Dissolving an FLP/LLC – Can you have your Tax Cake and Eat it Too?

Introduction

Family limited partnerships (“FLPs”) and family limited liability companies (“LLCs”) have been a mainstay of estate and related planning for decades. FLPs and LLCs (collectively, “FLPs”) could have been formed for a myriad of reasons. However, in many cases, achieving valuation discounts for gift or estate tax purposes was a major motivation. Many taxpayers who created these entities hoping to obtain discounts have forgotten the many other benefits these entities can afford them and their families and as such are push practitioners to dissolve these entities, or worse, terminate them on their own with no professional help. While in some instances it might make sense to liquidate the entity, in many, perhaps most cases, other options might warrant consideration. This article will outline the general issues and considerations, and present several options that do not receive enough consideration.

Valuation Discounts

Perhaps the primary benefit sought through the use of the FLP has been the discounts on the value of the FLP interest as contrasted with the fair market value of the underlying partnership assets. The IRS has regularly attacked valuation discounts taken on FLPs in the gift and estate context under many different theories and approaches.  Recent tax law changes have fundamentally changed the tax planning paradigm:

• The $5 million inflation adjusted estate tax exemption, $5,430,000 in 2015 or $10,860,000 for a couple,
• Portability (the surviving spouse can use the deceased spouse’s unused exemption) was made permanent.
• The 3.8% Net Investment Income Tax (“NIIT”) became law.
• Capital gains tax rates are higher.

Thus, for many even wealthy taxpayers, there is no federal estate tax benefit to FLPs because the discounts will not save a tax if none is due. But there may now be a tax planning negative (for all taxpayers, even wealthier taxpayers paying a federal estate tax). That negative is that the discounts reduce the basis step-up obtained on death. On death the “cost” for tax purposes increases in simple terms from what the decedent paid for the assets to its fair value on death. That can eliminate the unrealized capital gain inherent in the asset at death. Since discounts reduce the fair value of the FLP as compared to its underlying assets, the step-up is less and heirs may realize a larger capital gain when the asset is sold.

Get Real

The Dr. Phil approach to estate planning is to “get real.” As with so much of estate and tax planning, generalizations are dangerous. If the family faces a state or federal estate tax and the entity owns a building used in the family business that might not be sold for generations, if ever, the capital gains tax on a present value basis is irrelevant. This is perhaps the critical threshold planning point. Before a decision is made to dissolve or otherwise tamper with the structure of an existing FLP, all the relevant facts for your particular situation should be looked at. Relying on generalizations in the planning literature, or worse, what your golf buddy has done, are rarely going to lead to optimal planning results.

Various Benefits of Using and FLP/LLC Apart from Discounts

FLPs can provide a host of benefits. Before dismantling any FLP, evaluate the continued relevance of the FLP in light of your actual circumstances. Some of the many benefits  include, but are not limited to the following:

• Limited Liability: An FLP can, with the proper structure and operations, limit liability exposure. An FLP, if the general partner and the FLP itself and the respect of the formalities of the FLP entity operation (i.e., in accordance with formalities of the entity, pro-rata distributions, no commingling of personal and entity funds, etc.), provide the limited partners the benefits of limited liability if they do not undermine this benefit through acts reserved for general partners.  A properly formed FLP should provide all limited partners with limited liability. The general partner, if structured as an S corporation or LLC can also obtain limited liability. The pursuit of liability protection is a valid business purpose pursued by almost every business, regardless of the form of entity selected. FLPs should never have been only about discounts. Even if the senior generation at the current stage of their lives is not concerned about liability exposure (often they should be) the next generation may well benefit from an existing “old and cold” entity that has been operated for years. It might make sense to recapitalize the FLP with funds contribute by future generations, regardless of what is done for the senior generation’s interests.
• Limit Transfers: The use of an FLP and the restrictions on the transfer of partnership interests can safeguard assets from being transferred outside the family. This can include protection from donee’s making unauthorized transfers, attacks by creditors, and challenges in a divorce. An FLP can be used to preserve family business and investment continuity. If this is a factor, succession provisions, transfer provisions and a statement of intent in the recital clauses, should all be included in the partnership agreement.
• Dispute Resolution: An FLP partnership agreement can incorporate several different types of dispute resolution mechanisms. These can include variations in the level of approval necessary for certain acts, designation of a managing general partner to control designated decisions, or the inclusion of a mandatory arbitration clause. A partnership agreement can reserve certain issues to the general partner, others to a majority vote of all of the partners including limited partners, and almost an endless variety of variations on these. The agreement can set forth a host of mechanisms to address particular decisions. If this is a purpose for the partnership agreement, practitioners should assure that all partners contribute thoughts to the development of the partnership agreement so that as many control and decision making points as possible can be addressed. This purpose can be noted in the recital clauses for the partnership agreement. However, the inclusion of detailed provisions in the agreement itself should demonstrate the importance of the dispute resolution method purpose. It might be advisable to save all superseded drafts of the partnership agreement to demonstrate to the IRS or other third parties the importance placed on these issues.
• Control: Where an FLP is used, the principal of the business can, for example, serve as the sole general partner having substantial control (subject to fiduciary responsibilities to the entity and other equity holders) over the FLP operation. The key employees, children (or other donees), can own their economic interests as limited partners, but have virtually no control. In fact, by law, the limited partners are not permitted to participate in the management of the business.  The principal can manage the degree of control over the FLP through the control provisions of the limited partnership agreement, and through applicable provisions of state law. The designated general partnership can exercise exclusive management and investment control over the FLP’s assets. The partnership agreement can limit the right of a partner to demand a distribution or a return of his or her capital account.
• Avoid Ancillary Probate: Real estate or tangible personal property in a state other than the  State of domicile will be subject to ancillary probate proceedings in that other state. The FLP provides a vehicle to avoid ancillary probate and represents a viable alternative to the use of a revocable living trust in some circumstances. An interest in an FLP is deemed to be intangible personal property.  This can be important for a non-resident, since the ownership of intangible personal property should not subject the estate of a non-resident decedent to ancillary probate proceedings to affect the transfer of an FLP interest.

Options to Consider

Once all the relevant pros and cons of continuing the FLP have been evaluated consider the options available. These might include the following among others:

• Status Quo: Perhaps after a complete analysis weighing all relevant factors the existing FLP structure is a reasonable balance of all considerations.
• Revise the Investment Strategies: It may be feasible through a more carefully crafted investment policy to reduce the unrealized appreciation inside the FLP thereby reducing the benefits of a basis step-up on death. In such instances, the FLP may remain intact as is and perhaps the only document change might be a revised investment policy statement. For example, if the FLP contains only a portion of the family investment wealth, which is likely, then perhaps FLP asset can over time be shifted more towards income then growth, or actively managed growth investments so that unrealized appreciation is limited.
• Restate Governing Document to Eliminate Discounts: The FLP may still serve as a convenient investment vehicle. For example, there may be a large number of family members, family trusts and even other family entities that have all pooled their liquid assets in the FLP as a single investment vehicle. This use may still be relevant, but the discounts a negative from a tax planning perspective. It might be a relatively simple step to eliminate discounts while retaining the structure intact. This may continue to afford investment management advantages and save the cost and complexity of restructuring all the existing investment accounts and relationships. If the governing document is amended to provide that any member can receive his, her or its pro-rata share of the entity underlying assets on sixty days advance written notice, it would seem implausible for the IRS to argue that discounts could apply. A very serious negative to this approach is that it would also eviscerate any asset protection benefits previously afforded by the use of the entity because a creditor could make a similar demand. If the family members are reasonably not concerned about liability protection this might afford a reasonable, simple, easy to implement, means of eliminating discounts while retaining some benefits of the FLP. What if the parent/partners want to eliminate the discount to maximize basis step up but a child/partner is a physician worried about the loss of malpractice protection by this change? If some of the family members do have concerns about liability, malpractice or divorce, it may be feasible for them to contribute their FLP interests to an irrevocable trust in advance of this change to the governing documents. While they would lose the additional layer of protection the FLP level of planning might have afforded, the asset protection from the irrevocable trust might suffice, and this might afford the family overall a better planning result.
• Restate Governing Document to Reduce Estate Discounts but Retain Some Asset Protection: It may be feasible to take a somewhat narrower approach to the modification of the governing documentation that might facilitate retaining the FLP structure, a significant degree of asset protection for many equity owners, and the elimination of the discounts for the senior family members. Consider an FLP where the parents are in their 80s and want to garner a full basis step up through an IRC Sec. 754 basis adjustment without the negative implications of discounts. However, junior family members, children, are concerned about retaining asset protection benefits, and perhaps even discounts to leverage inter-vivos gift plans. What if the governing instrument were amended to provide that solely in the event of death, the executor of the deceased partner/member’s estate shall have from the instant of death the right to put the value of the entity interests to the entity in full redemption of the deceased partner/member’s interests at the undiscounted value of the underlying FLP assets. This right shall continue from the moment of death until sixty days following the appointment of the executor or personal representative of the deceased partner/member’s estate (but perhaps in no event for more than 180 days following death). This type of provision would seemingly make it difficult for the IRS to argue that a discount could apply to the valuation of a deceased partner/member’s interest. The hoped for advantage of this approach over the one suggested in the preceding paragraph is that for younger partners, the statistical likelihood of death is sufficiently remote that meaningful asset protection benefits would remain for them.  As a partner ages, or as a partner’s health declines, the existence of this  put right on death means that a creditor of the older/ill partner’s estate will be paid pursuant to the put right so that asset protection for the older partner will decline and at advanced ages be nearly nil. But this, for many, is the natural progression of asset protection worries: highest at younger ages and less decades following retirement.   Example: Assume a younger family member a physician age 40, but for the redemption at undiscounted value at his/her death it seems the approach should be viable as it arguably should not substantially undermine that younger living family member/partner’s asset protection. This approach cannot be used as a default resolution of the FLP discount challenge, but when there are senior family members well under the exemption amount, it could provide a viable family planning option unless there was a real asset protection worry by the older family members.
• Partial Liquidation of Senior Family Member’s Interests: If the parents tax planning will benefit from removing appreciated asset from an FLP structure to obtain a basis step up, but the remaining family members might still benefit from the entity, a partial liquidation of the parents’ interests might suffice to accomplish everyone’s goals. A partial liquidation might be planned by assets rather than by partner’s interests. For example, the FLP might, for example, hold appreciated securities and a family vacation home. A partial liquidation of the securities to obtain a basis step up to the extent that the distributed securities are included in the parent’s estates may be advantageous. The family vacation home might be held for generations to come, so that a basis step up would at most have an academic benefit. However, the use of the FLP structure might provide valuable management, control and other benefits to the continued holding of that property.
• Recapitalize the FLP: It may be possible that the parents who formed the FLP are no longer subject to an estate tax. Perhaps they are subject to a state estate tax in a decoupled state but that tax may be less than the capital gains costs to heirs of losing a basis step up as a result of discounts. However, two of their children may be licensed professionals (CPA, attorney, physician, etc.) so that the asset protection benefits afforded from holding significant assets in an FLP as a minority limited partner, could have important asset protection benefits. The fact that they do not have to incur the cost of creating their own structure, have trusted family members who may control management, and can then use FLP interests to fund their own irrevocable trust plans, may all be significant advantages. In these instances it may be advantageous for the family unit as a whole to recapitalize the FLP. Children facing liability and malpractice risks might contribute significant portions of their non-pension assets to the existing FLP. Consider lien and judgment searches and having them complete solvency affidavits in advance of the funding. The parents, who may have initially formed and funded the FLP a decade or more ago, in anticipation of estate planning valuation discounts might reduce their equity interests in the FLP to minimize the discounts that might reduce the income tax basis step-up on their deaths. Thus the children might contribute significant new assets and the parents may receive a distribution of existing appreciated FLP assets. However, in contrast to the approach used by many, the parents’ interests would not be entirely liquidated nor would their involvement with the FLP end. The FLP in being repurposed as an asset protection tool for the next generation may benefit from the parents owning partial interests as that may prevent any one child from having a controlling interest in the entity (e.g., a member managed LLC) and thereby strengthen that child’s asset protection benefits from the structure. The parents may not intentionally be placed in a position of serving as manager or general partner. In the past, when the parents were seeking discounts from the FLP structure, tax advisers would have counseled against the parents serving as managers or general partners for fear that the IRS would assert that they retained control and thereby argue for inclusion of the entity in the parents’ estate under IRC Sec. 2036. In a carefully crafted repurposed FLP it may be advantageous for the children’s asset protection benefits to have a parent rather than the child in control. Depending on the circumstances the old IRC 2036 worries may not be relevant to the parent’s planning.
• Complete Liquidation of FLP: In some instances there may be no perceived benefit of retaining the FLP structure. The intended heirs may really have no meaningful asset protection concerns. The FLP may hold primarily highly appreciated securities that would benefit from a basis step up, and the parents estates may be safely below the federal estate tax exemption level, especially with consideration of portability.

Tax Consideration on Termination of the FLP

Termination can have a number of potentially adverse tax consequences. For example, the partnership tax year will end.  Treas. Reg. §1.708-1(b)(1)(iii). Where the partners and the partnership have different tax years this can result of a bunching of taxable income into one year. Where the cash distributed by the partnership in the event of termination exceeds the partner’s tax basis in the partnership, gain will be recognized. IRC §731. A number of other consequences can also occur. An analysis by the FLPs accountant prior to implementing any plan for a partial or complete liquidation of the FLP is an essential prerequisite.

Conclusion

A partial liquidation of a senior generation’s (parent’s) interests in an old FLP might well be reasonable to avoid valuation discounts for estate planning purposes. Evaluating such a step should be a commonly considered pre-mortem planning step. In some instances, liquidating the entire FLP may in fact be warranted. However, there are many more options that warrant consideration, and a knee-jerk reaction without complete analysis of all relevant facts is unlikely to provide the optimal result.