NEW
FAMILY LIMITED PARTNERSHIP AND
FAMILY LIMITED LIABILITY COMPANY CASES
Numerous
family limited partnership tax cases have been decided
in recent years. These cases have involved both substantive
tax law issues (whether the FLP qualifies for discounts)
and valuation issues (how much discount should be
allowed). Interestingly, the taxpayers have won most
of the substantive law cases and the valuation issues
are often compromised by either the court or the parties.
However, three recent cases deserve special comment.
Strangi
II Case
This
recent Tax Court case (May 29, 2003), illustrates
the old maxim that bad facts make bad law. Mr. Strangi
was in very poor health, and two months before his
death his son-in-law, pursuant to a power of attorney,
created a family limited partnership. All of Mr. Strangi's
assets were transferred to the partnership, including
his residence. The general partner of the partnership
was a corporation in which Mr. Strangi owned a forty-seven
percent stock interest. The remaining fifty-three
percent interest was owned by Mr. Strangi's daughter
and grandchildren. The general partner hired the son-in-law
to manage both the partnership and the corporation.
During the remainder of Mr. Strangi's life and after
his death, a number of Mr. Strangi's personal expenses
were paid directly from the partnership.
On
these facts, a single Tax Court judge issued a memorandum
decision which is the first case to hold that both
I.R.C. § 2036(a)(1) and (a)(2) applied to a FLP.
As a result, the undiscounted value of all of the
transferred assets was included in Mr. Strangi's gross
estate for federal estate tax purposes.
Mr.
Strangi's Retention of Income From the FLP.
Under
the first of these subsections, (a)(1), transferred
assets will be included in the decedent's estate,
without discount, if the decedent retained the income
from or enjoyment of the assets during the decedent's
lifetime. The Tax Court judge held that the facts
of this situation established an implied agreement
between the decedent and his son-in-law that Mr. Strangi
would retain a beneficial interest in the income from
the partnership.
Most
commentators agree that this decision was correct,
and such inclusion can be easily avoided by the correct
implementation of an FLP or FLLC. Commentators make
the following recommendations:
· |
do
not transfer so much of the donor's assets that
the donor cannot continue to live in accustomed
manner without distributions from the entity in
excess of distributions that would be considered
normal for the type of assets held by the entity; |
· |
do not make non-pro rata distributions to owners; |
· |
do
not commingle the entity's funds with personal
funds; |
· |
keep
accurate records reflecting the operating agreement
and the entity's operations; |
· |
the
GP/manager should actively manage assets in the
entity; |
· |
comply
with all formalities imposed by state law; |
· |
comply
with partnership/operating agreement in every
respect or amend the agreement to reflect changes
in circumstances; |
· |
retitle
all assets transferred to entity; |
· |
personal
use assets should not be contributed to entity;
and |
· |
contributions from other family members are
helpful. |
Mr.
Strangi's Retention of Control of Beneficial Enjoyment. The
Tax Court's more controversial holding relates to
I.R.C. § 2036(a)(2). This subsection includes
all the transferred assets in the donor's estate,
without discount, if the donor has retained the right,
either alone or in conjunction with any other person
(who may even be adverse) to designate the persons
who shall possess or enjoy the property or its income.
Some commentators suggest it may be enough if the
control is only over the timing of the beneficiary's
enjoyment.
The
concern here is that if the donor is the general partner/manager,
or one of a group of general partners/managers, or
owns an interest in an entity which is the GP/manager,
then through management decisions the donor could
affect a beneficiary's enjoyment of the assets. This
follows because the GP/manager makes decisions concerning
the distribution of FLP/FLLC profits or assets to
partners/members.
Further,
even a limited partner or non-manager member usually
has the right to vote concerning liquidation of the
FLP/FLLC.
Most
agreements state that the entity cannot be liquidated
unless all of the partners/members agree. The Strangi
judge stated that such a right to vote on liquidation
is a legal right under subsection (a)(2) which affects
enjoyment of assets.
The
Bottom Line Concern: If the donor retains
any GP/manager or LP/non-manager member interest in
the FLP or FLLC, then one interpretation of the Strangi
holding is that all of the transferred assets will
be included in the donor's estate without discount.
For example, a donor could contribute substantial
assets to an FLLC, give away all interests except
a one percent manager interest, and at the donor's
death all such assets may be included back in the
donor's estate without discount.
Commentators
differ as to how much significance should be given
to the Strangi case holding with respect to subsection
(a)(2). The decision is only by a single Tax Court
judge and has not been reviewed by the full court
nor by appellate courts. Some commentators think that
the extreme facts of this death-bed planning, which
involved the transfer of almost all his assets and
the partnership payment of personal expenses, all
combined to influence the Tax Court judge in the decision
and breadth of the judge's application of the law.
However,
other commentators conclude that the subsection (a)(2)
holding should be respected until it is either reversed
or not followed by other courts. These commentators
stress that immediate planning should be accomplished
to avoid the application of the Strangi decision to
a client's FLP/FLLC. A number of techniques are available
to do to this. These planning techniques include certain
combinations of the following:
· |
Amending
certain relevant language in the partnership/operating
agreement; |
· |
Giving
away all FLP/FLLC interests; |
· |
Changing
voting power of interests; |
· |
Making
incomplete gifts to trusts; |
· |
Have
several family members make significant contributions
to the entity at formation; |
· |
Gifting
all interests to spouse, at formation. |
Review
of Your FLP/FLLC.
If you have formed a FLP or an FLLC, we recommend
that a conference be scheduled with our office to
review its implementation in view of the Strangi II
case. At that time, you can decide whether to use
the above-referenced approaches to avoid the implications
of the Tax Court decision.
Hackl
Case
Hackl
v. Commissioner is over one year old but deserves
review here. Often, the older generation will desire
to make annual exclusion gifts (tax-free gifts of
up to $11,000 per year) to their children and grandchildren.
Hackl involved a family limited partnership which
contained assets that produced long-term growth but
little annual income. The general partner was given
substantial discretion to decide when to make distributions.
As a result, the Tax Court held that gifts of partnership
interests did not qualify for tax-free annual exclusion
gifting. The court reasoned that such interests were
not “present interests” but rather were
future interests. Only present interests qualify for
tax-free annual exclusion gifting.
In
view of Hackl, if you desire to make annual exclusion
gifts of interests in your family limited liability
company (“FLLC”), we recommend that your
FLLC operating agreement be amended. Language will
be added which will give each recipient of a gifted
interest the right to sell the interest back to the
FLLC for its fair market value. This right will end
after thirty days. As a result, each recipient will
have a “present interest” for a thirty-day
period. This should be enough to qualify the gift
as a present interest pursuant to case law in the
Ninth Circuit.
McCord
Case
Good
news here. Many tax minimization approaches involve
the gifting or sale of family limited liability company
interests. The valuation of these interests is determined
by using various applicable discounts. The IRS may
challenge such valuation. If the challenge is successful,
then gift tax liability will result.
As
a backup safety device, sophisticated planners use
what is called “ value definition” clause.
That is, the amount which is transferred is defined
in terms of a certain value. If the value of the transferred
assets turns out to be greater than expected, the
excess is returned to the transferor or given to charity.
Up
until now, there has not been any case law dealing
with such a value definition clause. The McCord case,
decided by the Tax Court on May 14, 2003, was the
first such decision. There is good news and bad news.
First, the bad news is that the court held that the
type of value definition clause used in that case
did not work. However, the good news is the court
stated that if the value definition clause had been
drafted differently and implemented correctly, then
the Tax Court “might have reached a different
result.” This is very encouraging for a variety
of transactions that have used the language referred
to by the court and have been implemented through
the use of a trust.
Adjust
to Changing Law.
As
we have discussed with you before, the tax law is
a moving target. Our job is to assist you in making
adjustments to your planning so that it complies with
the present law. If you have used family limited partnerships
or family limited liability companies in your estate
planning, they should be reviewed periodically. Amendments
may need to be made to your documents. The implementation
of your FLP or FLLC should be discussed and adjusted
to meet existing case law.

NEW
2003 LEGISLATION:ALASKA TRUST LAW CHANGES
The
Alaska Legislature has adopted a number of provisions
which clarify and improve the Alaska Trust Act. This
Act was enacted in 1997 and one of its innovations
was to authorize the use of self-settled discretionary
spendthrift trusts (SSDS Trusts). This type of irrevocable
trust authorizes an independent trustee, in such trustee's
absolute discretion, to make distributions to a class
of beneficiaries that includes the settlors. Creditors
of a beneficiary (including creditors of the settlor/beneficiary)
are prohibited from reaching the assets of the trust.
Delaware immediately followed Alaska in 1997. Rhode
Island and Nevada enacted similar statutes in 1999.
Utah has enacted a similar statute in 2003. Therefore,
now ten percent of the states have these types of
statutes. In Alaska, a number of collateral implementing
provisions have been enacted during the last five
years. In this 2003 legislative session, the Alaska
Legislature has accomplished a significant re-write
of key provisions of the Act.
Statute
of Limitations. Perhaps the most novel new
provisions relate to the statute of limitations for
fraudulent conveyances. All of the five states' self-settled
discre-tionary spendthrift trust acts provide that
a fraudulent conveyance to a SSDS Trust will not be
effective. However, existing statutes, and case law
from other states, have created a great deal of uncertainty
concerning whether a conveyance will be considered
fraudulent, and when the statute of limitations runs
with respect to such claims. Alaska's first change
narrows the definition of what will be considered
a fraudulent conveyance. The Legislature deleted the
language “was intended in whole or in part to
hinder, delay, or defraud creditors or other persons,”
and replaced it with “was made with the intent
to defraud [a creditor of the settlor].” The
terms “in whole or in part” and “hinder,
delay” were considered too ambiguous to allow
for consistent application.
Definitions
of Existing and Future Creditors. The Alaska
Legislature clarified the distinction between an existing
and a future creditor. This distinction is important
because an existing creditor can assert a fraudulent
conveyance claim within the later of four years after
transfer to the trust is made, or one year after the
transfer is or reasonably could have been discovered
by the creditor. A future creditor may only bring
a fraudulent conveyance claim within four years after
transfer to the trust is made.
The
new Act limits the definition of an existing creditor
to a creditor who: “(1) can demonstrate, by
a preponderance of the evidence, that the creditor
asserted a specific claim against the settlor before
the transfer; or (2) files another action, other than
a fraudulent conveyance action, against the settlor
that asserts a claim based on an act or omission of
the settlor that occurred before the transfer, and
the action described in this sub-subparagraph is filed
within four years after the transfer.” These
new fraudulent conveyance provisions should provide
much greater certainty concerning the fraudulent conveyance
exception, and a settlor should know within four years
of a transfer whether a creditor can attempt to challenge
a transfer as fraudulent.
New
Affidavit Requirement. In a related improve-ment,
the Alaska Legislature decided to strengthen the Act
so as to minimize and hopefully eliminate the use
of these provisions for fraudulent transfers. Therefore,
the Legislature enacted a provision which states that
a settlor who creates a SSDS Trust must sign a sworn
affidavit before the settlor transfers assets to the
trust. The affidavit must state that: “(1) the
settlor has full right, title, and authority to transfer
the assets to the trust; (2) the transfer of the assets
to the trust will not render the settlor insolvent;
(3) the settlor does not intend to defraud a creditor
by transferring the assets to the trust; (4) the settlor
does not have any pending or threatened court actions
against the settlor, except for those court actions
identified by the settlor on an attachment to the
affidavit; (5) the settlor is not involved in any
administrative proceedings, except for those administrative
proceedings identified on an attachment to the affidavit;
(6) at the time of the transfer of the assets to the
trust, the settlor is not currently in default of
a child support obligation by more than thirty (30)
days; (7) the settlor does not contemplate filing
for relief under the provisions of 11 U.S.C. (Bankruptcy
Code); and (8) the assets being transferred to the
trust were not derived from unlawful activities.”
This new provision should protect both settlors and
their professional advisors. This new affidavit requirement
applies to all trusts created after October 8, 2003.
No
Implied Agreements. A significant concern
when designing a SSDS Trust is whether the use of
a non-corporate trustee will endanger the status of
the trust. The concern is that a court may find that
there is an agreement between the settlor and such
individual that the trustee will exercise authority
in a manner desired by the settlor. A new statute
has added a provision stating that “an agreement
or understanding, express or implied, between the
settlor and the trustee that attempts to grant or
permit the retention of greater rights or authority
than is stated in the trust instrument is void.”
In
addition to the above-described provisions which are
primarily applicable to self-settled discretionary
spendthrift trusts, the Legislature adopted several
new statutes that assist in the implementation of
all trusts.
Beneficiaries'
Use of Trust Assets. The new provi-sions
also clarify that the spendthrift trust protection
of a trust applies even though a beneficiary (including
the settlor) may use or occupy real property or tangible
personal property owned by the trust, if such use
or occupancy is in accordance with the trustee's discretionary
authority.
Trust
Protectors and Advisors. Two trust positions
are now expressly authorized by the new statutory
provisions: trust protectors and trustee advisors.
The
new statute defines a “trust protector”
as a disinterested third party whose powers may include:
the power to remove and appoint a trustee, the power
to modify or amend the trust instrument to achieve
favorable tax results, the power to increase or decrease
the interests of a beneficiary, and the power to modify
the terms of a power of appointment.
A
“trustee advisor” will not be liable for
the advice provided the trustee and will not be considered
a fiduciary. The trustee is not required to follow
the advice of such an advisor. The Act expressly states
that the spendthrift protection of a self-settled
discretionary spendthrift trust applies to a settlor
even if the settlor serves as a co-trustee or as an
advisor to the trustee, as long as the settlor does
not have a trustee power over discretionary distributions.
Also, such protection applies even if the settlor
has the power to appoint a trust protector or a trustee
advisor. Similarly, such spendthrift protection applies
to a beneficiary who is not the settlor, even if such
beneficiary serves as a sole trustee, co-trustee,
or a trustee advisor.
Powers
of Appointment. The new provisions expressly
state that property subject to a power of appointment
is not subject to the claims of the creditors of the
donee of the power, except to the extent that the
power is a general power and the donee has effectively
exercised the general power in favor of the donee,
the creditors of the donee, the donee's estate, or
the creditors of the donee's estate.
The
above-described new trust provisions apply to all
existing trusts as well as all future trusts. However,
the affidavit provision, described above, only applies
to new trusts after the effective date of these amendments.

NEW
2003 ALASKA LEGISLATION:UNIFORM PRINCIPAL AND INCOME
ACT
Alaska
has updated its estate and trust legislation by enacting
a version of the 1997 Uniform Principal and Income
Act. Alaska's prior provisions in this area were based
upon the 1962 uniform act. The new provisions are
designed to implement another uniform act, the Uniform
Prudent Investor Act of 1994, which Alaska adopted
in 1998. The Uniform Prudent Investor Act emphasizes
diversity of investments and obtaining a total return
from all investments. Investing in order to maximize
a total return can create a conflict between income
beneficiaries and remainder-persons who receive the
principal of the trust at a future date. As is discussed
below, Alaska's new act provides two solutions to
this conflict.
In
addition, the updated Uniform Principal and Income
Act contains modern concepts relating to investment
vehicles and business entities. New concerns, such
as environmental laws, are covered by the Act. The
new Uniform Principal and Income Act also spells out
timing and allocation rules.
Alaska's
version of the 1997 Uniform Principal and Income Act
adds changes adopted by Pennsylvania in 2002. Pennsylvania
attorneys generously worked with Alaska attorneys
to add technical corrections which improved Pennsylvania's
original provisions. Alaska also added a change relating
to allocating income to pecuniary bequests. Alaska's
new Uniform Principal and Income Act applies to trusts
existing on September 1, 2003, and to the estate of
a decedent who dies on or after that date.
Default
Rules. The Uniform Principal and Income Act
provides default rules for the allocation of principal
and income. That means that if subjects are not covered
in the will or trust, then the Act's default rules
apply. However, we can draft different provisions
and they will control. Often, we will be satisfied
with the Act's default rules, and they automatically
become a "part of" our wills and trusts.
Why
Are These Rules Important to Us- The distinction
between income and principal is important for a number
of reasons. For example, various estate and trust
federal income tax computations are dependent upon
how state law characterizes income and principal.
Marital trusts created in our estate planning may
require that all income be distributed to the surviving
spouse. Dispositive plans may direct that income from
a trust be distributed to certain beneficiaries and,
after a certain date or after the income beneficiaries'
deaths, that principal be distributed to other beneficiaries.
Subchapter S trusts require that all income be distributed
to one beneficiary. As is discussed more below, income
may need to be allocated during a period of administration
to pecuniary gifts. There are many other examples.
Two
Approaches to Resolve the Inherent Conflict Between
Income Beneficiaries and Remainderpersons. Several
important areas of Alaska's Act deserve emphasis.
The Act recognizes that a trustee's goal of maximizing
total return from trust assets is made difficult by
the conflicting interests of income and principal
beneficiaries. For example, an income beneficiary
will desire that trust assets be invested in income-producing
assets, such as bonds, in order to maximize annual
income. In contrast, the principal beneficiary will
desire that trust assets be invested in assets which
have long-term growth potential, such as stocks. The
1997 Uniform Act, as enacted by Alaska, includes the
trustee's power to adjust. This allows the trustee
to annually allocate some principal to income, or
vice versa, in order to provide fair and reasonable
allocations for both types of beneficiaries.
There
is another solution to the above-described inherent
conflict. For new trusts, instead of defining “income”
as the net income earned from assets, it may be defined
as a percentage of the assets of the trust, valued
annually. This is called a unitrust. The trustee may
then focus the trustee's efforts upon total return
from the trust assets. Whether they are invested in
income-producing assets or long-term growth assets,
the “income beneficiaries'” annual distribution
will be a certain percentage of those assets.
This
unitrust concept is relatively new in the estate planning
area. Many trusts exist which are of the older type
which allocate all annual net income to one beneficiary,
with the principal ultimately going to others. Pennsylvania's
version of the Uniform Principal and Income Act, which
was followed by Alaska, allows the trustee to convert
such a trust to a unitrust. The trustee must give
notice of the planned conversion to both income beneficiaries
and the remainderpersons. If a beneficiary objects
to the conversion, the trustee may petition the court
to approve it. Alternatively, a beneficiary may petition
the court to require the trustee to convert to a unitrust.
Once converted, “income” in the governing
instrument means an annual distribution equal to four
percent of the trust assets. The trustee or a beneficiary
may petition the court to select a different payout
percentage.
IRS
Position. The IRS has approved both the power
to adjust and the conversion to a unitrust approaches
in proposed regulations. [Prop. Reg. § 1.643(b)-1.]
It is hoped that these proposed regulations will be
finalized by the end of 2003. However, a theoretical
issue exists with respect to converting existing trusts
to unitrusts. In 2002, the IRS issued a private letter
ruling which concerned many of the experts who participated
in the drafting of statutes which allow for the conversion
to unitrusts. In PLR 200231011, the conversion of
a grandchild's income interest to a seven percent
unitrust interest was found by the IRS to be a taxable
event for income tax purposes. In the private letter
ruling situation, a dispute between income and principal
beneficiaries was settled by modification of the trust.
Many
experts now think that the IRS will not pursue such
a taxable event approach with respect to the conversion
of income trusts to unitrusts pursuant to an express
state statute. However, it will be prudent not to
convert trusts to unitrusts until the IRS' position
is clarified.
Allocation
of Income to Pecuniary Gifts. Many wills
and trusts contain provisions gifting pecuniary amounts.
For example, “$10,000 to my grandchild”
or “ten percent of my gross estate to my daughter.”
Some marital trusts are designed to be certain amounts
and therefore pecuniary gifts. In the past, Alaska
has had statutes which allocate income earned during
a period of estate or trust administration to such
pecuniary gifts. More recently, Alaska has had a statute
which provided that interest must be paid on such
gifts during a period of administration. However,
the IRS has taken the position that such interest
is nondeductible personal interest expense. [Reg.
§ 1.663(c)-(5), example 7.] Therefore, Alaska
decided to “clean up” this problem area
in its new uniform act. The new provision now requires
that a share of net income earned during administration
will be allocated to all pecuniary gifts. Alaska's
old interest statute was repealed.
This new provision may be burdensome for small pecuniary
gifts which will be distributed at a relatively early
time during an estate or trust administration. Consideration
was given to providing an exception to income allocation
for the payment of certain gifts during a certain
time period (for example, one year). However, there
was concern that such an exception might endanger
the marital deduction, would eliminate one approach
for qualification of allocation of GST exemption amounts,
and might produce unintended gift results if an income
beneficiary/trustee was making the decision of when
to pay such pecuniary gifts. Therefore, it was decided
that a broad income allocation rule be adopted. If
a contrary result is desired with respect to certain
pecuniary gifts, then this can be expressly stated
in the will or trust.
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