FLP's and FLLC's - Versitility Beyond Discounts

Versatility Beyond Discounts –

The Benefits of Family Limited Partnerships (FLP) and Family Limited Liability Companies (FLLC)

Dateline: January, 2002

By: Deirdre R. Wheatley-Liss, Esq.

I. Overview

A. Introduction: Many planners think of FLPs and FLLCs (which will be used interchangeably throughout) in terms of one thing: discounts, discounts, discounts. While leveraging gifts or reducing the value of the estate may be a motivating factor in considering an FLP or FLLC for your client, the totality of the available benefits of these entities argue for their increased use in your practice. It is the “family” element of these business entities that sets them apart.

B. Benefits of FLPs and FLLCs:

1. Continued control of assets by the client to a limited extent

2. Asset Protection against the primary fears of estate planning clients

3. Ease of Transfer of Interests during life and upon death

4. Valuation Discounts – Gift and Estate Tax Savings

II. Control

A. Client Concerns: Estate planning clients have different motivations for establishing FLPs and FLLCs then business clients. Whereas business clients may be most motivated by the taxation of a form of business and liability concerns, an estate planning client may intellectually want to design a plan with the most favorable tax and asset protection strategies, but often have an emotional barrier to planning, no matter the size of the estate, because they fear losing control over their assets. Essentially, they want to have their cake and eat it too.

1. Investment Management - Older generations have different investment needs, strategies, and risk tolerance then their children.

2. Asset Protection - Clients have a very real concern that if they give assets to their children today, and those children are divorced in the future, those assets will then pass on to the spouse. Even where gifting may be appropriate for tax or Medicaid planning purposes, real or imagined concerns about their children’s marital situation may prevent gifts. (Discussed in more detail below)

3. Timing of Gifts - Where a client wants to take advantage of their annual exclusion to make gifts now, they may not want the children spending the money now. They may want the assets to essentially accumulate a nest egg for the child for his or her early retirement, or fund some other future goal.

B. Solution: Establish an FLP or an FLLC with a two-tier ownership structure – a management class and a non-management class. Even after the parents make gifts of the limited partnership (“LP”) interest or non-managing member (“NMM”) interest, they maintain control over the investments of all the assets owned by the FLP or FLLC. Restrict the transferability of LP or NMM interest in the operating agreement to make the interest unappealing to creditors. Consider establishing a trust to hold any assets gifted to the children – this allows the parents to make a pro-rata distribution from the FLP or FLLC to the owners, but the Trustee of the trust still acts as gatekeeper in releasing the distribution to the child/beneficiary of the trust. (Refer to Exhibit 1)

C. Brief Comparison of FLP and FLLC

1. FLP – The enabling statute is located at NJS 42:2A-1 et seq. To form an FLP, refer to the following web site for, fees and forms: http://www.state.nj.us/treasury/revenue/dcr/programs/corpfile.html

(a) An FLP by definition of two classes of management. There is a general partner (“GP”), as well as LP’s. The general partner manages the day-to-day affairs of the partnership. The FLP must have at least 2 partners.

(b) By definition, an LP cannot have a voice in the management of the partnership, nor can the LP compel distributions of the partnership interest.

(c) Traditionally, a GP has unlimited liability for the acts of the partnership, while an LP has liability only to the extent of his investment in the partnership. The concern about the unlimited liability of the GP is many times addressed through the creation of a corporate general partner.

(d) The ability to transfer an LP interest may be restricted in the partnership agreement so that the only permissible beneficiaries are family members.

(e) A creditor’s sole remedy is a charging order (see below).

(f) Taxed as a partnership under Federal and State law. All items of income, loss, gain and deduction flow through to the partners and are reflected on their personal returns. There is great flexibility in the to determine how these items are shared in the Income Tax Code.

(i) Practice Tip: In family situations clients are generally looking for simplicity in accounting and administration. Accordingly, it is appropriate to recommend to clients that they only make pro-rata distributions based on the partnership interest held by the partners.

2. FLLC – The enabling statute is located at NJS 42:2B-1 et seq. To form an LLC, refer to the following web site for fees and forms: http://www.state.nj.us/treasury/revenue/dcr/programs/corpfile.html .

(a) The Limited Liability Company is a relatively new form of entity that was introduced in New Jersey in 1993. The statue gives the members great flexibility in determining the ownership, management, and transferability of membership interest in the LLC.

(b) The operating agreement determines the management structure of the entity. An LLC may be managed by its members, by a general manager, by a management committee (echoing a board of directors of a corporation), or by a managing member class of interests which is separate and distinct from a non-managing member class of interest. This final variation mimics the GP/LP distinction of an FLP.

(c) All members of an LLC, no matter the characterization of their ownership as management or not, have limited liability for the debts of the LLC. Many practitioners view the LLC as the preferred planning vehicle over the limited partnership because of the liability protection afforded to all of the owners. Liability protection is especially important in situations where there is real estate involved because real estate ownership involves large potential liability issues, both from an environmental and a tort perspective, that individuals may want to insulate themselves and their families from.

(d) An LLC may be formed with one or more persons. Accordingly, a client could establish a single member LLC currently, and later convert it to a multi-member LLC by making gifts of interests to family members.

(e) Similar to an FLP, the ability to transfer an LLC interest may be restricted in the operating agreement so that the only permissible beneficiaries are family members.

(f) Like an FLP, a creditor’s remedy is a limited to a charging order (discussed below).

(g) The entity may elect to be taxed as a sole proprietorship (if there is only one member), a partnership (if there are 2 or more members), or a corporation (if there are one or more members). Under the default rules in a family situation, a single member LLC will generally be taxed as a sole proprietorship and a multi-member LLC as a partnership.

(h) Unlike the body of law addressing corporations and partnerships, the body of law addressing the limited liability protections afforded members of LLC’s is much less diverse. Accordingly, some practitioners feel that there may be an inadvertent action that may allow the courts to “piece the corporate veil” of limited liability protection. This makes them wary of the LLC as a planning tool. In addition, there are certain concerns regarding the valuation of LLC interest versus FLP interests, discussed below.

III. ASSET PROTECTION

A. Charging Order Sole Remedy: The FLP or FLLC is an inherent asset protection vehicle because a creditor’s sole remedy against a debtor who owns an LP or LLC interest is to receive a charging order against that interest. This charging order allows the creditor to step into the shoes of the debtor, and to receive whatever distributions the debtor may have received. The creditor has no management rights. If no distribution is made on the debtor’s interest, no distribution is made to the creditor. Charging orders allow creditors to satisfy their judgments out of the partnership profit distributions, but only in a manner that minimizes the disruption to the partnership itself. Accordingly, unless the claim is against the partnership itself, partnership property may not be seized to satisfy any partner’s obligation.

1. Statutory Authority for FLP Asset Protection

(a) 42:2A-47. Assignment of partnership interest; rights of assignee: Except as provided in the partnership agreement, a partnership interest is assignable in whole or in part. An assignment of a partnership interest does not dissolve a limited partnership or entitle the assignee to become or to exercise any rights of a partner. An assignment entitles the assignee to receive, to the extent assigned, only the distribution to which the assignor would be entitled. Except as provided in the partnership agreement, a partner ceases to be a partner upon assignment of all his partnership interest. Notwithstanding the foregoing, a general partner who assigns all of his general partnership interest shall cease to be a general partner only upon the filing of a certificate reflecting that fact in accordance with this chapter. (emphasis added)

(b) 42:2A-48. Rights of judgment creditor of a partner: On application to a court of competent jurisdiction by any judgment creditor of a partner, the court may charge the partnership interest of the partner with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the partnership interest. This chapter does not deprive any partner of the benefit of any exemption laws applicable to his partnership interest. (emphasis added).

2. Statutory Authority for FLLC Asset Protection

(a) 42:2B-45. Rights of judgment creditor of member: On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the limited liability company interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest. An action by a court pursuant to this section does not deprive any member of the benefit of any exemption laws applicable to his limited liability company interest. A court order charging the limited liability company interest of a member pursuant to this section shall be the sole remedy of a judgment creditor, who shall have no right under P.L.1993, c.210 (C.42:2B-1 et seq.) or any other State law to interfere with the management or force dissolution of a limited liability company or to seek an order of the court requiring a foreclosure sale of the limited liability company interest. Nothing in this section shall be construed to affect in any way the rights of a judgment creditor of a member under federal bankruptcy or reorganization laws. (emphasis added).

(b) 42:2B-44 Company interest assignable; rights of assignee. a. A limited liability company interest is assignable in whole or in part except as provided in an operating agreement. The assignee of a member's limited liability company interest shall have no right to participate in the management of the business and affairs of a limited liability company except as provided in an operating agreement and upon:

(1) The approval of all of the non-assigning members of that interest, if any, of the limited liability company; or

(2) Compliance with any procedure provided for in the operating agreement.

b. Unless otherwise provided in an operating agreement:

(1)An assignment entitles the assignee to receive the distribution or distributions, and to receive the allocation of income, gain, loss, deduction, or credit or similar item to which the assignor was entitled, to the extent assigned;

(2)A member ceases to be a member and to have the power to exercise any rights or powers of a member upon assignment of all of his limited liability company interest; and

(3)The pledge of, or granting of a security interest, lien or other encumbrance in or against, any or all of the limited liability company interest of a member shall not cause the member to cease to be a member, to become dissociated or to fail to have the power to exercise any rights or powers of a member.

c. An operating agreement may provide that a member's interest in a limited liability company may be evidenced by a certificate of limited liability company interest issued by the limited liability company.

d. Unless otherwise provided in an operating agreement and except to the extent assumed by agreement, until an assignee of a limited liability company interest becomes a member, the assignee shall have no liability as a member solely as a result of the assignment.

e. An assignee shall have no authority to seek or obtain a court order dissolving or liquidating a limited liability company. (emphasis added)

B. Income Taxation: Partnership taxation indicates that the partners are individually taxed on their share of the items of income, gain, loss and deduction generated by the partnership (generally pro-rata). Per Rev. Rul. 77-137, 1977-1 CB 178, even though the holder of a charging order is treated as an assignee of the partnership distributions under state law, it is treated as a partner for income tax purposes. Accordingly, where the FLP or FLLC produces items of income or gain, a creditor with a charging order will be responsible to report its share of those items on its tax return, even though no distribution has been made. As a result, the creditor may have to pay taxes on money it does not actually receive. Since the income tax consequences of a charging order are so onerous, there are significant settlement opportunities between a debtor LP or LLC member and his creditors.

C. Bankruptcy: The bankruptcy of an LP or LLC member does not affect the FLP or FLLC directly because creditors only have access to the partnership interest. The bankruptcy trustee has power to sell the partnership interest/membership interest. However, this does not affect the asset protection aspects of the entity because under a properly drafted partnership agreement or operating agreement, the purchaser will just be a mere assignee. In addition, if as a result of the restrictions on transfers built into the partnership agreement or operating agreement the value of the entity is discounted, family members may purchase the interest from the bankrupt partner at a relatively low price.

D. Dissolution of Marriage: Many times a family owns assets with the intention of distributing those assets down the lineal family tree. It is common for non-blood relatives to be excluded from the distribution scheme. A concern is that in the event of a divorce a spouse may receive an interest in family assets, contrary to the wishes of the family plan. Use of an FLP or FLLC to gift interests in the entity, rather then outright ownership of assets, effectively combats this problem.

1. Equitable Distribution - In New Jersey, upon divorce the assets are divided by equitable distribution. Inheritance and gifts from family members are exempt from equitable distribution, so long as the party can trace the asset to the inheritance and or gift. Many times parents are concerned about giving assets to their children because the children will put them into a joint investment, or use the assets for joint purposes, thus transforming their exempt status to “included” status. An interest in a properly drafted FLP or FLLC is non-transferable, and accordingly should remain outside the reaches of equitable distribution.

2. Support - Notwithstanding, many family law practitioners have found that the court considers all of the assets in determining support payments, and may consider any income that one spouse is receiving from an inheritance or gift in structuring a support order even though the underlying asset itself is not subject to equitable distribution. By having an FLP or FLLC, the GP or Managing Members can effectively control the income flow to the child. Compare this to a gift to a trust with mandatory income.

E. Medicaid:

1. Spend-Down - As a general rule, prior to a person qualifying for Medicaid to cover the expenses of long term care, that person’s assets must be spent down to no more then $2,000. Certain assets are excluded from the spend-down, such as the family home, if a spouse continues to reside there, and “unavailable assets”. (A complete list of excluded assets can be found in N.J.A.C.10:71-4.4)

2. Unavailable Assets - Unavailable assets are resources that the applicant cannot convert to cash. These unavailable resources are not included in the assets that must be spent down before a person qualifies for Medicaid. (See 20 C.F.R. 416.1201(a)(1); N.J.A.C.10:71-4.4.) Examples of unavailable resources are those that are not accessible to the individual through no fault of their own. An example of such an assets in the Administrative Code is real property that cannot be sold because of the refusal of the co-owner to liquidate. See N.J.A.C.10:71-4.4.6. Presumably, a properly structured FLP or FLLC should be deemed an unavailable asset since the Medicaid beneficiary has no right to liquidate their interest or to withdraw from the FLP or FLLC.

3. Practice Tip - Be aware when utilizing this technique to protect assets from Medicaid, that if the FLP or FLLC was funded primarily with a person’s assets, and gifts were of interest in the entity made to beneficiaries within 3 years of the Medicaid application (5 years if the gifts were made to a trust) the transfer of those interests will cause a penalty period for Medicaid.

F. Fraudulent transfers:

1. Overview - A transfer with actual intent or constructive intent to place assets beyond the reach of creditors is a fraudulent conveyance pursuant to the New Jersey Uniform Fraudulent Transfers Act, NJSA 25:2-20 et seq. (“UFTA”). Such a transfer will be voided under New Jersey Law, and can subject the attorney who assisted the debtor in making the transfer to civil, criminal and disciplinary actions. (See Model Rules of Professional Conduct 1.2(d) (1990); NJ RPC 8.4(c)). A fraudulent transfer exists where a debtor has either (i) actual intent, or (ii) constructive intent to defraud a creditor. Two key factors in finding either type of intent are (i) whether or not the transfer was for fair consideration and (ii) whether or not the debtor was insolvent at the time or transfer, or became insolvent as a result of the transfer. While both of these determinations are made based on the facts and circumstances surrounding the transfer, the finding of constructive fraud is a more mechanical test.

2. Actual Intent to Make Fraudulent Transfer - A debtor has actual intent to make a fraudulent transfer if the transfer is make “[w]ith actual intent to hinder, delay, or defraud any creditor of the debtor”. NJSA 25:2-25(a).

(a) Gift: Where a debtor makes a gift in the face of known claim, a court would be likely to find that the debtor had actual intent to defraud his creditors. Courts have consistently found that the debtor has actual intent to defraud his creditors where the debtor makes a gift when there is a meritorious and substantial claim pending against him. See Jugan v. Friedman, 646 A. 2d 1112, 275 N.J.Super. 556, certification denied 649 A.2d 1291, 138 N.J. 271 (1994). A gift in this situation is a subject to the highest scrutiny, and would need to be coupled with facts which show a material change in the debtor’s circumstances for a gratuitous transfer not to be considered fraudulent.

(b) Transfer of Assets to LLC: Similarly, where a debtor transfers assets to an FLP or FLLC in the face of a known claim, a court is likely to find that a debtor had actual intent to hinder or delay collection of the debt by creating a form of ownership which has the advantage of the availability of a charging order. (See Shapiro v. Wilgus, 287 S.Ct. 348 (1933))

(c) Badges of Fraud: Where it is less clear that a transfer was made in an attempt to defraud a specific creditor, the courts will rely on the “badges of fraud” to determine whether there is actual intent. In examining the badges of fraud, the courts will pay particular attention to two factors: (1) whether or not the transfer was for fair consideration, and (2) whether or not the debtor was insolvent at the time or transfer, or became insolvent as a result of the transfer.

(i) Fair Consideration: A transfer will be made for fair consideration where it is made at an arms length and properly documented. Transfers for consideration between family members are subject to heightened scrutiny, but are not per se fraudulent.

(ii) Insolvency: Essentially, a debtor is insolvent if his assets exceed his liabilities. However, assets and liabilities are included or excluded in a specific manner under UFTA. Most importantly, assets are defined to exclude the value of the property that has been the subject of a fraudulent conveyance, and the value of contingent liabilities are discounted to reflect the possibility that the contingency will materialize. NJSA 25:2-23(d).

(d) Ability of Creditors to make claims:

(i) Fraudulent Taint: If there is actual intent to defraud, the transfer has a “fraudulent taint” so that any creditor, whether their claim arose before or after the transfer, may reach the transferred property in satisfaction or their claim.

(ii) Statute of Limitations: The statue of limitations for bringing an action to void a transfer where the debtor had actual intent to defraud his creditors is 4 years after the transfer, or 1 year after the transfer could reasonably have been discovered by the creditor. NJSA 25:2-31(a). Once actual intent to defraud a creditor is found, the surrounding circumstances of the transfer will not offer a defense.

3. Constructive Intent to make Fraudulent Transfer - In order to void a transfer for constructive fraud, a creditor need only show that the debtor’s transfer met a mechanical test.

(b) Test for Constructive Intent: The transfer will meet such a test if the debtor makes a transfer for less then fair consideration and any of the following three elements exist at the time of the transfer: (NJSA 25:2-25(b))

(i) The debtor was engaged or about to engage in a business for which the remaining assets of the debtor were unreasonably small in relation to the business (i.e.: the debtor transfers all of his personal assets to his spouse and then engages in a high risk business venture where only a small percent of the capital at risk is the debtors);

(ii) The debtor intended to incur, or should reasonable believed that he would incur debts beyond his ability to pay them as they become due; or

(iii) The debtor was insolvent at the time of the transfers, or became insolvent as a result of the transfer.

(i) Fraudulent Taint: If a debtor is found to have constructive intent under the first two tests, the transfer will have a “fraudulent taint” and be considered fraudulent as to both present and future creditors. NJSA 25:2-25. If the debtor is found to have constructive intent under the third test, the transfer will only be considered fraudulent as to creditors in existence at the time of the transfer. (NJSA 25:2-27)

(ii) Statute of Limitation: In either situation, the statute of limitations on an action to avoid the transfer will be 4 years from the time of the transfer. (NJSA 25:2-31).

IV. Transfers of FLP or FLLC Interests:

A. During Life: In order to transfer an interest in any FLLC or FLP, there need only be an assignment of that interest. This obviates the problem of either having to record a separate deed for real property, having to make transfers between investment accounts, or having to transfer stock in the corporate setting.

B. At Death: The FLP or FLLC interest is personal property. Accordingly, it is distributible through a person’s will. Even if the underlying assets are real estate, as the membership interest itself is personal property there need be no ancillary probate. Accordingly, even without any other motivation to create the FLP or FLLC, an FLP or FLLC should always be considered to hold title to out of state real estate.

V. Valuation Issues/Estate and Gift Tax

A. Overview: Fair market value is the price at which property will change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts. (Treas. Reg. §20.2031-1(b)). Because of the fact that an interest in an FLP or FLLC may be subject to severe restrictions on management, transferability, withdrawal and liquidation, an FLP or FLLC acts to create a situation where the value of an interest in an entity is less than the value of the pro-rata value of the underlying assets represented by that interest.

1. Gift Tax Benefits: The donor has the ability to leverage the value of gifts by making a gift of an FLP or FLLC interest as opposed to a gift of the underlying assets. The FLP or FLLC interest is worth less then the underlying interest, so the donor can effectively transfer more underlying assets through the FLP or FLLC.

2. Estate Tax Benefits: Similarly, a decedent’s interest in a entity subject to the restrictions set forth in a properly drafted partnership or operating agreement will be worth less than a pro-rata value of the underlying assets that the interest represents.

3. Appraisals. The determination of value must be supported by sufficient evidence. This normally would require a valuation done by a qualified appraiser.

(b) Practice Tip: Where annual gifts are being made, you may consider one appraisal at the end the year that will serve as an appraisal for current year and the next year.

B. Discounts. The most often heralded benefit of an FLP or FLLC are the discounts that are available. Discounts are a mere reflection of the fact that by placing assets in a FLLC or FLP, the donor’s relationship to the assets has changed so that the donor does not have as many rights over the assets as he did prior to placing them in the FLP or FLLC. Having fewer rights in assets makes an interest in an FLP or FLLC less desirable to a potential buyer then outright purchase of the assets would be. Accordingly, given the fair market value definition, an FLP or FLLC interest is worth less then the value of the underlying assets that interest represents. The difference between the fair market value of the underlying assets and the fair market value of the interest is known as the “discount”.

1. Lack of Marketability. The discount for lack of marketability reflects the fact that the owner of FLP or FLLC interest will have a more difficult time selling his interest then someone owning stock in a publicly traded company. Indeed, a well drafted operating agreement for a family enterprise will restrict all transfers on the assets, unless made to other family members. The lack of marketability discount is calculated separately from any other discount.

2. Minority Interest Discount. This discount is available because the holder of a minority interest, by definition, lacks the power to affect the management of the entity, control investments, cause distributions to be made, or otherwise ensure the long term growth of the entity.

(b) Attribution: When determining Minority Discounts, there is no attribution of ownership between family members, between individuals and entities owned by them, or between a beneficiary and a trust. See AOD CC-1999-0006 where the Service acquiesced in the decision in Estate of Mellinger v. Comr, 112 T.C. 26, 1999.

3. Control Premium. Where a person owns a small percentage of an entity, but that percentage has all the control over the entity, that ownership may be subject to a premium for control. For this reason is it recommended that the management interest, be it the GP or MM interest, be a small percentage of the entity.

C. IRS Challenges to FLP, FLLC: The Service does not like the use of discounts for FLPs or FLLCs in determining the value of an asset for gift and estate tax purposes. They see valuation discounts solely as a loophole to avoid taxation. For many years during the Clinton administration proposals had been made to ban discounts for FLPs and FLLC and only allow discounts for enterprises that have a “business purpose”. The Service has a myriad of arguments it uses to combat what it feels to be an abusive practice. Three recent cases, J.C. Shepard v. Commissioner, 115 T.C. 30 (2000), Ina F. Knight v. Commissioner, 115 T.C. No. 36; No. 11955-98; No. 12032-98, November 30, 2000, and Estate of Albert Strangi v. Commissioner, 115 T.C. No. 35; No. 4102-99, November 30, 3000, illustrate the arguments the Service has in its arsenal. These cases indicate that in addition to a properly drafted operating agreement, it is critical to pay attention to the form, substance and operations of FLPs and FLLCs. Any practitioner in this area would do well to study these cases as they act as a road map for how a partnership agreement or operating agreement should be drafted and, equally important, how the entity needs to be operated to preserve the discounts. The full decision of these cases can be found at the US Tax Court http://www.ustaxcourt.gov.

1. J.C. Shepard v. Comr, 115 T.C. 30 (2000)

(a) Facts: Taxpayer purported to be a 50% partner in a newly formed partnership, where each of his sons were 25% partners. Taxpayer transferred his interest in timberland subject to a long-term lease, and stocks in several banks to the partnership as its only capital. Taxpayer formed the partnership in the state of Texas on August 1, 1991 and transferred the timberland to the partnership that day. Taxpayer’s sons did not sign the partnership agreement until August 2, 1991. The partnership agreement provided that the taxpayer had a capital account of $10, and the sons of $5 each.

(b) IRS Arguments and Holdings:

(i) Indirect Gift - The transfer of the timberland to the partnership was an indirect gift of an undivided interest in the timberland to the sons. The Service argued that the gift was of the land itself, and not of an undivided interest in the FLP owning the land.

* Holding: The court agreed with the Service’s argument and held that the taxpayer made a gift of undivided interest in land, not an LP interest to his sons. The reasoning was very simple: a single person partnership does not exist under state or federal law. Thus, at the time the transfer of real estate was made, taxpayer could not have been making a transfer of a partnership interest to his sons because there was no partnership. Presumably, if taxpayer and taxpayer’s wife had first created the FLP, then transferred the property to the FLP, and then made a gift of an LP interest to his sons, the issue of what property was gifted, land or an LP interest, would never have been raised.

* Note that in examining the fair market value of an undivided fractional interest in real estate, the court allowed a 15% discount.

(c) Practice Tip: This question could easily have been avoided by adhering the property procedure. In setting up an FLP or FLLC, the following steps should be taken in sequence:

(i) Form entity and execute governing agreement.

* With an FLP this entails filing the Certificate of Formation and executing a partnership agreement between at least 2 people. Ideally, the two initial members will be of the same generation, husband and wife. If the client is single, a single member LLC would be appropriate, or the client should create a corporation to act as general partner and the client will be the LP.

* With an LLC there is additional flexibility because a person could set up a single member or multi-member LLC. An operating agreement should be executed, even for a single member, which contemplates gift transfers of interests and managing and non-managing membership interests.

(ii) Fund entity by transferring title or assets to the FLP or FLLC. Reflect the transferred assets properly on Schedule A of the agreement, which typically sets forth the capital contributions by the parties. Properly set up capital accounts to reflect the capital contributions.

* If additional capital contributions are made to the FLP or FLLC in the future, those contributions should result in an increase in the donor’s interest in the entity, and be properly reflected in the capital accounts.

(iii) Obtain an independent appraisal of the value of a minority LP interest or a non-managing member LLC interest in the entity.

(iv) After a period of time, transfer the LP interest or non-managing member LLC interest to the children, grandchildren, etc. or trusts established for their benefit.

2. Ina F. Knight v. Commissioner, 115 T.C. No. 36; No. 11955-98; No. 12032-98, November 30, 2000

(a) Facts: Husband and wife properly formed FLP, with a management trust they created as the 1% general partner. They funded the FLP with real estate, bonds, notes, insurance policies and cash. Husband and wife transferred a 22.3% interest to trusts created for each of their children. There were never any meetings nor business action taken on behalf of the LLC. The taxpayers frequently used the FLP property for personal uses before and after the formation of the entity.

(b) IRS Arguments and Holdings:

(i) Economic Substance - The partnership should not be recognized for federal gift tax purposes because it lacked economic substance.

* Holding – The court recognized the partnership for federal gift tax purposes due to the fact that the taxpayers met all the state law requirements for establishing a limited partnership.

(ii) §2704(b) Applicable Restriction - Under §2704(b), for purposes of determining the value of an interest transferred to a member of the transferor's family, a restriction on the right of an owner to cause a liquidation of the entity or of his or her interest in the entity will be disregarded as an "applicable restriction" if (1) the entity is controlled by the family before the transfer and the family can remove the restriction, or (2) the restriction will lapse after the transfer. The value of an “applicable restriction” is not subtracted from the initially determined value of an asset to arrive at the gift tax value. However, the owner’s restriction on the right to cause a liquidation will not be disregarded as an “applicable restriction” where the limitation is no more restrictive than the state's default rule.

* The court followed the analysis set forth in Kerr v. Comr., 113 T.C. 449 (1999) holding that so long as the partnership agreement either (1) requires dissolution on a specific date, or (2) requires liquidation or dissolution by agreement of all the partners (i.e.: GP and LP, or holders of both managing member interest and non-managing member interests in an LLC), then the limitations on an owner’s right to liquidate are not “applicable restrictions” because they are no more restrictive then state law. In Kerr, the court compared the restriction in the partnership agreement, namely that an LP could only force a liquidation with the consent of all the partners, to the state law provision addressing dissolution and liquidation of a limited partnership.

(iii) Excessive Discount – Discount should be reduced to 15% from a claimed 44%.

* Holding – The court agreed. Note that the court was swayed by the fact that taxpayer’s expert witness appeared entirely unprepared to give testimony, gave contradictory testimony, and was not a useful expert witness in supporting the discount stated in the return.

(i) Make sure to satisfy all of the requirements under state law to form the partnership or LLC

(ii) Treat partnerships and LLCs as if they were corporations in terms of the need to document that the entity operates separate from its owners. At a minimum, have resolutions and minutes prepared documenting annual meetings. Also, consider having your clients prepare and execute resolutions for major undertakings (invest in new enterprise, make a loan, sell a substantial portion of the assets).

(iii) Emphasize to your clients not to treat the LLC as a personal account. If they do not treat the entity as something separate from themselves, neither will the Service.

* As a similar example, in Estate of Trotter, T.C. Memo 2001-250, the decedent transferred her residence to a trust for her grandchildren’s benefit, but continued to reside there until her death. The court found there was an informal family arrangement for the decedent to continue to have full possession and enjoyment of the home, so included the home in her estate pursuant to §2036.

(iv) Make sure your appraisers are experienced enough to give credible, supportable valuations. A strong valuation will assist early settlement and compromise on an audit claiming a different discount should be applied.

3. Estate of Albert Strangi v. Commissioner, 115 T.C. No. 35; No. 4102-99, November 30, 2000

(a) Facts: Taxpayer created an FLP where a corporation, of which taxpayer owned 47%, was a 1% GP, and taxpayer owned 99% LP interest. Taxpayer transferred real estate, securities, annuities, insurance policies, receivables and limited partnership interests to the LP in return for his interest.

(b) IRS Arguments and Holdings:

(i) Economic Substance/Business Purpose – The partnership should be disregarded for federal tax purposes because it lacked business purpose and economic substance.

* Holding – The partnership had economic substance because it was valid and enforceable under state law, changed the taxpayer’s relationship to the assets, and it had a business purpose in protecting the assets from threatened litigation and executor’s fees. The economic substance argument states that if the sole motivation for taking an action is tax savings, then that action has no economic effect and will not be recognized for tax purposes. Note that the court was very concerned that although properly formed, the FLP was not properly operated as it frequently paid for personal expenses of the taxpayer.

(ii) §2703 Applicable Restriction – The partnership agreement was a restriction on the sale or use of property that should be disregarded pursuant to Code Section 2703(a)(2). Under §2703, a restriction on the right to sell or use the property, such as a ban on transfers or a mandatory buy-sell agreement, will be ignored as an “applicable restriction” for the purposes of determining the value of a gift unless (1) family members own less then 50% of the value or voting rights of the entity, or (2) the right or restriction meets the following requirements:

(a) The right or restriction is a bona fide business arrangement;

(b) The right or restriction is not a device to transfer the property to the natural objects of the transferor's bounty for less than full and adequate consideration in money or money's worth; and

(c) At the time the right or restriction is created, the terms of the right or restriction are comparable to similar arrangements entered into by persons in an arm's-length transaction.

* Holding – The court followed the analysis set forth in Church Est. v. U.S., 2000-1 USTC ¶60,369 (W.D. Tex. 2000) where the court held that §2703 did not apply to a partnership agreement where (1) the FLP has a bona fide business purposes of providing centralized management of family investments, preserving the investments for future generations, providing creditor protection; (2) the partnership was not a device to transfer the property to family members for less than full and adequate consideration because the (a) the value of the taxpayer’s partnership interest on the date of formation was directly proportionate to her contribution, and (b) profits, losses, and income were allocated in proportion to each partner's capital contribution; and (3) the partnership agreement was comparable to similar arms' length arrangements.

(iii) Gift on formation – The transfer of assets forming the partnership was a gift. The amount of the gift is the difference between the pro-rata value of the property contributed to the FLP by the taxpayer and the fair market value of the interest received.

* Holding – There was no gift on formation. The taxpayer followed the proper procedure of establishing and funding the FLP and then making a gift. Nobody else’s wealth was increased as a result of the transfer of assets to the partnership because the taxpayer received full consideration for the transfer in the form of a partnership interest. The court noted that the change in value of what the taxpayer owned as a result of transferring the assets to the partnership was a necessary result the lack of control and lack of marketability of the new partnership interest as opposed to the taxpayer’s prior outright ownership of the assets.

(iv) Excessive Discount – Discount should be reduced to 31%.

* Holding: Reduce discount from 44% to 31%. The court intimated that it might have reduced the discount further if the service’s valuation expert has suggested a lower figure.

(v) Practice Tips

* Set out in the partnership agreement or operating agreement the non-tax reasons for forming the entity such as centralized management and investment of family assets, asset protection, ease of transferring interests, etc.

* Ensure that the client’s treat the entity as separate and independent from themselves so that there will not be facts which call into question whether or not the FLP or FLLC has economic substance.

(c) Notice of Appeal: The IRS has filed a Notice of Appeal to the 5^th Circuit. Both parties have submitted their briefs and we are awaiting.

4. Estate of Elma M. Daily, T.C. Memo 2001-263 (Oct. 3, 2001)

(a) Facts: Taxpayer created an FLP in 1992 soley with marketable securities. Upon formation, she received a 98% LP interest and 1% GP interest. Her son also received a 1% GP interest. Later in 1992 the Taxpayer made a gift of a 60% LP interest to her son and his wife, and transferred the balance of her LP interest (38%) to a revocable trust. In 1995 Taxpayer converted her 1% GP interest to an LP interest. The estate claimed a 40% discount on the gift and estate tax returns

(b) IRS Arguments and Holdings:

(i) Economic Substance/Business Purpose – The partnership should be disregarded for federal tax purposes because it lacked business purpose and economic substance.

* Holding – The Court followed the holdings in Knight and Strangi that the partnership had economic substanc