Are Your Family's Assets Protected from the IRS?
By Michael Price and Raymond Ghelardi, ASA.
Although there is currently no estate tax for 2010, as stipulated by the Economic Growth and Tax Relief Reconciliation Act of 2001,1 Congress is expected to reinstate the estate tax at a higher level in 2011, as well as make the estate tax retroactive to include 2010.2 Thus, the use of Family Limited Partnerships (“FLPs”) will likely increase substantially as many taxpayers will attempt to take advantage of the tax benefits associated with FLPs.
The term “Family Limited Partnership” does not refer to a specific entity as defined by the IRS, but rather a limited partnership holding personal or business assets originally owned by a family or one of its members. When implemented correctly, FLPs reduce the taxes payable by the decedent’s estate and create tax benefits for the decedent’s family members due to the non-controlling, non-marketable nature of the FLP’s shares gifted by the decedent’s estate, allowing the net asset value of the FLP to be discounted to account for these aforementioned characteristics of the shares.
Unfortunately, in many cases, FLPs are incorrectly established and/or operated, failing to produce their promised benefits thus allowing the IRS to include the FLP’s assets in the estate from which they were originally separated. Family members can reduce potentially hefty taxes on a decedent’s estate by following the guidelines of Internal Revenue Code (“IRC”) §2036 and by applying the appropriate discounts to the net asset value of the FLP should the FLP be correctly established and operated. Therefore, it is critical for taxpayers to consult with accounting professionals familiar with tax and estate planning issues and a qualified, independent valuation expert when attempting to form and operate a FLP.
When dealing with FLPs there are two major issues that the IRS considers: a) the validity of the FLP and whether its assets should be included in the decedent’s gross estate; and, b) the FLP’s corresponding value.
Internal Revenue Code §2036 states:
The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period….which does not in fact end before his death –
1) The possession or enjoyment of, or the right to the income from, the property, or
2) The right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.3
This vague definition of what should be included in the gross estate leaves the IRS just enough wiggle room to find flaws in the operations of FLPs, enabling the IRS to assert that the assets of certain FLPs should be considered part of the decedent’s taxable gross estate. Thus, the intended tax benefit of the FLP is not realized.
Consider, for example, the case of Estate of Reichardt, where the donor (the FLP member who contributed the assets to the partnership) commingled his personal funds and continued to use the property that was donated to the partnership as his personal residence.4 Treating the assets in such a way gave the IRS reason enough to include the assets held by the FLP in Reichardt’s estate under the stipulations of IRC § 2036 (a)(1), because the taxpayer continued to enjoy the property in question. Additionally, Reichardt continued to manage the assets in a similar fashion as he did prior to them being transferred to the FLP, meaning he retained the right to designate the persons who shall “possess or enjoy the property.” Thus, it was also possible for the IRS to include the FLP’s assets in the estate under § 2036 (a)(2).
In a more recent tax case (Bongard v. Commissioner, 124 T. C. 95 (2005)), the Court established a test for the existence of the “bona fide sale” exception to IRC § 2036 - the business purpose test.5 The business purpose test states that the transfer of property to a FLP must be made for legitimate, nontax purposes. That is, the assets were not transferred for the sole purpose of avoiding additional estate taxes. In Bongard, the Court ruled that the transfer of shares of a holding company to Bongard Family Limited Partnership (“BFLP”) did not meet the “bona fide sale” test; thus, the assets transferred were included in the decedent’s estate. The Bongard Court reasoned that BFLP failed to diversify its assets during the decedent’s life, never had a stated investment plan, and never functioned as a business enterprise.6
As illustrated by the vagueness of the applicable IRC sections, and by the above cases, the facts and circumstances surrounding each case must be thoroughly examined in order to determine whether or not the assets in question can be excluded from a decedent’s estate. No single text can provide all of the possibilities and issues that can arise when establishing an FLP, making it imperative to consult an expert in both financial and legal matters in order to protect taxpayers from making the common mistakes that plague most failed FLPs.
Once it is deemed that the FLP has been established, the IRS’s focus shifts to the methods used to estimate the value of the partnership and its underlying assets.7 As expected, the government believes that “under certain circumstances, there should be minimal or no discounts from the pro rata value of the underlying asset value of the entity.” 8 However, the tax court’s views on the appropriate amount of discounts applied have changed over time.
In older cases, like Knight v. Commissioner,9 the tax court allowed a total discount of just 15% to account for the lack of marketability and minority interest characteristics of a FLP which held its investments in cash, municipal bonds and real estate. This ruling was based on the Court’s belief that the petitioner’s expert was acting as an advocate for Knight and did not provide an objective analysis.10 Had this case been presented to the court more recently, the discount applied most likely would have represented a weighted average discount comprised of the individual discounts applicable to each asset class.
For example, in Murphy v. Commissioner,11 the court analyzed the testimony of the Government’s and the tax payer’s valuation experts in detail. In this case, both parties’ experts estimated the discount for lack of control by dividing the FLP’s assets into distinct categories, each with specific risk and return profiles. The FLP consisted of investments in cash, equities, and fixed assets. The discounts selected, which were based on extensive research on each asset class by the experts, are detailed below:
|Asset Class||Tax Payer Expert||Government Expert|
Source: Murphy v. Commissioner, 2009 U.S. Dist. LEXIS 9492 (2009).
Ultimately, the tax court selected the discounts presented by the tax payer’s valuation expert because the court found his analysis more credible than the government expert’s analysis due the level of detail in the research he performed and his rationale for the sources of data he used to support his analysis. In addition to the above discounts, it was determined that the net asset value of the FLP should be discounted to reflect the non-marketable nature of the investments. The government’s expert estimated the marketability discount at 10.0%, citing restricted stock studies as the source. However, the term of most restricted stock is typically one to two years, and the assets of the FLP would most likely have a holding period that is substantially longer. The court, stating that the government’s expert did not take into consideration the longer time horizon of the FLP’s assets, selected the tax payer expert’s discount for lack of marketability of 32.5%.12 As exhibited in this case, had the tax payer not utilized the resources of an experienced, competent and independent valuation expert, the taxes paid on the pro rata value of the FLP’s underlying assets would have been substantially larger.
Knight and Murphy demonstrate that there are many factors and circumstances to consider when valuing a FLP. MarcumRachlin’s Advisory Services professionals have the knowledge and experience to quantify and/or opine on the applicable discounts to value that would be deemed acceptable by the Tax Court. Further, MarcumRachlin offers a wide range of professional services that can provide insightful tax and estate planning expertise to assist in the proper formation and operation of FLPs. By consulting with the professionals at MarcumRachlin, families can reduce potentially hefty taxes on particular assets that would have otherwise been included in the decedent’s estate allowing the family members to focus on the equitable distribution of the assets in question, rather than the tax bill associated with them.
1 Under the Economic Growth and Tax Relief Reconciliation Act of 2001, the estate tax was repealed for 2010 and is to be reinstated in 2011. Pub.L. 107-16, 115 Stat. 38, June 7, 2001.
2See Ryan Donmoyer, Estate Tax Expiration Sets up Battle on Retroactive Restoration, Bloomberg.com, Dec. 17, 2009, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=amAp4mEjfjFQ.
326 U.S.C. § 2036(a).
4Estate of Reichardt v. Commissioner, 114 T. C. 144 (2000). See also, David H. Glusman & Gabriel Ciociola, Accountant’s Roles and Responsibilities in Estates and Trusts 6-83 (CCH 2010) (2009).
5Glusman & Ciociola, supra note 4, at 6-86.
6See Bongard, 124 T. C. at 109. See also Glusman & Ciociola, supra note 2, at 6-87.
7Glusman & Ciociola, supra note 4, at 6-77.
8Id. at 6-78.
9Knight v. Commissioner, 115 T.C. 506 (2000).
10Id. at 519.
11Murphy v. Commissioner, 2009-2 U.S. Dist. LEXIS 9492 (2009).
12Id. at *49.