ESTATE PLANNING ADVISOR[i]

Vol.4, No. 16 June, 2003

CLIENT UPDATE ON FAMILY LIMITED PARTNERSHIPS AND LIMITED LIABILITY COMPANIES

We have prepared this Estate Planning Advisor to notify our clients and professionals with whom we work of important recent events in the estate taxation of Family Limited Partnerships and Limited Liability Companies. We will just use the word Partnership for the remainder of the Advisor [because in this contect partnership and limited liability companies are the same]. We will use the question and answer format so as to allow us to focus on one issue at a time.

1. What is this recent event that is important enough to notify us?

Before we discuss the specific event, we prefer to set the stage by discussing the estate and gift tax value of Partnerships. As we have discussed before, and you have likely read about in financial sections of newspapers, Partnerships have been an extremely popular method of estate planning for the last ten or so years.

2. Why are Partnerships so popular as an estate planning vehicles?

Good question. First, we need to introduce our “willing buyer.” As is obvious, the estate and gift tax is imposed on the fair market value of an item of property. Let’s use an apartment building with a fair market value of $1,500,000.

3. How do we know the apartment building is worth $1,500,000, is it just the owner’s guess?

Actually, that question is the very focus of the importance of Partnerships. Let’s introduce the “willing buyer.” For estate and gift tax purposes, the fair market value of property is determined by what a willing buyer will pay a willing seller, both with reasonable knowledge of the property and no compulsion to buy or sell. The willing buyer is not the owner of a parcel of property next to our apartment building that wants to buy the apartment building and expand it onto his or her land. That buyer has a “personality,” in that he or she has a “compulsion” to buy the apartment building because of the expansion plans.

The courts and the Internal Revenue Service, after much litigation by the Internal Revenue Service have finally agreed that the willing buyer is a hypothetical person, not the member of a family, not a next door neighbor who wants to expand, or not an environmental group that wants to set the property aside as waterfowl habitat.

4. Are you saying that we just imagine what a willing buyer will pay, and that’s it?

Not at all. First, lawyers and CPAs, unless specially trained, do not determine what the willing buyer will pay. That is properly the job of a licensed real estate appraiser familiar with valuing real property. Let’s assume that our appraiser has valued the building at $1,500,000. What that means, is that if we looked at the owner’s financial statement we would see a category: Real Estate Investments $1,500,000.

5. This is very interesting, but how does this affect Partnerships and the new event you are supposed to be notifying us of?

Patience. Assume we have advised the client to place the apartment building into a Partnership with other family members, or simply had our widowed client form the Partnership and make gifts of limited partnership interests to her children, or trusts for their benefit. Once that is done, we revisit the client’s financial statement and we notice that there is no category Real Estate Investments, it is simply gone, because the client no longer owns any real estate, the client now owns general and limited partnership interests in the Partnership that was created to hold the apartment. Let’s assume client owns:

2% General Partnership Interest (gives them management control), and
80% Limited Partnership Interests (provides very little control, and their children own,
18% Limited Partnership Interests.

Now we take a look at the client’s financial statement. We see a category Real Estate Partnership Interest: 2% General Partnership Interests and 82% Limited Partnership Interests ($? Value). As you can see, we don’t know what our willing buyer will pay for a 2% general and an 82% Limited Partnership interest in a Partnership holding a $1,500,000 apartment building.

6. How do we find out the value of the Partnership Interests?

We hire a business appraiser to determine how much less a willing buyer would pay for a 2% General Partnership Interest and an 82% Limited Partnership Interest in a Partnership owning a building with a fair market value, under the willing buyer test, of $1,500,000. Without becoming technical, partnership interests are more difficult to sell than an entire building, the willing buyer will have to deal with the children who own 18% Limited Partnership Interests. Let’s assume our appraiser determines that the structure of the real estate being owned by a Partnership such as the one we are using cause an “inconvenience discount” of a 35% reduction in which an interest in the Partnership is worth, when compared to a 1% pro rata value of the entire property outside of the Partnership. Mom dies.

7. What does this 35% “inconvenience discount” mean to the client’s estate tax bill?

Let’s assume mom was in the 50% estate tax bracket, here is the reduction in estate taxes imposed on the heirs, by the use of the Partnership:

100% Partnership Undiscounted Value	$1,500,000
Less 35% Inconvenience Discount	(525,000 )
Discounted Value	$975,000

Client’s Undiscounted Value (82% x $1,500,000)	$1,230,000	(Estate Tax 50% = $615,000)

Client’s Discounted Value (82% x $975,000)	$ 799,500	(Estate Tax 50% = $399,750)

The use of the Partnership to create “inconvenience discounts” has saved the heirs $215,250 in estate taxes. Remember, when mom dies, there may need to be audit battles with the Internal Revenue Service over the amount of the “inconvenience discount”, or the reality of the Partnership if it is not properly managed.

8. What is the big deal that has changed the potential for “inconvenience discounts?”

The Internal Revenue Service, in a Tax Court case called Strangi v. Commissioner of Internal Revenue, T.C. Memo. 2003-145 has successfully removed the “inconvenience discounts” because of certain actions of an otherwise valid Partnership. This becomes a little complicated so we will take it slow. There is a rule in the Internal Revenue Code that says if I give my property to a Partnership, but I continue to use the property the same way after the transfer to the Partnership as before the transfer to the Partnership, the Partnership will be ignored, and the undiscounted value of the Partnership will be included in my estate. This happens under Internal Revenue Code section 2036.

9. What happened in Strangi v. Commissioner?

One heck of a lot of bad facts. Among them:

· Voting Control of Limited Partnership Interests: The Decedent held 99% of the limited partnership interests through his attorney in fact, the client was incapacitated,

· Voting Control of General Partnership Interests: A corporation was a 1% general partner and the Decedent, through his attorney in fact owned 47%,

· The Corporation Names an Employee to be the sole General Partner: The corporation names the Decedent’s attorney in fact to be the sole general partner of the partnership. Therefore, the Decedent, through his attorney in fact was the 1% general partner and the 99% limited partner,

· Powers of the General Partner: Normally, a general partner has a strong fiduciary duty to the limited partners, and the Partnership in Strangi effectively removed this fiduciary relationship by placing distributions in the sole control of the general partner, who was the attorney in fact for the 99% limited partner,

· Advances of Funds to the Decedent: Partnership funds were advanced to the Decedent for personal reasons and booked on the Partnership books as loans, and

· The Decedent’s Contribution: The Decedent, through his attorney in fact, contributed his personal residence, in which he continued to live, rent-free, and all of his liquid assets. This ensured that the decedent, through his attorney in fact, would have to use the Partnership funds for his medical and living expenses. This, the Tax Court concluded, supported an implied agreement that the decedent would have the same access to his property before the creation of the Partnership as afterwards.

I don’t think it takes a genius to look at how the Partnership in Strangi v. Commissioner, T.C. Memo. 2003-145, gave the Decedent the same access to his funds after the Partnership was funded as before, and the Tax Court used Internal Revenue Code section 2036 to include the undiscounted value of the Partnership Interest in the Decedent’s estate.

10. What are the lessons from Strangi v. Commissioner?

While there are several technical lessons to be learned by the accountants and attorneys, as far as clients are concerned, the Partnership formalities must be respected or the Internal Revenue Service will simply ignore the Partnership. It is not clear that all of the criticisms of the Tax Court will be followed in the future, but, at a minimum, the following items need to be considered by planners:

· Contributions: Never contribute all of the client’s liquid assets to the Partnership, this ensures that personal expenditures on the part of the client will have to be made with Partnership funds,

· Personal Residence: Never contribute the client’s personal residence, even if fair market rent is to be charged for its use,

· Personal Expenditures: Never allow the client to make personal expenditures, even if they are recorded as notes. Make pro rata distributions to all partners and then let the client make the personal expenditures, and

· Drafting the Agreement: Never include language that allows a general partner to act in any manner that is not within the general partner’s fiduciary duty, and never limit the limited partner’s rights to avail themselves of state law rights to enforce the general partner’s fiduciary duty.

· Control: Strenuously avoid having all power held by the client, or you risk having the court ignore the Partnership as not being bona fide and use section 2036 to take away any discounts.

In other words, keep the transaction free of an over-controlling client who insists on having the same power before as well as after, because you are halfway to Strangi v. Commissioner if you do.

Schedule a Review of Your Partnerships

I strongly suggest you consider, and compare, the operations of your own family’s Partnership, and schedule a meeting for a review in light of the Internal Revenue Service’s goal to expand their attempts to eliminate the use of Partnerships for “inconvenience discounts” if there is the slightest abuse.

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