FLP Planning Considerations (Cont'd)

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Family Limited
Partnerships
By Robert J. Kiggins, Esq. of
McCarthy Fingar, White Plains, NY
Presented on June 10, 2005
INTRODUCTION
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How does FLP work as wealth transfer planning mechanism
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Example client has 100,000 shares of Microsoft and wants to gift 10,000 shares to a junior family member
(e.g. son)
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Primarily a discounting mechanism for transfers of property interests
At $25 per share this would be a $250,000 gift
However, if client gifts the MSFT to Family LLP or LLC and son has only 10% interest in the LLP the value of the gift
may well be less than $250,000 on account of minority interest discounts.
Example client owns 100,000 shares of auto dealership (“Auto’) worth $2.5 M and wants to transfer these at
death to son at discounted value for estate tax
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Pre-death sets up LLP
Transfers 99,000 Auto to LLP for 99% capital interest
1,000 Auto sold to son for FMV of $25K and son puts them into LLP for 1% capital interest
Son Runs LLP as GP
At death, client’s 99% LLP interest (assume $25 per share) will be valued at less than $2,475,000 (99,000 x $25)
Reason: lack of control discounts
What Else Does FLP Accomplish
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It May be A Way to Prevent Family Business
from Breakup through Splintering
It may also provide some protection from
creditors (limited liability)
May offer economies of scale
May be a way of dealing with family disputes
However, the discounting effect is the one that
we will focus on today
Rationale for Discounts
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Minority or Lack of Control Discounts:
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Business ownership is a bundle of rights.
A controlling co-owner may obligate other owners.
Elements of control may include
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appointment of management and determination of compensation;
deciding articles, bylaws and policy making/changing acts;
acquire and liquidate assets; selection and termination of business
relationships;
liquidate, dissolve, sell out or re-capitalize company; sell or acquire
treasury shares;
register for a public offering
and declare and pay dividends
Rationale for Discounts
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The distinguishing characteristic of a partial interest is co-ownership.
This co-ownership can diminish benefits
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Unless there are special laws in place
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due to lack of control and liquidity
may eventually entail disputes among owners, which may only be resolved through
the expensive process of litigation.
Once any of these rights are encumbered, it is likely to have an impact on value.
a controlling partnership interest is worth much more than a non-controlling one;
especially, an assignee interest with no voting rights.
In the absence of such control, a discount is often taken for the inability to
unilaterally influence the business or its investment performance.
This is often referred to as a non-controlling or minority discount.
Also these interests tend to be unattractive and difficult to market
These discounts can be significant and are supported by various market
studies and case precedent
IRS Attacks
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IRS attacks are currently being made under §2036(a)
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which pulls back into decedent’s estate transfers:
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where decedent retained income interests (Sec 2036 (a) (1)), or
where decedent retains right to direct beneficial enjoyment of
income of transferred property (Sec 2036 (a)(2)
In a series of cases courts held that decedent in connection
with FLP’s had retained an income interest in the transferred
assets
Also some of these cases held decedent had right to direct
beneficial enjoyment
IRS Attacks
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Estate of Strangi v. Commissioner, 115 TC 478 (2000), aff ’d in part and rev’d and
remanded in part, 293 F.3d 279 (5th Cir. 2002) (known as Strangi I) and Estate of
Strangi v. Commissioner, T.C. Memo. 2003-145 (May 20, 2003) (known as Strangi II).
Facts
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Decedent’s son-in-law, an estate planning attorney who also held the decedent’s power of
attorney, formed an FLP two months before decedent’s death.
After formation, the son-in-law transferred about $2 million of decedent’s assets to the
FLP in exchange for decedent’s receipt of a 99% limited partnership interest.
Decedent also received a 47% interest in the corporate general partner, which owned 1%
of the partnership,.
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Decedent’s children received 53% the corporation’s shares
But then gave a 1% share to a charitable foundation.
The partnership agreement gave the general partner the sole discretion to determine
distributions.
Decedent used partnership assets to pay for personal expenses, including nursing care.
At his death, decedent’s FLP interests comprised more than 96% of his estate.
Decedent’s estate tax return included the 99% limited partnership interest, but with a
43.75% discount for lack of marketability and minority interest.
IRS Attacks
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The IRS determined a deficiency in estate and gift tax
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The Partnership itself was a restriction under Section 2703 which should be
disregarded
The IRS claimed, in part, that Code Sec. 2036(a) ought to apply:
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to assets the decedent had transferred to the FLP
due to his retained interest in, and control of those assets.
The Tax Court in Strangi I as to Sec. 2703 held that the FLP was valid under state law:
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Largely on the basis that the decedent’s interest in the FLP should have been increased for
estate and gift tax purposes.
because the entity complied with all necessary formalities, and
because the partnership had sufficient substance to be recognized for tax purposes.
However, the Tax Court did note that it was skeptical of the non-tax avoidance
reasons for formation of the FLP.
The Tax Court refused to consider the Code Sec. 2036(a) issue because the IRS had
asserted the issue too close to the trial date.
The Fifth Circuit upheld the majority of the Tax Court’s findings, but remanded on
the 2036(a) issue.
IRS Attacks
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On remand, in Strangi II, the Tax Court:
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held that Code Sec. 2036(a) applied to assets transferred by decedent to the FLP
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because decedent implicitly retained economic benefit from the transferred property 2036(a)(1),
including the right to receive the income therefrom.
Also decedent impliedly kept right to designate persons who would enjoy beneficial use of the
property – Sec 2036(a)(2)
Thus, the decedent’s entire 99% limited partnership interest and 47% interest in the
corporate GP was included in his estate without discount
Crucial to the court’s decision under 2036(a) (1) were the following facts:
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Decedent died two months after the FLP was created;
Decedent transferred substantially all of his assets to the FLP;
Decedent’s attorney-in-fact controlled the FLP;
FLP assets were used for decedent’s personal expenses; and
No other partner had a meaningful economic interest in the FLP.
Decedent, through his attorney-in-fact, retained the right to determine who would benefit
from the assets and the income generated therefrom.
Implied agreement existed among the partners of the FLP to allow the decedent to retain
the use and enjoyment of, or the income from, the underlying assets.
IRS Attacks
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Crucial to the court’s decision under 2036(a) (2)
were the following facts:
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The decedent acting with others could have the
partnership liquidated
If all the LP’s and the GP agreed
 GP could consent to a P/P liquidation if all shareholders
voted for it
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Decedent acting with co-shareholders could control
P/P Distributions
IRS Attacks
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Note: full inclusion of all P/P assets was
required under Sec. 2036(a)(2)
CF: under Sec 2036(a)(1) only pro-rata inclusion
would normally be required
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Example - if a trust is created by X, and X retains
the right to received 2% of the trusts income, then,
only 2% of the trust corpus is included in X’s gross
estate under 2036(a)(1)
Stone Case - Bona Fide Sale
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Estate of Stone v. Commissioner, TCM 2003-309
FACTS
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The Estate of Stone examined five family limited partnerships
formed just two months prior to the death of Mr. Stone and six months prior to the death
of Mr. Stone's wife.
At the time of Mr. Stone's death, he held the majority of the general partner and limited
partner interests in each of the family limited partnerships as follows:
FLP #1 - 69.973% (inclusive of a 1.001% general partner interest)
FLP #2 - 94.877% (inclusive of a 1.003% general partner interest)
FLP #3 - 94.485% (inclusive of a 1.002% general partner interest)
FLP #4 - 95.300% (inclusive of a 1.003% general partner interest)
FLP #5 - 91.144% (inclusive of a 1.003% general partner interest)
Stone Case - Bona Fide Sale
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The day prior to the formation of the partnerships, small undivided interest
gifts were made to each of the Stone's children.
Each partnership held different real properties and other assets, including
some preferred stock in the family operating company.
On the date of formation, each of the Stone children received, in return for
their respective contributions, small general partner interests.
In each case, just enough general partner interest was provided to Mr. Stone
such that he held a simple majority of the general partner interests. Ms. Stone
held only limited partner interests.
The estate tax returns were filed claiming, in aggregate, 43-percent lack of
control and lack of marketability discounts on Mr. Stone's interests.
Moreover, four of the five partnerships made non-pro rata distributions to
the estate for the direct purpose of paying Mr. Stone's estate tax.
It took the IRS only three months from the estate tax filing to pick up the
estate of Stone's §706 for audit.
Stone Case - Bona Fide Sale
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Issue
both parties agreed a transfer took place,
 the Court's decision hinged on whether or not
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the transfer qualified under the bona fide sale exception
to §2036, a
 if not did the decedent retain possession or enjoyment
of, or the right to income from, the property transferred
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Stone Case - Bona Fide Sale
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Bona Fide Sale Exception
The IRS asked the Court to rule there was not a bona fide sale, in part, because:
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..a transfer is a sale for adequate and full consideration only if that received in exchange is
"an adequate and full equivalent reducible to money value." Treas. Reg. §20.2036-1(a) (crossreferencing Treas. Reg. §20.2043-1(a))
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The average 43-percent valuations discounts claimed on estate tax returns, and the stipulated
discounts to be applied in valuing Decedents' limited partner interests in the event the Court
concluded that section 2036(a)(1) was not applicable
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show that Stones admittedly do not consider interests in the Stone LPs to be the "full equivalent
reducible to a money value” of the proportionate amount of the underlying assets Decedents
contributed to the partnerships
Court rejected to the IRS argument:
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Mr. Stone and Ms. Stone received respective partnership interests in each of the Five Partnerships
the value of which, taking into account appropriate discounts, was less than the value of the
respective assets that they transferred to each such partnership, they did not receive adequate and
full consideration for the assets transferred.
Stone Case - Bona Fide Sale
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IRS argument in effect read out of section 2036(a) the exception for "a bona fide sale for an adequate and full
consideration in money or money's worth" in any case
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where there is a bona fide, arm's- length transfer of property to a business entity (e.g., a partnership or a corporation)
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for which the transferor receives an interest in such entity (e.g., a partnership interest or stock) that is proportionate to the fair
market value of the property transferred to such entity and
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the determination of the value of such an interest takes into account appropriate discounts.
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In reaching its decision, the Tax Court explicitly considered the following facts:
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Each member of the Stone family was represented by his or her own independent counsel
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Each member had input into the decision-making as to how each of the Five Partnerships was to be structured and
operated and what property was to be transferred to each such partnership.
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The Stone family understood that Mr. Stone and Ms. Stone would not be bound by any agreements that the children
were able to reach as a result of the children's negotiations and that Mr. Stone and Ms. Stone would make the
ultimate decision as to which, if any, of their respective assets to transfer to each of the Five Partnerships (i.e. the
kids weren’t running the show)
Stone Case - Bona Fide Sale
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- The Stones did not transfer "all their respective assets to such partnerships. Instead, they
retained sufficient assets to enable them to maintain their respective accustomed standards
of living."
- the respective transfers at issue did not constitute gifts by Mr. Stone and Ms. Stone...." (i.e.,
the transfers in exchange were pro-rata)
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All partners of each of the Five Partnerships held respective partnership interests in each such
partnership that were proportionate to the fair market value of the assets that such partners
respectively transferred to each such partnership;
the respective assets that the partners of each such partnership transferred to each such partnership
were properly credited to the respective capital accounts of such partners; and
upon the termination or dissolution of each of the Five Partnerships, the partners of each such
partnership were entitled to distributions from each such partnership in amounts equal to their
respective capital accounts.
The transfers were motivated primarily by investment and business concerns relating to the
management of certain assets of Mr. Stone and Ms. Stone during their lives
the Five Partnerships had economic substance and operated as joint enterprises for profit
through which the children actively participated in the management and development of the
respective assets
there was a genuine pooling of property and services
Stone Case - Bona Fide Sale
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the partnerships were formed such that it was "contemplated and intended that each such partnership
operate as a joint enterprise for profit for the management of its assets and the children contribute
services in providing such management.
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after the funding of [the partnerships, the respective children] actively participated in the management of
the assets of such partnerships.“
Court concluded
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the respective transfers of assets by Mr. Stone and Ms. Stone to each of the Five Partnerships were for
adequate and full consideration in money or money's worth.
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Moreover, "we find, that unlike the transfers involved in Estate of Harper and other cases factually
similar to that case, the respective transfers at issue by Mr. Stone and Ms. Stone did not constitute
'circuitous 'recycling' of value.'"
Retention of Possession or Enjoyment
Finally, because the transfers met the bona fide sale exception to §2036, it was not necessary for
the Tax Court to consider whether the decedents retained the right to "possession or enjoyment
of, or right to income from, the transferred property" under §2036(a)(1).
Estate of Bongard v. Commissioner, 124
T.C. No. 8 (2005)
Facts
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Decedent created an irrevocable trust in 1986
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Funded with some stock in his closely-held company, Empak.
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The trust made several distributions of stock to its beneficiaries between
1991 and 1994.
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Empak redeemed the stock as it was distributed, so that the beneficiaries
would have cash
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As part of a plan to make Empak attractive for outside capital (a “corporate liquidity event”), the
decedent formed a LLC on December 28, 1996.
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The decedent and the trust transferred all of their stock in Empak to the LLC holding
company.
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The LLC had Class A units and Class B units.
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There were Governing and Financial classes of the Class A and Class B units,
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Only the Class A units had voting rights.
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Decedent’s son was chief manager subject to a “Member Control Agreement”
Bongard – Cont’d
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Member Control Agreement
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2 Days later (on 12-30-96) Empak Directors were Changed
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Chief Manager was not granted sole decision making power over allocation of
distributions
Chief Manager power over accounting decisions limited if Class A disagreed
Chief Manager did not vote on this although LLC was sole Empak shareholder
Decedent and Trustee of the 1986 Trust voted on this
The next day (on 12-29-96), the decedent formed an FLP,
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Transferred all of his Class B units in the LLC to it in exchange for a 99%
limited partnership interest.
The 1980 irrevocable trust transferred some of its Class B units in the
LLC to the FLP in exchange for a 1% general partnership interest.
This was part of decedent’s estate plan and not a necessary step in the
business plan
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A gifting mechanism to family but without deterring them from working hard
and becoming educated
Protection of estate from creditors
Greater flexibility than trusts
Bongard – Cont’d
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The decedent created a Children’s Trust and Grandchildren’s Trusts in late
December 1996.
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He subsequently transferred enough of his Class A units in the LLC to those
trusts so
He held only a minority of the Class A units of the LLC.
About one year later (on 12-10-97), the decedent gave a 7.72% limited
partnership interest in the FLP to his wife.
Less than one year later than that (on 11-6-98), the decedent died
unexpectedly on a combined hunting/business trip to Austria.
IRS on ET Return Audit
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$52M deficiency
EMPAK stock transferred to LLC included in D’s estate because D had
retained rights in the stock
Bongard – Cont’d
Court Holdings
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Bona Fide Sale Exception Applies To Formation Of LLC.
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Decedent’s transfer of his Empak stock to the LLC satisfied the bona fide sale
exception to §2036
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Bona Fide Sale Exception Does Not Apply To Formation Of FLP.
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Decedent’s transfer of his LLC Class B units to the FLP did not satisfy the bona fide
sale exception.
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the decedent possessed a legitimate and significant nontax reason for the transfer (i.e. part
of the plan for the “liquidity event”)
because he received LLC interests proportionate to the value of the property transferred
to it.
No significant non-tax motive
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No real continued gifting plan
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Holding company already provided protection from creditors
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No evidence that holding LP interest provided extra flexibility than holding LLC
ouright
Implied Agreement For Retained Enjoyment Cause §2036(A)(1) Inclusion For
FLP Assets.
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An implied agreement existed whereby the decedent retained the benefit of the
LLC Stock transferred to the FLP
Bongard – Cont’d
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Court found Decedent kept control:
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Decdnt controlled whether FLP could transform LLC stock into cash
Decdnt as CEO and sole director of Empak controlled timing of stock redemptions for cash
He didn’t cause underlying Empak stock to be redeemed thereby assuring that FLP would not engage in
asset management
Dissent’s Attack on Section 2036(a)(1) Analysis.
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A separate opinion points out alleged weaknesses of the majority’s §2036(a)(1) analysis.
The opinion concurs as to the LLC issue, but dissents as to the FLP issue.
Only 3 of the 17 judges agree with dissent view
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it will tough in the future to defend against a §2036(a)(1) claim in the Tax Court if the
bona fide sale for full consideration exception does not apply.
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Seems like the case had good facts to defend against a §2036(a)(1) attack.
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The court found an implied agreement giving the decedent continued enjoyment of the
FLP assets
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despite the fact that the decedent never received ANY benefits whatsoever from
the FLP for the balance of his lifetime,
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indeed the court acknowledged that the decedent did not need the FLP assets to
maintain his standard of living.
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The only factored to support the existence of an implied understanding was the
purported ability of the decedent to control cash flow to the entity.
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Control over cash flow to the FLP does not logically lead to the existence of an
implied understanding as to how the cash would be used once it reached the FLP
Bongard – Cont’d
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Application of Discounts.
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The court’s decision that §2036 does not apply to the creation of the
LLC, and the refusal to bring back the underlying LLC assets (i.e., the
Empak stock) into the estate means that discounts attributable to the
LLC were allowed.
The parties stipulated that if §2036 did not apply to the transfers to the
LLC,
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a 13% lack of control discount
and a 17.5% lack of marketability discount (or a seriatim discount of 28.23%)
would apply to the Class A units owned by the decedent,
and an additional 5 % lack of voting rights discount (for a total seriatim
discount of 31.82%) applied to decedent’s ownership of the Class B units in
the LLC, that were directly owned or that were included in decedent’s estate
under §2036 as to the FLP.
The LLC discounts generated a total reduction of the gross estate by
almost $42.6 million.
FLP Planning Considerations
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Existing FLP’s – It is likely crucial for existing
entities to consider restructuring
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Eliminate right of potential decedent to vote on
liquidations and distributions
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Inter Vivos Gift
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But potential gift tax
Also Sec 2035 would disregard if made within 3 years of death
Reclassification
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Two classes
 One has all vote and liquidation rights
 Other class has no such rights
FLP Planning Considerations
(Cont’d)
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Amendment not produce gift because potential decedent owns
all limited partnership interests and still possesses all preamendment voting rights
If the interest carrying voting rights was small (e.g. .5% of FLP)
then likely no gift tax will be produced
Incomplete Gift Trust
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Transfer the voting and liquidation rights to a trust under which
potential decedent has right to change beneficiaries
The theory is that retained modification would mean no gift
However, as Trustee now has the rights potential decedent avoids
inclusion of those rights
Property in trust still in estate – but subject to discount
FLP Planning Considerations
(Cont’d)
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Section 2035 will generally defeat any of these strategies
if they occur within 3 year of death
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But in case of sale for full consideration Section 2035 bona fide
sale exception might be useable
On account of valuation rules (i.e. the sale needs to be for the
value of corpus not just life estate which inflates the estate of
the selling partner) this likely only works in context of sale to
spouse
Example
 Ptr with 98% LP interest and virtually all of GP with each
carrying voting rights that would trigger no-discount rules
of Strangi and Bongard
 Assume P/P Assets worth $20M but have a discounted
value of $15M.
FLP Planning Considerations
(Cont’d)
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Partner sells interests for discounted value of $15M (no gift)
However, doesn’t work if death w/n 3 years as case law
requires sale be for full $20M for full consideration
exception to Sec. 2035
So, to meet the full consideration requirement of Sec 2035
Partner would have to inflate his estate by $5M and receive a
taxable gift of $5M from his purchaser
If however, in the $20M scenario the purchaser is the
spouse of the partner there is no taxable gift, and no Sec
2035 inclusion
The selling partner’s estate is still inflated by $5 M but the
spouse estate is at the same time reduced by $5M which
offsets and preserves the discount of the couple.
FLP Planning Considerations
(Cont’d)
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Formation
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For “Pooling of Interests” Bona Fide Sale Exception
to Sec. 2036
All family members contribute property to FLP
 Each receives a P/P interest equal in value to contribution
 Keep in Mind
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Case law requires a “business purpose”
Each contributing partner needs to use independent wealth
(otherwise step transaction will be asserted by IRS)
Some concern that not all of potential decedent’s contribution
would be deemed by IRS as included in his/her capital account –
thus there is risk of a gift
FLP Planning Considerations
(Cont’d)
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Restriction on Voting Rights
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The essential idea is for the potential decedent to not have
voting rights re liquidations and distributions
This avoids Sec. 2035 as well
Issues:
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Gift on Formation – reduces value of what potential decedent
receives back for his/stock
Some clients will balk at this lack of control
Variations
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Transfer of Control to Spouse
Use of Incomplete Gift Trust
FLP Planning Considerations
(Cont’d)
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Other Considerations
Eliminate distributions to the contributing potential
decedent partner
 Contributing potential decedent partner needs to
maintain sufficient assets to live on outside of the
FLP
 Personal use assets should not be contributed
(residences, cars)
 Formalities must be observed – no conmingling of
assets
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Parting Thoughts
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In FLP’s one size does not fit all – careful
tailoring is required
This is a dynamic area legally – cases not totally
consistent – many may still be appealed - stay
alert
If when all is said and done, taxes seem to be
the only reason for the FLP, the Courts will
strain to “do equity” and disallow the discount
Thank You!
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If You Have Further Questions Contact:
Robert J. Kiggins, Esq.
McCarthy Fingar
Tel 914-946-3817 Ext. 251
Email rkiggins@mfdds.com
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