FLP/LLC Rector Checklist

Summary:

Family limited partnerships (FLPs) and limited
liability companies (LLCs) are viewed by many as modern day reverse-alchemy
able to turn valuable marketable securities into devalued interests for estate
tax purposes.  A recent case points
out (yet again!) that this stuff is not child’s play, and risks abound. And as
with so many estate, financial planning, asset protection and other techniques,
most folks remain their own worst enemy by not taking the time to meet
regularly with their advisers, adhere to formalities, and follow up. Yes
Virginia you have to come back regularly and meet with that crusty lawyer of
yours. This is like making gumbo, all of the many ingredients collectively have
to pass the smell and taste test when its done.

The following discussion
is merely a starting point for how to do an FLP/LLC right. Several of the
issues  in the recent case, Estate
of Concetta H. Rector, v. Comr.
T.C. No. 20860-05; T.C. Memo 2007-367 (12/13/07). Judge Laro’s again reminds
taxpayers that FLPs and Professor McGonagall’s Wand are not one and the same. Concetta
and her revocable trust formed an FLP with assets consisting of cash and
marketable securities, comprising most of her wealth. No significant change in
the assets occurred following the formation of the FLP. Concetta made gifts of
limited partnership (“LP”) interests. When she died she owned a 2% general
partnership interest and more than 70% of the LP interests. The Court found
that the FLP was really just a mechanism to transfer her assets at death, It
was primarily a “testamentary substitute.” The Court found that there was an
implied understanding that she would have access to FLP assets. The Court noted
that no principal distributions were made from the by pass trust for her
benefit set up under her husband’s will. No surprise there. The kids were
simply trying to keep assets in the by pass trust and out of her estate.

What lessons can be
learned this and other recent cases? We also consulted with Carnac the
Magnificent (he crossed the picket lines to help us on FLPs) for some ideas:

● While some advisers are
now advocating structuring arrangements as a co-tenancies (i.e., without the use of an entity) a co-tenancy
may be treated as a partnership under state law. Such an effort may be a vain
attempt to highlight lack-of-form over substance. Therefore, if such an alternative
is used, still address every issue in this checklist (and applicable case law).
Don’t rely on using a non-entity approach as a panacea. It won’t prove to be.

● There should be a
significant non-tax business purpose for the FLP. What a novel idea, a business
purposes for a business! Saving estate taxes (and making gifts) doesn’t get you
any Brownie points. The amazing thing about this requirement is that there are
a host of benefits you can score with an FLP with proper planning. FLPs can be
a tremendous tool to protect assets from lawsuits, keep ex-spouse’s at bay,
open up new investment opportunities, consolidate assets, maintain control,
provide business succession planning, and more. Corroborate them.

● The longer before death
that the FLP is set up and funded the less it will look like a testamentary
substitute (i.e. a mechanism to transfer wealth at death). Since the Grim
Reaper doesn’t usually send “reserve the date” notices, do it sooner, not
later.

● When the FLP is being
set up, have separate lawyers represent different partners. Follow Dr. Phil’s
advice and make it a “real deal” (maybe everywhere but California). Real deals
aren’t typically done with one lawyer. Each partner gets her own lawyer (you need
to maximize those legal fees). Have each partner’s attorney provide written
comments which can be saved to demonstrate this. Using Microsoft Word with
track changes and comments is a great way to corroborate that the different
attorneys and partners each had input. Real deals have negotiated changes, not
the first draft document being signed without comment.

● Purchase and maintain a
kit (analogous to a corporate kit). It’s a good repository for all the original
signed documents. Issue certificates (analogous to stock certificates).

● Let the assets you
transfer to the FLP age a bit before you make gifts. While in real deals with
unrelated parties transfers of equity interests are commonly made at the same
table as asset transfers, the courts have for some reason stated that time
should elapse. At minimum all transfer documents and steps should be completed
before gifts are made. This is why calling your attorney to form and make FLP
gifts a just prior to the end of the year isn’t advisable.

● Have periodic (at least
annual) entity meetings. Having your advisers attend the annual meeting (by
conference call if necessary to minimize costs). Minutes should be prepared and signed.

● Have entity operations
reviewed and monitored by all appropriate advisers.

● Persons and entities
other than the parents/donors should invest significant assets on the formation
of the entity. Having mom alone put most of her assets into an FLP just doesn’t
look great.

● Some modest
distributions in proportion to equity interests should be made to corroborate
that the ownership interests are being respected. Get the percentages right. The
income tax return for each partner should reflect their actual ownership. This
can be tricky during years when the ownership percentages change (e.g. a new
partner was admitted, or an existing partner made an additional contribution so
that her ownership interests increased). Have your CPA prepare spreadsheet
showing the changes in ownership interests in such years.

● No significant
distributions should be made that could be used to pay ongoing expenses of the
parents or other senior family members/donors. Don’t make distributions every
time mom needs money. Having FLP distributions track Mom’s personal
expenditures is a great proof for the IRS that mom had an implied agreement
with the rest of the family/partners to control the underlying FLP assets for
her use.

● Prepare a budget
demonstrating that more than adequate resources have been left outside the
entity to meet the needs of the parents. No magic numbers.

● Negotiations of the
transaction is cited in many cases as an important factor. Use a Word document
and track change comments from the various investors, accountant and attorneys
to demonstrate that this has been done (yes, this means you actually have to
read the document).

● Decedent’s advanced age
and poor health are cited in many cases as negative factors. The concept is
that the entity is being used as a will substitute. Obtain a written medical
opinion of the parents have a life expectancy.

● Courts pretty uniformly
look askance at only cash and marketable securities being the sole assets contributed
into the entity. When feasible, contribute other non-liquid assets as well.
Importantly, whatever assets are contributed initially, the more significantly
the nature of those assets changes will demonstrate a real pooling of family
resources to undertake new and hopefully more financially profitable
investments. Personal assets don’t belong in investment type FLPs.

● Have a pre-contribution
investment analysis completed, and then a post-contribution investment policy
statement (IPS) prepared, to demonstrate the changes made. Corroborate the
proper adherence to independent entity investment planning. Ideally there should
there be a marked change in investments, but the pre-contribution IPS should
reflect the parents pre-contribution risk tolerance and other objectives, and
the post-contribution IPS should reflect the entities risk tolerance and
investment objectives.

● Have your CPA review who
will be taxed on any gains realized if old assets are liquidated. IRC Sec.
704(c), etc.

● The donor/senior
generation should not serve as managers, general partners or otherwise control
the entity. That being said, many of you just won’t give up the reigns. Hold
them at your kids risk, they bear the burden of the estate tax cost of your
retaining control (absent a Ouija Board, you won’t know).