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Transfer to FLP Includible in Estate Where Decedent Retained Right to Participate in Decision to Liquidate
In the recently issued decision in Estate of Powell, 148 T.C. No. 18 (2017), the Tax Court held that assets transferred to a family limited partnership (“FLP“) in which the decedent had the ability, acting with the other partners, to dissolve the FLP were includible in her estate under Section 2036(a)(2) of the Code.
Section 2036(a)(2) requires the decedent’s gross estate to include property that the decedent transferred during life if the decedent retained “the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy” the assets transferred to the FLP “or the income therefrom.”
In Estate of Powell, while the decedent was incapacitated one week before the decedent’s death, the decedent’s son, acting under power of attorney, transferred some of the decedent’s cash and marketable securities to a FLP, which the son had formed two days prior, in exchange for a 99% limited partnership interest. The son was named the general partner of the FLP, and the partnership agreement of the FLP provided that the FLP could be liquidated with the unanimous consent of the partners. On the same day, the son, purportedly acting under power of attorney, transferred the decedent’s entire interest in the FLP to a charitable lead annuity trust (“CLAT“) with her two sons receiving the remainder upon her death.
The estate did not dispute that the decedent’s power to terminate the FLP, exercisable in conjunction with the other partners, constituted a retained right subject to Section 2036(a)(2). The estate also did not argue that the transfer was a bona fide sale for adequate and full consideration in money or money’s worth, which prevents the application of Section 2036. Instead, the estate’s sole argument was that the decedent did not own any interest in the FLP at her death, and as such, Section 2036(a)(2) could not apply.
The Tax Court, reviving its alternative holding in Estate of Strangi, T.C. Memo 2003-145, aff’d, 417 F3d 468 (5th Cir. 2005), reasoned that the ability of the partners of a limited partnership acting unanimously to dissolve a partnership is a Section 2036(a)(2) power and that the asset transferred to the limited partnership was included in the gross estate on that basis if the limited partnership interest was includible in the gross estate.
Ultimately, the Tax Court determined that the transfer to the CLAT was either void or revocable under California state law because the power of attorney did not authorize donations in excess of the annual federal gift tax exclusion. Thus, the interest in the FLP was includible in the decedent’s gross estate under Section 2033 or Section 2038(a).
The holding in Estate of Powell suggests that the consent of the limited partner of a FLP to the liquidation of the FLP would cause inclusion under Section 2036(a)(2) where the limited partnership interest is includible in the decedent’s gross estate. Moreover, the other bad facts of this case should be avoided, i.e., death bed transfer, transfer under power of attorney, transfer of only cash and securities without any apparent business purpose. FLPs can and do work as an estate planning tool, but they must be fully understood as they require careful planning and administration. Practitioners advising clients with respect to new or existing FLPs should be aware of the Powell decision and undertake a thorough analysis of the control structure involved in both a client’s FLP and overall estate plan.
Members of LLC Subject to Self-Employment Tax on Entire Distributive Share Where They Had Control of LLC’s Business
The Tax court recently held that three attorneys who were members of a Mississippi Professional Limited Liability Company (“PLLC“) were subject to self-employment tax on their entire distributive shares of the PLLC’s income, despite the fact that they received guaranteed payments commensurate with local legal salaries. See Castigliola, et al. v. Commissioner, TC Memo 2017-62. The case provides additional guidance on the self-employment tax status of members of a limited liability company, an area where statutory and regulatory guidance is lacking.
Section 1401(a) of the Code imposes a tax on self-employment income of individuals based on such individuals’ “net-earnings from self-employment” (“NESE“). NESE generally includes an individual partner’s distributive share of partnership income or loss from a trade or business carried on by a partnership of which the individual is a partner. Nevertheless, Section 1402(a)(13) of the Code excludes from self-employment income a limited partner’s distributive share of any item of income or loss, other than guaranteed payments to that partner for services actually rendered to, or on behalf of, the partnership to the extent that those payments are established to be in the nature of remuneration for those services.
In Castigliola, the taxpayers did not dispute that the guaranteed payments received for their legal services were subject to self-employment tax; however, the taxpayers argued that their distributive share of PLLC income in excess of the guaranteed payments should be excluded from NESE under the limited partner exception of Section 1402(a)(13). The IRS took the position that the taxpayers were not limited partners within the meaning of Section 1402(a)(13) and that, therefore, the taxpayer’s entire distributive shares of the PLLC’s income were subject to self-employment tax.
The Tax Court, in reviewing the history of the Revised Uniform Limited Partnership Act and its application by various states, found that the primary characteristics of a limited partner are limited liability and lack of control of the business. Furthermore, the Tax Court determined that the taxpayers in Castigliola participated in control of the business of their PLLC. In particular, the Court noted that the taxpayers collectively participated in making decisions regarding their distributive shares, borrowing money, the hiring and termination of employees and the rates of pay for employees. Each taxpayer also had check-signing authority on behalf of the PLLC. Accordingly, the Tax Court concluded that the taxpayers did not qualify as limited partners under Section 1402(a)(13) and that their entire distributive shares should have been subject to self-employment tax.
Based on the holding in Castigliola, the fact that an LLC member (in an LLC taxed as a partnership) is paid a reasonable compensation guaranteed payment, standing alone, is likely insufficient to sustain a position that a portion of such member’s income is not subject to self-employment tax. On the other hand, given the Tax Court’s reliance on control, a reasonable guaranteed payment combined with lack of management control could potentially justify classification as a limited partner.
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The information contained within this newsletter does not constitute legal advice and is not intended to create an attorney-client relationship. You should consult an attorney for individual advice regarding your own particular situation.