Family Limited Partnership - Warnings

IRS Recent Attack On FLP

Because Family Limited Partnerships (FLP) have been so popular and effective for taxpayers in reducing the estate tax owed on the death of a decedent, the Internal Revenue Service ( the "Service") is constantly trying to find ways to attack FLP. The Service has just recently published in May of this year, TAM Letter Ruling 9719006 (the "Memorandum"), which contains a fact pattern, the Service claims clearly is an abuse by the taxpayer in the use of a FLP to reduce estate taxes. Based upon the facts contained in the Memorandum, it is hard not to agree with the Service. This is a very good example of waiting literally until the last minute (death bed planning) and expect to obtainthe same result, had the taxpayer planned timely.

Facts in brief. Mary Smith died on March 9, 1994. Before March 7, 1994, her assets consisted of rental real property and marketable securities, held in a revocable trust. She was also the beneficiary of a marital trust funded with similar assets. On March 7, 1994, when Mary was terminally ill, a family limited partnership was formed in which her two children, who were co-trustees of the revocable trust, each contributed $33,048 in exchange for a 1% general partnership interest. The marital trust contributed property with a stated value of over $1.7 million in exchange for an 82.187% limited partnership interest. The revocable trust contributed property with a stated value of $551,446 in exchange for a 15.81% limited partnership interest.

Immediately after formation of the partnership, the marital trust transferred two 30% limited partnership interests, one to each child, in exchange for $10,000 cash and a 30-year promissory note from each in the face amount of $485,732 with principal and interest at 5.06% payable annually in 30 equal installments. Mary's executor valued the partnership interests held by the trusts as more than $1 million less than what they were worth just two days earlier.

Two-pronged attack. The Service said that:

The formation of the partnership and the transfer of the partnership interests should be treated as a single testamentary transaction. Under this approach, the partnership would be disregarded for estate tax valuation purposes. Alternatively, the transaction is subject to Code Section 2703(a)(2), which generally causes restrictions on property to be ignored for estate tax valuation purposes.

One final aspect of the Memorandum is interesting. The Service stated in the context of Section 2703(a)(2) that, when restrictions on the sale or use of a decedent's property transferred to a partnership are ignored, "only a discount to reflect the fractional interest in the [transferred] real estate would be available, and in the case of marketable securities, any such discount is not available." In essence, the Service recognized that some discount may be available in failed FLP transactions, as if the assets contributed to the entity were held by the decedent outright at death. As phrased by the Memorandum, "attempting to cover the decedent's assets with a partnership wrapper" may not create or increase any available discounts, but it also should not remove discounts that otherwise would apply.

What this Memorandum can mean, for taxpayers who plan timely, are discounts for "lack of minority interest" and "lack of marketability"will continue to be recognized by the Service. The real issue will not be whether or not the discounts will be acceptable, but rather, what the range of the discounts will be.

Aside from that ray of hope, however, the essence of the Memorandum (and there will be more like it involving other FLP or limited liability company transactions) is a shot across the bow of the good ship Discount Planning. The Service will constantly be looking for other factual situations, as in the Memorandum, favorable to it in preventing the taxpayer from reducing estate tax on their estate.