It's no longer necessary to go to Delaware, Georgia or South Dakota to form a family limited partnership or a limited liability company.
A common estate planning technique employed by New Jersey estate planners is the creation of family limited partnerships and, more recently, limited liability companies to enable clients to transfer assets to their family-owned FLPs and LLCs in exchange for ownership interests in these entities. Typically, the FLPs and LLCs are formed in states such as Delaware, Georgia and South Dakota, which restrict the ability of a limited partner of an FLP or member of an LLC from withdrawing from the FLP or LLC and liquidating his ownership interest.
Recent changes in the Limited Liability Company Act of New Jersey and a recent Tax Court ruling, however, suggest that the same estate planning advantages provided for in other states can be accomplished with New Jersey LLCs and FLPs.
As discussed above, the FLP or LLC technique first involves the formation of the entity. Once formed, the primary tax and estate planning advantage gained by clients in connection with the use of FLPs and LLCs is that if your client decides to gift limited partnership interests (in the case of the FLP) or membership interests (in the case of the LLC) to their beneficiaries in the future, since the client is gifting nonmarketable and noncontrolling interests in the entity, rather than gifts of the underlying assets in the entity, your client would be justified in discounting the value of these gifts for gift tax purposes. The discounted valuation enables the client to gift more assets each year without exceeding the $10,000 gift tax annual exclusions and the $675,000 applicable exclusion amount.
To illustrate the leveraged gifts, assume that the entity is funded with assets worth $1,000,000. Assuming a 33 1/3 percent discount, the client could gift a 3 percent interest to each of his beneficiaries or to a trust for their benefit and the client will leverage the use of his $10,000 annual exclusions. A gift of a 3 percent limited partner interest will only be valued at $10,000, because it is calculated as follows: $1,000,000 value x 1.5 percent FLP interest = $15,000, less 33 1/3 percent combined marketability and lack of minority discounts (or $5,000); so the value of the gift equals $10,000.
Under this approach, and assuming the 33 1/3 percent discount for each $10,000 gift that the client makes, $15,000 of current value plus future appreciation escapes gift and estate taxes.
To obtain even greater leverage, the client may want to consider larger gifts of FLP interests using all or a portion of his remaining applicable exclusion. Gifts using the client's applicable exclusion are also discounted. These gifts will consume less of the client's applicable exclusion than is represented by the true value of the gifts.
A gift of a client's 49 percent limited partner interests worth $490,000 will only use up $326,667 of the client's applicable exclusion because of the available discount. It is calculated as follows: $1,000,000 value x 49 percent FLP interest = $490,000, less 33 1/3 percent minority discount (or $163,333); so the value of gift equals $326,667.
Over the past few years, the Internal Revenue Service has been attacking the validity of the FLP and LLC technique. One such argument made by the IRS was the application of §2704(b) of the Internal Revenue Code of 1986 as amended, and Regulation 25.2704-2(a), which provides that if an interest in an entity is transferred to or for the benefit of a member of the transferor's family, any applicable restriction is disregarded in valuing the transferred interest.
Regulation 25.2704-2(b) defines an applicable restriction as a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the state law generally applicable to the entity in the absence of the restriction.
Numerous technical advice memoranda issued by the IRS (including TAMS 9723009, 9725002, and 9730004) concluded that provisions in a partnership agreement prohibiting a limited partner from withdrawing from the partnership constituted applicable restrictions, which were to be disregarded under §IRC 2704(b) because state law permitted a limited partner to withdraw and receive fair value for his interest in the partnership.
In each of the aforementioned TAMS, the FLPs were formed in states whose partnership statutes provided, in the absence of a prohibition in the partnership agreement, that a limited partner shall have the ability to withdraw and liquidate on six months' notice. The partnership agreements, on the other hand, specified that a limited partners could not withdraw from the partnership and liquidate his interest until the expiration of the partnership's term. This restrictive language in the partnership agreement should have the effect of reducing the limited partnership interests' value below liquidation value, since the interests were prohibited from being liquidated until the expiration of the partnership's term.
Withdrawal From Partnership
New Jersey's limited partnership law specifies that a limited partner has the ability to withdraw and liquidate his interest on six months' notice. Specifically, N.J.S.A. 42:2A-41 provides that if the partnership agreement does not specify the time or the events on the happening of which a limited partner may withdraw from the limited partnership, a limited partner may withdraw on not less than six months' prior written notice to each general partner.
Further, N.J.S.A. 42:2A-42 provides that on withdrawal, any withdrawing partner is entitled to receive any distribution to which he is entitled under the partnership agreement and, if not otherwise provided in the agreement, he is entitled to receive, within a reasonable time after withdrawal, the fair value of his interest in the limited partnership as of the date of withdrawal.
As a result, prudent New Jersey estate planners wary of the aforementioned TAMs formed FLPs in other states in order to take advantage of laws that generally prohibit withdrawal by a limited partner unless the partnership agreement affirmatively grants a right of withdrawal.
The Tax Court in Kerr v Commr., 113 T.C. 449 (1999), recently agreed with the taxpayers and concluded that the provisions in a partnership agreement dealing with the liquidation of the partnership and the withdrawal of a limited partner from the partnership were not applicable restrictions. The partnership was formed in Texas, and the Texas partnership law (which is similar to New Jersey's) provides that if the partnership agreement does not specify the time or event when a limited partner may withdraw from the limited partnership, then a limited partner may withdraw on giving written notice not less than six months before the date of withdrawal to each general partner.
The partnership agreement in Kerr provides that no limited partner shall have the right to withdraw from the partnership before the partnership dissolves and liquidates, and that limited partners shall not be entitled to the withdrawal or return of their contributions to the partnerships except to the extent, if any, that distributions are made pursuant to the partnership agreements or on termination of the partnerships.
The Tax Court concluded that the gift tax regulations deal with restrictions on the ability of the entity to liquidate, and the limitations on a limited partner's right to withdraw from the partnership were not within the scope of the regulations. Under the regulations, an applicable restriction is a restriction on the ability of the entity to liquidate, and not on the ability of a limited partner to withdraw. As a result, the limited partnership interests that were transferred may be valued taking into account said restrictions because they are not applicable restrictions.
Keeping It in New Jersey
This ruling should alleviate some concerns New Jersey estate planners harbor in connection with New Jersey's less restrictive partnership statute and could potentially provide the impetus to formation of FLPs and LLCs in New Jersey. It is important to note that while the Tax Court's analysis in Kerr has been applied and supported in other cases, (see Estate of Morton B. Harper v. Commr., TCM 2000-202), the IRS has not acquiesced in the Kerr decision and has appealed the decision, so it will be important to see how the case is finally resolved.
The importance of the Kerr decision cannot be understated. New Jersey clients can gain many economic advantages by forming their family-owned entities in New Jersey.
For example, New Jersey clients no longer would need to pay a corporate service company to maintain an office located in another state to serve as its registered agent, which fees can be in the hundreds of dollars per year. This fee is presumably saved because the New Jersey client has a New Jersey address that can serve as the address for the registered agent of the entity. Also, some of the other states charge a per general partner fee per year for each limited partnership formed, which would be eliminated by forming the limited partnerships in New Jersey.
Single Member LLCs
The New Jersey Limited Liability Company Act was modified to allow single member LLCs (effective Aug. 14, 1998) to be lawful entities in New Jersey. This change is important because a client now has the ability to form a family LLC without any other individual and in return own voting and nonvoting membership interests in the LLC. This is not the case with an FLP because two parties are always required to form a partnership.
In an estate planning context, with a single member LLC, your client can then undertake a gifting program with his nonvoting membership interests and take advantage of the discounting and leveraging of gifts that were discussed above without initially involving another party.
The New Jersey limited liability statute, in connection with withdrawal of a member from an LLC, is similar to the withdrawal of a partner statute - but for one important difference. Although N.J.S.A. 42:2B-38 provides that "if an operating agreement does not specify the time or the events upon the happening of which a member may resign, a member may resign upon not less than 6 months written notice," it also provides that "notwithstanding anything to the contrary set forth in this act, an operating agreement may provide that a member may not resign from a limited liability company prior to the dissolution and winding up of the limited liability company."
This statute authorizes language in an operating agreement that restricts a member from withdrawing from the LLC and liquidating his interest in the LLC, which for valuation purposes would reduce the value of the transferred membership interests.
Arguably, the transfer of a nonvoting membership interest that is subject to an operating agreement that prevents withdrawal prior to dissolution in New Jersey before the Kerr decision would not even expose the transferor to code §2704(b) because the restriction set forth in the operating agreement would not be an applicable restriction.
The law in New Jersey specifies that operating agreements can have such a restriction; thus, it would not be more restrictive than state law, and thus not an applicable restriction that is to be ignored for valuation purposes. New Jersey estate planners should feel comfortable that the restrictions on the transfer of membership interests will be respected.
While we are unable to predict how Kerr will ultimately be decided, the law appears to be moving in a direction that will enable New Jersey estate planners to tailor estate plans for their New Jersey clients that include the formation of FLPs and LLCs in New Jersey.
This article is reprinted with permission from the May 28, 2001 issue of the New Jersey Law Journal. 82001 NLP IP Company.
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