If you wish to transfer large amounts of wealth to your family at discounted values for gift tax purposes, you might consider forming a family limited partnership (FLP) or a limited liability company (LLC). However, a pitfall to be aware of when using an FLP or LLC is the step transaction doctrine. Let us take a closer look at how FLPs and LLCs work and how to avoid the step transaction doctrine.
Using an FLP or LLC
There are standard procedures for establishing an FLP or LLC:
- Set up the vehicle, initially retaining all of the partnership or membership units;
- Contribute assets to the entity, such as cash, real estate, marketable securities and/or business interests; and
- Give (or sell) minority interests in the entity to family members or to trusts for their benefit.
This process allows you to retain control over assets while shifting most of the ownership interests to your family at a minimal tax cost. 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.
To ensure the desired tax treatment, the FLP or LLC should have at least one 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 gift or estate 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.
Defining the Doctrine
The IRS sometimes invokes the step transaction doctrine to collapse a series of transactions into a single transaction for gift tax purposes. This dramatically alters the tax outcome.
Under the step transaction 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. In addition, the IRS may invoke the step doctrine if the steps were prearranged parts of a single transaction designed to produce a particular end result, or are mutually interdependent — that is, so closely intertwined that they are meaningless on their own.
Binding commitments are uncommon, but it is fairly common 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.
However, 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 cash, less-volatile securities or real estate, may require a longer waiting period to establish economic risk.
Getting the Timing Right
Using an FLP or LLC is a smart strategy for transferring a large sum of assets to loved ones at a discounted value for gift tax purposes. However, before taking action, work with your qualified tax or legal advisors to set up the ideal structure and determine the appropriate waiting period between funding an FLP or LLC and transferring interests to your family. Doing so can help you avoid having the IRS invoke the step transaction doctrine on your FLP or LLC.
For more information on how the step transaction doctrine can affect your FLP or LLC, contact Adam Pechin at [email protected] or at 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Group.