Creating a Valid Family Limited Partnership
The Mirowski CASE highlights the need for non-tax related purposes when forming a family limited partnership
The IRS has, as of late, been attacking transfers by decedents to Family Limited Partnerships ("FLPs") for estate tax purposes in instances where the entity does not properly follow funding and operating formalities. Many judgments have fallen in the government's favor. However, these cases tend to involve weak facts for the taxpayer. One recent Tax Court decision, Mirowski v. Commissioner, bucks the current trend (T.C. Memo 2008-74). As a result of strong supporting facts and lawyering, creation of an FLP by the decedent followed by a transfer of FLP interests, were excluded from the decedent's gross estate, the Court finding significant and legitimate non-tax purposes for the transfers.
FLPs can be a useful estate planning tool for family businesses, allowing the older generation to make transfers without estate or gift tax liability while retaining some management control. Also, by using an FLP, the older generation can shift income to others in a lower tax bracket. In addition, because there is no market for an FLP's shares (shares must remain within the family), the fair market value of the FLP's assets may be significantly discounted for tax purposes. With many possible tax-saving advantages, the IRS strictly monitors FLPs to be sure that there exists a legitimate business purpose for the entity, without which, the FLP is invalid. This was the position of the IRS in Mirowski.
Anna Mirowski, the decedent, had inherited from her husband in 1990 a significant estate. The estate included, among other assets, valuable patents for implantable cardioverter defibrillators (originally invented by her husband). The facts of the case show that Mrs. Mirowski encouraged a close-knit family and was in the habit of making frequent gifts to family, friends and charity. She had three daughters, each of whom had two children of their own. In 1992, the decedent created three irrevocable trusts, one for each daughter, into which she gifted equal interests in her patent licensing agreements. She maintained 51.09% of the total interest for herself. During the 1990s, the value of these agreements grew substantially.
With a large estate, Mirowski began to consider ways in which to provide for her children and ensure cooperation and unity within her family. She ultimately decided on creating a limited liability company (LLC). The family met in August of 2001 and finalized the plan. The LLC was created with Mirowski as the sole member. Over a period of four days in September, Mirowski transferred assets in excess of $60 million to the LLC. On the fourth day, she then transferred a 16% interest in the LLC to each of the three children's trusts, keeping a 52% interest for herself. Four days later, being sick (but not with an ailment considered life-threatening), she unexpectedly passed away. According to the findings of the Court, no one, including her doctors, knew that she was near death.
The IRS alleged that under I.R.C. §§ 2036(a), 2038(a)(1) and 2035 that the assets transferred to the LLC should be considered as part of the decedent's taxable gross estate. Ultimately, the Tax Court rejected the IRS's position. The Tax Court's analysis focused on whether or not the transfers could be considered a "bona fide sale", and thus excluded from inclusion within the gross estate under both I.R.C. §§ 2036 and 2038. The Court separated the first transfer from the decedent to the LLC and the second transfer of LLC interests to the trusts as two distinct steps, instead of one single integrated transaction as past courts had done.
First, examining the transfers which funded the LLC, the court determined that a bona fide sale had occurred, finding non-tax reasons for the LLC's creation as being (1) a desire for joint control and management of the family assets by decedent's daughters and then grandchildren, (2) consolidation of all assets in order to make possible investment opportunities that might not otherwise be available, and (3) providing for descendants in equal shares. The Court, however, did reject increased asset protection as a valid bona fide business purpose, noting that in previous cases gift giving was not considered a significant non-tax reason for creating an entity. The Court rejected IRS comparisons of the facts in Mirowski to other cases, reaffirming the approach of determining each case on its individual facts. The court also noted other elements that led to its decision in finding a bona fide purchase, including the daughters' candid and sincere testimony, the decedent's retention of assets outside of the LLC and the LLC's operation as a legitimate investing business.
The Tax Court next addressed the question of whether the gift of LLC interests to the daughter's trusts was also a bona fide sale, finding that it was not. However, looking beyond the automatic exception, the court determined that neither I.R.C. § 2036(1) or (2) was applicable. First, the court found the decedent's interest in the LLC did not fall under § 2036(a)(1). I.R.C. § 2036(a)(1) includes within a gross estate all property interests at the time of decedent's death in which the decedent maintains "the possession or enjoyment of, or the right to the income from." Looking at the LLC's operating agreement and applicable law, the decedent's authority, as General Manager, was found to have been significantly limited. Similarly, under § 2036(a)(2), "the right to designate persons who shall possess or enjoy the property" was found to have been significantly limited by the terms of the operating agreement. In addition, the Court rejected the IRS's contention of an implied agreement to keep income and/or enjoyment, citing it had already found a lack of any implied agreements since there had been a bona fide sale.
Essentially, Mirowski demonstrates that to meet the bona fide sale exception, it is important to have strong supporting facts and to present them clearly. The factors the court highlighted as supporting a bona fide sale are a good tool and basis to use when planning and formulating FLP/LLCs. Practitioners should be sure to emphasis the many non-tax purposes for creating an entity in order to anticipate and avoid potential undermining arguments by the IRS. By doing so, a practitioner can best assure that his or her client will be able to avoid inclusion of any assets held by an FLP/LLC as part of their taxable gross estate.