Family controlled entities, which often take the form of a limited partnership or limited liability company, (FLP) are useful estate planning tools to help consolidate the ownership of multiple assets into one or more investment entities. The FLP is treated as disregarded a entity for income tax purposes and also provides estate tax advantages by allowing for substantial valuation discounts of the fair market value of those investments. As part of this strategy, a family member contributes an asset to the FLP and then subsequently gifts fractional interests in the FLP to other family members. Because these fractional interests generally have limited control over the assets, are not liquid or marketable, and often may be limited in other ways based upon the entity documents, the fractional interests are valued at a 20% – 40% discount rate. This discount is significant because it allows the FLP creator to transfer high value assets while also reducing the reportable amounts for gift and estate tax purposes.
Given the substantial benefit a FLP provides for estate and gift tax purposes, it is not surprising that the IRS is starting to more heavily scrutinize such transactions and is also taking steps to limit the amount of valuation discounts. If a discount is given due to restrictions on the property, the IRS will look to whether the following three threshold elements are met in determining the value of the transfer:
- Is it a bona fide business arrangement?
- Is the transfer of property (gifting or sale) made to the FLP creator’s family members for less than full and adequate consideration?
- Are the terms comparable to similar arrangements entered into by persons in an “arm’s length” transaction?
If the transfers occur close to the FLP creator’s death, the transfers are even more heavily scrutinized. The IRS may reverse such transfers on grounds that the FLP creator is merely trying to avoid taxes and is not providing the transferees with anything more than they would have received through standard inheritance vehicles (e.g., probate, will, or trust).
By taking the following steps, a FLP creator may limit or avoid potential IRS challenges:
- The FLP should be established early to avoid it being considered a “death bed transfer”;
- The FLP creator should establish a history of operations for the FLP prior to the first gifts in order to give credibility to the business purpose of the transaction.
- The transfers should look and appear to the IRS as they would if they were arm’s length business transactions. Generally, family members should not be given special treatment and, if possible, should contribute capital to the FLP;
- The FLP creator should not commingle FLP bank accounts or funds with personal or other family accounts and funds in order to maintain the integrity of the entity structure and may consider transferring various asset types to the FLP which help to support the valid business purposes of consolidating and managing assets and diversifying risk; and
- Prior to making any transfers, the transferor will need to obtain a qualified appraisal from an independent appraiser that values the assets transferred and applies an appropriate discount. Such an appraisal will generally be required by the IRS when filing any gift tax returns associated with the transfer of interests or if the entity or estate is audited in the future.
Although there are already rules in place to monitor the proper use of FLPs, the IRS is trying to take another shot at them by limiting valuation discounts for FLPs. On August 2, 2016, the Treasury Department and the IRS released new proposed regulations under IRC Section 2704 that will reduce the minority and marketability discounts for business interest transfers between family members of family controlled entities; hearings are currently scheduled for December 1, 2016; this will be final sometime in 2017; they will probably not be retroactive but this cannot be assured. This is an important consideration when deciding which estate planning options to undertake. So, the sooner, the better, on forming FLPs and transferring interests in them.
This Advisor is one of a series of business, real estate, employment and tax advisories prepared by the attorneys at Buynak, Fauver, Archbald & Spray, LLP. This Advisor is not exhaustive, nor is it legal advice. You should discuss your particular situation with us or with your own attorney. Our legal representation is only undertaken through a written engagement letter and not by the distribution of this Advisor.
Stacie D. Nyborg
Estate and Tax Attorney
 IRC § 2703
 Transfers that occur near the date of death are deemed to be “death bed transfers” and without a legitimate business purpose. See TAM 97-19006 and TAM 97-19009. Gifts within three (3) years of death are essentially disregarded for the transferor’s estate and its taxes. See 26 USC 2305.