We are frequently asked to represent taxpayers before the IRS in gift tax audits. Many of these audits involve IRS review of taxpayers’ gifts of Family Limited Partnership (FLP) interests. Our experience has been that many of these audits are the result of improper gifting techniques and strategies used by taxpayers or their advisors, who do not consult with qualified tax counsel before making FLP gifts.
Following are some of the more common errors we have found and how to avoid them:
- Gifting FLP interests contemporaneously with (or very soon after) formation of the FLP. FLPs should be allowed to “season” for at least several months before a taxpayer makes gifts of FLP interests to family members. Gifts made at the time the FLP is created invite the IRS to take the position that the FLP was formed purely for tax avoidance. A transaction that has no purpose other than tax avoidance may be voided by the IRS. The FLP gifts would then also be voided and all the FLP assets would be back in the taxpayer’s estate. Indeed, in many of the tax court cases where FLP gifts were voided, the proximity of the gift to the formation of the FLP was a major factor in the court’s decision.Taxpayers should be able to document that their FLP was created for an independent purpose, other than tax avoidance. Such independent purpose may include asset protection, pooling of family assets to achieve investment efficiencies, involvement of family members in the management and/or investment of the FLP assets, family succession planning, limitation of family members’ liabilities in connection with FLP assets, concentration of control over assets in a senior family member, etc. Such documentation may include letters from legal advisors, minutes of family meetings, correspondence between family members and recitations in the FLP agreement.Taxpayers should wait a reasonable period (at least several months) after FLP formation before making gifts of FLP interests in order to undercut any potential IRS tax avoidance argument.
- Failure to adequately document FLP values. The primary area of IRS focus in almost every gift tax audit is the (proper) valuation of the assets gifted. Taxpayers often estimate the value of FLP assets by themselves, especially when the assets are real estate and the taxpayer is an active, experienced real estate investor, operator or developer. Even worse, taxpayers’ accountants often use “book value” for gift purposes, especially when the underlying assets are shares of a closely held corporation or family business. Book value is an artificial number subject to accountants’ manipulation, which is never accepted by the IRS. Gifts must be valued at “fair market value” at the time of the gift. Such fair market value must be well documented. In the case of real estate or closely held businesses, such documentation should include a detailed appraisal prepared by a recognized real estate or business appraiser and should, where appropriate, include details of comparable sales and capitalization, income and cash flow analyses. Unfortunately, some taxpayers seek to save the cost of such appraisals, only to find that they must spend much more in defending inadequately documented asset values in a gift tax audit.
- Claiming exaggerated discounts on FLP interests. Limited partnership (LP) interests in an FLP are subject to discounts in value for:
(a) lack of marketability, and (b) lack of control (minority interest). Unfortunately, the determination of the proper discounted value of an LP interest is more an art than a science. The IRS offers no guidance as to what is an appropriate discount, but it frequently disallows discounts that it believes are excessive. Taxpayers should therefore rely on guidance from experienced tax counsel with regard to the appropriate discounts to apply in their situation. Tax counsel will consider the following factors in determining a proper discount:
- Experience in other IRS audits;
- Tax court and circuit court decisions in cases involving discounts of LP and LLC interests;
- The nature of the FLP assets and the business of the FLP;
- The liquidity of the FLP;
- The history, frequency and size of FLP distributions;
- The likelihood of future FLP distributions;
- The age(s) of the general partner(s);
- The likelihood of an FLP liquidation.
- Denominating gifts in FLP units or percentages rather than in dollars. This is the most common mistake, made by taxpayers, accountants and even many estate planners. This is often the most costly mistake. It is also the most easily avoidable mistake. In a classic example, the taxpayer values the FLP assets at $10,000,000 and claims a 50% combined discount on the LP interests for lack of marketability and lack of control, thus valuing the total LP interests at $5,000,000 (50% x $10,000,000 = $5,000,000). The taxpayer then makes a gift of all the LP interests at a discounted total value of $5,000,000, utilizing his/her lifetime exclusion (for 2012 approximately $5,000,000) to claim full exemption from gift tax. Note that the gift was denominated in LP interests (e.g., “100% of the LP interests in XYZ FLP”). In its audit, the IRS determines that the true fair market value of the FLP assets was $15,000,000 rather than $10,000,000, or that the proper combined discount should have been 25% rather than 50%. In a “worst case” scenario, the IRS might disallow both the taxpayer’s claimed asset value as well as the discount. In such case, the IRS would determine that: (a) the proper FLP value was $15,000,000; (b) applying a 25% discount, the total LP value was $11,250,000 ($15,000,000 x 75% = $11,250,000), and (c) the actual value of the taxpayer’s gift of all the LP interests was $11,250,000, which exceeds his/her lifetime exclusion exemption by $6,250,000, and which at the current 35% gift tax rate, results in a tax liability of approximately $4,000,000 plus interest and penalties.This very expensive mistake is the result of poor planning by the taxpayer or his advisor. It could very easily have been avoided by simply denominating the gift in absolute dollar amounts, as follows: “The taxpayer makes a gift of $5,000,000 of LP interests (the lifetime exclusionary amount) in the XYZ FLP. The total value of FLP assets is $10,000,000 and the combined discount applicable to LP interests is 50%. Therefore, this gift of $5,000,000 worth of LP interests equals 100% of the LP interests.” In the “worst case” scenario described above, the IRS would be limited to disputing the percentage of LP interests actually given away, rather than the actual value of the gift. The IRS would claim that 44.44% of the LP interests were given away ($5,000,000 / $11,250,000 = 44.44%) rather than 100% (leaving 55.56% of the LP interests in the taxpayer’s estate); but the IRS could not dispute that the gift was worth $5,000,000, exempt from gift tax by the annual exclusion. Since the audit results in no tax gain to the IRS, the auditor might determine that it is not worth the IRS’ time and effort to pursue the audit. The U.S. Tax Court very recently upheld a less sophisticated version of this technique, where the taxpayer stated in his gift documents that he intended to gift no more than the applicable lifetime exclusion amount. See, Wandry v. Commissioner, 2012 T.C. Memo 88 (March 26, 2012).The lesson to be learned from the above is not to be “penny wise and pound foolish”. Taxpayers contemplating significant gifts, whether of FLP interests or other assets, should engage qualified, experienced tax counsel to properly plan, structure and document their gifts.