Family limited partnerships establish a business entity to hold assets that would otherwise be subject to transfer taxation. These can be an excellent vehicle for minimizing transfer taxes, says ThinkAdvisor in its recent article, “Estate Planning: The Family Limited Partnership Strategy.” It discusses the recent Purdue decision in U.S. Tax Court. That case held that when a family business entity is formed for legitimate non-tax reasons and managed appropriately, the transfer taxes can be minimized—despite the fact that minimizing these taxes was a component in creating the entity.
The Purdues had five children and several grandchildren and great-grandchildren. Their estate was worth about $28 million, much more than the current $5.49 million per person estate tax exemption amount. The couple funded a Purdue Family LLC with about $22 million in marketable securities and other assets and, at the same time, created a trust to benefit the Purdue’s descendants and spouses. The trust was funded with interests in the LLC in proportion to the gift tax annual exclusion each year. Each beneficiary could withdraw up to the gift tax annual exclusion amount or a per capita share of the assets transferred each year. The LLC’s operating agreement spelled out some non-tax reasons for creating the LLC, such as
- Avoiding fractionalizing ownership;
- Retaining assets within the extended family;
- Protecting assets from future unknown creditors; and
- Providing flexibility in managing the assets that wouldn’t be available in other entities.
When Mr. Purdue died, he created a bypass trust, a qualified terminable interest property (QTIP) trust and a GST-exempt trust—each of which owned a portion of the LLC. Mrs. Purdue and her husband had retained the right to income and distributions from the LLC assets, although the decedent had approximately $3.25 million outside of the LLC and trusts. After the decedent’s death, the IRS attempted to collect more than $4 million in estate taxes and challenged the LLC structure. Trust beneficiaries and the QTIP trust loaned the estate funds to pay the estate tax. The estate attempted to deduct interest paid on the loan, but the IRS challenged this.
Tax Code § 2036 stipulates that property transferred to a trust, in which a decedent holds an ownership interest, will be included in his or her gross estate, except when that property is transferred for adequate consideration. The estate was also required to show that there were valid non-tax reasons for creating the family LLC. The IRS said the LLC was created primarily to transfer wealth to the next generation and avoid taxes. But the Tax Court disagreed. It found the seven non-tax reasons for forming the LLC to be compelling: (1) relieving the decedent of having to manage the investments; (2) consolidating investments with a single advisor to reduce volatility under a written investment plan; (3) educating the children to jointly manage an investment company; (4) avoiding repetitive asset transfers among multiple generations; (5) creating common ownership of assets for efficient management and meeting minimum investment requirements; (6) providing voting and dispute resolution rules and transfer restrictions; and (7) providing the children with a minimum annual cash flow.
Reference: ThinkAdvisor (March 14, 2017) “Estate Planning: The Family Limited Partnership Strategy”