INTERPLAY OF BEHAVIORAL ECONOMICS AND PORTFOLIO MANAGEMENT WITH THE CURRENT EXAMINATION OF FAMILY PARTNERSHIPS BY THE COURTS, THE

Real Property, Probate and Trust Journal, Spring 2005 by Harrison, Louis S, Janiga, John M

Editors' Synopsis: The family limited partnership has long been used by estate planners to achieve estate tax savings. Over the past decade, the Internal Revenue Service increasingly has regarded these arrangements with heightened scrutiny. As a result, courts have been reluctant to find that family limited partnership are supported by any real investment justifications. The authors argue that substantive economic justifications support the use of the partnerships. The Article addresses these justifications, including both the tax and non-tax justifications. The authors argue that these justifications are compelling and support a finding that family limited partnerships should withstand scrutiny by the courts and the Internal Revenue Service.

I. INTRODUCTION

For decades, estate planners have used variations of the family limited partnership ("FLP"), the family limited liability company, and the family corporation to achieve federal estate tax ("estate tax") savings through valuation discounts in computing clients' taxable estates. Since the early 1990s, the use of the investment FLP1 as a sophisticated estate tax reduction technique has grown. Along with this increased usage has come heightened scrutiny and vigorous attack by the Internal Revenue Service ("Service").

Because the Service has been unsuccessful in its attempts to effect a change in the law to prevent valuation discounts, it has focused its efforts on challenging such discounts on audit and, when appropriate, through litigation. Almost universally, the Service asserts in these situations that a valuation discount should not be permitted because the investment FLP has no real investment purpose and therefore no economic substance apart from estate tax savings. The Service uses this argument to pave the way for courts to be more liberal in their statutory applications to invalidate the FLP. As more cases enter the Tax Court queue with fact patterns that have what the Service and the Tax Court view as questionable economic justifications, the trend has been to ignore the formalities of the partnership structure and hold against the taxpayer on the estate tax side.2

The environment has evolved to such a point that both courts and practitioners alike believe in the myth that no real investment justifications can support most of these FLPs. For example, both the Kimbell II and Thompson courts, though reaching opposite holdings on whether the partnerships should be respected, gave dubious regard to a FLP invested only in publicly traded securities.3 The purpose of this Article4 is to explode that myth. The authors believe that substantial economic justifications, from both a behavioral economics and portfolio management perspective, support the creation of investment FLPs.5 Consequently, courts need to refocus on the statutes themselves, and not on the propriety of the planning, when determining whether FLPs should be respected for estate tax purposes.6 Correspondingly, practitioners need to avail themselves of these justifications in setting up partnerships to avoid the difficult holdings coming out of the courts.

This Article focuses on the FLP, the primary purpose of which is to avoid estate taxes.7 The Article begins by detailing the benefits of an investment FLP from an estate tax perspective. Next, the Article discusses the Service's position and the court's evolving holdings on whether investment FLPs will be respected for estate tax purposes. Finally, the Article explores the non-tax investment justifications of the investment FLP and argues that these justifications are compelling reasons for the substantial contributor to set up a family partnership and not retain a controlling general partnership interest ab initio.

II. THE BENEFITS OF AN INVESTMENT FLP FROM AN ESTATE TAX PERSPECTIVE

The investment FLP is designed to reduce the value of the decedent's immediate interest in the FLP to less than the value the decedent would receive on liquidation of the FLP. The investment FLP does so by making certain interests in the FLP illiquid and therefore entitled to a discount.8 These interests are typically limited partnership interests, and to the extent that the decedent retains limited partnership interests at death, without a corresponding controlling general partnership interest, the argument is that these limited partnership interests are worth less than their pro rata liquidation value.

Structurally, limited partnership interests represent the majority of the equity in the FLP. For example, limited partnership interests could represent 90% or more of the equity in the partnership. The general partnership interests represent the minority of the equity, typically less than 10%.

The general partners control the partnership through their ability to elect managing partners. The managing partners decide when and if to make partnership distributions and whether to liquidate the partnership, sell assets, or merge the partnership with a third party. The limited partners are entitled merely to distributions from the partnership, which may be sporadic or may even first arise upon sale or liquidation.