Family Limited Partnerships

THE IRS FAILS TO MAKE A FLIP A FLOP
Baine P. and Mildred C. Kerr v. Commissioner of Internal Revenue
113 T.C. No.30 (decided December 23, 1999)

A rage in family estate planning for a number of years has been the creation of a family limited partnership ("FLIP"). The goal is to transfer assets from parents to children and/or grandchildren on an accelerated basis by being able to use a discount from market value. Some readers of this letter will be thoroughly familiar with the technique since this office has either established family limited partnerships for them or discussed the subject at length. In Kerr, the Tax Court gave every client that has utilized this technique and every practitioner who recommends it a substantial victory which re-validates the entire process including discounts under current law after the novel approach taken by the IRS in attacking the entities created by Mr. and Mrs. Kerr.

Before analyzing the Kerr decision and the arguments made by the government and the taxpayers it is necessary to take a step back in time. What is a share of IBM worth? If it involves the direct ownership of that share, at any point in time reference can be made to the trades on the New York Stock Exchange. That medium represents the perfect market where knowledgeable buyers and sellers who each meet the classic definition of a willing buyer and willing seller establish that price. What is the value of one unit of a FLIP with 100 units outstanding that owns 100 shares of IBM? Anyone who is conversant with a FLIP, knows that the answer is not the value of that share of IBM. For years planners have advocated the establishment of family limited partnerships for the purpose of transferring wealth at an accelerated basis because the value of the one unit is subject to discounts (there are a number of valid business reasons to establish a FLIP, but none of those arose in the Kerr context). The common discounts that are always discussed are non-marketability, minority interest and lack of control. For planning purposes on a conservative basis, this office has always said that the combination of these factors are equal to 30%. The result of the discount through the utilization of the medium of a FLIP is that the economic effect of transferring 1½ shares of IBM can be accomplished at a tax cost of 1 share as a result of the discounts.

In Kerr the Internal Revenue Service either picked the right or wrong FLIP to attack utilizing the applicability of §2704(b) of the Internal Revenue Code of 1986, as amended. From one perspective, Kerr presented a prime target since the creation of the FLIP and transfer of Units was strictly motivated by the tax saving motives. None of the 26 business reasons listed in a treatise on FLIPs was present. The Kerrs were very wealthy and the opinion states that their children were all independently wealthy. The IRS did roll out a new piece of heavy artillery to serve as its prime weapon for attempting to prevent discounting of interest in FLIPs. To continue the military analogy, the IRS launched what it felt would be an ICBM with 100 nuclear warheads and discovered that its missile was a July 4^th sparkler that never ignited.

For anyone who read Oil and Honor, the thoroughly enthralling account of the Texaco-Pennzoil wars for Getty Oil written by Thomas Petzinger, Jr. (of Youngstown), the name of Baine Kerr should strike a bell. Mr. Kerr had been President of Pennzoil during that period of time and the Tax Court decision notes that he received a $10 million bonus at the conclusion of that take over. Although Mr. Kerr was a lawyer, he hired S. Stacey Eastland, an attorney at Baker & Botts in Houston (his old firm) to do his estate planning for him. Attorney Eastland is one of the writers of the "book" on using FLIPS. Two articles written by Attorney Eastland were cited by the Tax Court in its opinion including one published after the present case had moved into the litigation area.

Two different FLIPS were created. One became the owner of insurance policies. This FLIP in turn became a partner in a second FLIP which owned cash, securities and other investment assets. Each agreement was created under the Texas Uniform Limited Partnership Act. Each provided for the standard provisions preventing free transferability of units and bifurcated rights between any transferee and the transferor until the General Partner consented to the transfer. The provisions relating to restrictions upon transfer provided the battle ground for the IRS to launch its assault. These are standard provisions in both a FLIP and any limited partnership. In addition, probably every other bell and whistle that can be imagined was added by Attorney Eastland to the entire scheme. This included making a transfer of interest to persons who would only be assignees and later would be admitted as limited partners, creating different classes of limited partnership units and adding the University of Texas as an assignee and ultimately a limited partner. Obviously if Attorney Eastland writes about these techniques, he will use them in practice. There is an installment sale of interests by the Kerrs to a Grantor Retained Annuity Trust established by them (the tax effect of that aspect of the transaction is a separate estate planning technique, was not part of the case before the Tax Court, and is not relevant to this discussion).

Adding the University of Texas to the mold and separating rights of an assignee versus outright ownership of a limited partnership unit were the embodiments of theories which had been developed by Attorney Eastland specifically to combat the argument made by the Internal Revenue Service in the instant case. Kerr was decided without the court considering the efficacy of these nuances.

A FLIP is the response of estate planners to a device that was extremely popular prior to Congress coming to the aid of the Internal Revenue Service by outlawing a number of techniques which would cap growth. The usual situation involved a family business. Parents often were willing to give up future growth in a family business while retaining control. The most common form of this went under the name of an estate freeze by creating a class of preferred shares which had voting rights and issuing all of that to the parents. This would use up all the value of the company. In turn, the existing common would become non-voting. Because preferred has a stated liquidation value, all future growth would be attributed only to the common shares. The common shares would be given to the children. Therefore, all appreciation in value would pass free of transfer taxes. The truly sophisticated plan had two classes of preferred with only one of them having voting rights. The parents would then undertake a giving program to transfer the preferred to the children reserving until the end voting rights which would be the subject of either the last gift or the bequest.

The final legislative response to this scheme is the enactment of §2701 through §2704. The basic thrust is to give no value to any gift when there is any one of a number of retained interests. In this instance the IRS argued that the specified retained interest would be the ability in the family context after making a gift of an interest that was subject to restrictions because of the continuing control of the entity by the family. As a result, the family had the ability to remove the restrictions. Section 2704(b) specifically addresses this situation with an important exception. These are the same sections which now limit grantor retained income trusts to personal residences and have kicked most of the teeth out of buy-sell agreements among family members. For years, the IRS had without end lost cases attacking discounts on other theories. Thus, advocating §2704 represented a new approach and the Kerr situation could have been a very easy target if the Tax Court would have been amenable to this legal argument. The Internal Revenue Service argued that §2704(b) is applicable to a family limited partnership and therefore valuation discounts are inapplicable for the types of gifts made by Mr. and Mrs. Kerr because of the alleged retained interest to remove the restrictions against transferability.

The taxpayers had loaded up their quiver with a lot of arrows including the two devices which had been the subject matter of the articles of Attorney Eastland. The Tax Court did not have to determine whether or not adding a charity which is an owner over which the transferors have no control or splitting the ownership of an interest between an assignee or a transferor are necessary to defeat §2704. The decision of the Tax Court is based solely on the provisions of the Texas Uniform Limited Partnership Act. Parallel provisions are included in the Ohio Revised Uniform Limited Partnership Act. Section 2704(b) does contain an exception arising from prior law concerning restrictions which are imposed by state law. The decision in Kerr is based solely on the general statutory scheme for a limited partnership and the Treasury Regulation which was promulgated under this section. The relevant portion of the opinion reads as follows:

"Section 25.2704-2(b), Gift Tax Regs., provides that an applicable restriction is a restriction on "the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction."

In sum, section 2704(b) generally provides that, where a transferor and his family control a corporation or partnership, a restriction on the right to liquidate the corporation or partnership shall be disregarded in determining the value of an interest that has been transferred from the transferor to a family member if, after the transfer, the restriction on liquidation either lapses or can be removed by the family."

In finding for the taxpayers, the Tax Court concluded that the Internal Revenue Service had been hoisted by its own petard since the cited provision of the regulation is more liberal than the statute. The conclusion provides judicial approval at the Tax Court level for the technique of creating a family limited partnership and achieving discounts by transferring minority interests. The minority interests themselves are not transferable freely because of restrictions which are contained in the partnership agreement. These restrictions themselves are an outgrowth of the limited partnership law.

Certainly this is not the last word on this subject. The legislation proposed by President Clinton in 1999 specifically addressed this issue. The Administration's proposal would have reached the type of activity which occurred in Kerr. The administrations proposal would only allow valuation discounts for actual businesses as opposed to the portfolio of investment assets. Since the first news stories of the domestic policy agenda for 2000 include a resubmission by the administration of a tax cut bill, this subject may again be on the front burner. The IRS may appeal Kerr or not acquiesce on the decision. Anyone who is considering the adoption of a FLIP for solely wealth transfer purposes only is well advised that sooner is most definitely better than later because later may not exist.