Watch your step!
Step transaction doctrine can increase tax on FLP and LLC gifts
Family limited partnerships (FLPs) and limited liability companies (LLCs) can allow you to transfer substantial amounts of wealth to your loved ones at discounted values for gift tax purposes. But watch out for the step transaction doctrine. The IRS sometimes invokes the doctrine to collapse a series of transactions into a single transaction for gift tax purposes, dramatically altering the tax outcome.
FLPs and LLCs in action
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 is because, for gift tax purposes, minority FLP and LLC interests generally are entitled to substantial valuation discounts (often in the neighborhood of 40% to 50%) for lack of marketability and control.
Pitfalls to avoid
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 are 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.
Step transaction doctrine explained
Under this 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 are meaningless on their own.
Binding commitments are uncommon, but it is 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 is 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 will not be enough.
But the U.S. Tax Court has held that a six-day delay was sufficient. In that case, 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.
Time it right
If you plan to use an FLP or LLC as an estate planning vehicle, work with your advisor to determine an appropriate waiting period between funding the entity and transferring interests to family members. And to avoid an IRS challenge, be sure to document these transactions properly.
Dotting the i's and crossing the t's
To preserve the gift tax benefits of a family limited partnership (FLP) or limited liability company (LLC), proper documentation is a must. Consider the case of Linton v. U.S. The Lintons, a married couple, signed paperwork transferring securities, real estate and cash to an LLC and transferring minority LLC interests to trusts for the benefit of their children, all in the same meeting, on Jan. 22, 2003. The latter documents were undated, but several months later an attorney filled in the missing dates as Jan. 22.
On their gift tax returns, the Lintons applied 47% valuation discounts to the LLC interests. The IRS rejected the discounts, arguing, among other things, that the transfers were indirect gifts of the underlying assets under the step transaction doctrine.
The Lintons claimed that the Jan. 22 date was erroneous — that in fact they transferred the LLC interests on Jan. 31. A federal district court agreed with the IRS, however, and granted summary judgment in favor of the government.
The U.S. Court of Appeals for the Ninth Circuit reversed the lower court's decision, finding sufficient evidence to justify a trial. Even though the Lintons signed the transfer documents on Jan. 22, there was evidence to support the inference that the gifts did not become effective until some later date — such as the date the documents were delivered to the trustee.
In addition, several documents — including the LLC's federal income tax returns, the Lintons' gift tax returns and a valuation report — indicated that the LLC interests were transferred on Jan. 31, which, the appellate court said, could be sufficient to overcome the step transaction argument.
Ultimately, the Ninth Circuit gave the Lintons another opportunity to prevail in court. But the family could have avoided many headaches and litigation expenses by executing the transactions over a longer time period and dating their documents properly.