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What to Do about FLP Plans - Abraham, Hillgren and More!

OWEN G. FIORE Fiore-Ramsbacher LLP


    The Federal transfer tax system is based upon taxation of the fair market value of transferred property interests other than such transfers as are for full and adequate consideration. If an irrevocable trust is the receptacle of the transfer of property, the trust restrictions do not justify any value reduction (discount) in the otherwise determined valuation of the property transferred. Therefore, in recent years, the insertion of an entity, such as a family limited partnership (FLP) or a limited liability company (LLC) into the picture prior to the transfer raises the possibility of entity level valuation discounts. This is due to the fact that the entity equity interest is transferred and, even if the underlying assets are marketable securities, the transferred property interests are not marketable, and thus subject to lack of control, marketability and other discounts based upon credible, independent appraisal evidence.

    Clearly, Congress and the courts have recognized the viability of pass-through entities such as FLPs and LLCs for income tax purposes, especially given IRC Sec. 704(e), enacted over 50 years ago. However, in the transfer tax area, there is a statutory version of the judicial doctrine of substance governs over form, namely, IRC Sec. 2036(a), and this area is the subject of recent litigation, which now is at the appellate court level in the 3rd and 5th Circuits.

    Abraham and Hillgren are recent Tax Court opinions that are instructive in this area.

    In Abraham, the 2036(a)(1) pitfall applied due to an inappropriate resolution in the clash of a court-supervised guardianship proceeding with the usual FLP program. The special guardian ad litem had ultimate authority over the distribution of income from the FLP for the benefit of the elderly person to be cared for in all events. Therefore, the FLP failed as a discount vehicle.

    In Hillgren, there were many defects in a brother-sister FLP, in terms of funding and other reality issues. However, as a backup for discounts, a business loan agreement between brother and sister (the decedent) was found to be viable as a contractual matter and the estate's appraiser presented credible evidence to the Tax Court on the discounts appropriate in the situation. So the 2036(a) battle was lost, but the war was won!

    All of this, as detailed in the article, presents estate planners and their clients with new challenges and opportunities in structuring FLP/LLC plans. Section 2036(a) can be avoided in appropriate circumstances, especially as seen in the Tax Court case of Estates of Stone decided in late 2003; further, fall-back approaches developing multiple trust share discounts (the Mellinger principle) and co-tenancy arrangements are possible to substantially reduce the impact on families of the Federal transfer tax.

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