Insight on Estate Planning - October/November 2013: Using an FLP or LLC? Beware the step transaction doctrine

by Adler Pollock & Sheehan P.C.
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Do you know how to transfer a significant amount of wealth to the next generation at a discounted value for gift tax purposes? The answer is to form either a family limited partnership (FLP) or a limited liability company (LLC). Before doing so, however, be aware of the step transaction doctrine. If the IRS invokes the doctrine on your FLP or LLC, the tax outcome may be different from what you intended.

Using FLPs or LLCs

If you follow a typical arrangement, you 1) establish an FLP or LLC, retaining all of the partnership or membership units, 2) contribute assets to the entity, such as cash, real estate, marketable securities or business interests, and 3) give (or sell) minority interests in the entity to family members or to trusts for their benefit.

This technique allows you to retain control over assets while shifting most of the ownership interests to your family at a minimal tax cost. That’s because, for gift tax purposes, minority FLP and LLC interests generally are entitled to substantial valuation discounts (possibly as much as 40% to 50%) for lack of marketability and control.

To ensure the desired tax treatment, the FLP or LLC should have a legitimate nontax business purpose, such as maintaining control over a family business, consolidating management of an investment portfolio or protecting family assets from creditors. Also, you must treat the entity as a legitimate, independent business, observing all business formalities and documentation requirements.

Even with legitimate nontax reasons for forming an FLP or LLC, families frequently get themselves into trouble because they’re lax about business formalities or they commingle personal and business assets. Failing to adhere to these formalities may cause the IRS to conclude that the entity is a sham, disregard it for gift and estate tax purposes, and assess tax on the full value of the assets, rather than the discounted amount.

Another common mistake is to complete all of the transfers at around the same time. People often set up an FLP or LLC, transfer assets to the entity and transfer FLP or LLC interests to family members all in the same meeting. If the IRS determines that the transactions were simultaneous — or, worse, that FLP or LLC interests were transferred before the entity was funded — it will likely apply the step transaction doctrine and treat the arrangement as an indirect gift of the underlying assets, taxable at full value. Even if the transactions are completed in the right sequence, the IRS may challenge the arrangement as an indirect gift under the step transaction doctrine.

Defining the doctrine

Under the step transaction doctrine, separate steps may be collapsed into a single transaction if the parties, at the time of the first step, had a binding commitment to undertake the later steps; the steps were prearranged parts of a single transaction designed to produce a particular end result; or the steps are mutually interdependent — that is, so closely intertwined that they’re meaningless on their own.

Binding commitments are uncommon, but it’s not unusual for the IRS or a court to invoke “end result” or “mutual interdependence” tests. Under these tests, a key to avoiding step transaction treatment is to establish that the intermediate steps have tax-independent significance. Among other things, this means that enough time should pass between funding an FLP or LLC and transferring minority interests so the assets are subject to “real economic risk” during the interim.

Unfortunately, there’s no magic number for determining how long you should wait; it depends on the nature of the assets, economic factors and other circumstances. Generally, funding an FLP or LLC and transferring interests later the same day won’t be enough.

But the U.S. Tax Court has held that a six-day delay is sufficient. In that case, Holman v. Commissioner, the parents funded an FLP with heavily traded, highly volatile stock and assumed the risk during the six-day period that the stock’s value would fluctuate before they transferred limited partnership interests to their children.

More stable assets, such as lightly traded securities or real estate, may require a longer waiting period to establish economic risk.

Taking the right steps

Using an FLP or LLC in your estate plan is a smart strategy for transferring a large sum of assets to loved ones at a discounted value for gift tax purposes. Before you take action, though, work with an estate planning advisor to determine the appropriate waiting period between funding an FLP or LLC and transferring interest to your family. Doing so can help you avoid having the IRS invoke the step transaction doctrine on your FLP or LLC.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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