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June 2006 Family limited partnerships under stronger IRS scrutiny A U.S. Court of Appeals ruling issues a stern reminder that FLPs must be properly managed and maintain a legitimate purpose The family limited partnership has long been a valuable estate planning tool, allowing families to pass on wealth by tax-efficient means while keeping management of the contributed assets within the family. But a 2005 IRS court victory, discussed below, makes it clearer than ever that proper use and operation of FLPs are essential to their effectiveness. Background. An FLP, like other limited partnerships, is a form of business entity that consists of one general partner and one or more limited partners. The difference in an FLP is that the people involved are usually members of the same family. A key advantage of a well executed FLP is lower federal estate and gift tax liability. Instead of transferring assets directly to beneficiaries, an individual may transfer interests in a limited partnership. Since an interest in an FLP is not marketable and a limited partner does not control management of the enterprise, the value of interests in an FLP usually can be discounted by anywhere from 25% to 50%, with a corresponding reduction in tax liability. As with many transactions involving family members, the IRS has a tradition of casting a skeptical eye on FLPs, to assure that tax advantages are not the main reason for an FLP’s existence. If the FLP is found to be a tax sham, the IRS is likely to challenge the valuation discount and even the very existence of the partnership. Challenge. In 2005 the U.S. Third Circuit Court of Appeals, in Bongard v. Commissioner, issued a ruling favorable to the IRS in a case that strengthens IRS scrutiny of FLPs. This means that families with such partnerships must be more careful than ever to treat them as true entities, respecting the form of the partnership. The Bongard case involved the estate of Wayne C. Bongard, who, in 1980, started Empak, a Minnesota corporation. Mr. Bongard was the company’s sole shareholder until a few years later, when he transferred a number of shares to an irrevocable trust for the benefit of his children. In 1996, Mr. Bongard and his children’s trust exchanged their stock in Empak for Class A (voting) and Class B (non-voting) member interests in WCB Holdings, a Minnesota LLC founded by Mr. Bongard. After the exchange, Mr. Bongard and the trust owned the same proportionate interest in WCB Holdings as they did in Empak (86.4% and 13.6%). The IRS challenged the exchange, arguing that it was not an arm’s-length transaction. The Tax Court disagreed, ruling that the transfer to WCB was a bona fide sale for adequate and full consideration. Later in 1996, the Bongard FLP was formed, whereby Mr. Bongard and the children’s trust transferred their Class B member interests in WCB to the FLP in exchange for partnership interests. The exchange left Mr. Bongard with a 99% limited partnership interest and the trust with a 1% general partnership interest. In a letter to his children, Mr. Bongard expressed his reasons for forming the FLP, including concern for asset protection and tax benefits. A year later, Mr. Bongard gifted to his wife a 7.72% limited partnership interest. Mr. Bongard died in 1998. His estate tax return, filed in 2000, reported a federal estate tax liability of $17 million. In 2003, the IRS, in a challenge to the validity of the Bongard FLP and certain tax-related transactions, issued to Mr. Bongard’s estate a notice of deficiency of almost $53 million. IRS victory. The Tax Court concluded that the record did not support any non-tax reasons for the FLP’s existence, noting that “the [FLP] never diversified its assets during the decedent’s life, never had an investment plan, and never functioned as a business enterprise or otherwise engaged in any meaningful economic activity. Additionally, the [FLP] did not perform a management function for the assets it received and never engaged in any businesslike transactions.” The court disregarded the formation of the FLP. The value of its underlying assets (the WCB Class B member interest) was included in Mr. Bongard’s gross estate under Sec. 2036(a). Also, any value apportioned in his gift to Mrs. Bongard was brought back into the estate using the three-year rule under Sec. 2035(a). Purpose and management. The
Bongard decision serves as a stern reminder that FLPs must be properly
managed and maintain a legitimate purpose. For example, an FLP is not to
be used as a personal bank account for any family member. Likewise, the
terms of the partnership agreement must be complied with, especially as to
distributions. Emerging from Bongard and similar cases are some rules of thumb for setting up and running an FLP in order to realize its tax benefits without running afoul of the IRS, such as the following:
If you own an interest in a family limited partnership and wish to ensure that the FLP’s purpose and management will survive IRS scrutiny, please contact your Schmidt Westergard & Company tax professional. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
