Brown & Associates - Attorneys & Counselors at Law, P.L.L.C.

TAX COURT DECIDES FAMILY LIMITED PARTNERSHIP IS A SHAM
(6/2/02)

In several of my columns over the past few months, I've talked about the availability of "lack of marketability" and "lack of control" discounts for certain entities, such as limited liability companies (LLCs) and family limited partnerships (FLPs). Among the points I stressed repeatedly was the need for you to follow the procedures set forth in the controlling documents, to make sure you complete all required actions in a timely fashion, and to document, document, document the actions as you take them.

Tax Court Rules Against Family Limited Partnership

On May 15, 2002, the U.S. Tax Court issued a decision in the case of The Estate of Harper v. Commissioner which should serve as a classic example for all of us of what not to do if we want to qualify for these entity discounts.

In Harper, the Tax Court held that an FLP was a "sham" for estate tax purposes because the senior family member failed to follow the partnership formalities set forth in the family limited partnership (FLP) agreement. As a result, it held that all partnership assets would be included in his estate for estate tax purposes, even though he had gifted over 60% of his limited partnership interests to his children.

Let's see where Mr. Harper went wrong.

What Happened-The Facts

Harper formed the FLP in 1994 when he was 85 and suffering from colon cancer. His revocable trust owned a 99% limited partnership interest in the FLP and his children owned the 1% general partnership interest. The partnership agreement was dated January 1, 1994, but Harper didn't file the Certificate of Limited Partnership with the Secretary of State's Office until June, 1994, some six months later.

Then, on July 1, 1994, Harper transferred 60% of his limited partnership interest to his two children. This wasn't a "pure" transfer, however. The transfer document guaranteed Harper preferred payments from the partnership equal to 4.25% of its value each quarter. This makes the transfer seem akin to a guaranteed annuity, not a simple transfer.

Did I forget to mention that Harper was an attorney who knew, or should have known, what was required to accomplish the tax saving purposes of this FLP? It reminds me of the old saw that an attorney who defends himself has a fool for a client.

Mistakes Abound

The first mistake Harper made was failing to document how the children acquired their 1% general partnership interest in the first place. The operating agreement indicated Harper contributed $1.7 million in marketable securities, closely held stock, and a promissory note to the FLP. Harper contributed everything he had except a checking account, his car and a condominium. For this, he received a 99% limited partnership interest in the FLP. Up to this point, everything is fine. Unfortunately, there isn't anything to show what, if anything, his children contributed in exchange for their 1% general partnership interest. This makes this agreement suspect from its inception. At the least, Harper should have "gifted" some of his investments to his children and then they jointly could have transferred them to the FLP. This gift to the children could have been documented with gifting letters, receipts, and a timely filed Form 709 Gift Tax Return. These, at least, would have created a presumption of legitimacy which the IRS would have had to challenge.

The second problem was Harper failed to document his own contributions in a timely manner. All though the agreement referred to Harper's contribution of his "portfolio," he didn't document any contributions until September and didn't finish transferring his property to the FLP until November, eleven months later.

Next, Harper failed to establish the legal identity of the FLP until September when he finally applied for and received its employer identification number. Even then, he didn't open a bank account or transfer his assets from his revocable trust to the FLP. He continued to have the income from these assets deposited into his trust's bank account.

Harper died in February, 1995, owning a 39% limited partnership interest in the FLP and virtually nothing else. During the three months preceding his death and for nine months thereafter, the FLP made random distributions which bore no relationship to the parties' respective ownership interests. Even this wouldn't have been so bad if the parties' ownership interests and individual capital accounts had been adjusted to reflect these non-pro rata distributions. Not surprising, they weren't.

What Happens if you don't "Follow Through"

I won't bore you with the entire decision which runs to some seventy-five pages. I felt it might be worthwhile, however, to examine some of the points made by Judge Nimns, who held that because of all these mistakes-the failure to segregate funds, the disproportionate distributions, the late contribution of assets to the FLP, the apparent backdating of documents, and the fact that the FLP wound up with all of Harper's assets-destroyed its character as a true FLP.

Judge Nimns found this was an attempt by Harper to leave his property to his children at his death and avoid paying estate taxes on the transfer. He looked through the "sham" FLP and ruled that the partnership was really a testamentary arrangement and all of the assets would be included in Harper's taxable estate under Section 2036 of the Internal Revenue Code.

If you're interested in some light bedside reading, this decision can be found on the US Tax Court's website. Go to http://www.ustaxcourt.gov and click on the historical cases section. Insert the date of the decision, May 15, 2002, and the name "Harper" and you're there.

If you're going to set up an FLP or LLC as a business, run it like a business. FLPs, LLCs, and revocable trusts can be useful estate and tax planning devices, but only when they are properly established and maintained. If you aren't sure if you're doing everything you should be, consult with a professional who can review your documents and procedures and, if necessary, point you in the right direction.

To return to the Strategic Planning Articles click here.