Typically, when an FLP strategy is initiated, a new limited partnership must be created, and some property transferred to it by the taxpayer desiring to reduce his eventual gross estate (referred to here as the “donor”). The creation of the partnership would have to be the first step. Often the donor and the donee/children would be named as the initial partners, the donor being the sole general partner. Once the partnership is formed, the donor/general partner would then convey title to the property to the partnership. It is common that the limited partners make no capital contributions (or only de minimus cash contributions), but they accede to a beneficial interest in the property contributed by the donor/general partner. Of course, there is a gift involved here. But what is given, and how should it be valued for gift tax purposes? That was the issue in Mark W. Senda, et ux. v. Commissioner; T.C. Memo. 2004-160; No. 17298-02. Senda argued that what was given were interests in the FLP. The IRS, however, contended that what was given was an indirect gift of stock. What difference does it make? If the gift is viewed as an indirect gift of stock, the aggregate value of the gift is simply the value of the stock. On the other hand, if the gift is made through a limited partnership in which the donees are limited partners, there could be a meaningful difference since the limitations normally inherent in a limited partnership interest make limited partnership interests demonstrably less valuable than the same pro-rata share of the underlying asset(s).
In Senda the Tax Court had no difficulty agreeing with the IRS contention that the transfers were mere indirect gifts because the taxpayers failed to follow in logical order the formation of the FLP, the funding of the FLP and failed to properly document the transfers. The Court explained it this way:
It is apparent from petitioner`s evasive testimony and from the total record that petitioners were more concerned with ensuring that the beneficial ownership of the stock was transferred to the children in tax-advantaged form than they were with the formalities of FLPs. Indeed, petitioner, as general partner, did not maintain any books or records for the partnerships other than brokerage account statements and partnership tax returns. Those tax returns were prepared months after the transfers of the partnership interests. Thus, they are unreliable in deciding whether petitioners transferred the partnership interests to the children before or after they contributed the stock to the partnerships. The same is true of the certificates of ownership reflecting the transfers of the partnership interests, which were not prepared until at least several weeks after the transfers. The informality is not surprising, inasmuch as petitioners alone, individually, or on behalf of their minor children were united in purpose and acted without restraint by any adverse interest. As a result, however, petitioners have presented no reliable evidence that they contributed the stock to the partnerships before they transferred the partnership interests to the children. At best, the transactions were integrated (as asserted by respondent) and, in effect, simultaneous. [Mark W. Senda, et ux. v. Commissioner; T.C. Memo. 2004-160; No. 17298-02.]
Typically, the limited partnership will first be formed, by the execution of a limited partnership agreement by the donor/general partner and one or more donee/limited partners. If the donor expects to transfer additional percentages of partnership interest in future years, the donor’s initial interest in the partnership will be divided so that most of his or her interest is a limited partnership interest (portions of which can be peeled off and transferred to donee/limited partners at any time—or each year, to take advantage of the $10,000 (as indexed) annual exclusion). Since the same person can be both a general partner (as to a portion of his beneficial interest) and a limited partner (as to another portion of his beneficial interest), partnerships are often established with the donor as general partner for purposes of controlling the partnership and as limited partner holding all of the interests that will eventually be transferred by gift. (Under most state laws, however, there must be at least one additional partner, or a partnership is not technically formed.)
The formal transfer of the property to the partnership sometimes takes place simultaneously with (or more conservative voices counsel a few days or weeks after) the formation of the partnership.
Thus the initial transfer of property should be handled in three fully documented separate steps:
1. First, the limited partnership is created by the execution of a limited partnership agreement by all of the partners. (As stated above, it cannot be formed by naming the donor as both general and limited partner, with no other partners.) At this stage the percentage interests of the limited partners should be next to nothing (e.g., 0.1 percent) and the donor should be named as a limited partner with a percentage corresponding with the interests ultimately destined for the limited partners. A token cash contribution should be made by each partner, general and limited, as his or her initial capital, and the amounts should be in proportion to the initial percentages of partnership interest. A certificate of limited partnership must be filed with the proper state office (in some states this is a pre-condition to the limited partnership’s existence).
2. Second, title to the property is transferred to the partnership.
3. Finally, after step two has been completed and fully documented, the donor would make a transfer of his limited partnership interest, or a portion of it, to the limited partners, in such portions among the limited partners as desired. This transfer would be formalized by an amendment to the partnership agreement reallocating the limited partnership interests.
Thus, following the 3-step process, the donor will be well positioned to assert that the valuation discounting for gift tax purposes will be based upon the transfer of limited partnership interests, and not the transfer of the property itself (except, possibly, for the de minimus initial gift, as described in step 2 -- See Shepherd v. Comm’r., 115 T.C. 376 (2000), aff`d 11th Cir. (Feb 28, 2002)]).
See also CURRENT COMMENT 04-18: Kimbell v. United States: Fifth Circuit Rejects IRS’s §2036 Attack on Family Limited Partnership.
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