TE Article
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FAMILY LIMITED PARTNERSHIPS
STEPHANIE LOOMIS-PRICE
BAKER BOTTS L.L.P.
One Shell Plaza
910 Louisiana
Houston, Texas 77002
713.229.1801
713.229.7801 (Fax)
s.loomis-price@bakerbotts.com
Presented at:
AMERICAN BAR ASSOCIATION
REAL PROPERTY, TRUST & ESTATE LAW’S
2007 FALL LEADERSHIP MEETING
October 18-21, 2007
Minneapolis, Minnesota
This material will be presented at the 42nd Annual Heckerling Institute on Estate Planning, scheduled for January 14-18, 2008 in Orlando, Florida. It is reprinted with the permission of the Heckerling Institute and the University of Miami. Further information on the Heckerling Institute is available at www.law.miami.edu/heckerling.
Table of Contents
I. Introduction
II. Consider Appropriateness of Partnership .
A. Keep Potential Future Audience in Mind
B. Consider Whether Clients Are Ready for Partnership
C. Evaluate Potential Assets
D. Evaluate Potential Partners
E. Engage/Consult with Experienced Advisors .
III. Partnership Formation
A. Consider Separate Counsel for Participants
B. Discuss Partnership Terms
C. Ensure Agreement’s Schedules Are Complete .
D. Prepare Transfer Documents in Advance and File with Relevant State
Authorities
E. File for Employer Identification Number
F. Create Partnership Accounts Timely
G. Engage Partnership Accountant
H. Reflect Contributions in Capital Accounts in Proportion to Fair Market
Value of Assets Contributed
I. Consider Deducting Partnership Set-Up Fees
J. If Necessary, Amend Partnership Percentages as Quickly as Possible
After Formation
K. Be Prepared to Produce Documents in Your File to the IRS, If Necessary
IV. Partnership Maintenance
A. Consider Filing Tax Returns for Each Year in Existence
B. File Any Required Annual/Bi-Annual Registration Statements
C. Comply with Terms of Partnership Agreement
D. Comply with Loan Terms, If Loans Are Made .
E. Distributions, If Made, Should Be Pro Rata
F. Refrain from Use of Partnership Assets for Partners’ Personal Obligations
G. Upon Transfers, Consider Whether to Make Section 754 Election
H. Avoid Irregular Transactions Between Partners and Partnership
I. Keep in Mind Non-Tax Reasons Stated for Forming Partnership
V. TRANSFERS OF PARTNERSHIP INTERESTS
A. Generally
B. By Gift
C. By Sale
D. At Death
E. By Redemption
VI. TRANSFER TAX REPORTING
A. Obtain Appraisal from Independent Qualified Appraiser
B. Confirm with the Appraiser the Interest to Be Valued
C. Consider Whether to Aggregate Interests .
D. Review Appraisal Closely for Facts
E. Try to Live by Factual Information Provided to Appraiser
F. Beware of Rounding on Appraisals and Tax Returns
G. Understand IRS Settlement Guidelines
VII. AUDIT
A. Consider Bringing in Litigation Counsel
B. Determine Whether a Document Destruction Policy Exists; If So, Suspend
C. Consider the Burden of Proof D. Consider the Impact of Privileges
E. Consider Whether Production of Privileged Information May Help
Your Case
F. Provide Responses to the IRS that Are True and Correct, to the Best
of Your Knowledge
G. Keep in Mind that Anything Stated or Written Can Be
Treated as an Admission
H. Produce Responsive Documents in Your Possession, Custody, or Control
I. Keep Careful Track of Documents and Electronic File Produced
to the IRS
J. Understand the IRS’s Broad Subpoena Power
K. File Protective Claims If Necessary
L. Consider Whether it is Feasible to Keep Partnership in Place
M. Treat Informal Interviews as Depositions .
Introduction
The steps that partners and their advisors take in forming and operating a family limited partnership can impact a court’s view on valuation to such a great extent that valuation evidence can become irrelevant. In transfer tax cases addressing legal issues such as indirect gifts and the applicability of Internal Revenue Code (“I.R.C.”) § 2036, courts may conclude that the facts in a given case are such that it is a proportionate share of the assets of the partnership, rather than the transferred partnership interest, that is to be valued for transfer tax purposes. In other words, if the existence of the partnership is judicially disregarded, the question of value of the transferred partnership interest need not be reached – only the value of the underlying assets of the partnership matters. The result to the taxpayer in such a situation is that although he may have transferred a partnership interest, which interest carries with it the duties and restrictions found in the governing partnership agreement (and thus, in determining the fair market value of that interest, discounts for lack of marketability and lack of control should be applied), for transfer tax purposes, those duties and restrictions are ignored, and the resulting discounts disregarded. Thus, when the existence of a partnership is judicially ignored, the value that is used for transfer tax purposes is the portion of the underlying assets of the partnership attributable to the transferred interest, without regard to the fact that a hypothetical buyer would take into account the terms of the partnership agreement when deciding on the price that he would be willing to pay for the interest.
In determining fair market value for transfer tax purposes, the value of a transferred interest to be transferred is determined according to the “hypothetical willing buyer/willing seller” test found in I.R.C. § 2031 (for estate tax purposes) and § 2512 (for gift tax purposes) and the related Treasury Regulations. But the fair market value of the transferred interests is not a proportionate share of the partnership’s assets, because a hypothetical willing buyer would not be willing to pay for a pro rata share of the underlying assets of the partnership, in part because the buyer would not own the underlying assets and in part because the terms of the partnership agreement burden the assets. Consequently, the fair market value of a partnership interest is almost certain to be less than the proportionate value of the assets of the partnership. And it is the fair market value of the transferred partnership interest that is used to determine the amount of tax due as a result of the transfer.
However, in some circumstances, the Internal Revenue Service (“the IRS”) has argued, and the courts have agreed, that the existence of a partnership should be, in essence or in fact, ignored. This article is intended to assist practitioners in advising their clients at each step of forming, operating, and defending a partnership to avoid pitfalls that the courts and the IRS are pointing to when opining that, in essence, the existence of a partnership should be disregarded for valuation purposes.
Consider Appropriateness of Partnership
Keep Potential Future Audience in Mind
Planning for the estate tax examination really begins at the estate planning level. Keep in mind that anything that you write (even if protected from discovery by one or more privileges) may later be viewed by the IRS, a judge, or even a jury. For instance, in cases where the IRS has asserted that I.R.C. § 2036 applies (and thus the client has passed away), the only evidence of non-tax reasons for forming a partnership may be found in the advisors’ files. While advisors should not shy away from explaining the tax effects of forming a limited partnership, it is preferable to have such discussions take place in the context of a discussion of the non-tax reasons, as well.
Consider Whether Clients Are Ready for Partnership
Family limited partnerships are like blowfish sushi – handled with precision and care, they can be wonderful; handled carelessly, they are downright dangerous. Family limited partnerships can be confusing, but at a minimum, they are complex. In that regard, it is important to evaluate whether the people who are considering forming a family limited partnership are up to the task. Can they get along? Are they willing to abide by the rules? Are they prepared to pay the legal and accounting fees that tend to come along with the entity? These questions and others are important to address in determining whether your clients are ready for a partnership.
Evaluate Potential Assets
The courts and the IRS have opined that partners should retain enough assets outside of the partnership to support their lifestyles. The IRS is fond of asserting that a contributing partner’s failure to retain sufficient assets outside of a partnership to maintain his or her standard of living is evidence of an implied agreement of that partner to retain rights to the income from the assets contributed to the partnership. See Estate of Stone v. Comm’r, 86 T.C.M. (CCH) 551 (2003). In combating, for instance, an I.R.C. § 2036 argument, it is helpful to have contemporaneous documentation of the fact that a contributing partner had sufficient cash flow outside of the partnership to support his or her lifestyle without depending on extraordinary distributions from the partnership.
In determining whether formation of a partnership is appropriate, partners should consider the nature of the assets to be contributed to the partnership. For instance, the IRS and the courts have, in their consideration of whether a partnership is to be respected, considered as a negative factor the contribution of “personal use” assets to partnerships. See, e.g,Estate of Harper v. Comm’r, 83 T.C.M. (CCH) 1641 (2002); Estate of Strangi v. Comm’r, 115 T.C. 478 (2000); Estate of Strangi v. Comm’r, 85 T.C.M. (CCH) 1331 (2003). Such assets include personal residences, vacation homes, and recreational equipment. If the partners feel strongly about contributing such assets to the partnership, care should be taken to avoid IRS attack by ensuring that the partnership is compensated for individuals’ (including and perhaps most importantly, partners’) use of those assets, i.e., rent should be paid to the partnership for use of the partnership’s assets. Failure to do so may lead the IRS to assert, for instance, that I.R.C. § 2036 should apply at death, in light of the fact that a contributing partner maintained the right to use partnership property without paying for it.
In recent cases, the courts have examined the propriety of partners’ capital accounts on formation as a factor in whether I.R.C. § 2036 should be applied to various partnership interest transfers. In that regard, advisors should keep the full and adequate consideration element of the exception to I.R.C. § 2036 in mind and ensure that capital accounts of all partners are properly created, credited, and maintained. Consequently, if partners intend to contribute assets to the partnership that are hard to value (i.e., real estate, oil and gas interests, interests in closely held entities), it is advisable to obtain appraisals of the fair market value of those assets so that the calculation of initial ownership interests in the partnership is as accurate as possible.
Likewise, if assets subject to debt or non-liquid assets (such as real estate) are to be contributed to the partnership, the partners should make sure to fund the partnership with sufficient cash to support those assets, such that the partnership can service its debt and pay real estate taxes related to its property. Doing so may help to minimize fuel for an IRS argument that a contributing partner’s debt service or payment of maintenance costs related to assets contributed to the partnership evidences an implied agreement under I.R.C. § 2036 of that partner’s right to use those partnership assets.
Finally, when determining which assets are to be contributed to the partnership, it is important to review any transfer restrictions that might be applicable to those assets. If the documents governing a particular asset do not permit transfer of that asset without, for instance, written authorization of a certain person or entity, it is important to begin that authorization process sooner rather than later (or to avoid contributing that asset to the partnership, if it is determined that that transfer restrictions are too onerous).
First, potential partners should consider with whom they wish to be partners. Family limited partnerships often have long terms of existence. It is a good idea to consider whether partners think that they will be able to work together throughout the term of the partnership. Evidence of discussion of such considerations is helpful in establishing that the terms of the partnership agreement were negotiated, a factor that is considered, for instance, in determining whether the bona fide sale element of the exception to I.R.C. § 2036 is applicable.
On a similar note, participants should consider the health of their proposed partners. The IRS likes to point to “deathbed partnerships” as evidence of its assertion that the only reason for forming the partnership was tax avoidance. If one or more of the potential partners is seriously ill, the partners might reconsider whether to include her. See, e.g.,Estate of Strangi v. Comm’r, 115 T.C. 478 (2000) (bad health); Estate of Strangi v. Comm’r, 85 T.C.M. (CCH) 1331 (2003) (bad health); Estate of Stone v. Comm’r, 86 T.C.M. (CCH) 551 (2003) (good health). And beware forming a partnership with a person who is not competent to execute the partnership agreement himself; when determining whether partnerships were formed for bona fide, non-tax reasons, the IRS and the courts have taken into account the fact that an agent, rather than the partner, executed the formation documents. See, e.g.,Estate of Strangi v. Comm’r, 115 T.C. 478 (2000); Estate of Strangi v. Comm’r, 85 T.C.M. (CCH) 1331 (2003); Estate of Stone v. Comm’r, 86 T.C.M. (CCH) 551 (2003).
Second participants should consider whether the partners will be individual family members, trustees of trusts for family members, entities formed by family members (such as a limited liability company, or “LLC”), or some combination of any or all of the above.
In choosing partners, the participants should consider who will be able to make meaningful capital contributions to the partnership. SeeEstate of Bongard v. Comm’r, 124 T.C. 95 (2005). To the extent possible, it is preferable to have each partner make a meaningful contribution to the partnership so as to establish that a real pooling of assets and services occurred and to avoid the IRS’s argument that, for instance, a child’s proportionately small contribution had no real impact – that creation of the partnership was a “mere recycling of value,” as that term is used in Estate of Harper v. Comm’r, 83 T.C.M. (CCH) 1641 (2002). (Beware, though, the implications of the investment company rules when determining the nature and amount of the assets to be contributed to a partnership.) See, e.g., I.R.C. §§ 721, 351, 368.
Finally, in determining who the partners will be, forming partners should consider what roles each of the partners will play, if any, in partnership management. Do the partners intend to have the parent manage the partnership? Is the partnership to be used as a tool to progressively teach the next generation? Or is management to be passed immediately to the children? A parent’s considerations in this regard and a written record of those considerations can play a pivotal role in later establishing the non-tax reasons for which a partnership was formed.
It is important to hire an attorney and an accountant who are experienced in family limited partnership issues to assist in the decision-making processes, and hiring such advisors should happen sooner rather than later. The earlier that experienced advisors are is involved, the less likely the partners are to make a misstep in what can be a convoluted process. Beware simplified “kit” partnerships that do not take into account the partners’ individual reasons for and goals in forming the partnership. See, e.g., Estate of Strangi v. Comm’r, 115 T.C. 478 (2000); Estate of Strangi v. Comm’r, 85 T.C.M. (CCH) 1331 (2003); Estate of Thompson v. Comm’r, 84 T.C.M. (CCH) 374 (2002).
In the IRS’s view, and more importantly, that of the courts, it is critical that partners in a partnership respect the entity as an entity (i.e., comply with the terms of the governing partnership agreement, treat assets of the partnership as partnership assets, etc.). If the partners fail to do so, it is highly unlikely that the IRS or a court will. In that regard, it is important to dot all of the Is and cross all of the Ts. Some suggestions follow:
Although implementation of this suggestion can be expensive, having each partner represented by separate counsel goes a long way toward ensuring that the interests of each partner are considered when forming the partnership and that the terms of the partnership agreement will be reviewed by and discussed among the partners at that time. It also serves to evidence the arm’s-length nature of the creation of the partnership. See Estate of Stone v. Comm’r, 86 T.C.M (CCH) 551 (2003).
In establishing that the creation of the partnership is a bona fide sale as that term is used in I.R.C. § 2036, it is important to document any facts evidencing the arm’s-length nature of the transaction. Negotiation of the terms of the partnership agreement by the intended partners is precisely the type of evidence that can be used to establish that the bona fide sale element of the I.R.C. § 2036 exception is met, as was the case in Estate of Stone v. Comm’r, 86 T.C.M (CCH) 551 (2003). (Using a “kit” partnership may play into the hands of the IRS, as such pre-formulated documents rarely leave room for the tailoring that an attorney with experience in family partnerships can provide. See, e.g., Estate of Strangi v. Comm’r, 417 F.3d 468 (5th Cir. 2005); Estate of Thompson v. Comm’r, 84 T.C.M. (CCH) 374 (2002).
Some of the partnership agreement terms that family members might consider important to negotiate and discuss in this regard are:
Purpose – what are the family-specific reasons that this taxpayer and her family have for forming the partnership?;
Management structure – who will serve as general partner(s)? Will there be a managing partner(s)? Will unanimity be required for management decision-making if more than one person or entity is managing the partnership?;
Management powers – what actions may partnership management take without the approval or input of the other partners?;
Compensation to managers – will the general partners/managing partners be compensated? If so, at what level?;
Investment policy – what will the partnership’s investment policy be?;
Distribution policy – will the partnership make regular distributions? Will it make distributions sufficient to cover each partner’s income tax liability attributable to his partnership interest?;
Transfer restrictions – what transfer restrictions should be included in the partnership agreement? How will those transfer restrictions impact each partner?;
Partnership term – how long should the partnership stay in existence?; and
Use of partnership assets – under what terms may a partner or third party rent a partnership asset?
Most partnership agreements refer to an attachment, schedule, or exhibit that is intended to list all of the assets that the partners agree to contribute to the partnership at formation and the resulting partnership interests to be received by the partners in return. In some states, such attachments are required by statute; and in some of those states, the attachments must also detail the fair market value of the assets to be contributed. In combating IRS arguments that the formalities of a partnership were not respected, it is important that any such attachments to a partnership agreement be complete at the time that the partnership agreement is signed. And in order to best anticipate questions in audit, such attachments should accurately set forth the assets contributed to the partnership, the fair market value of those assets, and the resulting ownership interests of each partner of the partnership.
Sometimes it is impossible to know the fair market value of contributed assets – and thus the amount of the resulting percentage interests – at the time that the partnership agreement is signed. This situation can occur if, for instance, there are hard-to-value assets such as real estate for which an appraisal as of the formation date is being obtained. This can also occur with regard to securities, for which the value cannot be known until the close of business on the day of formation. If necessary, an amendment to the partnership agreement can be executed once accurate fair market values are known.
As referenced above, in disputing the IRS’s assertions that a partnership should not be respected, it is important to establish that the formalities surrounding formation (and operation) of a partnership are respected. One of those formalities is the transferring of assets to the partnership that the partners agreed to contribute when creating the partnership. In that regard, it is most efficient to have the transfer documents ready at the time that the partnership agreement is signed, so that partners can sign all of the relevant documents necessary to form the partnership agreement and transfer title to the assets into the partnership’s name all at once. Doing so also ensures that this very important step does not get overlooked.
Typically, a limited partnership is not formed until a Certificate of Limited Partnership or similar document is filed with the relevant state authority (often, the Secretary of State). Be sure to file such required documentation with the state (and obtain any state licenses or registrations) timely. Delays between the date that a partnership agreement is executed and the date that the partnership is actually formed under state law can be problematic when the IRS gets involved. See, e.g., Senda v. Comm’r, 88 T.C.M. (CCH) 8 (2004), aff’d, 433 F.3d 1044 (8th Cir. 2006); Shepherd v. Comm’r, 115 T.C. 376 (2000), aff’d, 283 F.3d 1258 (11th Cir. 2002); Estate of Erickson v. Comm’r, 93 T.C.M. (CCH) 1175 (2007); Estate of Harper v. Comm’r, 83 T.C.M. (CCH) 1641 (2002).
Likewise, in order to avoid IRS attack, once a partnership is formed, it is important to apply to the IRS for a federal employer identification number (“EIN”) as quickly as possible, e.g., as soon as the certificate of limited partnership is filed and returned by the relevant state authority. See Estate of Thompson v. Comm’r, 84 T.C.M. (CCH) 374 (2002), aff’d, Turner v. Comm’r, 382 F.3d 367 (3rd Cir. 2004). As with the failure to timely file certificates of limited partnership, the IRS has pointed to delays in obtaining EINs as evidence that partnership formalities were not respected.
It is important to set up partnership bank and brokerage accounts and transfer contributed assets to those accounts as soon as possible after formation for two reasons: first, to establish that the partnership entity is being respected by its partners and the partners understand that the partnership’s assets are just that – partnership assets; second, to ensure that any income earned on partnership assets is credited to the partnership – not to the contributing partner. Otherwise, the door is left open for the IRS to assert the applicability of I.R.C. § 2036, on the grounds that the contributing partner had an implied agreement to retain the income from the assets contributed to the partnership. See Estate of Thompson v. Comm’r, 84 T.C.M. (CCH) 374 (2002), aff’dTurner v. Comm’r, 382 F.2d 367 (3rd. Cir. 2004).
Accounting issues can make or break a court’s view of whether to respect the existence of a partnership. In that regard, it is important to hire an experienced partnership accountant who has knowledge of, among others, such partnership issues as capital accounts, the impact of distributions on partners’ basis in their partnership interests, the impact of additional capital contributions, redemptions, and sales on ownership interests, I.R.C. § 754 elections, protective claims, and audit procedures, etc.
This step is critical in establishing the existence of proof that a transfer of assets in exchange for partnership interests was for full and adequate consideration, as that term is used in the exception to the application of I.R.C. § 2036, or was not an indirect gift of the assets contributed to the partnership. To avoid IRS attack, each partner’s capital account should reflect the value of the assets that he contributed to the partnership and the percentage interest received by the partner in return. In order to refute the application of, among other theories, I.R.C. § 2036, the percentage interests received by the partners should be proportionate to the fair market value of the assets that each contributed.
The IRS consistently examines the identity of the payor of partnership set-up fees. If a partner has paid the legal and accounting fees related to creation of the entity and has not been repaid by the partnership, the IRS typically asserts that the partnership has not been respected; that, if it were truly a business entity (and not merely an entity created for tax avoidance purposes), the paying partner would have sought reimbursement by the partnership. Keep in mind that a partnership that pays for (or reimburses) set-up fees may, in most cases, deduct those fees for income tax purposes, although, depending on the amount, it may have to do so by way of amortizing them.
In order to minimize IRS attack, if assets were contributed to the partnership but the precise fair market value of some or all of those assets was not known on the date of formation (as is likely to be the case with hard-to-value assets such as real estate or mineral interests), the partnership agreement (or its attachments) should be amended as soon as information on all contributed assets becomes available. If such amendments are not made, the IRS is likely to assert that the capital accounts of the contributing partners are not proportionate to the fair market value of the assets contributed and, as a result, the exception to I.R.C. § 2036 cannot apply.
The best evidence of a taxpayer’s rationale for forming a partnership often comes from the correspondence prepared in connection with the decision to create the entity. In that regard, it is important always to keep the potential audience in mind as communications among the partners and their advisors occur. In attempting to establish the non-tax reasons for forming a partnership, it is helpful if the documentation is such that the taxpayer feels comfortable waiving the attorney-client privilege and producing requested communications that would otherwise be protected from discovery under the attorney-client privilege. Further, keep in mind that assertion of privileges may lead to negative inferences by the IRS.
It seems common sense – a legal entity has been established; thus, at the appropriate time, a tax return for the partnership must be filed, right? But what if the entity is formed on December 27? Should a tax return for those 4 days be filed? And what if the entity has no income for the first two or three years that it exists (perhaps it holds only cash and non-income producing real estate, or non-dividend paying stock)? What then?
In both examples, it may be tempting to forgo filing an income tax return. However, to minimize avenues of IRS attack, it is advantageous to file, despite the apparent lack of necessity to do so. First, partnerships often rely on the information contained in the partnership income tax return to document partners’ capital accounts. If no partnership income tax return is filed in the partnership’s first year of existence, it may be difficult to evidence that the capital accounts were properly created, reflecting the proportionate exchange of assets for partnership interests. Second, even if the partnership has no income, the IRS has been known to assert that the failure to file an income tax return reflects the partners’ intent in forming the partnership only as a transfer tax device. Consequently, despite the fact that doing so may seem unnecessary, it is advisable to file income tax returns for partnerships consistently from inception.
It is important to maintain the partnership in good standing with the relevant state authorities. It is not uncommon for IRS litigators, as their first step in reviewing a transfer tax case, to check with the state authorities for all documents on file for the relevant partnership. It is often at this stage that it is first discovered that an entity’s good standing has been revoked for the simple failure to send in annual updates or confirmations of the partnership’s address. When such revocations occur, even if for very short periods, the IRS likes to argue that such lapses indicate that the entity is an entity without any purpose other than transfer tax avoidance.
This suggestion seems only common sense. However, the IRS likes to go through partnership agreements with a fine-toothed comb. If the partners have not themselves done so, they may have neglected to comply with some of the more straightforward requirements of the partnership agreement. Consider reading the partnership agreement with a fresh eye and making a list of all periodic administrative requirements. For instance, are regular meetings required? If so, in light of the IRS’s frequent assertions that partnerships are nothing other than transfer tax avoidance devices, partners might choose to take minutes, even if not required (although continuing to keep in mind the eventual potential audience), to establish the business approach taken by the partnership. Are annual statements (other than tax returns) required? Are annual distributions required? Are payments on preferred interests required? Is documentation of the partners of the partnership required to be kept in a certain manner? In order to avoid IRS attack, it is important to ensure that partners treat the entity as a business entity and comply with the terms governing that entity.
Beware of lending from the partnership to family members. The IRS and the courts have not looked kindly on partnerships where such loans were made, particularly where the terms of the loans were either undocumented or, where documented, were not complied with. To minimize IRS attacks, any loans made by the partnership should be properly documented and should comply with the terms of the governing partnership agreement. See Estate of Thompson v. Comm’r, 84 T.C.M. (CCH) 374 (2002), aff’d, Turner v. Comm’r, 382 F.3d 367 (3rd Cir. 2004). Loan terms should be reasonable, and payments should be made timely. In addition, both the partnership and the debtor should comply with the terms of the loans, including foreclosure, if necessary. As noted in various discussions in this chapter, it is important to treat the partnership for what it is – a separate, legal entity.
In order to minimize avenues of IRS attack, and assuming that the partnership agreement requires pro rata distributions (as most do), make sure that any distributions made by the partnership are proportionate to the percentage interests held by the partners in the partnership. In cases under IRS scrutiny where non-pro rata distributions have been made (typically to the parent partner), the IRS has typically argued that the partner receiving distributions retained rights to the assets contributed to the partnership such that I.R.C. § 2036 applies. If a non-pro rata distribution has been made, consider making “make-up” distributions to the remaining partners, perhaps with interest at a reasonable rate.
Once contributed to the partnership, partnership assets belong to the partnership – not to the contributing partner and not to any of the other partners. Consequently, in order to avoid IRS scrutiny, it is important that partnership assets be treated as such. Where partners may have used partnership funds to pay for their individual expenses or used partnership real estate without contemporaneously paying rent, the IRS has often asserted the application of I.R.C. § 2036, on the grounds that there was, at a minimum, an implied agreement that the contributing partner retained the right to use the assets contributed. As discussed above, where I.R.C. § 2036 is held to apply, the existence of the partnership is essentially disregarded, and evidence as to the value of a transferred partnership interest becomes irrelevant, as it is the value of the underlying assets, rather than the partnership interest itself, on which the transfer tax is imposed.
As indicated above, it is important to keep the partnership’s assets separate from the partners’ assets. This suggestion applies as well at the death of any of the partners. Often, death causes financial hardship, in that a decedent’s assets may be frozen for the time between date of death and the date that a personal representative for the estate is appointed. If expenses of the decedent must be paid in the interim, and no one has access to the decedent’s assets, the partnership’s checking account should not be used to pay those expenses. (In such cases, despite objections that post-death facts are irrelevant to valuation of the decedent’s partnership interests, the IRS has argued that the fact that partnership funds were used to pay a decedent taxpayer’s debts is evidence of an implied agreement by the decedent to retain the right to use assets contributed to the partnership, such that I.R.C. § 2036 should apply.) If absolutely necessary, the partnership may wish to make a loan to the estate of the decedent so that the estate’s representative can take care of business. Alternatively, perhaps beneficiaries of the estate or a third‑party lending institution could loan funds to the estate.
Many factors should be taken into account when determining whether an I.R.C. § 754 election should be made when an interest in a partnership is transferred (whether by sale, by gift, or by transfer at death). One such consideration, however, is whether any transfer tax return related to the transfer may be audited by the IRS. If the return is audited, to the extent that it is finally determined that the value of any partnership interest is greater than the value reported on the estate tax return, an election by the partnership under I.R.C. § 754 may be advantageous, as it could apply to cause a step-up in the partnership’s inside basis in the decedent’s proportionate share of the partnership’s assets. Thus, any finally determined increase in value of the decedent partner’s partnership interest, where such an election has been made, may allow the partnership to seek an income tax refund related to sales of partnership assets since date of death, as any capital gains related to such sales will have been reduced. (Keep in mind that protective claims may need to be filed if the statute of limitations is close to running on the income tax returns but the examination of the transfer tax return has not been completed.)
When asserting that I.R.C. § 2036 should apply, the IRS looks for any facts that it can find to indicate an implied agreement that a taxpayer retained rights related to assets transferred to a partnership. For example, where a partnership has redeemed numerous partnership interests held by a partner, or made multiple loans, non-regular distributions, or non-pro rata distributions to that partner, the IRS may argue that the facts indicate an implied agreement that the taxpayer retained rights to the assets that he transferred to the partnership, such that I.R.C. § 2036 should apply to, in effect, disregard the existence of the partnership for valuation purposes. In order to avoid such arguments by the IRS, numerous transactions of this type between the partnership and its partners should be avoided.
As the partnership grows and the partners develop a working relationship, keep in mind the non-tax reasons that were given for forming the partnership at the outset. To the extent possible, try to implement them. Doing so can help undercut an IRS attack that the partnership was formed only for tax savings.
When partnership interests are transferred, it is a good time to review the books and records of the partnership to ensure that they are in order. Due diligence at this stage (and at all others) bolsters the position that the partnership is a respected, stand-alone entity.
Regardless of the nature of the transfer, it is also important to consider whether a transfer of a partnership interest triggers any rights of first refusal; if so, it is important in warding off IRS attacks to comply with any such transfer restrictions.
In general, it is helpful at the audit stage in particular if partnership management (and its accountants) have kept careful track of changes in partnership interests (perhaps through keeping a historical spreadsheet outlining each transfer of partnership interests) and to update the partnership books and records to reflect any such changes. Doing so concurrently with transfers assists at the audit level, as such a record provides contemporaneous evidence of the transfers and can, again, bolster the position that the partnership is an entity separate from its partners. If necessary, consider restating the applicable schedule or exhibit to the governing partnership agreement to reflect the change.
Regardless of the nature of the transfer, it is important to document the transfer of partnership interests. In order to minimize IRS attacks, such transfer documents should be executed by transferor and transferee, and the document should be dated on the date that they are signed (though the effective date may be different).
Finally, ensure that the Certificate of Limited Partnership for the partnership is amended, if necessary, and filed with the relevant state authority. Failure to do so may give the IRS room to argue that the entity was not respected by its partners.
In addition to the considerations discussed in paragraph A above, when the transfer is to occur by gift, it is important to refrain from gift planning until the partnership is formed and operating in order to avoid the indirect gift theory discussed above. See, e.g., Senda v. Comm’r, 88 T.C.M. (CCH) 8 (2004), aff’d, 433 F.3d 1044 (8th Cir. 2006); Shepherd v. Comm’r, 115 T.C. 376 (2000), aff’d, 283 F.3d 1258 (11th Cir. 2002).
When a transfer occurs by sale, be sure to consider the income tax implications of such a transfer.
When the transfer of partnership interests occurs as a result of a partner’s death, it is especially important to review the transfer to determine whether a lapse occurs under Chapter 14 of the Internal Revenue Code and to report the interest transferred accordingly. While many partnership agreements are written with an eye toward avoiding the application of Chapter 14, not all have incorporated this concept.
Further, in order to simplify estate administration and potential audit, consider maintaining the partnership interest in the hands of the Executor, subject to estate administration, until a closing letter is received from the IRS. Once an IRS closing letter is received and the partnership interest is to be transferred into the hands of the appropriate beneficiary, document the transfer from the estate to the beneficiary, and that transfer document should be executed by both the executor and the recipient beneficiary.
When a partnership interest is transferred by way of redemption from a partner by the partnership, be sure to review the partnership agreement to ensure that the partnership is not prohibited from redeeming the interest from the interest holder. Next, be sure to document the redemption, to be executed by partnership management and the transferring partner. Finally, be sure that the books and records of the partnership reflect a decrease in the transferring partner’s interest and a corresponding proportionate increase to all remaining partners’ interests. Taking these steps will help avoid IRS attack.
In order to ensure that any transfer tax return, whether Form 706 or Form 709, is prepared in a manner that is most defensible in audit, the taxpayer should engage an experienced attorney or accountant to prepare such returns.
To minimize IRS attack, the taxpayer should select an appraiser who will provide an independent and qualified appraisal of fair market value of the transferred interest. In that regard, consider whether the selected appraiser is independent from the taxpayer, is credible, is experienced in the area of partnership valuation, and has the appropriate certifications. Perhaps most importantly, the appraiser should not act as an advocate for the taxpayer.
Depending on the terms of the partnership agreement and the identity of the transferee, the interest transferred by the taxpayer may be a general partnership interest, a limited partnership interest, or an assignee interest in a limited partnership interest (and, depending on the terms of the partnership agreement, there may be classes within one or more of these types). It is important to identify the nature of the interest transferred, as each type carries with it specific rights and responsibilities that are likely to impact value.
If the transferred partnership interests include more than one class (i.e., general partnership interests and limited partnership interests), be sure to clarify with the appraiser as to whether those interests should be aggregated for valuation purposes. For instance, if a general partnership interest and a limited partnership interest are transferred by the decedent, it is likely that the interests should be aggregated. If, however, the general partnership interest is held by the decedent, and the limited partnership interest is held in a marital trust created by the decedent’s pre-deceasing spouse, the taxpayer may be able to take the position that the interests should not be aggregated. See, e.g.,Estate of Bonner v. United States, 84 F.3d 196 (5th Cir. 1996); Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981).
In opining as to fair market value, the appraiser will likely take into account numerous partnership-specific facts, such as the terms of the governing partnership agreement, the fair market value of the partnership’s underlying assets, cash flow to the partnership, and the distribution policy of partnership management. As a result, when reviewing the appraiser’s conclusions, it is important to confirm that the appraiser has properly reflected these facts in his report so that his valuation conclusions are not based on incorrect factual assumptions. (It is also helpful to make sure that a copy of the partnership agreement is included with the final appraisal, perhaps as an exhibit.)
Once the appraiser has completed his appraisal, it is helpful in defending his conclusions if, after the valuation date, the partnership is operated in the manner reported to the appraiser, for example, in such areas as the distribution policy, anticipated cash flow, etc. Arguably, post-valuation date facts are irrelevant to valuation conclusions. However, the IRS may assert that deviation from the factual assumptions by the appraiser indicate that the appraiser’s conclusions were faulty, especially if the partners anticipate at the time of the transfer that such a transaction might occur. Living with the factual information provided to the appraiser may help avoid such assertions.
If there is a reason to round value up or down, be sure that the appraiser explains his reasons in the appraisal. If the appraiser cannot explain why the value should be rounded up or down, he likely will not be able to do so on the stand either. And the courts are increasingly examining and parsing practically each and every valuation conclusion of appraisers of limited partnership interests. Unexplained rounding may cause a court to question other conclusions that the appraiser has made in the appraisal.
In early 2007, the IRS issued new settlement guidelines for matters involving limited partnerships. In those guidelines, the IRS explained that its goal was to promote consistency of approaches across different jurisdictions and that its primary modes of attack would be the indirect gift theory and I.R.C. § 2036. See Settlement Guidelines, 07 No. 020 BNA Taxcore 25.
Once the audit begins, it is particularly helpful to involve litigation counsel sooner rather than later. Doing so allows the litigator to be involved from step one, assisting in determinations related to the assertion or waiver of various privileges, responsiveness of documents and information, and consideration of the eventual burden of proof under I.R.C. § 7491.
Some corporate trustees and executors have document destruction policies. It has become advisable for attorneys whose clients are involved in litigation to ensure that their clients suspend document destruction policies. The consequence of failure to do so may include sanctions against the attorney and the client for spoliation of evidence. See, e.g., Phoenix Four, Inc., v. Strategic Resources Corp ., 2006 WL 1409413 (S.D.N.Y.).
Until the late 1990s, the burden of proof in a tax case fell on taxpayers. In other words, if a court could not decide who should win in light of the evidence, the IRS won. For examinations beginning after July 22, 1998, however, it became possible for taxpayers in certain circumstances to shift the burden of proof to the IRS, so that if a court could not decide who should win in light of the evidence, the taxpayer would win. Under I.R.C. § 7491, if a taxpayer (who is not a partnership, corporation or trust) maintains all required records under the Code and complies with the IRS’s reasonable requests for documents, information, and interviews, the burden of proof shifts to the IRS, and if a court cannot decide, the taxpayer wins. Although cases in which a court weighs the evidence and still comes down on the fence are very rare, the IRS has, in recent years, been very reluctant to agree that taxpayers meet the factual requirements of I.R.C. § 7491.
Various privileges apply in the context of estate planning, the most familiar of which is the attorney-client privilege (often referred to simply as “the privilege”). Keep in mind that the privilege is the client’s to waive, not the attorney’s. As a general rule, the privilege covers client communications made to the attorney with the purpose of seeking legal advice.
The work-product doctrine, on the other hand, protects an attorney’s thoughts and work in preparation for litigation. Contrary to common misconception, the work-product doctrine only begins to apply to an attorney’s work that is done “in anticipation of litigation.” According to the Seventh Circuit, audit can be the antechamber to litigation, and thus, the work-product doctrine may apply to an attorney’s work even during the audit process. See United States v. Frederick, 182 F.3d 496, 502 (7 th Cir. 1999).
More recently, the U.S. Congress enacted a new federal privilege under I.R.C. § 7525 – the tax practitioner’s privilege. This privilege applies only in non-criminal tax cases, and it protects from discovery communications that, if communicated to an attorney, would have been protected from discovery under the attorney-client privilege. Note, however, that in some jurisdictions, the tax practitioner’s privilege has been interpreted not to cover advice related to tax return preparation. See United States v. Frederick, 182 F.3d 496 (7 th Cir. 1999).
While privileges can be waived, and often waiver is highly recommended (particularly in cases where the IRS is asserting the application of I.R.C. § 2036), beware of subject matter waiver. Once the privilege has been waived on a particular subject matter, that waiver covers all communications on that subject matter. Unfortunately, one cannot just pick and choose to waive the privilege with regard to favorable documents.
Various privileges may apply in any given situation – the attorney-client privilege; the work product doctrine; and the tax practitioner’s privilege under I.R.C. § 7525. As discussed above, however, there are often times when, if appropriate, it is helpful if the taxpayer waives such privilege, such that documents and information that would otherwise be protected from discovery is produced. This is particularly true in estate tax cases, where the best person with personal knowledge is the decedent taxpayer – and is not available to testify.
The taxpayer’s duty is to provide responses to IRS requests that are true and correct to the best of the taxpayer’s knowledge. However, the taxpayer need only produce responsive documents in his possession, custody, or control; generally, there is no need to create documents to respond to IRS requests. If necessary, indicate in responding to the IRS that the taxpayer has no such documents in his possession, custody, or control that are responsive to the request.
As mentioned several times above, it is important to keep in mind that a judge or a jury might eventually read what is written related to the taxpayer’s planning. Anything stated or written to the IRS at this stage can be treated as an admission. Further, anything written to the appraiser or any expert may be discoverable by the IRS.
It is the taxpayer’s duty to produce responsive documents in his possession, custody, or control. While documents held by the taxpayer’s attorney, accountant, or bank are likely to be construed as within his possession, custody, or control, documents held by others may not. Be sure to consider the relationship between the taxpayer and the advisor in analyzing this issue.
Be precise when responding to the IRS. For instance, if the partnership owns primarily real estate, but has a small equity portfolio, be sure to disclose the existence of both (and in detail) when asked by the IRS for the assets of the partnership.
Particularly if litigation counsel becomes involved at some point, it is helpful to have a precise record of the documents and electronic files that have been provided to the IRS, from inception of the audit through the close of discovery. In that regard, consider Bates-labeling every page produced to the IRS, such that there is a number associated with every page. (Doing so also helps in the stipulations process, as each exhibit can be identified by Bates-label number, ensuring that everyone (including the judge) is literally on the same page.)
The IRS has a very broad power to subpoena practically any information, books, and records that it deems necessary to carry out is mission. The IRS may examine or summons a laundry list of items and people for the purpose of “ascertaining the correctness of any return, making a return where none has been made, or determining the liability of any person for any internal revenue tax.” I.R.C. § 7602(a). As might be expected, however, this broad power is subject to traditional privileges.
Keep in mind that sometimes resolutions of estate tax issues may impact income tax issues related to the partnership or the estate. Be sure to analyze whether the resolution of the estate tax issue might come too late to file a claim for refund on the income tax side. If so, you may find it necessary to file protective claims for refund to protect rights to income tax refunds that may eventually be due.
At least until the examination of the transfer tax return has been closed and the taxpayer’s tax liability finally determined, it is better if the partnership remains in place. As discussed earlier, although facts that occur after the valuation date are arguably irrelevant, the IRS does not hesitate to use those facts when doing so might result in the increase in value of the transferred interest (and resulting transfer tax); and terminating the partnership could play into the IRS’s hands in this regard.
Although interviews by the IRS can be quite informal, neither the taxpayer nor his advisors should be caught off guard. These interviews are, in essence, depositions. In order to ensure that any additional requests for documents and information are provided in writing, such interviews likely ought to be held at an advisor’s office (that of the attorney or accountant), rather than at the taxpayer’s office or home. Consider also having a court reporter present to ensure that the taxpayer’s responses are not misconstrued.
Although this article refers to limited partnerships, many of the suggestions contained herein also apply to other closely held entities, such as limited liability companies.
Keep in mind, however, that relief of the contributing partner’s debt in this regard may require consideration of income tax issues for that partner. |
