Mark W. Williamson is a partner in the Boston law firm of Casner & Edwards and chairman of the Probate Law Section.
One day, the federal estate tax may be consigned to the dustbin of history. Although this tax impacts a miniscule demographic group, nonetheless a remarkable amount of legislative attention has been lavished on repeal efforts. A well-financed and effective lobbying effort is afoot, it would appear, for the stakes are high to that select society, and there is ample incentive to continue their struggle for complete repeal.
On the other hand, in an atmosphere of growing concern over mounting federal deficits, the estate tax, although just a morsel in the tax revenue banquet, is a tempting morsel indeed. With the aging of America, a financially ailing Social Security system will exist in tantalizing proximity to the cascade of wealth pouring down the generational divide as the boomers expire. It will take a great deal of collective willpower to forego partaking of this easy and available revenue source, and it has often been noted that a tax, once passed, is rarely dismantled. So whether we can expect repeal, reform or business as usual, estate planning attorneys must continue to provide tax-minimization strategies that take into account the real possibility that the estate tax will continue to thrive.
One popular strategy minimizes transfer taxation through the utilization of valuation discounts within the context of partnership-type entities - either "Family Limited Partnerships" (FLPs) or family-owned Limited Liability Companies (LLCs). Although these transactions have been subject to a somewhat heightened scrutiny of late by the IRS, the use of such entities appears to remain viable for estate planning and tax-minimization purposes, provided certain precautions are observed.
A client may have a variety of investments that must ultimately be transferred to the next generation - active businesses, real estate, even marketable securities. Such an individual may wish to consider transferring the assets into an FLP or an LLC, after which interests in the entity may be sold or given to the beneficiaries.
There are both tax and non-tax reasons why such an approach may be desirable, and the true value of entity planning lies in the confluence of both tax and dispositive concerns.
From a transfer tax perspective, it is generally more efficient to make gifts during lifetime than at death. This is due to two basic principals: first, when one pays gift tax, only the value of the gift is taxed, whereas when one pays estate tax, the funds used to pay the tax are themselves subject to tax.
For example (assuming the gift tax and estate tax rate are both 50 percent, and that the donor has no available exemptions or exclusions), if a donor gives a donee $1 million, the donor must then pay the IRS $500,000 in gift tax. Thus, it costs $1.5 million to make a gift of $1 million. If, instead, the donor wished to give the donee $1 million, net of taxes, upon the donor's death, the donor would need an estate of $2 million. Subject to an estate tax of 50 percent, this would leave $1 million for the donee. Thus, the $1 million transfer costs $500,000 more in taxes when made from the estate than when made as a lifetime gift (this benefit is somewhat diminished, under present law, by the fact that the gift donee acquires the carry-over basis of the donor, whereas the estate beneficiary receives the assets at a basis of fair market value, but in the case of a lifetime cash gift, this difference has no effect).
The second way in which lifetime gifting is superior to gifts upon death is that income and appreciation flows to the beneficiary after the gift is complete, thus avoiding ultimate inclusion in the donor's taxable estate.
In light of these two substantial benefits, one would think that lifetime gifting would be the preferred method of transferring wealth. However, tax considerations usually run a distant second to most donors' foremost consideration - the loss of control over the gifted assets. The challenge to the estate planning attorney is to find a way to allow the client to transfer ownership while retaining adequate control to assure that the transferred asset is properly managed (and also that it is not squandered). To have one's cake, so to speak, and eat it, too.
One way to retain control over transferred assets is through the use of trusts. Trusts could be set up and trustees appointed to provide the necessary post-transfer administration. Unfortunately, if a donor makes a gift to a trust of which the donor is the trustee, the control that the donor retains as trustee will generally bring the transferred asset, and all of its accretion in value during the donor's lifetime, back into the donor's estate for tax purposes (see IRCSection 2036(a)). Thus, trusts are not viable vehicles for lifetime gifting if continued control is required by the donor.
However, the IRS makes a distinction (and will hopefully continue to do so) between the business context of an FLP or LLC and the donative context of a trust, allowing for a greater degree of continuing control by the donor when the transferred asset is a partnership interest. In Private Letter Ruling 9415007 and TAM 9131006, the donors made gifts of limited partnership interests in partnerships of which the donors retained control as general partners. In these cases, the donors were not considered to have retained an interest that would bring the assets back into their estates, because of the high fiduciary standard required of a general partner to the limited partners in a partnership.
Of late, the IRS has tried (successfully in certain occasions) to dispute the validity or existence of a partnership entity, because of deficiencies in the formality of the creation or operation of the entity. If the IRS can deem the entity not to exist, there can be a number of devastating results, including the underlying entity assets being taxed in the estate of the donor (at their date-of-death values). Therefore, if using such entities, it is vital that nothing about the documentation or operation of the enterprise would undermine the fiduciary obligations of the general partner to the limited partners. For example, all aspects of the transaction, from the entity filings to the execution of legally enforceable, irrevocable instruments of gift must comply fully with state law. It is also vital that no "excessive control" be retained on the part of the donor. For example, the retention of the absolute right to all of the income from the transferred assets would provide a basis for the IRS to disregard the transfer. There are a number of additional circumstances in which the IRS would refute the validity of the partnership. Lack of business purpose, lack of respect for the entity's formalities and commingling of personal assets with business assets are all bases upon which the IRS has launched challenges.
The recent case of Estate of Theodore R. Thompson, et al. V. Commissioner, T.C. Memo. 2002-246, provides an excellent primer in what sort of behavior the IRS finds offensive. In this case, the court disregarded the entity because, among other reasons, the donor parted with virtually all of his assets to fund the partnership, and the partnership assets were then applied to his living expenses when and if he required such distributions. In addition, Annual Exclusion gifts were made from the partnership assets (as gifts of the donor). The court further found that the partners did not really pool their assets for a common business purposes (in fact, there was a provision in the agreement that allocated the gains arising from specific assets contributed to the partnership to the partner who contributed such assets). In short, the transaction was considered a sham, and the transfers into the entity essentially disregarded. The underlying assets were brought back into the donor's estate, at their full date-of-death value.
However, the typical administrative controls that one would retain as a general partner or an LLC manager, exercised within the context of customary business and fiduciary practice, will not draw the assets back into the taxable estate. So, if properly structured, partnership entities allow one to make lifetime gifts (which are generally superior to transfers upon death) without a fundamental loss of control over the gifted asset. Gifts may be made on a tax-free basis utilizing the $11,000-per-donor, per-donee so-called "annual exclusion gifts."
Two caveats, however, apply to the annual exclusion vis-‡-vis partnership interests. First, in order to qualify as an annual exclusion gift, the transfers must be of actual ownership interests in the entity. Indirect gifts, in which a donor transfers assets into an FLP or LLC of which the donees are limited partners or members, respectively, are generally not eligible for annual exclusion treatment. Second, undue restrictions on transferability of the membership interests (other than the natural economic restrictions of the marketplace, which would themselves seriously limit the marketability of the interests), could disqualify the interests from annual exclusion treatment, on the theory that such the transfer of interests with significant explicit transferability restrictions would not constitute a so-called gift of a "present interest," a necessary requirement for annual exclusion treatment.
For example, the IRS would find that a gift of limited partnership interests would not be considered a gift of a present interest if there were no rights for the limited partners to transfer, pledge, withdraw, assign redeem or otherwise liquidate their interests. This would be especially true if the general partner retained the unfettered right to accumulate partnership funds.
If explicit restrictions on transferability are strongly desired (or, in any event, for gifts in excess of the annual exclusion) the $1 million lifetime gift-tax exemption could also be utilized.
Another significant benefit of utilizing partnership entities as gifting vehicles (beyond the ability to retain control over the transferred assets) is that the gifts of partnership interests can be subject to valuation discounts. These discounts are based on such considerations as lack of marketability and lack of control. Thus, for gift tax purposes the partnership interests can be valued at substantially less than the proportional interests in the underlying assets. This can allow one to greatly leverage lifetime and testamentary gifting. Of course, such valuation discounts rely on the validity of the entity and of its ongoing operation.
There are other qualities of LLCs and FLPs that also give them value unrelated to gift and estate taxation. Such benefits are centralization of management and the availability of restrictions on transferability outside of the family unit. Perhaps the most important function offered by such entities is their strong ability to protect assets from the claims of creditors.
Under Massachusetts law, one generally cannot create a spendthrift trust for oneself. In other words, transfers into a trust over which one is both grantor and beneficiary do not remove such assets from the claims of one's creditors (this type of protection may be available in certain other states, although the ultimate enforceability of laws to such effect - even in such states - is somewhat questionable). However, one can use the FLP and the LLC as analogs to the self-settled spendthrift trusts. This is why:
When one transfers assets into an LLC or a FLP, one trades those assets for ownership interests in the entity. One no longer owns the underlying assets. If the LLC or FLP interests are non-transferable, then a creditor cannot reach the underlying asset (assuming that the transfer into the partnership was not a fraudulent conveyance), nor can a creditor take direct possession of the partnership unit. All the creditor can do is stand between the debtor/partner and the partnership entity. Utilizing a so-called "charging order" or similar device, the creditor can require that any partnership distributions to the debtor be given instead to the creditor.
What the creditor cannot do, in general, is compel the general partner (in a FLP) or the manager (in a LLC) to make a distribution from the entity to the debtor. So if the debtor is also the manage/general partner, the creditor can be left with an essentially useless power: the right to receive distributions that most likely will never be made.
This may allow a debtor to negotiate a settlement with a creditor, under much more beneficial terms to the debtor than would otherwise be possible. If you gave the creditor the choice of waiting forever to receive a distribution that will never be forthcoming, or to take a far smaller small payment in return for an immediate release, most creditors will take the diminished settlement - a bird in hand, after all, is worth two in the bush.
In the context of the FLP, the general partner does not have the protection from liability enjoyed by the limited partners. For this reason, it is sometimes advisable to use a corporation or irrevocable trust as general partner, of which the donor is trustee. If an irrevocable trust is used, the donor should not be a beneficiary. Often, the children of the donor are an appropriate beneficiary choice.
Unlike FLPs, an LLC does not have a problematic class of owners with unlimited liability. The donor may act as the manager of the LLC, with complete control over the entity, and not even retain an ownership interest in it. The LLC agreement can easily provide that the manager retains control for life and cannot be removed by the LLC members - thus allowing a transfer of the complete equitable ownership of a company to the next generation without any loss of donor control whatever. However, this benefit must be weighed against the greater annual fees imposed on LLCs in the commonwealth (there are no annual fees for FLPs). There is also a greater corpus of limited partnership law than that of the relative newcomer LLC, and many are more comfortable in the familiar environs of the family limited partnership.