Surviving The Latest IRS Challenge

For years, the IRS has used a variety of tactics to challenge family limited partnerships (FLPs). In 2008, it took a relatively new approach — arguing that transfers of partnership interests in an FLP were actually taxable indirect gifts of the assets held by the FLP. But the U.S. Tax Court rejected the IRS’s argument, as well as its claim that the “step transaction” doctrine applied, in the latest case to consider this argument, Gross v. Commissioner.

Gross anatomy

Bianca Gross was a widow in New York with two adult daughters and more than $2 million in publicly traded securities. To involve her daughters in the management of the portfolio, she decided to form an FLP. Gross and her daughters agreed to the essential terms and conditions of the FLP and filed a certificate of limited partnership with the New York Department of State on July 15, 1998.Between Oct. 15, 1998, and Dec. 4, 1998, Gross transferred securities to the FLP. On Dec. 15, 1998, she transferred a 22.25% limited partnership interest to each daughter and also executed a document titled “Limited Partnership Agreement.”Gross filed a gift tax return that reported the gifts at a net value of $312,500 after a 35% discount. The IRS assessed a deficiency of approximately $121,000, claiming Gross had made an indirect gift of $480,299. In its notice of deficiency, the IRS claimed that Gross’ transfers were not direct gifts of FLP interests but rather indirect gifts of the securities she’d contributed to the FLP.

Critical dates

At trial, the IRS argued that formation of the FLP, the daughters’ acquisition of limited partnership interests and Gross’ contributions of securities all occurred on Dec. 15. Gross countered that the FLP was formed on July 15, the securities were contributed by Dec. 4 and the gifts occurred long enough after Dec. 4 that no indirect gift occurred.The IRS contended that the FLP wasn’t created until Dec. 15 because New York law requires that a partnership agreement be executed before a limited partnership can be formed. But, as the court noted, New York law provides that, when parties seeking to form a limited partnership don’t satisfy the requirements, they may be deemed to have formed a general partnership “if their conduct indicates that they have agreed, whether orally and whether expressly or impliedly, on all the essential terms and conditions of their partnership arrangement.”The court found that Gross and her daughters had agreed to form a partnership on the terms dictated in the eventual partnership agreement by the time the certificate was filed on July 15. The FLP, therefore, was formed on that date.

Indirect gifts

The IRS claimed that, regardless of the date the FLP was formed, Gross had made indirect gifts to her daughters because she’d contributed her securities to the FLP for inadequate consideration.It also argued that she’d received inadequate consideration because, proportionate to her interest in the FLP, only 55.5% of the value of the securities was credited to her capital account in the FLP. She’d made indirect gifts, the IRS continued, because the securities’ remaining value was credited to the daughter’s capital accounts, proportionate to their FLP interests. In response, Gross argued that 100% of the value of the securities was credited to her account well in advance of her gifts of the FLP interests.The court found that Gross had made a series of contributions and received increasing partnership interests in return. All of the contributions were reflected in her capital account, and the value of the daughters’ capital accounts wasn’t enhanced as a result of the contributions. After completing her contributions, Gross made gifts of partnership interests. Therefore, the form of the transactions accorded with their substance: The transfers were direct gifts of FLP interests, not indirect gifts of securities.

Step transaction doctrine

The IRS also asserted that the transfers were indirect gifts under the step transaction doctrine, which embodies substance over form principles. It “treats a series of formally separate steps as a single transaction if the steps are in substance integrated, interdependent and focused toward a particular result.” In such cases, the tax consequences are determined by considering all of the steps as an integrated whole.The Tax Court had considered a similar IRS argument three months earlier in Holman v. Commissioner. In that case, it ruled against the IRS, concluding that the taxpayers bore a “real economic risk of a change in the value of the partnership for the six days that separated their transfer of the shares to the partnership and the gift.”The court reached the same conclusion in Gross. It declined to apply the doctrine because 11 days had passed between the conclusion of Gross’ transfer of securities to the FLP and her gifts to the daughters, and the securities were mostly heavily traded, relatively volatile common stocks subject to changes in value.

Tips for practitioners

Both Gross and Holman offer some insights into how an FLP can survive this type of IRS challenge. Among them:

• Don’t delay execution of the partnership agreement or other formalities.
  
  
• Make any initial contributions described in the agreement as soon as possible and reflect the contributions in the partners’ capital accounts.
   
• As additional contributions are made, increase the ownership percentage of the contributing partner and credit his or her capital account.Also, the appropriate delay between the contribution of assets to an FLP and the transfer of interests in an FLP should depend on the nature of the assets. The delay needs to create a real economic risk of a change in value.

Anticipate attacks

Although the IRS has now suffered defeat twice on the indirect gift argument, it may continue to pursue this route. Attorneys need to anticipate all such attacks when forming and administering an FLP to help ensure their clients obtain the expected tax benefits.

Additional Reading:

"Financial Statement Analysis: Don't Value A Business Without It"

"Rocky Economy Alters The Valuation Landscape"

"What's Normal? How Valuators Adjust Earnings To Reflect Market Value"

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