By: Eric R. Kaplan, Esq.
Many high-net-worth families utilize family limited partnerships and family limited liability companies for investment purposes, as well as a means of gifting assets to future generations. While there has always been some concern regarding gifted family entities, especially if the donor retained significant powers over the gifted entity, Estate of Powell v. Commissioner , 148 T.C. 392 (May 18, 2017), significantly increased the risk that the Internal Revenue Service will not respect many transfers of family entities.
While many post-Powell gifts incorporate provisions to address the retained powers that were problematic in Powell, many families gifted significant interests in family entities prior to Powell . If you or any member of your family gifted any interests in corporations, limited liability companies, partnerships, or other entities prior to 2017, and have not revisited such gifts since that time, a knowledgeable attorney should now revisit these gifts to determine if there is any risk that the Internal Revenue Service will not respect these gifts and, if necessary, update entity agreements to address the Powell decision.
In Powell , the decedent’s son, Jeffrey, began his mother’s estate planning nine days prior to her death. On the first day, Jeffrey created a family limited partnership (“FLP”) naming himself as the general partner. Jeffrey thereafter funded the FLP with $10 million in cash and securities from his mother’s revocable trust in exchange for a 99% limited partnership interest in the FLP. Notably, the Agreement of Limited Partnership allowed for the entity’s dissolution with the written consent of all partners.
The next day, Jeffrey, purportedly acting on his mother’s behalf vis-à-vis a doctor’s note that allowed him to act as her agent under her Durable Power of Attorney following her incapacity, settled a charitable lead trust (“CLAT”), and transferred the 99% limited partnership interest in the FLP to the CLAT. The CLAT paid the annuity interest to a charitable organization (specifically, a private foundation in his mother’s name) for the remainder of her life, and named Jeffrey and his brother as remainder beneficiaries upon their mother’s death. Thereafter, Jeffrey filed a gift tax return for the transfer to the CLAT. Jeffrey determined the value of the 99% limited partnership interest in the FLP to be $7.5 million after a 25% discount for lack of marketability and lack of control. This resulted in a discounted gift to the remainding beneficiaries. Consequently, however, the Internal Revenue Service issued deficiency notices for both the gift tax return and the estate tax return that Jeffrey filed after his mother’s passing.
The Tax Court held: (1) the assets gifted to the CLAT were includible in the decedent’s (Jeffrey’s mother) gross estate under Code Section 2033 (property in which the decedent had an interest ) or Code Section 2038 (revocable transfers ) because Jeffrey exceeded his authority granted under his mother’s Durable Power of Attorney when making a gift; (2) the decedent’s ability (along with the other FLP partners) to dissolve the partnership constituted a right “to designate the persons who shall possess or enjoy” the cash and securities transferred to the FLP “or the income therefrom”, within the meaning of Code Section 2036(a)(2) (transfer with right to designate enjoyment of the property ); (3) because the decedent’s interest in the FLP was transferred less than three years before her death, the value of the cash and securities transferred to the FLP was includible in the value of her gross estate to the extent required by Code Section 2035(a) (certain gifts within three years of death ); and (4) the exception under Code Section 2036 (transfers for full and adequate consideration ) did not apply in this case because Jeffrey had no significant non-tax reason for the transfer.
The first notable mistake in Powell was the misuse of Jeffrey’s authority as agent under his mother’s Durable Power of Attorney. Specifically, the Durable Power of Attorney granted Jeffrey the authority to make gifts of up to the $14,000 (at that time) annual gift exclusion to his mother’s family members; however, he exceeded this power by gifting $7.5 million to his family and his mother’s private foundation. As such, the blatant misuse of authority granted under the power of attorney caused the Tax Court to disallow the gift.
Another notable mistake in Powell was the last-minute aggressive estate planning that was implemented within days of the decedent’s death. Sophisticated estate planning techniques require time to implement. Compressed planning such as that under the facts of Powell may have negative implications by triggering a challenge of the transactions under the “step-transaction doctrine”, which looks at the economic substance of each transaction, and when applied, can cause a multiple-step process to be treated as one transaction (i.e., transferring property to a family limited partnership and then transferring interests in the entity to younger generations collapses into a single indirect gift of the underlying property, without protection of the overarching family limited partnership, to the younger generations).
Further, the implication of Code Section 2036 within the context of such planning is also worth noting as Code Section 2036 is frequently used to bring prior transfers into one’s gross estate at such times when a decedent transferred property while retaining “the possession or enjoyment of, or the right to the income from, the property”, or the right to direct (either alone or with another person) who has possession, enjoyment of, or the right to income from the property for a time that is based on the decedent’s life, or does not end before the decedent’s death. In this regard, the Tax Court stated that the decedent retained the power to direct the possession or enjoyment of the property along with her children, who were the other partners in the FLP.
The Powell decision was significant because it was the first case where the Tax Court applied Code Section 2036(a)(2) even though the decedent was a limited partner (and did not own a general partner interest). As such, Powell established that the applicability of Code Section 2036(a)(2) does not depend on the type of ownership interest in the partnership (or LLC) but rather focuses on the actual powers held by the owner/decedent. Further, Powell shed light on practitioners and clients reviewing Durable Powers of Attorney so as to tailor the gift provisions to what might be appropriate for the particular client’s circumstances.
For high net worth clients, the gifting provisions should be specifically tailored to allow whatever type of gift or other transfers that might be appropriate to planning but constrained to minimize the risk of abuse. In addition, emphasis should be placed on the importance of periodic reviews of one’s estate planning documents for purposes of avoiding a compressed planning time frame prior to death, as negatively noted in Powell . Lastly, clients with FLPs (or LLCs), or those seeking to create FLPs (or LLCs), should consider certain risks of the Internal Revenue Service asserting Powell type arguments about estate inclusion, in that post-transfer appreciation could result in a double counting, thus placing the client in a worse situation than if the entity had not been pursued. This can be avoided if, for example, any FLP or LLC to be gifted is owned just by the donees of the gifted interests and a trust as the donor. This way, the settlor retains no powers over that entity (but instead, voting powers are among only the donees and the independent trustee of the trust).
Consequently, the time is now to review your limited partnership and limited liability company agreements, especially if you have gifted or plan on gifting any interests in those entities, to ensure that we eliminate any problematic powers that you may have retained over such entity. Although each entity has unique facts, there are ways to eliminate any problematic retained powers. Once all such retained powers have been relinquished, however, you will need to survive that date by at least three years.
As a final note, there are also strategies to avoid the Powell issue without amending the entity documents. This could involve, for example, selling the entity interests to a trust in exchange for an installment note. The installment note can then be the subject of other estate planning strategies.
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