Parents often create a family limited partnership (FLP) or similar entity to provide a vehicle for cohesive management of assets, secure some measure of creditor protection, or create a common pool for investment in marketable securities. FLPs generally encumber their members’ interests with restrictions for various reasons. The Internal Revenue Service in turn attacks FLP restrictions because encumbrances reduce estate and gift tax value when FLP interests transfer. In two cases in the spring of 2010, the IRS successfully pressed attacks that tilt the battlefield against the taxpayer. Nevertheless, rules remain for defeating IRS attacks. These rules fall within two overarching taxpayer imperatives. First, the taxpayer must seek something other than tax savings in order to achieve tax savings. Hence, “context matters.” Second, the taxpayer must act with respect to the FLP in all respects as she would with unrelated parties. Hence, “do unto yours as you would do unto others.”

I. Context Matters: The Requirement of a Nontax Purpose

A. The Nontax Purpose

In Holman v. Commissioner (Holman II), the Eighth Circuit emphasized the importance of context in determining value for gift tax valuation purposes. The court reviewed the “entirety of the surrounding transactions” in finding a lack of sufficient nontax purpose for an FLP. Taxpayers need the same focus.

The need for a nontax purpose is well articulated in Estate of Bongard v. Commissioner. Mr. Bongard established Empak, Inc. in 1980. In 1996, Mr. Bongard and Empak’s other shareholder, a trust for his children, transferred all Empak stock to a limited liability company, WCB. A significant portion of WCB’s equity was immediately transferred to a family limited partnership, BFLP. Gifts, distributions, and other transfers followed. In 1998, Mr. Bongard died unexpectedly. His federal estate tax return claimed discounts on his WCB and BFLP interests. The IRS objection to the discount claim centered on § 2036, which taxes property that is no longer owned at death but is still subject to a retained interest. Under an exception, property is not taxed if its transfer to another, or to an FLP, was a bona fide sale for “adequate and full consideration.” The Tax Court found that the exception applies “where the record establishes the existence of a legitimate and significant nontax reason for creating the [FLP], and the transferors received partnership interests proportionate to the value of the property transferred.” To satisfy that standard, the nontax purpose must be “an actual motivation, not a theoretical justification.” If the taxpayer stands on both sides of the transaction, depends financially on distributions from the partnership, or combines partnership and personal funds, the transfer to the FLP will likely fail the bona fide sale exception.

Thus, the first objective in FLP planning that achieves tax savings is having an objective other than tax savings. That objective may be, for example, providing a hurdle for creditors, pursuing a strategy that requires undisturbed investment for some period, or pooling assets to reduce overall management fees or to qualify for investment opportunities that are available only for larger positions.

B. Avoiding What Belies Nontax Purpose

Regardless of the assertions of the taxpayer concerning nontax purpose, the IRS still challenges FLPs when it can find evidence that counters the taxpayer’s claim of a nontax purpose, particularly the presence of “bad facts” of one kind or another. The IRS has thus successfully eliminated valuation discounts by attacking “sloppy” and “abusive” FLPs (for example, where formalities in forming or operating the FLP were missing or where a taxpayer placed all of her assets in an FLP on her deathbed or continued to control property transferred to an FLP as if no transfer had occurred).

Not surprisingly, taxpayers eventually learned to satisfy the formalities of forming and operating FLPs while forgoing transparent efforts at tax savings. The IRS consequently refocused its attack on more subtle arrangements. An example of such an attack occurred in Estate of Strangi v. Commissioner. Mr. Strangi’s son-in-law and attorney-in-fact, Michael Gulig, set up an FLP with a corporation as its general partner. Mr. Strangi held a minority interest in the corporate general partner, and his four children owned a majority interest. Mr. Gulig was the manager of the corporate general partner, which had exclusive authority to act on behalf of the partnership and discretion to determine partnership distributions. At his death, Mr. Strangi owned all of the ninety-nine percent limited partnership interests and forty-seven percent of the corporate general partner that held the remaining partnership interests.

The IRS claimed in part that Mr. Strangi’s control over the FLP caused it to be subject to estate tax at his death under § 2036(a)(2). Mr. Strangi’s estate countered that he retained no legally enforceable right over FLP property and that his management powers, because they were constrained by fiduciary obligations, did not cause estate inclusion. The Tax Court sided with the IRS, holding that § 2036(a)(2) applied because: (1) there was no independent person who could participate in decisions about partnership distributions; and (2) there were no real constraints on the taxpayer’s right to designate who would receive distributions. Thus, the unfettered retention of the income from, or the control over, FLP interests that belie their genuine business purpose will jeopardize valuation discounts and must also be avoided.

II. Do unto Yours As You Would Do unto Others: The Step Transaction Doctrine and Section 2703

A. Step Transaction

In addition to attacking FLPs for lacking a nontax purpose, the IRS in 2010 successfully invoked the step transaction doctrine and § 2703. In Pierre v. Commissioner (Pierre I), the focus was the effect of state law property rights on FLPs. The taxpayer in Pierre I formed a single-member LLC and funded it two months later with cash and marketable securities. Twelve days after funding the LLC, the taxpayer transferred her entire interest in the LLC to a trust for her son and a trust for her granddaughter. After considering her available unified credit against estate and gift tax and her generation-skipping tax exemption, the taxpayer made a gift of a 9.5% membership interest in the LLC to each trust and sold each trust a 40.5% membership interest in exchange for a promissory note. At issue was whether the LLC would be respected for federal gift tax purposes.

The IRS argued that the federal “check-the-box” regulations governing the income tax treatment of an LLC as a “disregarded entity” determine the treatment of a transfer of an LLC interest under federal gift tax provisions. The Tax Court disagreed. Emphasizing the sequence of steps, the court held that transfers of LLC interests would not be treated as transfers or indirect gifts of the underlying assets of the LLC. Significantly, the taxpayer respected the steps necessary to form and fund the LLC before making any transfers. Thus, state law property rights incident to the LLC would be respected, but their valuation under the federal gift tax regime would be another matter.

The taxpayer win in Pierre I was followed by a setback in a supplemental opinion (Pierre II). The Tax Court found that the gifts and sales occurred on the same day, contemporaneous documentation characterized the transfers as two gifts of fifty percent interests, nothing of tax-independent significance existed to distinguish the gift transactions from the sale transactions, and the taxpayer “intended not just to minimize gift tax liability but to eliminate it entirely.” As a result, the Tax Court collapsed the gifts and sales under the step transaction doctrine, treating them as gifts of fifty percent interests in the LLC (offset by the value of the promissory note owed to the taxpayer).

In Holman v. Commissioner (Holman I), however, the Tax Court refused to extend step transaction treatment to collapse a series of transfers that occurred just days apart, even though the FLP held only marketable securities. Unlike the same-day transactions of Pierre II, the husband-and-wife taxpayers in Holman I first created the FLP, then transferred Dell stock to it, and then waited six daysbefore making gifts of FLP interests. The IRS argued that those gifts should be treated as gifts of the underlying Dell stock without any entity-level discounts.

The Tax Court held that, given the nature of Dell stock (heavily traded and relatively volatile at that time) and the resulting change in value of the FLP units in the interim, the six-day interval provided a change in circumstances that gave independent significance to the initial contribution of assets to the FLP and to the subsequent transfer of the FLP interests. The passage of time—only six days in this case—made the initial funding and later transfer of FLP interests independent of one another because of the “real economic risk of a change in value of the partnership” during the intervening days.

Taken together, the Pierre and Holman cases demonstrate that the formation, funding, and transfer phases of an FLP transaction must have independent significance in order to withstand step transaction treatment. The passage of time between transactions helps demonstrate independence, but specific utility and attendant consequence to each transactional element help more.

B. Section 2703: “Just Family” Doesn’t Do It

Although the Holman transaction survived collapse under the step transaction doctrine, the IRS succeeded in an alternative attack. In the Eighth Circuit decision (Holman II), the court, relying on § 2703, disregarded certain restrictions in the partnership agreement for valuation purposes. Section 2703(a)(2) provides that the value of property for gift and estate tax purposes is determined without regard to restrictions on the right to use or sell that property unless it fits within certain exceptions. A qualifying restriction must satisfy a three-prong test: (1) the restriction must be a bona fide business arrangement; (2) the restriction must not be a device to transfer property to family members for less than full and adequate consideration; and (3) the restriction must be comparable to those in similar arrangements in arm’s-length transactions.

Both the taxpayers’ expert and the IRS’s expert agreed that transfer restrictions similar to those in the challenged partnership agreement were “common in agreements entered into at arm’s length.” Nevertheless, the IRS argued that there was in fact no business purpose behind the restrictions and that they were merely a device to transfer property to family members for less than full and adequate consideration.

Testimony at trial indicated that the taxpayers created the FLP to keep assets from being dissipated by family members and to educate the taxpayers’ children about financial responsibility, but there was no evidence of an intent to hold the Dell stock for a strategic purpose or to implement any particular investment strategy. The Eighth Circuit thus described the FLP as a “mere asset container,” emphasizing that the taxpayers did not form the FLP to carry out a particular investment philosophy. The court repeated in its analysis that “context matters” and found that in creating the restrictions the taxpayers were motivated primarily by personal objectives, including estate planning, tax reduction, and wealth transfer, rather than an interest in a bona fide business arrangement. Thus, the restrictions in the partnership agreement were disregarded in valuing the partnership interests as something other than a genuine business arrangement—echoing nontax-purpose issues from the § 2036 cases.

In Fisher v. United States, a federal district court adopted the reasoning of Holman II and similarly concluded that the transfer restrictions in an FLP agreement did not qualify as a business arrangement under § 2703(b). The taxpayers gifted minority interests in an LLC to their seven children in 2000, 2001, and 2002, claiming valuation discounts. The LLC’s principal asset was a parcel of undeveloped land on Lake Michigan. The FLP agreement stated that the entity was formed in order to invest and hold investment real estate. However, the court concluded that the facts were analogous to Holman and that transfer restrictions in the FLP agreement did not serve a bona fide business purpose because the LLC was not a business. Pointing to the absence of investment strategy and activity, the court noted that “‘context matters.’”

III. Obstacles Ahead

There are prospects for further challenges to transactions that cause value to disappear because assets are encumbered in an FLP. Earlier this year, the economic substance doctrine was enacted into law and will be codified in § 7701(o). Section 7701(o)(5)(A) limits its application to an income tax context, and § 7701(o)(5)(B) excludes personal transactions except when they are entered into in connection with a trade or business. Nevertheless, given the requirement of a business arrangement set out in the exception to § 2703, § 7701 may foreshadow lack of economic substance as an additional basis for attacking FLP discounting.

The Treasury Department’s current “Greenbook” sets forth the Obama Administration’s revenue proposals for fiscal year 2011. The proposals include an effort to restrict valuation discounts, specifically lack-of-marketability and lack-of-control discounts, by amending § 2704 to create a further category of restrictions that are disregarded for valuation purposes among related parties. Those restrictions include limitations on a right to liquidate. Limitations on an assignee’s ability to be admitted as a full partner or hold an equity interest would also be disregarded. The Greenbook proposal does, however, indicate that regulatory authority would set forth “safe harbors to permit taxpayers to draft the governing documents of a family-controlled entity so as to avoid the application of § 2704 if certain standards are met.” It may be reasonable to infer that qualification for a safe harbor will require, at minimum, an arrangement that third parties would be likely to enter when conducting their own business affairs.

Conclusion

The mounting case law dealing with FLPs leaves taxpayers with an array of IRS arguments as obstacles to anticipate and avoid in FLP planning, but it can be done. Adhering to the following rules should do it:

In reading FLP decisions, it is easy to miss the fact that the IRS often forgoes a challenge to a valuation discount susceptible to a particular line of attack, even at the cost of a taxpayer win, in order to test or establish another line of attack. This is not capitulation; it is strategy. The IRS effectively moved its focus this year to the step transaction doctrine of Pierre II and § 2703 as used in Holman II, in contrast to the Service’s earlier emphasis on § 2036. Practitioners can expect both reliance on these successful lines of attack as well as experimentation with other lines of attack. A successful defense depends on recognition in all planning that context matters and that the taxpayer must therefore seek something other than tax savings in order to achieve tax savings, while at the same time embracing her family only at arm’s length.

The authors are trust and estate lawyers in the Connecticut offices of Day Pitney LLP.

Preferred citation: Steven M. Fast et al., Context Matters: Rules for Reducing Taxable Value, 120 Yale L.J. Online 141 (2010), http://yalelawjournal.org/forum/context-matters-rules-for-reducing-taxable-value.