A FLP Tax-Saving Strategy

Letter Ruling 200243001 presents a wealth-transfer strategy for a majority shareholder of a closely held corporation (CHC) that has an employee stock ownership plan (ESOP) as a minority shareholder. The strategy achieves three objectives: it (1) diversifies the majority shareholders portfolio, (2) allows him or her to discount the value of gifts made to his or her children, for gift and estate planning purposes and (3) achieves these goals in a tax-efficient manner.

In the ruling, the taxpayer transferred CHC stock to a family limited partnership (FLP) for a 99% limited partnership interest. An S corporation controlled by the taxpayer owned the remaining 1% general partner interest, which gave the taxpayer control over partnership elections. The taxpayer gifted FLP interests to his children. The FLP then converted into a limited liability company (LLC) that elected to be treated as a partnership for Federal tax purposes; the taxpayer continued to gift LLC interests.

In the ruling, the taxpayer sought to use a Sec. 1042 election to defer tax on the FLPs sale of CHC stock to the ESOP. Under Sec. 1042(b), for a sale to an ESOP to qualify for deferral, the ESOP, after the sale, must own at least 30% of either (1) each class of outstanding CHC stock or (2) the total value of all outstanding CHC stock. The seller must also purchase qualified replacement property (as defined in Sec. 1042(c)(4)).

Analysis

Sec. 1042(c)(1) will allow for tax deferral on sales of qualified securities sold to an ESOP if certain requirements are met. The ruling mainly addresses whether use of a FLP followed by a conversion into an LLC satisfies the three-year holding period, required under Sec. 1042(b)(4) for qualified property sold to an ESOP, and whether the disposition of a qualified replacement property (QRP) on a gift of a FLP (or an LLC) interest or on a conversion of a FLP into an LLC triggers Sec. 1042(e) recapture.

According to the ruling, the transfer of the CHC stock to the FLP and the conversion of the FLP into the LLC do not trigger new holding periods. Rather, under Sec. 1223(2), if the basis of property in the transferees hands is the same as that in the transferors hands, the transferee takes the transferors holding period. Thus, under Secs. 723 and 1223 (assuming Sec. 721(b) does not apply), the FLPs holding period in the CHC stock contributed by the taxpayer will include the period he held the stock. The LLCs holding period will include the periods that the FLP and the taxpayer held the CHC stock.

As for whether gifting of the FLP interest was a QRP disposition, the ruling provides that for Sec. 1042(e) purposes, the transaction would not trigger gain recognition otherwise deferrable under a Sec. 1042 election. This is due to the exception provided in Sec. 1042(e)(3)(C) for gifts.

The ruling also considers whether the conversion of the FLP into the LLC would be a QRP disposition. Rev. Rul. 84-52, amplified by Rev. Rul. 95-37, addressed conversions of a general partnership into a limited partnership, and a domestic partnership into a domestic LLC (classified as a partnership for Federal tax purposes), respectively. They held that after the conversion, the new entity is a continuation of the old partnership. Further, because the conversion of the FLP into the LLC will not result in a termination of the FLP under Sec. 708, Letter Ruling 200243001 concluded that (1) the LLC will be a continuation of the FLP and (2) the FLP will not have disposed of the QRP and will not have to recognize otherwise deferred gain.

Conclusion

This structure has several benefits as a wealth-transfer strategy. First, by making a Sec. 1042 election, a taxpayer can diversify his or her holdings on a tax-deferred basis. Second, by retaining a general partnership interest in the FLP through S stock ownership, the taxpayer retains the exclusive ability to make a Sec. 1042 election for the partnership. Third, by gifting FLP (and, later, LLC) interests, rather than directly gifting the replacement property purchased via the Sec. 1042 election, the taxpayer insulates himself or herself from the possibility of recognizing gain under Sec. 1042(e) due to a disposition of a QRP by a beneficiary. Instead, the beneficiary can dispose of a FLP (or an LLC) interest (which is not the same as disposing of the replacement property) without triggering Sec. 1042(e) recapture. Finally, the use of a FLP and an LLC as a means of transferring wealth allows the taxpayer to discount the gifted interests.

From Goodarz Agahi, Washington, DC