Partnerships, and limited liability companies (LLCs) taxed as partnerships (both to be referred to as LPs), are ubiquitous in the planning and compliance process. The following are tips and planning ideas, generally with an estate planning flavor, that practitioners can identify when preparing or reviewing partnership tax returns. Any references to partnerships will include LLCs when taxed as partnerships. With the practical demise of the federal estate tax for most clients after the Taxpayer Relief Act of 2012 (ATRA) as a result of the $5.25 million inflation adjusted permanent exemption, planning for partnerships has changed dramatically. Partnerships have for well more than a decade been used by many clients as estate tax discount machines. The prevalence of lack of marketability and lack of control discounts have been used to reduce many estates. With this use no longer relevant to most clients, what’s left? The answer is “plenty.” There are many opportunities to repurpose existing partnerships to serve clients in the new post-ATRA tax environment.
√ Not an LP
LPs are frequently associated with creating discounts for estate planning purposes, so much so that some clients may not realize that there are other applications. The primary reason for the use of LPs has always been to limit liability risks. Practitioners should be alert to client real estate investments, home-based businesses, and other endeavors that remain held in personal name rather than in LP format. Restructuring those assets or activities to provide asset protection should remain a key focus of all planning.
√ No Form 1065
While this is a checklist for partnership income tax returns, the most important LP planning opportunities might be identified when there is in fact no Form 1065 filed. When a husband and wife own a business organized as an LP, if the requirements of a qualified joint venture (“QJV”) are met, they can avoid filing partnership income tax returns. IRC Sec. 761(f). This is typically viewed as a beneficial result as it can save the annual filing fees. In fact, that may well prove a significant detriment and not a benefit. If the business is sued and there is no Form 1065 to provide to the claimant, the income tax return reporting the results of that business will be the clients’ personal Form 1040. Having a separate tax return may suffice to protect the remainder to the client’s confidential information in a lawsuit. Similarly, if a client has a single member disregarded LLC, they may view that as a benefit as they can merely file a Schedule C or E on their personal Form 1040 instead of incurring the cost of filing a separate Form 1065. However, just like with the QJV, most clients would be advised to file the separate Form 1065 by adding a second member to the LLC so it will no longer be a disregarded entity. There are significant legal reasons for this step as well. A single member LLC will not be afforded charging order protection under most state laws, whereas an LLC with a legitimate second member will. Charging order protection may serve to severely limit the rights of a claimant to receive merely the client’s interests in profits of the LLC, and not to become a substitute member. Since the primary reason clients use LLCs is asset protection (insulating personal assets from business or investment risk) in most cases adding the second member will help achieve the client’s objectives.
√ Permanent File
If you’re preparing a Form 1065 you should have a permanent file for the LP. At minimum documents should include the partnership (LLC) certificate used to form the partnership as well as any amendments filed changing this. At minimum you should have a copy of the current (and if feasible all prior) partnership agreements (operating agreements for LLCs). Some partnerships and LLCs issue certificates, similar to stock certificates, evidencing ownership interests. Also, some partnerships and LLCs sign periodic documents, analogous to corporate minutes. These might be called consents or actions or by some other name. While CPAs tend to view all of these documents as within the purview of the attorneys, they are squarely within the responsibility of the CPA as well. You should not file an LP return before confirming the ownership interests you are reporting on the Forms K-1 are consistent with all the underlying legal documentation. If there is an inconsistency, legal counsel for the entity should resolve it. However, failing to look can exacerbate tax, legal and other problems. Other discussions in this checklist will highlight other issues to consider in looking at these documents.
√ Income Shifting
With the demise of the federal estate tax for most clients, LPs from a tax perspective may shift focus back to their historical roots of being used to shift income from higher bracket to lower bracket family members. If a parent, or other benefactor, gifts LP interests to a child (or other donee), then that donee may be able to report the income attributable to that interest on his or her return and at his or her tax rates which may be lower than the donor’s marginal tax rates. For this tax shift to succeed, capital must be a material income-producing factor in the LP. IRC §704(e)(1); Treas. Reg. §1.704-(e)(1)(ii). But the use of LPs to shift income is quite different today than it had been decades ago when this type of planning was so popular. The Kiddie Tax will result in a child paying tax at the parent’s highest tax bracket for children as old as 23. The Kiddie Tax creates a considerable restraint on shifting income to younger children, but doesn’t obviate the benefits of planning. The permanent increase in the estate tax exemption to $5 million inflation adjusted, has also changed the dynamic of LP income shifting. Most clients can now shift any amount of LP interests to young adult children no longer subject to the Kiddie Tax with no practical concern about the gift tax. This is because the $5 million permanent inflation adjusted exemption makes the gift tax irrelevant for the vast majority of clients. Years later, when a young adult child’s income grows, the child could gift the LP interests back to the parent, or perhaps to a trust to benefit the parent if advisable at that time from a Medicaid or other planning perspective. Years ago when using FLPs to shift income was a popular planning technique, the $600,000 non-inflation adjusted gift exemption had posed a significant constraint on transferring FLP interests.
√ Don’t Liquidate FLPs Without Consideration
With the practical permanent demise of the estate tax for most clients, many may request that FLPs be liquidated to save the costs of tax filings, legal fees and so forth. Before pursuing that option carefully review non-estate tax benefits of the FLP with the client. For example, if the client or the client’s heirs face any type of liability risk, the asset protection benefits may well be worth retaining the LLC. Many clients evaluate this only with respect to their concerns, which post-retirement may be negligible in their view. However, if the clients will be shifting significant wealth, or already have made substantial gifts, the FLP can be a valuable asset protection tool for heirs. Another less common consideration should also be evaluated before liquidating an FLP. If the client, or a client’s business, owns any significant life insurance, consider the possible benefits of the FLP to avoid the transfer for value rules. The transfer for value rules can result in the proceeds of a life insurance policy being subject to income tax. However, transfer of an insurance policy to a partner of the insured (or a partnership in which the insured is a partner) will not trigger the transfer for value rules. IRC Sec. 101(a)(2)(B). Be alert for opportunities to help clients restructure the partners in a partnership to include those taxpayers who may be involved in insurance transfers, such as a closely held business that no longer requires buy-out insurance, etc. The partnership involved, however, must be a bona fide entity, and not merely an entity established to effectuate the insurance transfer. If the partnership owns significant other assets, and was not formed for the purpose of facilitating the transfer of the insurance policies, it may be respected as qualifying for an exception to the transfer for value rule. PLR 200120007.
√ Annual Gifts of FLPs Over
Annual gifts of FLP interests had been a common estate planning tool. The planning, in big picture terms, was quite simple. Parents established an FLP and gifted assets, quite often marketable securities. The FLP interests were appraised, almost universally considering discounts for lack of control and lack of marketability. Then each year the parents would gift annual exclusion gifts, currently $14,000/year/donee, to each heir. This apparently common and “simple” planning step was fraught with complexity and costs. The costs of appraisals were significant, and the reality has been that in too many cases clients have shortcut the required appraisal steps. The partnership agreements (operating agreements in the case of an LLC) had to be reviewed by counsel to be certain that the requirements for a present interest gift (a prerequisite to qualifying for a gift tax an annual exclusion) are met. IRC Sec. Sec. 2503(b). The Regulations provide that a future interest may be created by the limitations contained in an instrument of transfer used in effecting the gift. Regs. Sec. 25.2503-3(a). Thus, the partnership agreement, the assignment forms used to transfer the partnership interests, or other documents may all undermine the clients sought after tax benefit. Price v. Commissioner, T.C. Memo. 2010-2. All this was compounded by the legal documentation to effectuate small dollar gifts, and the accounting work to determine the appropriate allocates each year. This type of planning in most circumstances is not really worthwhile. For most clients seeking to reduce their estate (or shift income) larger periodic gifts are more advisable. This can simplify and cut costs. If the client is financially insecure about making a larger gift the answer in many cases will be to evaluate who the donee should be. Instead of making gifts to heirs outright, which is complex in terms of recordkeeping, involves heirs in the entity, may expose entity interests to being evaluated during a divorce of heirs, etc., advise the client to make the gift instead to a spousal lifetime access trust which the other spouse and heirs can be beneficiaries of. For a single client, consider a gift to a self-settled trust formed in a state that permits this technique, with the spouse as a beneficiary of his or her own trust. Annual gifting may never be the same.
Martin M. Shenkman, CPA, MBA, PFS, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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