Saving Estate Tax with a Family Limited Partnership

In order to reduce your potential estate tax you must reduce your taxable estate. One customary way to reduce your estate is to make gifts to your ultimate beneficiaries such as your children and grandchildren. Removing an asset from your taxable estate by gift though, will generally require you to part with all dominion and control of the gifted asset. Gifting interests in a Family Limited Partnership which owns the assets that you wish to transfer to your beneficiaries when, properly structured, will remove the assets including appreciation (at a discounted value) from your taxable estate while allowing you to retain control of the assets.

A Family Limited Partnership (FLP) is nothing more than a traditional limited partnership with the donor and the donor’s family members as the general and limited partners. A Limited Liability Company (LLC) is synonymous with a partnership for this purpose since an LLC can be taxed as if it were a partnership. Limited partners by law have no say in the operation and management of any limited partnership which accounts for the discount in value of their partnership interest. General partners control the operation of a limited partnership regardless of their percentage of ownership.

A typical FLP might be organized and operated in the following manner. Donor transfers an asset worth $1,000,000 to a newly created FLP in exchange for a 1% general partnership interest and a 99% limited partnership interest. Donor immediately gifts the 99% limited partnership interest to his children, retaining the 1% general partnership interest. Donor dies 10 years later when the asset is worth $2,000,000. Had Donor gifted 99% of the asset directly to his children, the value of the gift would have been $999,000. Since the children have no control over the asset, the value of the gifted limited partnership interest can be discounted for gift tax purposes. Properly structured and operated it is reasonable to assume the IRS would accept a discount for lack of control and marketability of at least 35%. The value for gift tax purposes of the limited partnership interest assuming a 35% discount would be $643,500. Assuming Donor retains control of the asset until death by retaining the 1% general partnership interest, he or she has removed $1,980,000 from his or her estate at a gift tax cost of only $643,500.

The IRS and Congress have been increasingly concerned with this estate tax saving opportunity. IRS has repeatedly challenged what it believes to be the abusive use of Family Limited Partnerships. The kind of asset transferred to the FLP can be an issue. If marketable securities are the only asset, one can expect IRS scrutiny. At this point though, funding the FLP with something like a rental property appears to be safe.An IRS challenge can also be expected if the FLP fails to operate as such. For example, if the 1% general partner in our example receives distributions in excess of his or her ownership percentage, IRS can be expected to object.

The amount of minority or lack of marketability discounts continues to be an issue. A review of the case law and my personal experience leads me to feel comfortable with a combined discount of 35% when indicated by a sufficient appraisal. The courts have delineated the factors which constitute a sufficient appraisal. A potential donor would be well advised to engage an appraiser conversant with these factors.

Certain members of Congress are interested in legislating away this tax saving opportunity. The “Certain Estate Tax Relief Act of 2009” would eliminate discounts to Family Limited Partnerships as a matter of course. Nevertheless, unless this bill is passed and made retroactive, properly formed and operated, transfers to and gifts of FLP interests are an effective way to reduce estate tax while retaining control of the transferred assets. As always, an attorney well versed in these provisions should be consulted.

Roth Conversions

The advantages of a Roth IRA over a Traditional IRA or 401(k) plan have been well documented. Withdrawals from Roth IRAs (including untaxed earnings) are generally not taxable. Furthermore, unlike other tax deferred arrangements, mandatory distributions upon attaining age 70 ½ are not required from a Roth IRA.

Unfortunately, many people have not been able to take advantage of this tax saving opportunity. If your income exceeds certain levels ($176,000 for joint filers, $10,000 for married filing separately filers and $120,000 for all others) you cannot make a direct contribution to a Roth IRA. You cannot convert a Traditional IRA or 401(k) to a Roth IRA before 2010 if your income exceeds $100,000 or you are married but file separately.

Beginning in 2010 though, you will be able to convert a traditional IRA or in some circumstances your balance in a 401(k) plan to a Roth IRA regardless of your income or filing status. Income tax will be due on the conversion of pre tax contributions and earnings, but for 2010 conversions only, one half of tax will be due on your 2011 return and one half on your 2012 return. Taxable income will be accelerated though to the extent you make distributions from the Roth IRA before 2012.

There are several planning opportunities available in 2009 for those who plan to convert in 2010 or later. As previously mentioned, higher income taxpayers are not eligible to make direct contributions to a Roth IRA. Such taxpayers can make non deductible contributions to a traditional IRA before converting this account to a Roth effectively avoiding the Roth income limitation. Please be advised though that you cannot roll over just after tax contributions. A partial rollover is deemed to be a proportionate amount of pre tax and after tax dollars. All traditional IRAs are considered one for this purpose regardless of which IRA is to be converted.

Another planning opportunity exists for participants in a 401(k) plan. Since 2008, otherwise eligible participants can directly roll 401(k) balances into a Roth IRA if the plan so allows. This opportunity also effectively avoids the Roth income limitation.

If you are planning to convert in 2010, you may also want to consider accelerating 2010 income to 2009 and deferring 2009 tax deductions to 2010 where possible in order to even tax brackets as much as possible.

Whether a Roth conversion is beneficial depends upon a number of factors such as your post retirement income tax rate, your state income tax rules and the length of time your money will remain in the Roth IRA. While these considerations are complex, within certain time limits you may be able to reverse a Roth conversion. As always, you should consult your CPA, attorney or financial advisor to help you plan for this potential retirement savings opportunity.

Garnett Decision Rejects Treatment of Losses from LLC and LLP Interests as Presumptively Passive

The passive activity loss rules in general prevent individuals and certain other taxpayers from deducting passive activity losses against non-passive income. In most cases whether an activity is passive depends on whether the taxpayer materially participates in it. In the case of limited partnerships, Code Section 469(h)(2) treats a taxpayer with a limited partner interest as not materially participating in the partnership’s activity except as provided in regulations (the “per se rule”). Those regulations in turn allow a limited partner to establish material participation, but only by using one of three tests—the 500 hours-per-year test, the test that requires material participation during five of the preceding ten years, or the test that requires three prior years of material participation in the case of a personal service activity. Temp.Reg.Sec. 1.469-5T(e). Were it not for the per se rule, the taxpayer could establish material participation under any of those tests or any of four additional tests—one of which allows aggregation of “significant participation activities” to achieve 500 hours of participation. Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009) holds, based on an analysis of state law governing the limited liability companies (“LLCs”) and limited liability partnerships (“LLPs”) at issue in the case, that interests in those entities are not subject to the per se rule. As a result, the taxpayers in the case are allowed to use any of the seven regulatory tests for material participation. The court reached the same conclusion with respect to certain interests of the taxpayers as tenants-in-common in rental properties.

The taxpayers in Garnett owned direct or indirect interests in seven LLPs and two LLCs engaged in various agricultural businesses. Under applicable state law, they had no personal liability for obligations of the entities. The IRS argued that such limited liability made the taxpayers’ interests limited partner interests for purposes of the per se rule. The Tax Court, however, pointed to the “general partner exception” of Section 1.469-5T(e)(3)(ii) under which an individual’s partnership interest is not treated as a limited partner interest if the individual is a general partner at all times during the relevant tax year. While that provision is aimed primarily at situations where the individual is both a general and a limited partner in the same partnership, the court found that the exception by its own terms is not limited to such dual-status cases. Noting the lack of a statutory or regulatory definition of “general partner”, the court looked to the legislative history of Section 469, which justifies the per se rule on the basis of state law principles that preclude a limited partner from participating in a partnership’s business while retaining limited liability protection. The court therefore concluded that the state law prohibition against limited partner participation in the partnership’s business—rather than limited liability—is the defining characteristic of a limited partner interest for purposes of the per se rule. Turning to the law of the state of formation of the entities (Iowa), the court noted that—in contrast to restrictions on the activities of limited partners—members of LLCs and LLPs can participate in management. Accordingly, the court concluded that taxpayers held their interests in the LLPs and LLCs as general partners for purposes of the per se rule. While the court acknowledged that a factual inquiry into the authority of taxpayers to act on behalf of their LLCs and LLPs may be appropriate in the context of determining material participation, it found such an inquiry unnecessary to determine the application of Section 469(h)(2).

Less than a month after the Garnett decision, the U.S. Court of Federal Claims decided Thompson v. U.S., 2009 TNT 138-4 (July 20, 2009), which also holds that an interest in an LLC is not an interest as a limited partner for purposes of the per se rule. While the court acknowledged certain legislative history suggesting that Treasury may have regulatory authority to treat “substantially equivalent entities” as limited partnerships for purposes of the per se rule, it found that an LLC is not such an entity. Whereas the Thompson decision is a final judgment while the Garnett decision is for partial summary judgment, should the government decide to appeal both cases it is likely the Thompson case would be decided first on appeal.

The Garnett and Thompson decisions may also benefit a real estate professional who qualifies for the “real property business” exception to the general rule that treats rental activities as automatically passive (Code Section 469(c)(2) and (c)(7)). This is because a real estate professional who holds an interest as a limited partner must still apply the per se rule before determining material participation (subject to a narrow de minimis exception contained in Treas.Reg.Sec. 1.469-9(f)(2)).

It is unclear what effect, if any, Garnett and Thompson may have on application of the self-employment tax to members of LLCs and LLPs. In this regard Code Section 1402(a)(13) excludes from self-employment earnings the distributive share of income of a limited partner, subject to an exception for certain guaranteed payments. Complicating any inquiry into this area are longstanding proposed regulations that create a separate series of tests for determining whether a taxpayer is a limited partner for self-employment tax purposes—tests relied upon today by some practitioners despite their status as proposed regulations. See Prop.Treas.Reg.Sec. 1.1402(a)-2(h).

Contributed by Glenn Madere, Esq. Glenn Madere is the Editor of The Readable Code and Regs: Partnerships (Blue Bell, PA: Readable Press, 2009)   Readable Press Website