Have family limited partnerships (FLPs) and limited liability companies (LLCs), those extremely popular estate- planning tools of recent years, outlived their usefulness? Some might say so. Last year, several courts issued decisions that threaten to cripple the effectiveness of these entities for leveraging gifts and reducing estate taxes. But this threat need not be realized if care is taken to structure and operate FLPs and LLCs as real businesses.
An FLP or LLC is a business, typically designed with the senior generation as general partners or managers and the children or grandchildren as limited partners or members. The senior generation may contribute their operating business interests, real estate holdings or even investment interests to the FLP or LLC, which then serves as a kind of umbrella company for the family’s assets. The general partner or manager typically has absolute control over the assets and distributions as well as sole and absolute authority to run the business.
Parents who use FLPs or LLCs for estate tax planning typically make gifts of limited partner or member interests to their children. The value of these gifts may be deeply discounted for gift and estate tax purposes because they are typically minority interests that can’t be transferred and have no market outside of the family. This means that the parents may remove a substantial amount from their taxable estate at a very low gift tax price.
The popularity of FLPs and LLCs has not rested solely on tax savings. These business entities offer a multitude of other benefits to family business owners:
• They provide children or grandchildren with the opportunity to participate in the family business without gaining control of the business before they are ready.
• They permit consolidation of family assets into one central business for management and investment purposes.
• They provide a level of protection for family assets from creditors, outsiders and divorcing spouses.
• They offer more flexibility than trusts in handling disputes and responding to changes in the law.
In 2003, however, the IRS had its way in a number of trend-setting cases. So in 2004, those of us interested in preserving the tax-savings aspects of these techniques must regroup, and perhaps revise partnership and operating agreements, to keep pace with current law.
Annual exclusion gift or not?
Under the Internal Revenue Code, we are taxed not only on income, but also for making gifts. Gifts to children can end up being taxable unless the child actually receives a current economic interest in the asset (“present interest rule”) and the value of the gift is not greater than $11,000 per child per year (the “annual exclusion”). Annual exclusion gifts are absolute gift and estate tax freebies and do not require a gift tax return. Many family business owners have given family members FLP and LLC interests valued at or less than $11,000 based on a deeply discounted valuation, for which they never had to file gift tax returns.
But last year, in the case of Hackl v. Commissioner, the U.S. Court of Appeals for the Seventh Circuit agreed with the IRS position that the parents’ gifts of LLC units to their children and grandchildren did not qualify for the annual exclusion.
According to the IRS and the court, the gifts did not satisfy the present interest rule because the LLC agreement did not allow the partners to sell or redeem their LLC units or to force a dissolution of or distribution from the LLC. In short, the court concluded that the children and grandchildren did not receive a present economic interest in the LLC because of all these restrictions. As a result, the parents’ LLC transfers were treated as taxable gifts not protected by the annual exclusion.
Does the Hackl case mean that families can no longer make annual exclusion gifts of FLP and LLC interests? Not necessarily. If your FLP or LLC operating agreement permits the limited partners or members to transfer or redeem their interests, then gifts of such interests should qualify for the annual exclusion. If not, and if you wish to continue to make annual exclusion gifts of your FLP or LLC, remember that FLPs and LLCs are extremely flexible tools. The partners or members can amend the partnership or operating agreement to provide more flexibility, or to allow partners or members to “put” (redeem) the interests you give them for a limited period after the gift.
Is the gifted interest out of your estate?
Under the Internal Revenue Code, your taxable estate will not include the value of any gift you make during your lifetime unless you retain any kind of control over the gift, or if you continue to benefit from the gifted asset after you give it away. Before 2003, estate-planning experts typically advised business owners that gifts of FLP or LLC interests would not be included in their estates after death because the gifts were final and complete gifts of real equity interests in the business, even though the parent (as general partner or manager) continued to control the business.
Last year, however, the U.S. Tax Court made a serious dent in this argument as Estate of Strangi made its way through the appeals process. In the 2003 Strangi decision, a complex case with unusual facts, the tax court held that assets transferred by Albert Strangi to an FLP and the FLP’s corporate general partner were included in his estate for estate tax purposes.
The court noted that Strangi and the other partners and shareholders (the Strangi children) could vote together to control distributions to the partners and to liquidate the businesses—which, if it occurred, would result in most of the business assets going back to Albert Strangi.
The tax court’s decision in Strangi may be overturned on appeal. Moreover, most business owners will not push the legal envelope as far as the Strangis did, so this decision may not apply to everyone, even if the IRS is successful on appeal. (For example, two months before his death, Albert Strangi transferred virtually everything he owned, including the home he was living in, to the FLP.) In any case, Strangi is not a death knell for FLPs and LLCs, so long as business owners are willing to adjust the way they do business with these entities and able to transfer power, along with equity, to the next generation.
Here are a few basic business rules that should govern FLPs or LLCs in light of Strangi. If you have an existing FLP or LLC, you may need to amend your partnership or operating agreement to follow some of these rules.
1. Don’t transfer everything you have to an FLP or LLC.
2. Don’t transfer personal-use assets, like your home, to an FLP or LLC.
3. Don’t make non-pro rata distributions to partners or members.
4. Run it like a business—keep accurate records, hold partner/member meetings and actively manage the FLP or LLC assets.
5. Follow through on retitling all assets contributed to the FLP or LLC.
6. Involve all partners/ members in business discussions and negotiations regarding the formation, purpose and management of the business.
7. Encourage all partners/members to seek independent legal advice regarding the terms of the partnership/operating agreement.
8. If possible, restructure the partnership/operating agreement so that you no longer have voting rights on decisions involving distributions or liquidation.
9. As an alternative to rule #8, transfer FLP or member interests to a trust with a completely independent trustee.
10. If possible, all partners/members should contribute capital to the FLP or LLC.
All FLPs and LLCs, and the families who run them, operate under their own set of family and business facts and circumstances. In the end, these facts and circumstances determine whether an FLP or LLC is honored for tax purposes. The legal environment is not as friendly toward these entities as it was a few years ago. Nonetheless, careful planning, sound advice and good common business sense should allow you to continue to benefit from all the advantages of using FLPs and LLCs in your estate plan—including the tax savings.
Margaret Gallagher Thompson chairs the estates and trusts practice group at Cozen O’Connor in Philadelphia (mthompson@cozen.com).