July 2008Newsletter Word Template
Single Spaced Times Roman New 10 point bold
MONTH YEAR: Lead Article: 1 ¾ pages [2nd page about 45 lines]
Lead Article Title: FLP Gift Planning: Holman Case Part IISummary: A recent Tax Court case, Thomas Holman, 130 TC No. 12, 5/27/08, has some several important lessons for planners and taxpayers using family limited partnerships (“FLPs”) and limited liability companies (“LLCs”), especially for gifts. Last month’s lead article provided an overview and analysis of the case in Part I. This month’s Part II, reviews planning lessons, and several important points that seem to have gotten short shrift in the professional literature.
General Planning Considerations of the Holman Case.
◙ The IRS has had a lot of success attacking FLPs and LLCs for estate tax purposes under Code Section 2036. The Section 2703 attack may become the IRS’ new weapon of choice on gifts of FLP and LLC interests. Expect repeat performances. ◙ Evaluate the magnitude of discount that may be achievable. ◙ Weigh the potential estate tax benefit versus the income tax detriment (no step up in basis, and the possibility of higher capital gains rates under the next administration). ◙ Weigh the discount benefits of an FLP (or LLC) versus mere tenants in common ownership which is cheaper and simpler (but it doesn’t provide control, asset protection and other FLP non-tax benefits). ◙ Compare the hoped for tax benefits of each possible approach against the real non-tax benefits each provides.
◙ Document real non-tax business reasons for the FLP and the transactions. These should be reflected in the partnership agreement. ◙ Observe all formalities that an independent real business would (well, at least as the Tax Court defines “real”). ◙ File tax returns. ◙ Have a CPA prepare a statement (or at least have annual QuickBooks or equivalent reports). ◙ Be sure all appraisal assumptions are subjected to sensitivity analysis. What happens if a fact or assumption changes? What are the consequences if an assumption or calculation is carried through or projected forward? Do the results remain reasonable? ◙ All positions and arguments should be consistent. The Holman court was clearly disturbed by inconsistent assumptions and positions by the taxpayer’s appraiser. ◙ Appraisals shouldn’t use guesstimates. But, in many situations it’s impractical or impossible not to do so. If it is essential at least discuss the rationale and implications of the guesstimates so that they are supported as reasonable, and determine the consequences of changing the guesstimates (sensitivity analysis). ◙ Use letterhead. ◙ Have partners other than parents contribute assets to the FLP on formation (but something more than the .14% contributed by the Trust in Holman would probably be a good thing). ◙ Have a written business plan (or an investment policy statement, or both). ◙ Execute governing documents (e.g. partnership agreement) for each phase and transfer to corroborate that each step of the transaction (e.g., after each gift) is a complete and meaningful step. This should help demonstrate that each step is independent and legally sufficient. ◙ File gift tax returns. ◙ Obtain an FLP telephone listing. ◙ Every document should be dated the date it is signed (regardless of whether it has a different effective date). ◙ Clients should understand the partnership agreement or other governing documents. The Holman Court said “Tom impressed us with his intelligence and understanding of the partnership agreement…” Taxpayers should make changes to conform them to their wishes. Corroborate this development trail (e.g., save track change documents, etc.). ◙ Hold non-marketable assets. The Holman Court accepted the use of general equity funds for the evaluation for the evaluation of discounts of the Holman FLP holding only Dell stock. Introduce non-marketable assets and your discount may differ favorably from those found by the Holman Court and some of the analysis of the Holman court that was detrimental to the taxpayer may take a different spin for your case. ◙ If later contributions are made to the FLP formally treat them as being made for additional FLP interests of the appropriate value, and document the change in ownership interests in an amended and restated partnership agreement.
◙ How long do assets have to age in an FLP before you can make gifts? How long must they age to face a “real economic risk of change in value”? The Court said “We draw no bright lines.” Thanks, you could have at least left a light on! ◙ If you’ll only make annual gifts how can you cost effectively comply with the Holman standards? It’s not reasonable to obtain the level and quality of appraisals and analysis the Holman court seeks if you’re merely giving a couple of kids $12,000 gifts. ◙ The Holman Court considered a private market for limited partnership interests among the FLP’s partners. This completely violates the tax law prescription for determining “fair market value” for a gift based on a hypothetical willing buyer and willing seller. There are lots of definitions of “fair value”. The highest value for many assets is “strategic value”, when the asset or business involved fulfills a unique need of the buyer so that the buyer is willing to pay far more than going rate because of the unique value of the asset to them. The Holman Court took a dangerous misstep in this direction. What happens to the definition of value next?
Important Points Overlooked in Some Articles Examining Holman.
◙ Formalities: The kids trust to which the Holman’s made gifts was signed by the parents on 11/2, the trustee on 11/4 and made effective 9/10. This is reasonable and realistic, but looser then the ǘber perfection some courts have demanded of FLPs. ◙ The partnership agreement was signed 11/2 but the FLP was formed 11/3. The court and most commentators were silent on this snafu. ◙ The 11/8/99 gift was made by a document saying it was effective 11/8/99 but which itself was undated. When was it signed? It’s one thing to forgo a witness or notary, but a date? ◙ Count the dating goof-ups – at least three! Yet the Court felt that the formalities in the case sufficed! Commentators noted that the appropriate steps were taken in proper order. But were they? Was the Holman case a new version of the Dating Game? While Holman will undoubtedly be cited by taxpayers that have a dating error if challenged, more care is certainly advisable.
◙ Fiduciary Obligations: The general partner of a limited partnership is held, vis-à-vis the limited partners to a fiduciary standard. Could the general partner of the Holman FLP have generally adhered to such a standard if he didn’t diversify the Dell holdings as generally required under the Prudent Investor Act (PIA)? Might the IRS argue that a failure to follow the PIA indicates a failure to respect fiduciary obligations? Also, central to the Court’s analysis was a discussion of a case, the Estate of Amlie v. Commr., TC Memo. 2006-76 which involved a conservator entering into a series of agreements while “…seeking to exercise prudent management of decedent’s assets…consistent with the conservator’s fiduciary obligations to decedent.” The Court noted that a fiduciary’s efforts to hedge the risk of a ward’s holdings and plan for estate liquidity may serve a business purpose under IRC 2703(b)(1). What is the distinction between the fiduciary obligations of a general partner to a limited partner versus a trustee to a beneficiary versus a guardian to a ward? Would the result have differed had Holman had a wealth manager create an IPS and implemented an asset allocation model to hedge the risks of the limited partners to whom the GP owes a fiduciary duty? The Holman Court was not convinced by the taxpayer’s appraisal expert that a lack of portfolio diversity and professional management should justify an increased discount. So you get no discount benefit (not to mention investment return) from lousy investing, and you undermine your business purpose as a fiduciary. Should all FLPs have IPS’s? Yes, Jane, they should.
◙ Fair Market Value: The Holman court found a low discount because it was swayed by the argument that there was no economic reason why the FLP would not be willing to let somebody be bought out because the remaining partners would be left holding the same portion of assets and the same types of asset after the buyout. If the FLP held real estate or business interests this might not be true. Creditworthiness of the FLP to obtain credit for new real estate or business interests could be adversely impacted. But the Holman Court’s conclusions are questionable even for an FLP holding marketable securities. If the FLP assets are reduced below the minimum accounts size for the asset manager the FLP had used, a change might be mandated. That could be very significant. If FLP assets drop below a certain threshold certain types of investment products may no longer be available. So the Holman conclusion may be distinguishable in other marketable securities FLPs.
Another fact specific FLP case, full of good facts, bad facts, new theories that don’t fully make sense. Planning with FLPs (and LLCs), as before, remains complex and uncertain. Yet, as before, when business and personal reasons, independent of any sought after tax benefits, are served by and FLP structure, they can and should be used. Planning, especially for gifts of FLP interests, should proceed with consideration to the new lessons gleaned from Holman.
Checklist: Second Article 2 lines less than One Page [about 54 lines]:
Checklist Article Title: Significance of Palimony for all non-married partners to consider.
Summary: So Junior wants to spend his inheritance faster than you can earn it and has his eye on a new red Lamborghini. What can you do to assure that Junior won’t burn through his inheritance faster than a meteor hitting the Earth’s atmosphere (for you science buffs re-entry temperatures can reach as high as 3,000 degrees F). Here’s a checklist of things you can do:
¶ Buy an annuity: Mandate that your executor take some portion of Junior’s inheritance and buy a non-cancellable annuity. If Junior cannot cancel or accelerate the annuity, the principal should remain relatively secure. If Junior is young, consider an annuity that will pay Junior an inflation adjusted amount every quarter for the rest of his life. This will assure Junior has enough money to buy chips and beer forever.
¶ Trust: Put all of Junior’s inheritance in a trust and name a tough trustee who will be able to withstand Junior’s whining and begging so that the funds can be used judiciously over Junior’s life. Institutional trustees, use to dealing with trust fund babies, and fixed hours (they don’t have to listen to Juniors whining for money on weekends like Uncle Harry would have to), are a great choice. Delineate in the trust agreement specific items the trustee should pay for (tuition, technical school, etc.), and specific things the trustee should not pay for (bling, private yachts, etc.).
¶ Incentive Trust: Make distributions from Junior’s trust in part based on Junior’s performance and conduct. If Junior earns $50,000, let the trust match it plus pay certain other expenses. If Junior earns nothing limit the trust to cover just basic needs and expenses. These trusts have been touted as a great technique to motivate underachieving heirs. In reality, these are not simple documents. How is “income” to be defined? If Junior joins the Peace Corp. or something equivalent he might earn little while accomplishing a lot. You may want a greater incentive for such altruistic conduct. The problem with incentive trusts is that it is difficult, if not impossible, to address the myriad of circumstances that might arise. It might be just as effective, perhaps more so, to have a discretionary trust and give the trustee the flexibility to react to the beneficiary’s circumstances, rather than endeavoring to embody the range of behaviors in an incentive formula.
¶ Charitable Lead Trust: Put some portion of Junior’s money in a charitable lead trust (“CLT”). A CLT is a “split interest” trust. Charities receive a specified amount during the trust term, and thereafter a non-charitable beneficiary, such as Junior, receive the trust assets. It is a “split interest” since both charitable and non-charitable beneficiaries share. A CLT can be structured as a grantor trust (taxable to the parent) or a non-grantor trust (the CLT itself pays tax, but most of the tax liability will be offset by charitable contribution deductions). For example, a specific charity could receive a unitrust, or an annuity, payment for some stated period, say 20 years. That payment could be made to a donor advised fund so Junior can appoint the money to charities he selects. This can help teach Junior about philanthropy in addition to Gucci. At the end of 20 years Junior will get the money in the trust (or it can be paid into a further trust to continue to protect him). This approach defers Junior’s access to this portion of the inheritance, provides something analogous to a retirement plan in case he burns through everything else, and hopefully improve his values during the interim. The IRS recently issued new sample forms to be used for CLTs Rev. Proc. 2008-45 and 2008-46, 2008-30 IRB.
¶ FLP/LLC: Convince Junior to contribute his assets to a family limited partnership or limited liability company for which you (or someone else trustworthy and stern) are the general partner or manager to control Junior’s access to the assets. As a limited partner (“LP”) Junior has no say in the management of the FLP, and in particular in distributions. If Junior is still a minor carefully evaluate transferring custodian accounts of Junior to an FLP/LLC. While many people are cavalier about doing this, it raises issues as to Junior’s rights upon attaining the age of majority. See “Custodial Account into FLP”, Practical Planner May 2008, page 4.
¶ Go Skiing: Hey, if all else fails, do like the bumper stickers in Boca Raton say, SKI! Spend Kids Inheritance.
Recent Developments Article 1/3 Page [about 18 lines]:
Summary: Palimony is an equitable type of support awarded when a long term non-marital, but spousal-type relationship between unmarried parties terminates. This remedy is intended to achieve substantial justice in light of the realities of the relationship. It is significant for all non-married partners to consider.
“You’ve Come A Long Way Baby”. That is not only a great slogan for Virginia Slims, but aptly describes the evolution of palimony. In the landmark 1976 California case, Marvin v. Marvin, 18 Cal. 3d 660, Lee Marvin, star of file “The Dirty Dozen”, had his laundry washed in public when he broke off his relationship with ex-dancer Michelle Triola. The two had lived together in Marvin’s Malibu pad from 1964 – 1970. Triola won a settlement based on a theory of implied contract. She provided homemaking and other services to Marvin, and he and impliedly agreed to provide for her. In a recent New Jersey case, Devaney v. L’Esperance, A-20-07, the court found that palimony could be awarded even if the couple didn’t live together. Palimony has come a long way baby! Now your paramour doesn’t even have to live with you to fleece you! Up until recently you would know if you were in the mix for this claim if your lover moved in. But, this recent New Jersey court decision has broken the precedent set in almost every other court by holding that a palimony claim might succeed even if your paramour never occupied your secret pied-a-Terre. Cohabitation is, according to the court in Devaney v. L’Esperance, only one of the many factors to consider. To win such a palimony claim, you ex-paramour still has to prove that the two of you maintained a marital type of relationship, and that there were promises of support. That promise, however, can be express, or implied. The moral of this tale is if you have a relationship you need a living together agreement.
Potpourri ½ Page:
Alternate Valuation Date: Usually when someone dies you value the estate assets at the date of death for tax purposes. A special election permits you to value all assets six months after death. A useful rule when the stock markets are tanking. More than a score of states of decoupled their estate taxes from federal law so you could owe state tax even if your estate is less than the $2 million required to file a federal estate tax return. So how do you make the election for a state return when no federal return is filed? The State of New York Department of Taxation, Estate Tax Department advised that you can elect the alternate valuation for New York tax purposes, even if there is no federal return filed. However, you have to prepare a federal estate tax return using the alternate valuation. This “mock” federal return must be filed with New York, even though it is not required to be filed with the IRS.
GRAT Operations: No, this is not a new form of surgery. Grantor Retained Annuity Trusts (GRATs) are a great tool to leverage gifts to children. Word on the street is the IRS is planning greater audit scrutiny of the operations of these trusts. This means the periodic annuity payments must be properly and timely made, and this should be documented. Other trust provisions will likely be considered. Get an annual GRAT checkup. Have counsel review the trust document and coordinate with your CPA and wealth manager to assure that all formalities are met. Get an investment policy statement. If the GRAT owns closely held business interests, be sure the trustees sign shareholder agreements and minutes to prove they’re acting like real shareholders.
1031 Exchanges of a Residence: Real estate investors love 1031 exchanges that avoid current taxable gain on swapping properties. To qualify the property has to be held for productive use in a trade or business or for investment. Can a residence ever qualify? Yes, according to a recent IRS Revenue Procedure, 2008-16. You have to have owned the residence for 24 months before the exchange and in each of the two 12 month periods you had to rent it 14 or more days and your personal use had to be less than the greater of 14 days or 10% x rental days.With housing prices in meltdown mode, how many folks have profits to 1031 a residence any how? Is the IRS giving free ice to the Eskimos in winter?
Back Page Announcements:
Save to Y:\ARTICLES\FIRMNEWS\MONTHYEAR\MONTHYEAR#.DOC
FLP Gift Planning: Holman Case Part II
Significance of Palimony for all non-married partners to consider.
“You’ve Come A Long Way Baby”
Alternate Valuation Date
1031 Exchanges of a Residence
FLP Gift Planning: Holman Case Part II
- A recent Tax Court case, Thomas Holman, 130 TC No. 12, 5/27/08, has some several important lessons for planners and taxpayers using family limited partnerships (“FLPs”) and limited liability companies (“LLCs”), especially for gifts. Last month’s lead article provided an overview and analysis of the case in Part I. This month’s Part II, reviews planning lessons, and several important points that seem to have gotten short shrift in the professional literature.