- Owen Fiore Paper 1 by fsb96139


									                              Spring Meeting - ABA RPPTL Section

San Francisco, CA                                                                  April 25-26, 2002

                                   FLPs and LLCs: Their Uses
                                   in Family Wealth Transfers


We review here the lawyer’s opportunities, pitfalls and duties in advising clients on FLP/LLC

planning, compliance issues, audit strategies and efficient handling of tax controversies. The total

Valuation Planning Spectrum should be considered in order to properly serve and protect our

clients in using pass-through entities and wealth shifting techniques. This means that, in addition to

planning and its implementation, entity operations, compliance and handling IRS examinations and

controversies are important to success of such plans. Family Wealth Succession is enhanced and

client goals better realized with effective entity and valuation planning.

                                   Owen G. Fiore, JD, CPA
                                  The Fiore Law Group LLP
                               125 South Market Street, Suite 1150
                                   San Jose, California 95113
                                   Telephone: (408) 293-3616
                                      Fax: (408) 293-0430
                                e-mail: mflg@fiorelawgroup.com

                                 “A Fortress of Entity Bricks”

(Cartoons courtesy of Owen’s son, Mark Fiore, an editorial cartoonist, animator and illustrator.
See his website: www.markfiore.com/)

Focus & Overview

As lawyers we are asked by our clients to consider many personal, business and investment
alternatives designed to achieve client goals. During the past few years, the popularity of FLP/LLC
planning has increased substantially; however, IRS has reacted to the perceived compliance problem
with a National Office-directed exam, Appeals and litigation program that reminds us somewhat of
the “abusive tax shelter” program of years ago.

IRC Sec. 704(e), enacted in 1951, the “check-the-box” Treasury Regulations, the very definition of a
“partnership” per Treasury Regulations, and Tax Court guidance in cases such as Estate of Strangi
(cited and discussed in the materials), together provide the substantial basis for using such pass-
through entities in family wealth preservation.

Yet we must acknowledge that there have been abuses in FLP/LLC-based valuation adjustments
(“discounts”) for transfer tax valuation purposes. We thereby contend that lawyers operating under
the highest standards of tax practice, due diligence, competence and client communication and
education can avoid the pitfalls, thereby developing and monitoring successful FLP/LLC plans.

The attached materials consider various procedural, substantive and practical issues involved and the
panel will consider effective, efficient FLP/LLC plan design, documentation and operation.

                                                                                     Owen G. Fiore

                                                                                 February 13, 2002
                                                                                     San Jose, CA

                                     Table of Contents

       Description                                               Ref.

Focus & Overview                                                 OGF-3

Table of Contents                                                OGF-4

Valuation Controversies                                          OGF-6

Topics for Panel Consideration                                   OGF-9

A.     Selected Reference Material                               OGF-10

B.     A View From the Bench                                     OGF-11

C.     Other Materials                                           OGF-11

The IRS National Compliance Program                              OGF-12


Fiore & Ramsbacher, “Protecting The Reality In Entity-Based
Transfer Tax Valuation Adjustments”, draft article submitted
Dec. 2001 to Matthew Bender for publication in the Proceedings
of the 60th NYU Inst. on Fed. Tax. (pub. 3/02)

“Here Comes The Judge!”

Valuation Controversies

Transfer tax (gift, estate and GST) valuation will continue in 2002 as a “hot topic”, impacted by a
number of 1999-2001 developments in planning, compliance and tax controversy areas that lawyers,
CPAs and other tax and financial services professionals must take into account in order to fully serve
our clients. Private tax practitioners must develop and broaden their professional practices following
the 2001 major legislative changes in tax law, including, of course, transfer tax changes.

Certainly, the impact of H.R. 1836, enacted June, 2001, was a major development, which calls for
review of most estate planning. Inter-vivos planning is especially impacted with transitioned estate
tax repeal, continuing of the gift tax, the coming carryover basis regime and substantially increased
exemption equivalent amounts. The tax bill provides phased-in repeal of the estate and GST taxes
(2002-2009, inclusive, but note the “sunset” provision effective January 1, 2010!), with the gift tax
continuing - $1 million unified credit exemption equivalent at highest individual income tax rate
(35% - 2010 and beyond, subject again to the “sunset” provision). Thus, for e.g., use of the straight
or IDGT installment sale seems guaranteed to be very popular; especially in view of the “spread”
between a capital gains rate of 20% on gain, and the 2010 35% gift tax rate, plus the beneficial
“freeze” effect of a sale. Of special significance to our panel discussion is that H.R. 1836 did not
contain any provisions changing the Code and other rules respecting valuation.

Valuation uncertainty continues, however, by reason of legal and tax issues on entity reality and
consideration of appropriate methodologies to use in particular cases. The appraisal profession, tax
advisors and the courts struggle with the “valuation game”, i.e. the battle of the appraisers. And
now, as witnessed by 9th Circuit Court of Appeals reversals of the Tax Court in Kaufman, Mitchell,
and Simplot, as well as another reversal, Jameson, in the 5th Circuit ( all cited and discussed in the
appendices), the appellate courts have been somewhat critical of the Tax Court’s statements and
conclusions on valuation.

And, as we’ll see, given that transfer tax valuation also involves both procedural and substantive
legal issues, we have a number of significant developments that are worthy of consideration and
which clearly support use of strategic alliances of tax lawyers, CPAs, and appraisers in management
of valuation issues throughout the Spectrum of Valuation Planning. For example, we will see how
tax professionals can advise their clients to create valuation discounts through multiple entities
(including even trusts, ala Mellinger, see the NYU article discussion) without violating client control
goals. This, of course, assumes that such entities will be respected for tax purposes - an issue still
contested by the Service.

Perhaps the most important entity valuation developments, with a number of Tax Court, U.S.
District Court and even Circuit Courts of Appeal cases during the past couple of years, have been in
the exciting area of planning with pass-through entities - such as, general partnerships, FLPs,
LLCs. Also, “S” corporations, being pass-through entities, are in the same area for consideration.
Can “deathbed” entities work? - A question posed by IRS audit and litigation initiatives commenced
back in early 1997. The answer is simple - for this practitioner you bet! So we’ll consider Kerr,
Harper, Church, Strangi, Knight, Jones, Reichardt, Dailey, etc., and develop the “Box Score” on
FLP litigation after the IRS has pursued it so vigorously. Nevertheless, as evidenced by the IRS

opening statement in the Estate of Morton Harper Tax Court trial on March 23, 2001 (Docket No.
19336-98, Tax Court Judge Nims), the Service continues the battle:

               “Your Honor [Ms. Donna Herbert, IRS counsel], this case concerns
               what’s perceived by respondent as a transfer tax shelter, that is, the
               family limited partnership .... But regardless of whose idea it was,
               the formation of this partnership enabled the decedent and his
               children to claim large discounts on the value of this portfolio for
               both gift and estate tax purposes .... It is undisputed that the decedent
               transferred virtually all of his assets into the partnership .... [H]ow
               was he going to live? ...[I]t is the government’s position that the
               partnership lacked economic substance in that it had no business
               purpose, and because it was created solely for the purpose of
               reducing estate and gift taxes .... [T]he formation of the partnership
               was tax avoidance.... Your Honor [in response to Judge Nims’
               question about Strangi], while we are aware that this division of the
               Court is bound by Strangi, we wish to preserve the issue for appeal.
               And we believe that essentially the same record is needed to support
               the economic substance argument as the 2036 argument in most

All in all, we are nearly overrun by new developments in transfer tax valuation - fortunately, they
mostly are “taxpayer-friendly”. Note, however, that the impact on planning and the costs thereof
(as well as costs associated with compliance, examination and controversy) are quite significant. I
believe the “due diligence bar” has been raised substantially, and perhaps this is in the best interests
of our clients. Lawyers can and should be involved in advising clients on a practical basis. I hope
our panel review of valuation issues, supported by the outlines and appendices, will add to the
knowledge of conference attendees, and more importantly, will be a call to action for you and your

           “The Shell Game”

Topics for Consideration in Entity-Based
  Valuation and Succession Planning

       •       The Spectrum of Family Wealth Planning

       •       Status of IRS Reorganization and Impact on Field Audits in the Transfer Tax Area

       •       IRS Audit and Litigation Initiatives - What Are They?

       •       Dealing with the 1998 Act, in particular IRC Section 7491 (Shifting of Burden of
               Proof) and other aspects of the “Taxpayer Bill of Rights 3”

       •       Choices and Documentation relating to the “Adequate Disclosure” statutory and
               regulations requirements for running of the Gift Tax Statute of Limitations (gifts
               after 12/31/96)

       •       The Reality of Entities and Transactions for Transfer Tax Purposes, including FLPs
               and FLLCs in light of Shepherd, Strangi, Knight, Jones, and Dailey

       •       IRS Use of IRC Section 2036 - ala Schauerhamer, Reichardt, Wineman, and Trotter

       •       “Substance Over Form” - What Does It Mean, and can this Doctrine Trump IRC
               Sections 704(e) and 2035? - ACM Partnership, Costanza, Murphy and Frank

       •       Consideration of special valuation issues, such as the scope and interpretation of the
               hypothetical willing buyer-willing seller standard of value per applicable Treas.
               Regs. and Rev. Rul. 59-60, use of “actual sales”, “post-transfer” events, selection of
               valuation methodology, the Mellinger non-aggregation rule, “layered discounts”,
               “built-in gains” (Davis and Eisenberg), premium on voting stock (Simplot), Chapter
               14 (esp. IRC Secs. 2703 and 2704)

       •       Valuation Evidence - Audit, Appeals and Tax Court Levels of Evidence

       •       Audit and Controversy Management Suggestions for Practitioners

The foregoing topics all relate to legal, procedural and factual issues involved in transfer tax
valuation. Detailed discussion of many of these topics is contained in the several articles attached
hereto as appendices.

There is a wealth of information available on valuation issues, and the attendees at this CEB
advanced course of study should take advantage of this material, especially since valuation both is
uncertain and a “moving target” for all concerned.
Therefore, I offer the following selected references for your consideration:

A.     Selected Reference Material

     1.     “Ownership Shifting to Realize Family Goals, Including Tax Savings”, 37 Fiore,
            NYU Inst. on Fed. Tax. ch. 38 (1978)

     2.     “Developing Valuation Discounts to Withstand Challenge”, Dennis A. Webb, MAI,
            ASA, Estate Planning, Vol. 27, No. 5 (June, 2000, at p. 214)

     3.     “Valuation Principles and Recent Developments: Practical Guidance For The Estate
            Planner”, Benford and Zeydel, 34 Real Property, Probate and Trust Journal, No. 2
            (Summer, 1999), p. 207

     4.     “Why Tax Advisers and Appraisers Are in a New ‘Valuation Partnership’”, Fiore,
            NACVA’s The Valuation Examiner, Oct.-Dec., 1999, p. 18

     5.     “Adequate Disclosure of Gifts”, Kahan, The Practical Accountant, Feb. 2000

     6.     “Obtaining the Best Results in an IRS Estate Tax Audit”, Carpenter, Estate Planning,
            Aug.-Sept., 1999

     7.     Anticipating the Estate Tax Audit and Proving the Real Estate Valuation Case in Tax
            Court”, Keith Schiller, CA Trusts and Estates Quarterly, Vol. 6, No. 1 (Spring, 2000)

     8.     “A Gift In Time Can Save An Estate Tax Gold Mine”, Fink, Practical Tax Strategies,
            Feb., 2000

     9.     “Minimizing the Risks of Estate Litigation: Estate Planning for the High Net Worth
            Client in Anticipation of Litigation”, Belcher and Pomeroy, T.M. Estates, Gifts and
            Trusts Journal, Vol. 25, No. 1, Jan. 13, 2000

     10.    “Settlement Data and The Effect on FLP Discounts”, Eggers, CEB Estate Planning &
            California Probate Reporter, Vol. 21, No. 5, Apr., 2000

     11.    Fiore, ACTEC Notes article, June, 1998, “Planning, Operating & Defending
            FLP/FLLC-Based Entities Spawning Valuation Discounts”, plus update article,
            published December, 2001, in the ACTEC Journal: “Coping with Continuing
            Uncertainty in FLP/LLC-Based Valuation Discount Strategies”

     12.    Yuhas and Radom, “Maximizing Discounts For Both Spouses Using LLCs and
            FLPs”, CCH Journal of Practical Estate Planning, June-July, 2000, p. 33

B.   A View From the Bench

     Tax Court Judge David Laro provided his personal insights for CPAs in the area of transfer
     tax valuation at the California CPA Education Foundation’s 2001 Advanced Estate Planning

     Institute (SF, 1/18-19/01) when he presented a paper titled “Valuation Issues: A Judicial

C.   Other Materials

     1.     Mulligan, “Valuation Idiosyncrasies - Rules Governing (Distorting?) Federal Estate
            and Gift Tax Values”, 2001 AICPA Advanced Estate Planning Conference, paper
            presented July 24, 2001.

     2.     California CEB Advanced Course of Study, Oct. 2000, “FLPs and LLCs: Their Uses
            in Family Wealth Transfers”, seven (7) chapters with separate authors (e.g. John
            Porter, Phil Jelsma, Lance Hall) covering various aspects of the subject.

     3.     “Comprehensive Guide for the Valuation of FLPs”, 2001 Edition, Johnson and
            Jefferies, published by Partnership Profiles, Inc., Dallas, TX.

     4.     Shannon Pratt valuation appraisal publications, including newsletters, books, and
            studies: www.BVResources.com.

                             The IRS National Compliance Program

The following material, prepared by Owen Fiore for the January, 2002 State Bar (Section of
Taxation) 10th Annual Estate Planning Conference (audio tapes available) relates to IRS guidance on
its National Office-directed compliance program relating to FLPs, LLCs and S corporation-based
transfer tax valuation adjustment (“discount”) plans. Mr. Fiore and Chuck Morris, IRS Territory 5
E&G Manager, were panelists on this program.

The National Office of IRS has been operating at several levels (exam, Appeals, litigation) a national
program relating to FLP, LLC and S corporation situations wherein valuation discounts for transfer
tax purposes are claimed based upon the use of fractionalized pass-through entity equity interests.
As described in the “What’s the Score” section of the OGF/JFR NYU article included in these
materials (page 19 thereof), there have been developed by IRS a number of arguments to challenge
the viability of substantial valuation discounts, many of which are grounded in use of statutory and
judicial theories as yet not generally adopted by the courts. Of particular interest is the IRS effort,
which is quite serious, to apply the doctrine of economic substance to the FLP, et al, area of tax
controversy - in spite of the Strangi and other taxpayer friendly cases.

The Service clearly believes there is a substantial compliance problem in this area, while also
understanding that some entity planning can be accomplished without there being a basis for attack
and litigation by IRS. This problem first surfaced nationally, after years of simmering in the field, in
Final Treasury Regulations Sec. 1.701-2, the so-called “partnership anti-abuse regulations”
(12/29/94). However, at the urging of some Congressional leaders, those portions of these
regulations setting out two FLP situations (one abusive, one considered non-abusive) were
rescinded, and, most notably, the regulations were restricted in scope to income tax situations.

Private practitioners were incorrect if they assumed the Service would not continue its analysis and
study of the perceived compliance problem. Thus, in 1997, a substantial number of letter rulings
were issued, in the form of TAMs (see the NYU article citations), specifically attacking FLP-based
valuation discount plans, in most situations involving so-called “death-bed FLPs”. None of these
TAMs ended up in the Tax Court since it is understood that the taxpayers in all of these situations
settled their cases with IRS, most likely conceding the abuse in entity use or excessive valuation
discounts. On the positive side, early in 1997 the Estate of Winkler was decided by the Tax Court
(T.C. Memo. 1997-4), approving a “lottery ticket” oral partnership by applying IRC Sec. 704(e) in a
gift tax case.

Many private practitioners believe the Service national program is an overreaction to acknowledged
abuses and is not supported by existing law. In this regard, note the fundamental principles
supporting pass-through entity use include the following:

       (1)     The transfer tax is an excise tax and only relates to the specific property interest
               passing by gift or at death.

       (2)     IRC Sec. 704(e), enacted in 1951, provides a “safe harbor”.

       (3)     “Choice of entity” is a taxpayer choice - whether FLP, LLC or S corporation. The
               “check-the-box” Treas. Regs. show the broad choices available.

       (4)     The Code and Regulations as to entities are clear - passive investment assets can be
               held by an entity.

       (5)     IRC Sec. 2035 (as amended in 1981) allows for “gifts in contemplation of death”
               (except as to life insurance).

The most complete statement of the early positions of the Service is found in a 1998 FLP ruling,
namely, TAM 9842003. This was followed later by the Service applying essentially the same
arguments in a ruling on an LLC situation, namely FSA 200049003. The referenced “box score” on
issues illustrates ongoing uncertainty of result. Issues include Chapter 14’s IRC Secs. 2703 and
2704(b), “gift on formation” and similar “reality attacks”, IRC Sec. 2036, and the appropriate
valuation discount level. The Service can be expected to continue to use these arguments, and even
others - such as; characterizing an FLP as a “trust” where passive assets are held by the entity. (See
E&G Attorney (FL) George Del Duca’s article appearing in a 2001 issue of The Florida Bar
Journal.) However, this practitioner points to as yet not fully explored taxpayer-friendly positions
supporting FLP reality: IRC Sec. 704(e) (the family partnership “safe harbor”), IRC Sec. 2035
(Congress approved most “gifts in contemplation of death” in 1981), and the “check-the-Box” and
entity definition Treasury Regulations.

Finally, most recently, in FSA 200143004 (released 10/31/01), the Service applied its national
program arguments in attacking use of an S corporation as an investment holding company for
marketable securities where the stock of the S corporation then was gifted (as part of a prearranged
plan) at substantial discounts from underlying asset value to the founding shareholder’s children.
The most recent of these rulings (FSA 200143004) is attached so that our panelists can discuss this
guidance, even though, as with all letter rulings, the caveat applies that they cannot be used or cited
in other cases.

As is made clear by the foregoing outline materials, especially the draft NYU article, the Service has
selectively picked cases for litigation. While generally, except as to the 2036 issue and
inappropriate entity formation situations, the Service has not been successful in advancing reality
arguments at the trial level (and even in the 5th Circuit Court of Appeals), several cases still are on
appeal. Plus, note the quote from IRS counsel in the Harper case, to the effect the Service considers
the FLP, et al valuation area a “transfer tax shelter”.

As early as 1998, Chuck Morris, IRS Tax Territory 5 Estate & Gift Manager, was involved in
development of draft examination guidelines on the perceived FLP compliance problem; and these
guidelines, in their present form, have been distributed in the field and at IRS continuing education
meetings marked “For Official Use Only”. As a practical matter, the guidelines are in use at this
time. The above-referenced rulings, the nature and scope of IDRs from examiners to taxpayer
representatives, and discussions with examiners and their supervisors have given some shape to our

perception of these examination guidelines - even though as yet they have not been released to the
public. It is hoped that the guidelines at some point, earlier rather than later, will be released. By
doing so, the Service would be alerting practitioners and their clients about the pitfalls of use of
pass-through entities and valuation discounts without carefully avoiding the perceived abuses.

As a practitioner involved in planning as well as controversy work, I personally would welcome
publication of the IRS guidelines as they would be an educational tool for clients and their advisors.
 Obviously, we no doubt would disagree with the guidelines in some respects; but at least we would
be forewarned and, at the planning stage, could take action to avoid most of the risks of Service
attack. Since the “audit lottery” is a reality, release of the guidelines in my opinion, would be
helpful to IRS as well as to private tax practitioners.

In spite of the referenced Strangi case opinion’s apparent disregard for “business purpose”, my own
view is that an entity program where family members are involved requires some substantial non-tax
avoidance purpose (whether it is a business, management or investment protection purpose). This is
especially the case in view of the referenced rulings’ continuing emphasis on the doctrine of
“economic substance”, citing, among other cases, the decision of Judge David Laro in ACM
Partnership v. Commissioner, cited in the above materials. See, for example of deficient planning
bringing into play a “judicial reality check”, Judge Laro’s opinion in Estate of Constanza, T.C.
Memo. 2001-128. This case involved a “SCIN” (self-canceling installment note) that, by reason of
“bad facts” was disregarded resulting in a 100% gift!

Further, it appears to me that generally careful planning and operation of an entity plan can avoid the
2036 risk (as broad as it is due to the “implied agreement” concept). As to issues such as those
raised in Shepherd and Jones, these can be avoided by careful practitioners. Thus, a high level of
due diligence and client education is required if the wealth preservation goals of pass-through entity
planning are to be achieved.

Finally, the level of uncertainty of valuation discounts, even assuming entity reality will continue to
be a source of dispute with IRS. The Service has increased its resources devoted to appraisals, and
has developed independent appraisers capable of providing opinions as to lower discount levels.
The timing and expense of appraisals is an important matter for consideration by private
practitioners, just as it is of concern to Service representatives.

The referenced rulings (as well as my CCH article: “First FLPs and LLCs, Now S Corporations”,
CCH Estate Planning Review, 12/19/01) should be studied by practitioners and used in planning to
minimize the risk of audit attack, at lest until the Service publishes its examination guidelines.
Further, practitioners should understand there are important practitioner and preparer standards in
tax practice, including, but not limited to, those set forth in Circular 230. I refer you to the Bernard
Wolfman, James P. Holden, Kenneth L. Harris “Standards of Tax Practice” book, 5th ed. (1999),
published by Tax Analysts, Inc.


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