Family Entities Under Attack by Judy Tuggle and Todd McKinnis

Many clients have chosen to establish closely-held family entities, such as limited partnerships and limited liability companies (herein referred to as a “family entity”), as a part of their estate plan. The advantages and benefits of utilizing such an entity include asset protection, as well as centralized management of family assets as each generation moves into different stages of their lives. One benefit of this type of arrangement has historically been the ability to discount the value of an individual’s interest in a family entity because of its lack of marketability. Additional discounts in value are also often associated with ownership of a minority interest.

Historically, any challenge to the valuation of a family entity interest by the IRS has focused on the percent of discount allowed for these family entity interests when included in a decedent’s estate. However, more recently, the IRS has been successful in making a completely different attack on a decedent’s discounted values for family entity interests using what is called a 2036 argument. This refers to a section of the Internal Revenue tax code which pulls the whole value of an interest back into an estate if the decedent has “retained an interest” in the property. As a result of recent court decisions, the IRS has more aggressively attacked the family entity interests when held by a decedent at the time of his or her death. As a result of these latest developments, the prudent entity owner should take note of the rulings and apply them in structuring and operating the family entity. Failure to do so could result in negative tax consequences.

Based upon language of the recent court rulings, below is a brief summary of steps to consider to reduce the entity’s vulnerability to IRS attacks:

1. Include, if possible, operating business or real estate investments.

2. Create the family entity well before the death or life-threatening illness of an owner.

3. Run the family entity as though the owners were all strangers, i.e., at arms’ length, pursuant to the terms of the family entity’s governing document and by keeping accurate books and records.

4. Document the business and non-tax purposes as much as possible.

5. Keep one’s discounts reasonable by using a reputable valuation firm to value a family entity for any discount valuation to be claimed. (Remember the old adage that pigs get fat, but hogs get slaughtered.)

6. Make sure the owners are financially independent at all times subsequent to the creation of the entity and at the time of death; that is, an owner of an interest in a family entity should have sufficient assets outside of the family entity to maintain their lifestyle and to cover post-death expenses, such as estate taxes. DO NOT TRANSFER ONE’S PERSONAL RESIDENCE, OR OTHER PERSONAL USE ASSETS, TO A FAMILY ENTITY.

7. If possible, have each owner initially contribute to the family entity rather than exclusively relying upon gifts.

8. Make pro-rata distributions to the owners of the family entity.

9. Do not commingle the family entity’s funds with the personal funds of the owners.

10. Make sure the family entity assets are actively managed.

11. Retitle those assets which are transferred to the family entity to reflect the new ownership by the family entity.

Most importantly, respect the family entity. The bottom line is whether the entity looks like a business or does it look like an extension of the family purse and reflect the personality of a matriarch or patriarch’s estate plan.

The use of a family entity provides both tangible and intangible benefits to multi-generational wealth preservation. However, the structure and operation of these entities should be planned and executed with careful attention to the recent court rulings and IRS actions.