Family Limited Partnerships

Attacking the Hurdles

There is a host of ways to attack the FLP structure. Some are specific challenges to specific arguments preventing settlement (eg, the ex-spouse's brother has extracted all earnings under the guise of a management fee to eliminate the ex-spouse's earnings prior to the divorce). The most significant attack is a challenge to the viability and legitimacy of the entire FLP entity. Even if this is not the remedy required, it may very well prove to be the most effective approach. Applicable tax laws, mentioned throughout this article, provide a road map of issues to attack, based on the myriad reported cases of the IRS challenging FLPs. Whether the IRS was successful or not, each case can provide a road map to analyze and challenge the ex-spouse's FLP and the restrictions it imposes.

Distributions

As part of the matrimonial action, your client's ex-spouse may cease receiving distributions from an FLP, and thereafter claim that there is no cash flow from the entity upon which to base child support or alimony payments.

• In that case, review the distribution provisions in the FLP agreement, and determine whether there are any restrictions. Sometimes broad distribution provisions are provided. Also review prior tax returns to determine the history of distributions. It is not uncommon for ongoing distributions to be made and then to cease, or to change form a year or two prior to the divorce action. For example, whereas distributions may have been predominantly pro rata and in accordance with partnership interests, at the mere contemplation of a divorce, cash flow may be reinvested by a non-objective manager or general partner (eg, the ex-spouse's father). Otherwise available cash flow may be reinvested in new assets to prevent distributions. In many instances, these seemingly simple steps will be enough to demonstrate the manipulations of your client's ex-spouse to minimize income and/or cash flow.
• You must also check fees paid to family members. In many instances, key family members will be paid a management fee for running FLP operations. How much are these fees? How much have they been historically? How do they compare to arms'-length fees? Are there any documents supporting or corroborating the basis or rationale for such fees? It may take little more than these few points to defeat this type of manipulation – it may require in-depth exploration.
• Review the tax planning provisions. Does the partnership agreement contain a clause mandating, or suggesting, distributions to avoid phantom income (taxable income to the partners without cash flow sufficient to pay income tax)? If so, it may be necessary to assume some minimum cash flow for matrimonial calculations.
• Determine the method of fund distributions. Distributions other than compensation must be pro rated in accordance with membership interest. Variations from that are often a kind of manipulation.

Equitable Distribution

A common claim by the attorney of the ex-spouse is that assets within the FLP are not available for equitable distribution because the ex-spouse does not own the underlying assets but rather owns merely an interest in the partnership. It should be verified, in fact, that the assets in question have been properly retitled to the name of the partnership. It is not uncommon to find that this work was never completed. In discovery, request copies of deeds and other actual title documents to verify that the claimed assets reflected on an FLP balance sheet (Form 1065, Schedule L) have, in fact, so been transferred.

Unwinding the Entire FLP Transaction

The most significant challenge to the opposition's attempts to hide assets or income behind a FLP structure is to assert the entire structure is not valid, and to thereby provide a basis for the court to pierce the entity. Obviously the first course of action is to name the entity in the action to give the court jurisdiction over it. The next step is to evaluate the overall purpose and use of the entity. If that alone is not sufficient to unwind it, then it may be necessary to evaluate the actual operations of the entity. The following is a checklist of factors that can be used to demonstrate that the formalities of the entity have not been followed, that the entity itself has been disregarded, or that the entity has not been validly formed. The greater the number of factors identified and demonstrated, the more likely a matrimonial court will be to disregard the entity. Citations to applicable tax cases where the IRS challenged and often succeeded in disregarding claimed FLP benefits provide excellent guidance in considerable detail for a practitioner to follow in the event that there is no applicable law in a matrimonial context.

The Checklist

• Was the FLP properly formed under state law? Request a copy of the certificate of formation or organization, and confirm that it was prepared and filed in accordance with applicable state statute. Is the date of filing consistent with the date operations began? Assets were transferred? Partnership agreement signed? If formalities were not adhered to was the formation sufficient to constitute a de facto formation?
• Did the partners execute a partnership agreement containing restrictions of their ability to transfer interests, dissolve the FLP/LLC, or obtain a return of their capital? If not or if the terms of those provisions are too broad, then the ex-spouse may not be able to use them as a shield.
• Did the partners properly contribute assets to the partnership before transferring units to the ex-spouse? For real estate transfers, determine whether deeds were properly recorded. For security transfers, verify whether the transfers are completed and reflected in the entity account under the entity tax identification number. For personalty, a completed bill of sale should exist. See Estate of Morton B. Harper v. Comr. 2000 Tax Ct. Memo, LEXIS 242; T.C. Memo 2000-202 (June 30, 2000); J.C. Shepherd, 238 F.3d 1285 (11th Cir., 2002). In a surprising number of instances, many of the formalities, even for key assets, are ignored.
• Did the ex-spouse contribute virtually all liquid assets to the FLP/LLC? If sufficient assets have not been retained outside the FLP/LLC, the transaction may be overturned on the theory of a fraudulent conveyance. Did the ex-spouse contribute personal assets that undermine the business purpose and nature of the partnership? See Reichardt v. Commr., 114 T.C. No. 9 (2000). Did the ex-spouse remain solvent after the transfer?
• Partners can only receive distributions in proportion to their partnership interests. Other than legitimate management or other fees, distributions cannot otherwise be made except in liquidation. See Schauerhamer Est. V. Comr., T.C.M. 197-242; and Estate of Morton B. Harper v. Comr. 2000 Tax Ct. Memo, LEXIS 242; T.C. Memo 2000-202 (June 30, 2000); Thompson v. Comm'r., T.C. Memo 2002-246. Review bank statements and tax returns to determine whether distributions were properly made.
• Did the partnership open a partnership bank account immediately following the formation (Harper)? Often, partners, especially in family partnerships, run transactions for an initial period through a personal bank account. The more infractions and violations of law and failure to address formalities, the more likely a court should be to overturn and disregard the partnership. Compare initial checks and transactions to the initial partnership bank account. Compare deductions, revenues and other items reported on the tax return to the partnership bank accounts for missing items.
• Did the partners commingle partnership funds with funds of any partner? Did the FLP handle financial and other business affairs as those of any independent business? The courts consider whether acts that would be completed contemporaneously for a business were in fact so handled by the FLP/LLC. Was money transferred on a timely basis? Reflect on whether the entity booked a loan, receivable or other transaction with a partner/member when it was consummated. Were there inaccurate payments of funds and a later reclassification (eg, via journal entry) by the entity accountant? Check the journal entries to see if the accountant has made an adjsutment. The more entries, the more likely a position challenging the partnership's validity. Estate of Morton B. Harper v. Comr. 2000 Tax Ct. Memo, LEXIS 242; T.C. Memo 2000-202 (June 30, 2000).
• Did the ex-spouse file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, to report the gifts of FLP interests to trusts (or did the donor's to the ex-spouse as a donee)? Failure to file a gift tax return as required is another factor supporting a position that the gift was validly made. For example, if the ex-spouse transferred a significant FLP interest to an irrevocable dynasty trust (or other irrevocable trust), the failure to file the required gift tax return may be an important part of trying to overturn the FLP. If the gift tax return was prepared in a manner to meet the “adequate disclosure” requirements that tolls the statute of limitations for tax audit purposes, the required disclosures will be a veritable treasure trove of data to be used in your analysis. Partnership agreements, in response to recent IRS tax court successes, are more likely to give the limited partners who are donees sufficient rights so that the gift will qualify as a gift of a present interest for gift tax purposes. This may involve a right to demand a withdrawal of up to $11,000 in value of FLP interests (similar to a Crummey power in a trust), the right to sell the ex-spouse's entire interest to a third party, or other rights. These rights can all be used as a means to “pry open” the FLP for consideration in establishing alimony or child support, and/or equitable distribution.

Obtain copies of all FLP correspondence. Disingenuous letters have proven fatal to taxpayers in battling the IRS, and can similarly prove fatal to an ex-spouse's arguments. In Murphy, an accountant's letter, and in Thompson, a daughter's letter, contributed to the taxpayers' demise. Letters may address the payment of non-arm's length fees, the making of investments intended to minimize available cash flow, etc. Many partnership agreements address the Kimbell case by stating clearly that the general partner is a fiduciary and has a fiduciary obligation to the limited partners. State law will support this. If the general partner has a fiduciary obligation to other partners, can he or she really justify machinations to protect one partner's divorce result?

What restrictions on distributions are contained in the partnership agreement? Generally, restrictions beyond the maintenance of reasonable reserves (which should be documented and justified to meet the reasonable needs of the business) are inappropriate for tax purposes and might prove helpful to your client's attempts to pierce the FLP.

Conclusion

FLPs and LLCs are common to estate and asset protection planning, and thus increasingly likely to be present in a matrimonial negotiation. When your adversary puts forth the FLP as a roadblock to payments to your client, use the body of tax case law and IRS rulings, some of which have been noted above, to attack and pierce the FLP/LLC to negotiate a fairer settlement for your client.

Family limited partnerships and limited liability companies (collectively, FLPs) are ubiquitous in estate and asset protection planning. The odds are that you will encounter one or more FLPs in discovery with increasing frequency. The question is, what do they mean to the divorce negotiations and settlement, and how can you be certain that your client gets a fair deal? When these entities are set up for estate and asset protection planning, the very mechanisms that reduce values for estate and gift tax purposes and make it harder for creditors to reach the assets will also make it more difficult for you to negotiate a fair and equitable distribution settlement, and a reasonable alimony and child support payment based on the income generated by the entity. This article explains and highlights in general terms how these mechanisms work, and provides a checklist of issues that you can use to attack these entities – thereby obtaining a better settlement for your client.

The Hurdles

There are several hurdles to overcome in order to settle the distribution of an FLP. Some of these include:

• Discounts. If your client's ex-spouse had formed a family limited partnership, he or she may claim that the value of the underlying partnership assets have to be substantially discounted in determining equitable distribution. While the status of such discounts is uncertain (the IRS challenges them for tax purposes, and some state courts have questioned their applicability to divorce cases), the issue may have to be addressed.
• Control. If the distributions from the FLP are subject to substantial restrictions, they may arguably be beyond the control of your client's ex-spouse. Thus, the FLP could generate substantial earnings, yet the ex-spouse may claim that he or she has no access to them. Furthermore, the FLP agreement may designate a person who is not party to the action as general partner (or manager for an LLC) and grant him or her veto power over distributions.
• Decreased Assets. A general partner or manager may extract a substantial portion of the earnings of the LLC in the form of salary, thus minimizing the earnings allocable to your client's ex-spouse. The partnership (operating) agreement may have severe restrictions on sale or transfer of FLP interests.

How does the matrimonial attorney confront these roadblocks to a settlement?

Attacking the Hurdles

There is a host of ways to attack the FLP structure. Some are specific challenges to specific arguments preventing settlement (eg, the ex-spouse's brother has extracted all earnings under the guise of a management fee to eliminate the ex-spouse's earnings prior to the divorce). The most significant attack is a challenge to the viability and legitimacy of the entire FLP entity. Even if this is not the remedy required, it may very well prove to be the most effective approach. Applicable tax laws, mentioned throughout this article, provide a road map of issues to attack, based on the myriad reported cases of the IRS challenging FLPs. Whether the IRS was successful or not, each case can provide a road map to analyze and challenge the ex-spouse's FLP and the restrictions it imposes.

Distributions

As part of the matrimonial action, your client's ex-spouse may cease receiving distributions from an FLP, and thereafter claim that there is no cash flow from the entity upon which to base child support or alimony payments.

• In that case, review the distribution provisions in the FLP agreement, and determine whether there are any restrictions. Sometimes broad distribution provisions are provided. Also review prior tax returns to determine the history of distributions. It is not uncommon for ongoing distributions to be made and then to cease, or to change form a year or two prior to the divorce action. For example, whereas distributions may have been predominantly pro rata and in accordance with partnership interests, at the mere contemplation of a divorce, cash flow may be reinvested by a non-objective manager or general partner (eg, the ex-spouse's father). Otherwise available cash flow may be reinvested in new assets to prevent distributions. In many instances, these seemingly simple steps will be enough to demonstrate the manipulations of your client's ex-spouse to minimize income and/or cash flow.
• You must also check fees paid to family members. In many instances, key family members will be paid a management fee for running FLP operations. How much are these fees? How much have they been historically? How do they compare to arms'-length fees? Are there any documents supporting or corroborating the basis or rationale for such fees? It may take little more than these few points to defeat this type of manipulation – it may require in-depth exploration.
• Review the tax planning provisions. Does the partnership agreement contain a clause mandating, or suggesting, distributions to avoid phantom income (taxable income to the partners without cash flow sufficient to pay income tax)? If so, it may be necessary to assume some minimum cash flow for matrimonial calculations.
• Determine the method of fund distributions. Distributions other than compensation must be pro rated in accordance with membership interest. Variations from that are often a kind of manipulation.

Equitable Distribution

A common claim by the attorney of the ex-spouse is that assets within the FLP are not available for equitable distribution because the ex-spouse does not own the underlying assets but rather owns merely an interest in the partnership. It should be verified, in fact, that the assets in question have been properly retitled to the name of the partnership. It is not uncommon to find that this work was never completed. In discovery, request copies of deeds and other actual title documents to verify that the claimed assets reflected on an FLP balance sheet (Form 1065, Schedule L) have, in fact, so been transferred.

Unwinding the Entire FLP Transaction

The most significant challenge to the opposition's attempts to hide assets or income behind a FLP structure is to assert the entire structure is not valid, and to thereby provide a basis for the court to pierce the entity. Obviously the first course of action is to name the entity in the action to give the court jurisdiction over it. The next step is to evaluate the overall purpose and use of the entity. If that alone is not sufficient to unwind it, then it may be necessary to evaluate the actual operations of the entity. The following is a checklist of factors that can be used to demonstrate that the formalities of the entity have not been followed, that the entity itself has been disregarded, or that the entity has not been validly formed. The greater the number of factors identified and demonstrated, the more likely a matrimonial court will be to disregard the entity. Citations to applicable tax cases where the IRS challenged and often succeeded in disregarding claimed FLP benefits provide excellent guidance in considerable detail for a practitioner to follow in the event that there is no applicable law in a matrimonial context.

The Checklist

• Was the FLP properly formed under state law? Request a copy of the certificate of formation or organization, and confirm that it was prepared and filed in accordance with applicable state statute. Is the date of filing consistent with the date operations began? Assets were transferred? Partnership agreement signed? If formalities were not adhered to was the formation sufficient to constitute a de facto formation?
• Did the partners execute a partnership agreement containing restrictions of their ability to transfer interests, dissolve the FLP/LLC, or obtain a return of their capital? If not or if the terms of those provisions are too broad, then the ex-spouse may not be able to use them as a shield.
• Did the partners properly contribute assets to the partnership before transferring units to the ex-spouse? For real estate transfers, determine whether deeds were properly recorded. For security transfers, verify whether the transfers are completed and reflected in the entity account under the entity tax identification number. For personalty, a completed bill of sale should exist. See Estate of Morton B. Harper v. Comr. 2000 Tax Ct. Memo, LEXIS 242; T.C. Memo 2000-202 (June 30, 2000); J.C. Shepherd, 238 F.3d 1285 (11th Cir., 2002). In a surprising number of instances, many of the formalities, even for key assets, are ignored.
• Did the ex-spouse contribute virtually all liquid assets to the FLP/LLC? If sufficient assets have not been retained outside the FLP/LLC, the transaction may be overturned on the theory of a fraudulent conveyance. Did the ex-spouse contribute personal assets that undermine the business purpose and nature of the partnership? See Reichardt v. Commr., 114 T.C. No. 9 (2000). Did the ex-spouse remain solvent after the transfer?
• Partners can only receive distributions in proportion to their partnership interests. Other than legitimate management or other fees, distributions cannot otherwise be made except in liquidation. See Schauerhamer Est. V. Comr., T.C.M. 197-242; and Estate of Morton B. Harper v. Comr. 2000 Tax Ct. Memo, LEXIS 242; T.C. Memo 2000-202 (June 30, 2000); Thompson v. Comm'r., T.C. Memo 2002-246. Review bank statements and tax returns to determine whether distributions were properly made.
• Did the partnership open a partnership bank account immediately following the formation (Harper)? Often, partners, especially in family partnerships, run transactions for an initial period through a personal bank account. The more infractions and violations of law and failure to address formalities, the more likely a court should be to overturn and disregard the partnership. Compare initial checks and transactions to the initial partnership bank account. Compare deductions, revenues and other items reported on the tax return to the partnership bank accounts for missing items.
• Did the partners commingle partnership funds with funds of any partner? Did the FLP handle financial and other business affairs as those of any independent business? The courts consider whether acts that would be completed contemporaneously for a business were in fact so handled by the FLP/LLC. Was money transferred on a timely basis? Reflect on whether the entity booked a loan, receivable or other transaction with a partner/member when it was consummated. Were there inaccurate payments of funds and a later reclassification (eg, via journal entry) by the entity accountant? Check the journal entries to see if the accountant has made an adjsutment. The more entries, the more likely a position challenging the partnership's validity. Estate of Morton B. Harper v. Comr. 2000 Tax Ct. Memo, LEXIS 242; T.C. Memo 2000-202 (June 30, 2000).
• Did the ex-spouse file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, to report the gifts of FLP interests to trusts (or did the donor's to the ex-spouse as a donee)? Failure to file a gift tax return as required is another factor supporting a position that the gift was validly made. For example, if the ex-spouse transferred a significant FLP interest to an irrevocable dynasty trust (or other irrevocable trust), the failure to file the required gift tax return may be an important part of trying to overturn the FLP. If the gift tax return was prepared in a manner to meet the “adequate disclosure” requirements that tolls the statute of limitations for tax audit purposes, the required disclosures will be a veritable treasure trove of data to be used in your analysis. Partnership agreements, in response to recent IRS tax court successes, are more likely to give the limited partners who are donees sufficient rights so that the gift will qualify as a gift of a present interest for gift tax purposes. This may involve a right to demand a withdrawal of up to $11,000 in value of FLP interests (similar to a Crummey power in a trust), the right to sell the ex-spouse's entire interest to a third party, or other rights. These rights can all be used as a means to “pry open” the FLP for consideration in establishing alimony or child support, and/or equitable distribution.

Obtain copies of all FLP correspondence. Disingenuous letters have proven fatal to taxpayers in battling the IRS, and can similarly prove fatal to an ex-spouse's arguments. In Murphy, an accountant's letter, and in Thompson, a daughter's letter, contributed to the taxpayers' demise. Letters may address the payment of non-arm's length fees, the making of investments intended to minimize available cash flow, etc. Many partnership agreements address the Kimbell case by stating clearly that the general partner is a fiduciary and has a fiduciary obligation to the limited partners. State law will support this. If the general partner has a fiduciary obligation to other partners, can he or she really justify machinations to protect one partner's divorce result?

What restrictions on distributions are contained in the partnership agreement? Generally, restrictions beyond the maintenance of reasonable reserves (which should be documented and justified to meet the reasonable needs of the business) are inappropriate for tax purposes and might prove helpful to your client's attempts to pierce the FLP.

Conclusion

FLPs and LLCs are common to estate and asset protection planning, and thus increasingly likely to be present in a matrimonial negotiation. When your adversary puts forth the FLP as a roadblock to payments to your client, use the body of tax case law and IRS rulings, some of which have been noted above, to attack and pierce the FLP/LLC to negotiate a fairer settlement for your client.