Wealth Planning with Family Limited Partnerships and Limited Liability Companies

Tax Management Portfolio, Wealth Planning with Family Limited Partnerships and Limited Liability Companies, No. 722-4th, discusses income and transfer tax considerations and nontax considerations relating to the formation, operation and termination of family limited partnerships and limited liability companies (LLCs). The portfolio includes a general discussion of the goals of family members in establishing limited partnerships and LLCs, the various techniques available for reducing or eliminating transfer taxes, and the income tax rules pertaining to the recognition of an entity as a partnership for federal income tax purposes. To view this Portfolio, take a free trial to Bloomberg Tax.

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Description

Tax Management Portfolio, Wealth Planning with Family Limited Partnerships and Limited Liability Companies, No. 722-4th, covers the following topics:
  • Income and transfer tax considerations and nontax considerations relating to the formation, operation and termination of family limited partnerships and limited liability companies (LLCs).
  • The goals of family members in establishing limited partnerships and LLCs.
  • The various techniques available for reducing or eliminating transfer taxes, and the income tax rules pertaining to the recognition of an entity as a partnership for federal income tax purposes.
  • Valuation issues, including the various discounts or premiums that may apply to transfers of interests in limited partnerships and LLCs and the special valuation rules under Chapter 14 as they apply to family limited partnerships and LLCs.
  • The validity of a partnership or LLC formed for the purpose of holding marketable securities and the Internal Revenue Service's challenges to valuation discounts.
  • The availability of the annual exclusion for transfers of interests in family limited partnerships and LLCs and the potential inclusion of transferred interests in the transferor's estate.
  • The issues involved in choosing the appropriate entity for holding family assets, including marketable securities, real estate, and operating businesses with a detailed discussion of the desired characteristics of the family business entity.
  • The issues involved in forming and liquidating the entity, including the potential application of the anti-abuse regulation under the partnership rules, tax-free formation treatment, and classification of the entity for federal tax purposes.
  • The issues that should be considered when drafting the limited partnership agreement or operating agreement.
  • The business and other nontax reasons for a family to use a limited partnership or LLC to hold family investments and operating businesses.

Authors

Louis A. Mezzullo

Louis A. Mezzullo, University of Maryland (B.A. 1967, M.A. 1976), University of Richmond (J.D. 1976); Partner, Luce, Forward, Hamilton & Scripps LLP (2006–present); Partner, McGuireWoods LLP, Richmond, Virginia (2003–2006); Member, Mezzullo & Guare, PLC, Richmond, Virginia (2000–2003); Founding Member, Mezzullo & McCandlish, Richmond, Virginia (1982–2000); Adjunct Professor, University of Miami School of Law (2004–2007); University of Richmond Law School (1978–2006); Author, 803 T.M., The Mobile Client: Tax, Community Property, and Other Considerations; 809 T.M., Estate Planning for Owners of Closely Held Business Interests; 378/814 T.M., Estate and Gift Tax Issues for Employee Benefit Plans; 831 T.M., Valuation of Corporate Stock; 835 T.M., Transfers of Interests in Family Entities Under Chapter 14: Sections 2701, 2703, and 2704; Author, An Estate Planner's Guide to Buy-Sell Agreements; An Estate Planner's Guide to Life Insurance; An Estate Planner's Guide to Qualified Retirement Plan Benefits; An Estate Planner's Guide to Family Business Entities; and Valuation Rules Under Chapter 14, all published by the American Bar Association, and Limited Liability Companies in Virginia, published by the Virginia Law Foundation; Co-author, Advising the Elderly Client, published by Clark, Boardman, Callaghan; Fellow and Past Chair, American College of Tax Counsel; Fellow and Secretary, American College of Trust and Estate Counsel; Charter Fellow, American College of Employee Benefits Counsel; Past Chair, ABA Section of Real Property, Trust and Estate Law (2000–2001); Vice-Chair of Publications and Current Chair of the Business Planning Subcommittee of the Estate and Gift Taxes Committee of the ABA Section of Taxation; and Academician and Vice President, International Academy of Trust and Estate Law.

Table of Contents

Detailed Analysis
I. Introduction
A. Goals of Family Limited Partnerships and Limited Liability Companies
B. Entities Commonly Used in Estate Planning
1. Trusts
2. Business Entities
a. Corporations
b. General Partnerships
c. Limited Partnerships
d. Limited Liability Companies
e. Business or Land Trusts
C. Common Techniques to Reduce Transfer Taxes
1. Lifetime Giving
2. Discounts and Premiums Available for Lifetime Gifts
II. Family Limited Partnerships and Limited Liability Companies for Income Tax Purposes
A. Recognition of Family Partnerships and LLCs — Introduction
B. Section 704(e) and its Regulations
1. In General
a. Income Tax Treatment of Donee Partner
b. Donee's Real Ownership of Transferred Interest
c. Capital as a Material Income-Producing Factor for Partnership
d. Capital Interest Defined
e. Motive for Transferring Interest
2. Basic Tests for Donee's Ownership of Transferred Interest
a. General Principles
b. Relevant Factors in Determining Ownership
(1) Controls Retained by Donor
(2) Donor's Indirect Controls
(3) Donee's Participation in Management
(4) Income Distributions to Donee
(5) Conduct of the Partnership's Business
c. Trustee of Donee Trust as a Partner
d. Minor Child as a Partner
e. Donee as a Limited Partner
3. Allocation of Family Partnership Income
4. Purchased Interest
C. Selected Income Tax Issues for Family Limited Partnerships and LLCs
1. Income Taxation
2. Deduction for Qualified Business Income of Pass-Thru Entities
a. Key Definitions
b. Calculation of Deduction
3. Excess Business Loss
4. Miscellaneous Income Tax Provisions
D. Prior Law
III. Valuation Issues for Family Limited Partnerships and Limited Liability Companies: In General
A. Introduction
B. Lack of Control Discount
1. In General
2. Prior Law
C. Lack of Marketability Discount
D. Premiums
E. Valuation of Assets Versus Cash Flow
F. Valuation Issues for Specific Entities
1. Corporations
2. Limited Partnerships
a. In General
b. Selected Cases and IRS Guidance
(1) IRS Guidance
(2) Assignee Interests
(3) Partnership Formation
(4) Limited Partnership Underlying Assets
(5) Substance Over Form Doctrine
(6) Section 2036
3. LLCs
a. In General
b. Selected Cases
G. The Importance of Obtaining Professional Business Appraisals
H. Entities Holding Marketable Securities
I. IRS Challenges to Valuation Discounts for Interests in Family Limited Partnerships and Limited Liability Companies
1. Various Arguments Advanced by Technical Advice Memoranda
a. Argument 1 — Transfer is a Single Testamentary Transaction
b. Argument 2 — Transfer is of the Underlying Assets
c. Argument 3 — Restrictions on Right to Transfer Should be Disregarded Under 2703
d. Argument 4 — Restrictions on Right to Liquidate Should be Disregarded Under 2704(b)
e. Argument 5 — Gift on Formation
2. The §2036(a) Argument — Transferor's Retained Rights over Transferred Interest Result in Inclusion in Transferor's Gross Estate
a. Introduction
b. Selected Cases
(1) Gross Estate Inclusion Under §2036(a)(1)
(2) Gross Estate Inclusion Under §2036(a)(2)
(3) Bona Fide Sale Exception to §2036(a)
(a) Active Management of Family Business
(b) Investment Philosophy
(c) Business Opportunity
(d) Asset Protection from Familial Discord
c. Planning Strategies
d. Section 2043 Application
3. Applying The Step Transaction Doctrine to Transfers
a. General Rule
b. Three Tests Available to Apply Doctrine
c. Selected Cases
4. Denial of Gift Tax Annual Exclusion for Transfers
a. In General
b. Planning Strategies
J. Using Defined Value Formulas to Limit Gift Tax Exposure
1. Introduction
2. IRS Challenges to Defined Value Formulas
3. Selected Cases
4. Planning Strategies
K. IRS Appeals Settlement Guidelines
IV. Special Valuation Rules Applicable to Family Limited Partnerships and Limited Liability Companies Under Chapter 14 of the Code
A. Introduction
B. Section 2701 — Transfers of Partnership and LLC Interests
1. General Rules
2. Planning Strategies
C. Section 2702 — Transfers of Interests in Trusts
1. General Rules
2. Planning Strategies
D. Section 2703 — Rights or Restrictions
1. General Rules
2. Selected Cases
E. Section 2704(a) — Lapsing Voting and Liquidation Rights
F. Section 2704(b) — Applicable Restrictions
1. General Rules
2. Selected Cases
3. Planning Strategies
a. Planning with Partnerships
b. Planning with LLCs
G. Attempts to Expand the Application of Chapter 14
V. Other Transfer Tax Issues Involved with Family Limited Partnerships and LLCs
A. The Gift Tax Annual Exclusion
1. General Rules.
2. Selected Memorandum and Cases
B. Retained Interests or Powers Resulting in Gross Estate Inclusion under §2036(a), §2038 and §2036(b)
C. Gift-on-Formation Theory
1. In General
2. Rejection of the Gift-On-Formation Theory
D. Gift-After-Formation
E. Using the Marital Deduction
F. Section 2035 — Transfers Within Three Years of Death
VI. Choice of Entity
A. Introduction
1. Significance of Issue
2. Tax Issues
3. Nontax Issues
4. Importance of State Law
5. Disregarded Entities
B. Desirable Characteristics of Entity
1. Desirable Nontax Characteristics
a. Limited Liability of Owners
b. Retention of Control After Transfer of Business Interest
c. Continuity of Life
d. One Business Entity
e. Restrictions on Transferability of the Younger Generation's Interests
f. Restrictions on Voting and Management Rights of the Younger Generation
g. Protecting Assets from Exposure to Liability
h. Protecting Assets from Creditors of the Owner
i. Simple and Inexpensive
j. Dealing with Recalcitrant Family Members
2. Tax Characteristics
a. Partnership Tax Treatment
b. No Restrictions on Ownership
c. No Restrictions on Capital Structure
d. Tax-Free Formation
e. Tax-Free Contributions
f. Tax-Free Withdrawals
g. Adjustment to Basis
h. Discounts and Premiums
i. Self-Employment Tax
VII. Formation and Liquidation Issues for Family Limited Partnerships and Limited Liability Companies
A. Introduction
B. Anti-Abuse Regulation
C. Tax-Free Formation
D. Classification as a Corporation or Partnership for Tax Purposes
1. Current Law
2. Prior Law
E. Avoiding an Indirect Gift When Funding the Business Entity
1. Introduction
2. Selected Cases
3. Planning Strategies
F. Liquidation Issues
1. In General
2. The Gain Provisions
a. Built-In Gain
b. Marketable Securities Treated as Money
c. Precontribution Gain
3. Disproportionate Distributions
4. Avoiding Gain on Distributions
VIII. Drafting Considerations for Family Limited Partnerships and Limited Liability Companies
A. Introduction
B. Important Provisions in the Operative Agreement
1. Business Purpose
2. The Economic Arrangement Among the Partners or Members
3. The Management Structure
4. Dissolution and Liquidation
C. Classification for Income Tax Purposes
1. Current Law
2. Prior Law
D. Self-Employment Income
E. Estate Planning Considerations when Drafting the Operative Agreement
1. Special Valuation Rules
2. Gift and Estate Tax Issues
F. Other Tax Considerations
1. Cash Method of Accounting
2. Special Allocations
3. Contributions of Appreciated Property
4. Family Partnership Rules
5. Constructive Termination of the Entity
6. Basis Adjustments
7. Representing the Entity before the IRS
a. Current Law — Partnership Representative
b. Prior Law — Tax Matters Partner
8. Passive Loss Rules
IX. Business and Other Nontax Reasons for Using Family Limited Partnerships and Limited Liability Companies
A. Introduction
B. Retaining Control over the Business
C. Reduced Expenses
D. Protection from Creditors
1. Protection of the Owners
2. Protection of Entity's Assets from Owners’ Creditors
E. Investment Policies
F. Dealing with Disputes

Working Papers

Table of Worksheets
Worksheet 1 Example of Tax Savings Using Real Estate in an LLC
Worksheet 2 Sample Limited Partnership Agreement
Worksheet 3 Sample Certificate of Limited Partnership
Worksheet 4 Sample Deed of Gift for Limited Partnership Interest
Worksheet 5 Sample Letter to Client Explaining Provisions of Limited Partnership Agreement
Worksheet 6 Sample LLC Operating Agreement (Manager-Managed)
Worksheet 7 Sample LLC Articles of Organization
Worksheet 8 Sample Consent of LLC Organizer
Worksheet 9 Sample Deed of Gift for LLC Interest
Worksheet 10 Sample Letter and Memorandum to Client Explaining Provisions of LLC Operating Agreement
Worksheet 11 Appeals Coordinated Issue Settlement Guidelines