The family limited partnership (FLP) can be a powerful tool for consolidating and managing family wealth while reducing gift and estate taxes, in part through valuation discounts. But it’s an attractive target for IRS attacks.
Recent court cases demonstrate that a properly planned and operated FLP can support substantial valuation discounts for transfer tax purposes. But if the parties are unable to provide a legitimate nontax reason for establishing an FLP or fail to operate it as a legitimate partnership, the benefits may be lost.
Case in point
In Keller v. United States, the Fifth U.S. Circuit Court of Appeals upheld 47.5% valuation discounts for FLP interests (see the sidebar “Quantifying valuation discounts”), even though the decedent’s estate plan was incomplete at the time of her death and she hadn’t yet funded the FLP.
The decedent in this case, Maude Williams, worked with her advisors to explore options for protecting her family’s assets after her husband’s death in 1999. Ultimately, she decided to form an FLP funded with $250 million in corporate bonds and certain other assets. The FLP would have two limited partners: two trusts, each holding a 49.95% interest. An LLC initially owned by Williams would hold a 0.1% general partnership interest.
Williams died before she had completed the documentation necessary to establish and fund the FLP. Believing it was too late to take advantage of the FLP’s benefits, her advisors arranged for her estate to pay more than $147 million in estate taxes. Later, after one of her advisors learned about promising new case law, they reconsidered their position.
The estate filed a refund claim, arguing that under Texas law Williams’ intent to transfer the bonds to the FLP was sufficient to transform them into partnership property, despite her failure to complete the documents. In addition, because this transfer required the estate tax payment to be recharacterized as a loan from the FLP, the estate argued it was entitled to an interest deduction.
The district court, and ultimately the Fifth Circuit, agreed with the estate, accepting its valuation of the FLP interests, with a 47.5% discount, as well as its interest deduction. The courts found that the FLP had legitimate nontax purposes — including asset and divorce protection — and that the detailed and well-documented planning efforts demonstrated Williams’ intent.
A look from the other side
Even if substantial valuation discounts are supportable, the tax benefits of those discounts can be lost through poor planning and improper operations. That’s what happened in Estate of Liljestrand v. Commissioner.
The decedent in this case had properly formed an FLP but, according to the U.S. Tax Court, failed to follow “even the most basic of partnership formalities,” including maintaining books, holding meetings and keeping minutes. In addition, the decedent failed to open a bank account for the FLP until several years after it was formed, took disproportionate distributions, didn’t retain assets outside the FLP sufficient to support his lifestyle and used FLP assets to pay his personal expenses.
The court found that the decedent had retained possession or enjoyment of, or the right to the income from, the property transferred to the FLP and that his estate was unable to establish a legitimate, nontax purpose for the FLP. As a result, the decedent’s asset transfers to the FLP weren’t bona fide sales. So, the full, undiscounted value of the FLP assets was includable in his estate.
Standing up to IRS challenge
As these cases demonstrate, thorough planning and proper operation evidenced by continuous, sufficient documentation are key to making an FLP, and any accompanying valuation discounts, stand up to IRS challenge. Depending on state law, a well-thought-out and documented plan can preserve an FLP’s benefits even if a client dies before the plan is fully executed. But even if an FLP is properly executed, an FLP can be undone, and its valuation discounts lost, through poor planning and operation.
Quantifying valuation discounts
FLP interests generally are entitled to substantial valuation discounts, primarily because of a limited partnership interest’s lack of marketability and a limited partner’s lack of control over partnership affairs. In Keller (see main article), the fair market value of the FLP’s assets was some $260 million, but the fair market value of the 49.95% limited partnership interests was around $68 million each — reflecting a 47.5% discount.
To quantify valuation discounts, experts often rely on market data. For example, to quantify discounts for lack of control, an expert might rely on studies that compare control acquisition prices to preacquisition minority interest transaction prices. And to quantify marketability discounts, he or she might rely on studies that compare pre-IPO transactions to IPO prices or measure discounts on sales of restricted shares of publicly traded stock. Typically, the expert adjusts this empirical data to reflect specific entity characteristics that affect the marketability of its shares.
Keller v. United States, No. 10-41311 (5th Cir. 9/25/2012)
Estate of Liljestrand v. Commissioner, T.C. Memo 2011-259 (11/09/2011)