By: Drew LaGrande and Jeffrey M. Gad
Akerman Senterfitt
Tampa, Florida
Those of us in the Tampa Bay, Florida area need to be aware of the restrictions against transferability in partnership agreements. In Holman v. Commissioner, the Eighth Circuit recently concluded that the transfer restrictions of a family limited partnership agreement would be disregarded when determining a discounted value of a family limited partnership. Holman also held that gifts of family limited partnership interest made six (6) days after a family limited partnership’s formation would not be viewed as an indirect gift of the underlying property owned by the family limited partnership.
Mr. and Mrs. Holman created an estate plan and implemented the use of a family limited partnership (the “FLP”). They executed their estate planning documents at the same time they signed the FLP documents and the FLP was subsequently funded with a block of Dell stock. The taxpayers argued that the estate and family limited partnership planning was designed to: 1) reduce taxes; 2) transfer wealth to the Holman children; 3) protect the Holman children from themselves by preventing the reduction in wealth from free spending of large sums of money; and 4) teach the Holman children to manage wealth. The FLP, they argued, was not designed to operate or run an independent business, but was simply used as a “family bank” to hold liquid assets.
Mr. and Mrs. Holman gifted limited partnership interest to their children and filed gift tax returns to reflect the gifts. The gifts of FLP interest to the Holman children were made six (6) days after the creation of the FLP. At the time of the gifts to the Holman children, an appraisal of the FLP was completed. The appraisal determined a 49.25% discount on the value of the FLP interest.
The IRS argued that the gifts of FLP limited partnership interest to the Holmans’ children were actually indirect gifts of the Dell stock. The IRS also sought to disregard the transfer restrictions in the FLP Agreement in determining the value for discount purposes of the FLP. Based on the foregoing, the IRS countered that the amount of the overall discount was 28%.
Generally, when a family limited partnership agreement contains a provision which restricts the transfer or sale of an interest in a family limited partnership, the value of the family limited partnership interest is “discounted” for lack of marketability.
Typically, the transfer restrictions will be respected if such restrictions meet a 3-part test, as follows:
1. The restrictions must be “a bona fide business arrangement,”
2. The restrictions must not be “a device to transfer such property to members of the descendant’s family for less than full and adequate consideration,” and
3. The terms of the restrictions must be “comparable to similar arrangements entered into by persons in an arms-length transaction.”
In Holman, the Court ruled that the gifts made six (6) days after the formation of FLP were not considered indirect gifts of the Dell stock owned by the FLP. However, the Tax Court and the Eighth Circuit concurred that the transfer restrictions within the FLP Agreement would be disregarded for valuation purposes since they seemed to fail the “bona fide business arrangement” test. In addition, the Eighth Circuit agreed with the Tax Court that the appropriate discount of the value of the FLP should be an overall 22.4%.
In light of Holman, estate planners and their clients need to reexamine the transfer restrictions in their family limited partnership agreements and consider whether such restrictions meet all three elements as set forth above. One should be wary of not including any transferability restrictions in the partnership agreement. If no transfer restrictions are included in the partnership agreement, then a limited partner may be able to transfer his or her interest to his or her creditors, a divorcing spouse, or an unrelated third party with no oversight from the general partners.
The good news is that Holman seems to reaffirm that gifts made six (6) days after formation of a family limited partnership will not be viewed as indirect gifts of the underlying property transferred to the family limited partnership. In addition, the discounts accepted by the Eighth Circuit (approximately 22%) provide some relief, even though the discounts fall well short of the 49.25% sought by the taxpayers.
