FLP Gift Planning: Holman Case Part II

Summary:

A recent Tax Court case, Thomas Holman,
130 TC No. 12, 5/27/08, has some several important lessons for planners and
taxpayers using family limited partnerships (“FLPs”) and limited liability
companies (“LLCs”), especially for gifts. Last month’s lead article provided an
overview and analysis of the case in Part I. This month’s Part II, reviews
planning lessons, and several important points that seem to have gotten short
shrift in the professional literature.

General
Planning Considerations of the Holman Case.

◙ The
IRS has had a lot of success attacking FLPs and LLCs for estate tax
purposes under Code Section 2036. The Section
2703 attack may become the IRS’ new weapon of choice on gifts of FLP and
LLC interests. Expect repeat performances. ◙ Evaluate
the magnitude of discount that may be achievable. ◙
Weigh the potential estate tax benefit versus the income tax
detriment (no step up in basis, and the possibility of higher capital gains
rates under the next administration). ◙ Weigh
the discount benefits of an FLP (or LLC) versus mere tenants in common
ownership which is cheaper and simpler (but it doesn’t provide control, asset
protection and other FLP non-tax benefits). ◙  Compare the hoped for tax
benefits of each possible approach against the real non-tax benefits each
provides.

Specific
Recommendations.

◙ Document
real non-tax business reasons for the FLP and the transactions. These should be
reflected in the partnership agreement. ◙ Observe
all formalities that an independent real business would (well, at least as the
Tax Court defines “real”). ◙ File tax returns.
◙ Have a CPA prepare a statement (or at
least have annual QuickBooks or equivalent reports). ◙
Be sure all appraisal assumptions are subjected to sensitivity
analysis. What happens if a fact or assumption changes? What are the
consequences if an assumption or calculation is carried through or projected
forward? Do the results remain reasonable? ◙ All
positions and arguments should be consistent. The Holman court was clearly
disturbed by inconsistent assumptions and positions by the taxpayer’s appraiser.
◙ Appraisals shouldn’t use
guesstimates.  But, in many
situations it’s impractical or impossible not to do so. If it is essential at
least discuss the rationale and implications of the guesstimates so that they
are supported as reasonable, and determine the consequences of changing the
guesstimates (sensitivity analysis). ◙ Use
letterhead. ◙ Have partners other than
parents contribute assets to the FLP on formation (but something more than the
.14% contributed by the Trust in Holman would probably be a good thing). ◙ Have a written business plan (or an
investment policy statement, or both). ◙ Execute
governing documents (e.g. partnership agreement) for each phase and transfer to
corroborate that each step of the transaction (e.g., after each gift) is a
complete and meaningful step. This should help demonstrate that each step is
independent and legally sufficient. ◙ File
gift tax returns.  ◙ Obtain an FLP telephone listing. ◙ Every document should be dated the date it
is signed (regardless of whether it has a different effective date).  ◙ Clients
should understand the partnership agreement or other governing documents. The Holman Court said “Tom
impressed us with his intelligence and understanding of the partnership
agreement…”  Taxpayers should make
changes to conform them to their wishes. Corroborate this development trail
(e.g., save track change documents, etc.). ◙ Hold
non-marketable assets. The Holman Court accepted the use of general equity
funds for the evaluation for the evaluation of discounts of the Holman FLP
holding only Dell stock. Introduce non-marketable assets and your discount may
differ favorably from those found by the Holman Court and some of
the analysis of the Holman court that was detrimental to the taxpayer
may take a different spin for your case.
◙ If later contributions are made
to the FLP formally treat them as being made for additional FLP interests of
the appropriate value, and document the change in ownership interests in an
amended and restated partnership agreement.

Unresolved
Issues.

◙ How
long do assets have to age in an FLP before you can make gifts? How long must
they age to face a “real economic risk of change in value”? The Court said “We
draw no bright lines.” Thanks, you could have at least left a light on! ◙ If you’ll only make annual gifts how can you
cost effectively comply with the Holman standards? It’s not reasonable to
obtain the level and quality of appraisals and analysis the Holman court seeks
if you’re merely giving a couple of kids $12,000 gifts. ◙ The Holman Court considered a private market for
limited partnership interests among the FLP’s partners. This completely
violates the tax law prescription for determining “fair market value” for a
gift based on a hypothetical willing buyer and willing seller. There are lots
of definitions of “fair value”. The highest value for many assets is “strategic
value”, when the asset or business involved fulfills a unique need of the buyer
so that the buyer is willing to pay far more than going rate because of the
unique value of the asset to them. The Holman Court took a
dangerous misstep in this direction. What happens to the definition of value
next?

Important
Points Overlooked in Some Articles Examining Holman.

◙ Formalities: The kids trust to which the Holman’s made
gifts was signed by the parents on 11/2, the trustee on 11/4 and made effective
9/10. This is reasonable and realistic, but looser then the ǘber perfection
some courts have demanded of FLPs. ◙ The
partnership agreement was signed 11/2 but the FLP was formed 11/3. The court
and most commentators were silent on this snafu. ◙ The
11/8/99 gift was made by a document saying it was effective 11/8/99 but which
itself was undated. When was it signed? It’s one thing to forgo a witness or
notary, but a date? ◙ Count the dating
goof-ups – at least three! Yet the Court felt that the formalities in the case
sufficed! Commentators noted that the appropriate steps were taken in proper
order. But were they? Was the Holman case a new version of the Dating Game?
While Holman will undoubtedly be cited by taxpayers that have a dating error if
challenged, more care is certainly advisable.

◙ Fiduciary Obligations: The general partner of a limited
partnership is held, vis-à-vis the limited partners to a fiduciary standard.
Could the general partner of the Holman FLP have generally adhered to such a
standard if he didn’t diversify the Dell holdings as generally required under
the Prudent Investor Act (PIA)? Might the IRS
argue that a failure to follow the PIA indicates a failure to respect fiduciary
obligations? Also, central to the Court’s analysis was a discussion of a case,
the Estate of Amlie v. Commr., TC Memo. 2006-76 which involved a
conservator entering into a series of agreements while “…seeking to exercise
prudent management of decedent’s assets…consistent with the
conservator’s fiduciary obligations to decedent.” The Court noted that a
fiduciary’s efforts to hedge the risk of a ward’s holdings and plan for estate
liquidity may serve a business purpose under IRC 2703(b)(1). What is the
distinction between the fiduciary obligations of a general partner to a limited
partner versus a trustee to a beneficiary versus a guardian to a ward? Would
the result have differed had Holman had a wealth manager create an IPS and
implemented an asset allocation model to hedge the risks of the limited
partners to whom the GP owes a fiduciary duty? The Holman Court was not
convinced by the taxpayer’s appraisal expert that a lack of portfolio diversity
and professional management should justify an increased discount. So you get no
discount benefit (not to mention investment return) from lousy investing, and you
undermine your business purpose as a fiduciary. Should all FLPs have IPS’s?
Yes, Jane, they should.

◙ Fair Market Value: The Holman court found a low
discount because it was swayed by the argument that there was no economic
reason why the FLP would not be willing to let somebody be bought out because
the remaining partners would be left holding the same portion of assets and the
same types of asset after the buyout. If the FLP held real estate or business
interests this might not be true. Creditworthiness of the FLP to obtain credit
for new real estate or business interests could be adversely impacted. But the Holman Court’s
conclusions are questionable even for an FLP holding marketable securities. If
the FLP assets are reduced below the minimum accounts size for the asset
manager the FLP had used, a change might be mandated. That could be very
significant. If FLP assets drop below a certain threshold certain types of
investment products may no longer be available. So the Holman conclusion may be
distinguishable in other marketable securities FLPs.

Conclusion.

Another fact specific FLP case, full of good
facts, bad facts, new theories that don’t fully make sense. Planning with FLPs
(and LLCs), as before, remains complex and uncertain. Yet, as before, when
business and personal reasons, independent of any sought after tax benefits,
are served by and FLP structure, they can and should be used. Planning,
especially for gifts of FLP interests, should proceed with consideration to the
new lessons gleaned from Holman.