Abstract:   Wealthy taxpayers sometimes incorporate family limited partnerships (FLPs) in their estate plans to help minimize federal estate and gift taxes. Historically, the IRS has been aggressive in challenging such arrangements. This article summarizes a recent case in which the U.S. Tax Court sided with the IRS, offering a valuable reminder that, when it comes to the federal tax effect of intrafamily transfers of interests, labels aren’t determinative. Rather, the court will consider the substance of the transaction. A sidebar explains how the court handled valuation discounts.

Estate of Streightoff v. Commissioner, T.C. Memo. 2018-178, Oct. 24, 2018

Limited partner or assignee interest: Tax Court sides with IRS

Wealthy taxpayers sometimes incorporate family limited partnerships (FLPs) in their estate plans to help minimize federal estate and gift taxes. Historically, the IRS has been aggressive in challenging such arrangements. In Estate of Streightoff, the U.S. Tax Court sided with the IRS, offering a valuable reminder that, when it comes to the federal tax effect of intrafamily transfers of interests, labels aren’t determinative. Rather, the court will consider the substance of the transaction.

Lure of FLPs

The value of limited partner interests in an FLP generally is discounted from the value of the partnership’s underlying assets to account for the lack of marketability and lack of control associated with limited partner interests. This can mean lower gift taxes for family members.

FLPs also can reduce estate taxes. When the taxpayer who establishes an FLP passes away, his or her taxable estate usually will be reduced. This is because it includes only the value of any retained partnership interests, not the value of the FLP’s underlying assets.

The IRS sometimes asserts that the undiscounted value of an FLP’s assets is includable in the decedent general partner’s taxable estate. In the recent case, however, it was a transfer of an FLP interest to a revocable trust under scrutiny.

Transfer in question

In October 2008, a taxpayer, now deceased, formed an FLP under Texas law. The partnership was essentially an asset holding company that managed a portfolio of cash and investments. The general partner in the FLP was a limited liability company (LLC) managed by the decedent’s daughter. The decedent, his children and a former daughter-in-law were the original limited partners.

On the day the partnership was created, the decedent formed a revocable trust for himself, with the daughter as the sole trustee. She executed an agreement titled “Assignment of Interest” that transferred her father’s 89% interest in the partnership to the trust.

After the decedent’s death in May 2011, his estate valued the transferred interest at about $4.6 million. The IRS subsequently sent a notice of deficiency for nearly $500,000, arguing that the value of the interest was about $6 million.

The estate turned to the Tax Court for relief. It argued that the transfer agreement created an assignee interest in the decedent’s limited partnership interest under Texas state law and, therefore, was properly valued. The IRS countered that the agreement didn’t create an assignee interest. Instead it transferred to the trust a partnership interest and, with it, all the rights of being a limited partner.

Tax Court decision

The Tax Court began its analysis by recognizing that state law generally determines the type of property interest transferred for federal estate tax purposes. However, the federal tax effect of a particular transaction is governed by its substance, rather than its form. The court emphasized that it looks beyond formalities when evaluating intrafamily partnership transfers. In this case, it concluded that both the form and the substance (or “economic realities”) established that the decedent had transferred a limited partnership interest to the trust.

In regard to form, the court looked at the transfer agreement and provisions in the partnership agreement that allowed transfers of limited partnership interests and the admission of substituted limited partners. It found that the transfer satisfied all the partnership agreement’s conditions for a transferee to be admitted as a substituted limited partner.

As for substance, regardless of whether an assignee or a limited partnership interest had been transferred, no substantial difference existed before and after the transfer. For example, the partnership agreement provided that only the general partner had the right to direct the business. Neither limited partners nor assignees had managerial rights.

The court conceded that, under the agreement, assignees also had no rights to any information on the partnership’s business or to inspect books or records. It pointed out, though, that this distinction was ultimately irrelevant because the daughter was both a partner entitled to that information and the sole trustee.

The court similarly dismissed assignees’ lack of voting rights. It found the restriction had no practical significance here, because the limited partners had never before held a vote.

Critical consideration

FLPs remain a viable estate planning tool. Your clients need to understand, though, that the proper tax treatment will depend on both the form and the economic realities of the property transfers.

Sidebar: Split verdict on the valuation discounts

In Estate of Streightoff, the U.S. Tax Court considered whether a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM) apply when valuing the 89% limited partner interest that was transferred to the trust. The estate’s expert valued the interest as an assignee interest and applied a 13.4% DLOC and a 27.5% DLOM. The IRS’s expert valued it as a partnership interest, with only an 18% DLOM.

Because the court held that a partnership interest had been transferred, it disallowed the estate’s 13.4% DLOC. The court noted that, under the partnership agreement, limited partners with a 75% interest had the power to remove general partners, which would terminate the partnership. Prospective purchasers of the interest would pay more, not less, for that degree of control.

The court ruled a DLOM was appropriate, however. Because the estate’s expert had incorrectly valued an assignee interest, its discount was too high. So, instead, the court accepted the IRS expert’s 18% DLOM.

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