Alan J. Mittelman tells LISI members that family partnership planning recently became much more difficult – at least in one state.

But regardless of where you – or your client live – you can learn a lot from the Berry case.

And if you want a quick review of the state of the estate tax law on FLPs, this is a really great way to do it.

Alan is Chair of the Trusts and Estates Department at Spector Gadon & Rosen, P.C. of Philadelphia, PA and Florida.  He is Editor of the Philadelphia Estate Planning Council Newsletter, speaks and writes frequently on estate planning, life insurance, and business planning subjects, and is a contributing author of the Pennsylvania Bar Assn. treatise "Estate Planning in Pennsylvania."

EXECUTIVE SUMMARY:

The PA Dept. of Revenue had disallowed discounts that even the IRS agreed were reasonable.  The Orphans' Court affirmed this result.  The Pennsylvania Commonwealth Court ruled in Berry that an estate should not be allowed a discount for the valuation of an FLP interest owned by a decedent.

BERRY CASE FACTS:

The Pennsylvania Department of Revenue has weighed into the valuation discount battle in the Estate of Berry.

The Berry case was first tried in the Venango County Orphans' Court.  The court there affirmed a decision of the Pennsylvania Dept. of Revenue Board of Appeals disallowing a valuation discount taken for an FLP.

The estate appealed the Orphans' Court decision to the Commonwealth Court of Pennsylvania, which then affirmed the Orphans' Court.

The decedent had been an original partner in an FLP formed in 1998.  She initially owned a 1% general partner interest and a 97% limited partner interest.  (The case does not indicate who owned the other 2% and whether the 2% was a general or limited partner interest.)

About a year later, the decedent gave away 30% of the limited partner interest to her children and later made 33 annual exclusion gifts of limited partner interests to other persons.

The decedent then died in 2003.

The Commonwealth Court opinion does not provide a lot of facts, but it suggests that the decedent was the only person who received any substantial benefit from FLP distributions.

It also indicates that the FLP did not have much in the way of business activity.  It held a portfolio of marketable securities, and its only real activity was to sell stocks and distribute the proceeds to the decedent who then that money to make additional gifts.

This fact pattern easily could have caught the attention of the IRS.  It sounds familiar to many of the Code Section 2036(a)(1) cases described in LISI Commentaries. But curiously, the IRS did not concern itself with this case.

The estate took a 33% discount on the value of the FLP in the decedent's federal estate tax return, reducing the value by over $500,000, and the federal estate tax return was accepted as filed.

The same valuation and discount was taken on the Pennsylvania inheritance tax return filed by the estate.

But much to the estate's surprise, the PA Dept. of Revenue rejected the discount -  entirely!

The principal theories of the Commonwealth were that:

• the FLP did not operate as a legitimate business enterprise and

• the estate failed to demonstrate that a partner would have disposed of his or her interest at a discount.

There is nothing in the Commonwealth Court opinion regarding the second part of the theory, so one concludes that the decision of the Commonwealth Court affirming the disallowance of the discount is mainly if not totally based on the estate's failure to prove that the FLP was a legitimate business enterprise.

The parties agreed that the Commonwealth had no regulations pertaining to FLPs.

The estate claimed that without any such regulations, the Dept. of Revenue had to accept the valuation agreed to by the IRS.

In fact, it is noteworthy that the Dept. of Revenue generally accepts the valuation agreed to by the IRS and typically uses criteria to value assets similar to the IRS methods.

However, the court disagreed with the estate.  It stated that even though the Dept. of Revenue generally applies federal regulations, it does not have to interpret those regulations in the same manner as does the IRS.

The court went on to quote a 3rd Circuit opinion from Estate of Thompson v. Comm'r, stating that it is

"…established federal case law that a decedent's inter vivos transfer of assets to a family limited partnership is not a transfer of assets or bona fide sale, as would warrant the exclusion of the assets from decedent's estate for estate tax purposes, if the partnership does not engage in "any valid, functioning business enterprise."

It stated that the FLP did not engage in any business transactions with anyone outside the family and that the decedent received no benefit from the partnership other than tax benefits.

In addition, the court agreed that the decedent continued to be the principal economic beneficiary of the FLP after the transfer of assets to the FLP.

Furthermore, the estate presented no evidence of any business activity.

COMMENT:

LACK OF BUSINESS PURPOSE FATAL:

One wonders how this result can occur.  In affirming the Dept. of Revenue's disallowance of any discount for lack of marketability or lack of control, it is clear that the court was mostly interested in the (lack of) business purpose of the FLP.

This should not be surprising.  Business purpose is the linchpin of all partnerships.  If there is no business purpose, the IRS can disallow partnership income tax treatment.  This is not a new concept.

And, yet, there are many federal cases in which taxpayers have prevailed with fact patterns that are much worse than Berry.

DID THIS ONE FLY UNDER THE IRS RADAR?

One wonders whether this is a case to which the IRS should have paid more attention and somehow flew under the IRS radar, or whether the estate was poorly represented in state court.

One cannot tell from the court's opinion whether the appraisal was done by a qualified appraiser, nor how thorough the appraiser was in preparing the appraisal.

But before discussing my opinion on this case, let's review why FLP's are such great estate planning tools and what has been happening with them on the federal level.

WHY FAMILY PARTNERSHIPS?

Family limited partnerships ("FLP") have been the centerpiece of countless estate plans over the last couple decades.  Along with family limited liability companies (also referred to as FLPs here), many estate plans have been built around the following concept:

• Family-owned real estate/other investments are transferred into an FLP

• Gifts of limited partner interests (or non-voting member interests in an LLC) are made to children and grandchildren or to trusts under which the children and grandchildren are beneficiaries

• Fairly large discounts are taken from the value of the gifts to minimize gift taxation and maximize the gift

• Much of the income and growth in value of the real estate and other investments is shifted to the donees.

IMPACT OF THE VALUATION DISCOUNT:

Taxpayers have been able to obtain appraisals prepared by qualified appraisers that use discounts often ranging from 25% to over 50% depending on the kind of assets held in the FLP and the restrictions on partners imposed by the partnership agreement.

The impact of the discount can be striking.  For example, if a partnership has assets worth $10 Million and a parent/partner gives a 40% limited partner interest to a child, the value of the gift would have a nominal value of $4 Million.

If the parent is married, the parent can split the gift with his or her spouse, and each spouse will be treated as making a $2 Million gift prior to applying the discount.  With an unused lifetime exemption of $1 Million available, each parent would be making a $1 Million taxable gift resulting in gift taxes of $450,000 per spouse at the current 45% gift tax rate (total gift taxes for both spouses of $900,000).  Not a very desirable result.

However, if an appraiser applies a 50% discount to the value of the gift because it lacks control and also lack marketability, then the fair market value of the gift may be only $2 Million.  Now when the spouses agree to split the gift, each spouse will be treated as making a $1 Million gift.

Since the exemption for lifetime gifts is $1 Million, the entire gift will be sheltered from the gift tax.  Hence, there will be no gift tax payable on this gift.  Without the discount, most donors would make smaller gifts in order to avoid paying gifts taxes on the gifts.

FACTORS INFLUENCING THE SIZE OF THE DISCOUNT:

The amount of the discount will depend on many factors, including the:

• terms of the partnership agreement,
• type of assets owned by the partnership, and
• kind of interest being transferred.

All appraisals are subject to review by the IRS which has been challenging discounts aggressively over the last decade.

There are no guarantees that the discount applied by the appraiser will be accepted by the IRS.

In addition to shifting an extra $2 Million worth of assets without $900,000 of gift tax, taxpayers also are able to shift more income to the donees and more growth in value.  This result occurs because the donees own a larger share of the FLP after the discount is applied.

The net result is that more wealth is transferred free of gift and estate taxes since the remaining estate of the parents (the donors) is smaller than it would have been if gifts could not be discounted.

IRS RESPONSE AND THEORIES OF ATTACK: 

As one might expect, the Internal Revenue Service ("IRS") has not been a fan of the FLP.

The IRS has used a variety of theories to challenge the discounts.

Among the theories used by the IRS to attach FLP discounts are the argument that:

• the partnership was a sham transaction and that there was no substance to the FLP

• there was a step transaction and the act of forming the FLP and then making a gift should be collapsed into just a straight gift

• Code Section 2703 applies and the entity should be ignored

• Code Section 2704(b) applies and therefore restrictions on transferability should be ignored

• there was a gift on formation
• the discounts used by the appraisers were too high and not justifiable

IRS LOSES MANY – BUT WINS SOME:

Most of these challenges have been defeated by taxpayers in the courts, with the IRS winning an occasional case when the facts were particularly egregious.

WINNING ARGUMENTS (FOR THE IRS)

However, in recent years, the IRS is winning more frequently.

The key theories under which the IRS has been succeeding are under Code Sections 2036(a)(1) and 2036(a)(2).

Code Section 2036(a)(1) brings back into a decedent's estate any assets over which the decedent made a lifetime transfer (other than a bona fide sale for adequate consideration) and had retained the "…possession or enjoyment of, or the right to the income from, the property …". 

This argument has defeated FLPs where the parent made the gift but really retained all the benefits of the partnership.  Especially in cases where only the parent received any distributions or income, the courts have been persuaded that the parents had a secret arrangement to be able to use or get the assets if needed.

This theory also has succeeded where parents put nearly all of their assets into the FLP.  The courts have been persuaded that no one would do something like that without a secret deal to be able to get them back at any time.  Perhaps, the IRS is right about these cases.

Code Section 2036(a)(2) brings back into a decedent's estate any assets that the decedent had 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."

BYRUM AND THE EVER GROWING EXCEPTION:

This theory is much more sophisticated, and had to clear a hurdle that many advisors thought was impenetrable - U.S. v. Byrum.

The Byrum case was a great victory for taxpayers.  The IRS had tried to make the case that a gift of stock to a donee should be brought back into the donor's estate if the donor had any voting power in the company attributable to the gifted stock or any other voting stock.  The Court held that the stock should not be brought back into a donor's estate under such circumstances because of the fiduciary obligations of the donor to the donees.

Congress later carved out an exception to the Byrum rule when it passed Code Section 2036(b).

For years, many advisors thought this section only applied to trusts.

However, in a couple recent cases the IRS has succeeded in proving to the tax court that Code Section 2036(a)(2) should apply to FLPs in which the parent/donor was and remained a general partner.  In effect, the donor had retained the power to vote on how the gifted property was being managed -  even though a general partner has a fiduciary obligation to all the partners.

The same theory would apply if the parent was a manager of an LLC or a voting member of the LLC.  In effect, the tax court seems to be repudiating or eroding the holding of Byrum.

The IRS definitely does not win every case and they do not even challenge in court many gifts of FLP interests either during lifetime or at death.

Many of the cases with bad results for taxpayers appear to be cases with bad facts, and such cases should not be the basis for a general law.

Advisors have been trying to sort out the reasons for taxpayer losses, and either draft or redraft FLP agreements that are less likely to be challenged by the IRS.

PLANNING TACTICS FROM THE BERRY CASE:

• The FLP needs to establish a business purpose.
• All partners need to receive benefits from the FLP, not just the parent.

• A parent should not put all her assets into the FLP so that it is necessary to get a distribution to make additional gifts of cash (or live, for that matter).

• The FLP should have activity.  There should be meetings of the partners and the entity should keep minutes just like any other business.

• Don't just create the shell and forget about it.  The FLP should be monitored and advisors consulted from time-to-time to make sure that new developments in the law don't overtake the "old estate plan."

FLPs ALIVE AND WELL:

FLP's are still viable planning tools.  Even without a discount, an FLP can enable significant wealth shifting, and it may be one of the best means of generating cash to trusts to fund life insurance premiums.

And, as evidenced by the IRS handling of the Berry estate, it is still possible to obtain a significant discount when valuing an FLP for federal estate tax purposes which usually is the larger tax, anyway.

It just takes more care now than before!

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Alan Mittelman

Edited by Steve Leimberg

CITE AS:

"Steve Leimberg's Estate Planning Newsletter # 1177 (September 26, 2007) at http://www.leimbergservices.com"

Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

CITES:

Estate of Berry v PA, 27 Fid. Rptr 2d 219 (Commonwealth Ct. 2007)

© Alan J. Mittelman 2007 All Rights Reserved. Alan J. Mittelman can be reached at amitt@lawsgr.com.