Scrutiny of Tax Shelter Gains Steam in Court (James P. Weller Commentary)

As Frank Sinatra once sang, “It was a very good year!”

Unfortunately, 2003 has been a very good year for the Internal Revenue Service. There have been significant developments in the IRS’ favor in the area of family limited partnerships. They include:

– Retention of Enjoyment of FLP Assets — In several court cases in prior years, the IRS has been successful in finding that the contributor of assets to a FLP had retained the enjoyment of those assets.

Typically, this has been based upon a string of events that has lead the courts to find that the FLP was not being properly administered, and the FLP was in essence not being respected as a separate entity. Such retention of enjoyment can cause the full (undiscounted) value of the contributed assets to be included in the contributor’s estate for estate tax purposes.

In a case earlier this year, the Northern District Court for Texas found retention of enjoyment even though the FLP was properly administered. Instead, the court focused on the terms of the FLP agreement, which allowed the taxpayer to remove the general partner, and appoint herself. It also allowed the general partner to control distributions.

– Retention of Control over FLP Assets — If control is retained over assets contributed to a FLP, the full (undiscounted) value of the contributed assets will be included in the contributor’s estate for estate tax purposes.

In a Tax Court memorandum decision in May of this year, it was held that the contributor retained enjoyment over the FLP assets because: he could control distributions through his son-in-law who was his attorney-in-fact and managing general partner of the FLP, and he could control liquidation by joining together with other partners. This decision has created somewhat of a cloud over the ability to remain general partner without aggravating the estate tax picture.

– Layered Valuation Discounts by Asset Class — As a bellwether of things to come, another Tax Court memorandum decision in September of this year blessed the layering of valuation discounts by asset class. For instance, the discount for lack of marketability would be applied against each asset class such as real estate, stock, cash, and bonds. The overall discount would then be determined by a weighted average.

– IRS Internal Memo dated Oct. 19 — In this memo, the IRS has indicated the following: (1) lower discounts on audit for plain vanilla FLPs, (2) expectation of audit of 100 percent of FLPs, and (3) more focus on the quality and content of FLP appraisals.

The above developments are troublesome. However, FLPs remain viable planning tools.

If 2003 points out anything, it emphasizes the need to have knowledgeable advice and guidance in establishing an FLP and in maintaining an existing FLP.

An example of what good advice and guidance can achieve is a memorandum decision rendered by the Tax Court on Nov. 7 that found in favor of the taxpayer on the retention of enjoyment argument, and the retention of control argument was not even raised.

(James P. Weller, LL.M, is a lawyer and personal trust manager at Bank of Arkansas in Fayetteville. He may be reached via e-mail at [email protected].)