote the transferred stock and to veto the sale or disposition of the stock by the trustee. The Court held that the decedent, as a controlling shareholder and a member of the board of directors, had a fiduciary duty to promote the interests of the corporation and not to exercise his voting power to promote his personal interests at the expense of the minority shareholders. Accordingly, the decedent's retained power to vote the stock did not constitute the retained enjoyment of the transferred stock or right to designate the income from the transferred stock for purposes of section 2036.

[54] As indicated above, a Class A owner, in this case, is the equivalent of a general partner in a partnership and as such has management authority over Business Trust including the authority to control distributions. The Class B and C interest holders are the equivalent of limited partners. However, as in the case of the decedent in Byrum, a Class A owner in this case occupies a fiduciary position with respect to the Class B and C owners and cannot distribute or withhold distributions or otherwise manage Business Trust for purposes unrelated to the conduct of its business.

[55] Section 2038 provides that the value of the gross estate shall include the value of all property of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth) in trust or otherwise, where the enjoyment thereof was subject to a power in the decedent to alter, amend, revoke or terminate such interest or where any such power was relinquished during the 3-year period ending on the date of the decedent's death. The foregoing analysis with respect to section 2036(a), also applies to section 2038.

[56] Accordingly, we conclude that the value of the Class B or C interests transferred by Taxpayer or Spouse will not be includible in respective individual's gross estate under sections 2036(a) or 2038 by reason of their status as general partners.

ISSUE 5

[57] Section 2503(b) provides that, in the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of the gifts to the person shall not be included in the total amount of gifts for the year.

[58] Section 25.2503-3(a) no part of the value of a gift of a future interest may be excluded in determining the total amount of gifts made during the calendar year period. The term "future interest" is a legal term, and includes reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time.

[59] Section 25.2503-3(b) provides that an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain) is a present interest in property.

[60] In this case, Section 2.3 of the agreement provides that any person may make a payment to Business Trust for the benefit of the owner designated by the person. Upon the receipt of the payment, the Trustee will hold the amount in a separate account and will notify the designated owner of the receipt of the amount. If, within 60 days, a recipient requests that the Trustee distribute the amount, the Trustee will promptly distribute the amount to the recipient. Upon the expiration of the 60-day period, the Trustee will add the amount to the recipient's account and adjust the ownership interests to properly reflect the addition. Accordingly, we rule that transfers by Taxpayer or Spouse pursuant to the terms of Section 2.3 are transfers of present interests that will qualify for the Federal gift tax annual exclusion under section 2503(b).

ISSUE 6

[61] Section 2601 imposes a tax on every generation-skipping transfer made after October 22, 1986.

[62] Section 2611(a) provides that the term "generation- skipping transfer" means (1) a taxable distribution, (2) a taxable termination, and (3) a direct skip.

[63] Section 2612(c)(1) provides that the term "direct skip" means a transfer subject to a tax imposed by chapter 11 or 12 of an interest in property to a skip person.

[64] Section 2613(a) provides that the term "skip person" means -- (1) a natural person assigned to a generation that is 2 or more generations below the generation assignment of the transferor, or (2) a trust -- (A) if all interest are held by skip persons, or (B) if -- (i) there is no person holding an interest in the trust, and (ii) at no time after the transfer may a distribution (including distributions on termination) be made from the trust to a non-skip person.

[65] Section 2613(b) provides that the term "non-skip person" means any person who is not a skip person.

[66] Section 2642(c)(1) provides that, in the case of a nontaxable gift, the inclusion ratio shall be zero.

[67] Section 2642(c)(2) provides that section 2642(c)(1) does not apply to any transfer to a trust for the benefit of an individual unless --

 

(A) during the life of the individual, no portion of the corpus

or income of the trust may be distributed to (or for the benefit

of) any person other than the individual, and

 

(B) if the trust does not terminate before the individual dies,

the assets of the trust will be includible in the gross estate

of the individual.

 

[68] Section 2652(a)(1) provides generally, that the term "transferor" means -- (A) in the case of any property subject to the tax imposed by chapter 11, the decedent, and (B) in the case of any property subject to the tax imposed by chapter 12, the donor. An individual is treated as transferring any property with respect to which the individual is the transferor.

[69] Section 2652(b)(1) provides that the term "trust" includes any arrangement (other than an estate) which, although not a trust, has substantially the same effect as a trust.

[70] Under Section 2.3, an individual may make a payment to Business Trust for the benefit of an owner. The amount will be added to the owner's capital account if the owner has not withdrawn the amount within the 60-day period following the transfer. Business Trust has been classified as a partnership for Federal tax purposes and, therefore, a transfer by Taxpayer or Spouse for the benefit of a specific owner will not be considered a transfer to a trust that is subject to the provisions of section 2642(c)(2).

[71] Furthermore, a transfer by Taxpayer or Spouse to a designated owner pursuant to the terms of Section 2.3 is a gift that is subject to the imposition of the tax under section 2501. If the owner is a skip person as that term is defined in section 2613(a), the transfer is a direct skip. Section 2612(c). Accordingly, to the extent the gift qualifies for the gift tax exclusion under section 2503(b), the inclusion ratio with respect to the transfer will be zero. Section 2642(c)(1).

[72] Except as we have specifically ruled herein, we express no opinion about the proposed transaction under the cited provisions of the Code or any other provisions of the Code. In accordance with the power of attorney on file with this office, we are sending a copy of this letter to your authorized representative.

[73] This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) provides that it may not be used or cited as precedent.

[74] A copy of this letter should be attached to the first gift tax return filed with respect to these transactions. A copy of this letter is enclosed for that purpose.

 

Sincerely yours,

 

Assistant Chief Counsel

(Passthroughs and Special

Industries)

 

By: Frances Schafer

Senior Technical Reviewer

Branch 4

 

Enclosure

Copy for 6110 purposes

Copy of letter

9415007

Section 2503 -- Taxable Gifts

UIL Number(s) 2036.00-00, 2038.00-00, 2503.00-00, 2701.00-00

Summary

TRANSFERS OF FAMILY PARTNERSHIP INTERESTS NOT SUBJECT TO SPECIAL VALUATION RULES.

Parents, trustees of trusts for the parent's children, and a custodian under the Uniform Gift to Minors Act are limited partners in a family partnership. The father, as general partner, has exclusive management and control of the partnership, including discretion to determine the amount and timing of distributions to partners. The father is bound, however, by the partnership agreement and state law fiduciary duties. The father proposes to make gifts of limited partnership interests outright and in trusts that meet the requirements of section 2503(c).

The Service has ruled that proposed gifts are gifts of present interests that will qualify for the annual exclusion. The Service reasoned that the management power possessed by the father, as general partner, is limited by his fiduciary duties and is thus not the equivalent to a trustee's discretionary authority to distribute or withhold trust income or property. As such, the power does not make the transfers gifts of future interests.

The Service also ruled that section 2702 will not apply. The Service reasoned that the partnership is a controlled entity because of the father's status as general partner. The Service further reasoned, however, that the rights to distributions retained are rights with respect to an interest that is of the same class as the interest that he proposes to transfer. As such, concluded the Service, an applicable retained interest will not exist after the proposed transfers.

The Service also concluded that the value of the transferred partnership interests will not be included in the father's gross estate under section 2036 or 2038 by reason of his status as general partner. Following United States v. Byrum, 408 U.S. 125 (1972), the Service reasoned that the father's fiduciary duties prevented him from distributing, withholding distributions, or otherwise managing the partnership for purpose unrelated to the conduct of partnership business.

Full Text: LTR 9415007 - this was a hyperlink to the tax library on CD Tax Analysts

9131006

Section 2503 -- Taxable Gifts

UIL Number(s) 2503.03-00, 2036.02-00

Summary

TRANSFERS OF FAMILY PARTNERSHIP INTERESTS ARE PRESENT-INTEREST GIFTS.

An individual conveyed her interest in unimproved land to a newly created limited partnership in exchange for all of the partnership units. The individual then transferred general and limited partnership units to her descendants, retaining a sufficient interest in the partnership to enable her to control its management and the timing and amount of any distributions. Just before her death, more units were transferred to her descendants. After those transfers, the individual lost voting control of the partnerships. No gift exceeded $10,000. The partnership agreement gave the limited partners the right to sell the units, subject to a right of first refusal in the other partners.

The Service has ruled in technical advice that gifts of partnership interests were gifts of a present interest that qualified for the annual exclusion. The Service reasoned that the donees received the immediate use of the property and the current right to economic benefits generated by the property. The Service said also that the individual's management powers were not the equivalent of a trustee's discretionary authority to withhold or distribute trust property. Rather, a general partner is bound to a high standard of conduct toward limited partners, similar to that of a corporate director to shareholders, said the Service.

The Service ruled further that the value of the transferred partnership units is not includable in the individual's gross estate under section 2036 or section 2038. The Service stated that the individual's retained power to manage the partnership and control distributions did not cause an inclusion under section 2036 because the individual's fiduciary position as general partner precluded her from distributing or withholding distributions or otherwise managing the partnership for purposes unrelated to the conduct of partnership business. For the same reasons, the Service found that the individual did not retain the power to alter the beneficial interests of the other partners and that, therefore, section 2038 did not apply.

Full Text

 

Date: April 30, 1991

 

Control No.: TR-32-248-90

 

Taxpayer's Name: * * *

Taxpayer's Address: * * *

Taxpayer's ID No.: * * *

Date of Death: * * *

Conference: * * *

 

ISSUES

1. Whether the transfers of partnership units to the decedent's children and grandchildren constituted gifts of present interests for purposes of section 2503(b) of the Code.

2. Whether the value of the transferred partnership units is includible in the decedent's gross estate under section 2036 or 2038 of the Code in view of the decedent's retained powers as a general partner to control management of the partnership.

FACTS

The decedent, a resident of Washington state, died on August 7, 1988. She survived her husband who died in 1985. At the time of his death, the marital community owned a 110 acre "farm". The property was no longer being actively farmed. On the decedent's husband's federal estate tax return, his community one half interest in the property was valued at $500,000 which was represented to be reflective of the property's value for residential development. At the conclusion of the probate of his estate, the property was distributed to a testamentary trust for the benefit of the decedent, as a portion of her spousal share of the community estate.

On December 28, 1986, the decedent created a limited partnership pursuant to the provisions of Chapter 25.10 of the Revised Code of Washington, as amended. According to the partnership agreement, the business of the partnership was to invest in, own, develop and operate real estate and other property and to engage in any other business authorized by law. The stated purpose of the partnership was to provide a means for members of the decedent's family to acquire an interest in the partnership business, to participate in the business, and to ensure that the partnership's business is continued by and closely held by members of the decedent's family.

The partnership capital was represented by 1,000 "units" consisting of both general and limited partnership interests. All 1,000 units were originally issued to the decedent in exchange for her one half interest in the "farm". Net income, net losses and distributions were to be apportioned among partners in the same proportions as the number of units held by each bears to the total number of units outstanding. Overall management authority was invested in the general partners. The amount and timing of all distributions was reserved to the discretion of the general partner. The limited partners were prohibited from taking any part in or from interfering in the management of the partnership. The limited partners, however, had the right to sell their units to third parties subject to a right of first refusal in the other partners.

On December 29, 1986, the decedent formally conveyed an undivided one-half interest in the farm to the partnership. On the same day, the decedent assigned 17 partnership units to each of her four children and 15 grandchildren (a total of 323 units). Seventeen of these units which were assigned to the decedent's son were general partnership units. The remaining units were limited partnership units. The interests the taxpayer retained (both general and limited) enabled her to control management of the partnership including control over any distributions to be made from the partnership.

A few months prior to her death, the decedent assigned another 335 partnership units to the same individuals as in the previous assignment. On this occasion, however, the distribution was not equal. Each of the decedent's 4 children received 35 units and each of the grandchildren received only 13 units. After these transfers, the decedent no longer possessed voting control of the partnership. Thus, she could be removed as a general partner by a vote of a majority of the units. At the time of the transfers no gift exceeded $10,000.

No federal gift tax returns were filed for either the 1986 or 1988 assignments. For the 1987 and 1988 calendar years, the partnership reported zero net income; i.e., its gross income exactly equaled its expenses. The estate's representative explained that rather than preparing numerous schedule K-1's for the partnership return, he decided to "zero out" the partnership income by paying the decedent a "management fee" equal to the amount by which the partnership income exceeded expenses. This fee amounted to approximately $800.00 each year.

The property held by the partnership consisted primarily of unimproved land. For two years prior to the decedent's death, she and her son had actively attempted to market it for residential real estate development. Because of zoning problems, the property remained unsold at the decedent's death.

APPLICABLE LAW (Issue 1)

Section 2501(a)(1) of the Internal Revenue Code provides for the imposition of a tax on the transfer of property by gift. Section 2511(a) of the Code provides that the gift tax applies to a transfer by way of gift whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.

Section 2503(b) of the Code provides that in the case of gifts (other than gifts of future interests in property) made to any person by the donor during the calendar year, the first $10,000 of such gifts to such person shall not be included in the total amount of gifts made during such year. The annual exclusion is only available for gifts of present interests in property. Section 25.2503-3(b) of the Gift Tax Regulations provides that a present interest in property is an unrestricted right to the immediate use, possession or enjoyment of the property (such as a life estate or a term certain).

Section 25.2503-3(a) of the regulations defines "future interests" as a legal term that includes reversions, remainders, and other interests or estates whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession or enjoyment at some future date or time.

APPLICABLE LAW (Issue 2)

Section 2036(a) of the Code provides that the decedent's gross estate includes the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or moneys worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period that does not in fact end before his death (1) the possession or enjoyment of, or the right to income from the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

Section 2036(b)(1) provides that the retention of the right to vote (either directly or indirectly) shares of stock of a controlled corporation shall be considered to be the retention of the enjoyment of the transferred property.

DISCUSSION (Issue 1)

The general partners had the right under the partnership agreement to determine the timing and method of the partnership distributions similar to the right of a corporate board of directors to declare and pay dividends. The general partners are also bound to a high standard of conduct toward limited partners similar to that of corporate boards of directors to shareholders. See A.B. Willis, J.S. Pennell, P.F. Postlewaite, Partnership Taxation (4th Ed. 1989), section 1.05.

The Washington State Supreme Court has held that general partners have a fiduciary duty to limited partners and that limited partners should be able to expect the highest standard of conduct from general partners. See In re Wilson Estate, 50 Wn 2d 40, 315 P.2d 287 (1957); Bassan v. Investment Exchange, 83 Wn 2d 922, 522 P2d 233 (1974). In Bassan, the Washington Supreme Court stated that "the duty of loyalty resulting from the partner's fiduciary position is such that the severity of a partner's breach will not be questioned. The only question is whether there has been any breach at all." Bassan v. Investment Exchange, supra, at 928.

In the instant case, the powers possessed by the general partners under the partnership agreement, including control over partnership distributions, are common to most limited partnership agreements. The decedent, as general partner, possessed no powers that are not otherwise contained in the standard limited partnership agreement, regardless of whether the partners are related or not.

The property held by the partnership consisted primarily of unimproved land that the partnership had been seeking to develop or sell. Because of zoning problems, the property had not been sold at the date of the decedent's death. Thus, the partnership had little or no income to distribute.

In the instant case, the gifts of the partnership interests constituted outright gifts of ownership interests in a business entity. Each donee received the immediate use, possession and enjoyment of the subject matter of the gifts, the interests in the partnership. These interests entitled the donees to any current economic benefits generated by the property. In addition, the donees had the right at any time to sell or assign the interests (subject to a right of first refusal). Management and control of the partnership assets were vested in an individual, the general partner. However, as discussed above, strict fiduciary duties are imposed on the general partner. Such management powers, therefore, are not the equivalent of a trustee's discretionary authority to distribute or withhold trust income or property; powers which would generally result in characterization of a gift in trust as a future interest.

Accordingly, we find that the gifts of limited partnership interests from the decedent to her children and grandchildren are gifts of present interests which qualify for the annual exclusion.

DISCUSSION (Issue 2)

In United States v. Byrum, 408 U.S. 125 (1972), 1972-2 C.B. 518, the decedent was a controlling shareholder and a member of the board of directors of a closely held corporation. The Supreme Court held that stock in the corporation transferred by the decedent to an irrevocable trust was not included in his gross estate under section 2036 of the Code, although the decedent expressly retained the right to vote the transferred stock and to veto the sale or disposition of the stock by the trustee.

The court held that the decedent, as a controlling shareholder and a member of the board of directors, had a fiduciary duty to promote the interests of the corporation and not to exercise his power to promote his personal interests at the expense of the minority shareholders. Accordingly, the decedent's retained power to vote the stock did not constitute the retained "enjoyment" of the transferred stock, or the right to designate the income from the transferred stock, for purposes of section 2036.

In the present situation, the decedent was (after the initial transfers) the controlling general partner who had management authority over the partnership including the express authority to control partnership distributions. However, similar to the decedent in Byrum, the decedent in the instant case occupied a fiduciary position with respect to the other partners and could not distribute or withhold distributions, or otherwise manage the partnership for purposes unrelated to the conduct of the partnership business. Therefore, as was the case in Byrum, the value of the transferred units is not includible in the decedent's gross estate under section 2036 of the Code. See also Estate of Gilman v. Commissioner, 65 T.C. 296, 316 (1975).

Based upon the foregoing, the value of the transferred units is also not includible in the decedent's gross estate under section 2038 of the Code, because under that section she retained no power to alter the beneficial interests of the other partners.

CONCLUSION

1. The gifts of the transferred partnership units qualify for the gift tax annual exclusion.

2. The value of transferred partnership units are not includible in the decedent's gross estate under either section 2036 or 2038 of the Code.

A copy of this technical advice memorandum should be given to the taxpayer. Section 6110(j)(3) of the Internal Revenue Code provides that it may not be used or cited as precedent.

Do you want to focus and plan only for current year to year gift tax issues and ignore the estate tax issue, at the risk of losing the entire balance of the estate to liquidate it to pay taxes, estate and final expenses?

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How much do you need for personal living and savings needs?

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Do you want to provide for your current living expenses and save some for the future?

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Do you want John and Sue to have a "nest egg" and provide for a permanent savings for their future needs?

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Or - would you prefer to provide for their current needs and not be concerned with their future/permanent welfare?

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Do you want to preserve assets upon creation of both the first and second estate, or do you believe a liquidation of some or all of the assets should be allowed or required?

Allowed? -------- Required ? ----------- ------------------------------------------------

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How much do you want to give to John each year?

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How much do you want to give Sue each year?

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How much to the grandchildren each year?

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Do you want to support any charities? How much?

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What amount of savings do you want to leave for the surviving spouse?

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Do you have long term care insurance or provisions for long term care?

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