Last week, the IRS issued proposed regulations that will significantly reduce valuation discounts for gifts or sales of interests in family limited partnerships, family limited liability companies, and closely-held corporations.  It will take years and several court cases to determine the overall effect of the regulations.  My best guess is that the regulations will reduce the valuation discount for a typical family limited partnership gift or sale from approximately 35% to approximately 5% or 10%.

These regulations were issued pursuant to a statute that was enacted in 1990.  The reason the IRS waited so long to promulgate these regulations is because they preferred for Congress to change the law.  They have given up on Congress.  The regulations may eventually be ruled to be invalid for exceeding the statutory authority that was given to the IRS to promulgate these regulations.  Nevertheless, my advice is to plan as if the proposed regulations will be valid when issued as final regulations.  Trust me.  You don’t want to pay the legal fees to overturn the validity of IRS regulations.

When will the regulations become final?  We do not know for sure.  The IRS will hold hearings on the regulations on December 1, 2016.  Generally, it takes several weeks or months to finalize the regulations after the public hearings. The IRS will undoubtedly receive vociferous complaints from different groups around the country.

In summary, any planning transactions involving gifts or sales of family limited partnerships, family limited liability companies or closely-held corporations should be completed prior to December 1, 2016.

Two of my clients have already contacted me about the renewal form sent to them by the Tennessee Department of Revenue regarding the exemption of their LLC from Tennessee franchise and excise tax.  If your LLC (or limited partnership) is exempt from Tennessee franchise and excise tax, it is very important to fill out this form each year.  You do not have to pay anything to renew the exemption. 

The most common exemption is obligated member entity (“OME”).  The OME exemption applies when the members waive liability protection.  If you are relying on this exemption, check the obligated member entity box and all the boxes on Schedule F.  Additionally, if any new members have been admitted, they must sign an Amendment to the Articles of Organization that waives liability protection and file it with the Tennessee Secretary of State. 

The two most common other exemptions for our clients are the family owned non-corporate entity (“FONCE”) and the farming/personal residence exemptions.  My recommendation is to allow your CPA who prepares the tax return for the LLC to complete the form, if you are relying on either of these exemptions.  There is information from the LLC’s federal income tax return (Form 1065) that will be needed. 

Not all LLCs are exempt from franchise and excise taxes.  Generally, these LLCs operate a business or own commercial real estate.  Even though not exempt, the earnings from an LLC operating a business may not be subject to tax if they are treated as self-employment income by the owners of the LLC for federal income tax purposes.  No application for exemption is filed to claim this benefit.

In summary, you can avoid an unpleasant tax bill for your LLC if you or your CPA annually renews the exemption of your LLC from Tennessee franchise and excise taxes.

The Tax Court recently ruled that gifts of family limited partnership interests qualified for the gift tax annual exclusion, which is currently $13,000 per donee per year. Estate of George Wimmer involved a family limited partnership that was funded with marketable securities. Mr. Wimmer made gifts of limited partnership interests to children and trusts for grandchildren. The IRS disallowed annual exclusions for the gifts which forced Mr. Wimmer’s estate to sue the IRS in Tax Court.

As is typical with limited partnership agreements, the Wimmer limited partners could not freely transfer their interests to third parties. Because the partners could not sell their interests, the Judge required the partnership to satisfy three income tests: (1) the partnership would generate income, (2) some portion of that income would flow steadily to the donees, and (3) that portion of income could be readily ascertained.  Because the Wimmer FLP had predictable income and made regular income distributions to its partners, the Judge allowed annual exclusions for the gifts.

This case is welcome news for taxpayers. Two prior cases decided by the Tax Court, Hackl and Price, had ruled against the taxpayer. The partnership in Hackl did not make distributions and the partnership in Price made irregular distributions. At least for now, the Tax Court has established a rule that the limited partnership must make regular income distributions in order for gifts of limited partnership interests to qualify for the gift tax annual exclusion.

When you desire to transfer a limited partnership interest, an LLC interest or stock that is not making regular income distributions, you should be aware that the IRS may challenge your qualification for the annual exclusion. You should consider making taxable gifts or sales of these interests and using your annual exclusion to make gifts of cash or other income-producing assets.

A lot of my clients recently received a Franchise and Excise Tax Annual Exemption Renewal Form from the Tennessee Department of Revenue. This form applies to Limited Liability Companies and Limited Partnerships that claim an exemption from Tennessee Franchise and Excise Taxes.

The three most common exemptions that apply to my clients are the obligated member entity (“OME”) exemption, the family-owned non-corporate entity (“FONCE”) exemption, and the farm exemption. If your company qualifies for one of these exemptions, you need to fill out the renewal form with the help of your CPA and send it to the Department of Revenue no later than April 15, 2010. If your company qualifies for an exemption and you have not received the form, you can get the form at http://tennessee.gov/revenue/forms/fae/fae183.pdf, or you can call the Department of Revenue at (615) 253-0600.

If you do not file the form by April 15, 2010, you will lose your exemption for 2009. The Department has the discretion to allow a late filing. If they allow a late filing, they will charge you a $1,000 penalty.
 

Tennessee imposes Franchise and Excise Tax on limited partnerships and limited liability companies unless they qualify for an exemption. Due to a law change enacted earlier this year, numerous entities converted from the family owned non-corporate entity (“FONCE”) exemption to the obligated member entity (“OME”) exemption.

The OME exemption requires the entity’s owners to assume personal responsibility for liabilities of the entity. Most entities that switched to the OME exemption own commercial real estate.

In order to qualify for the OME exemption for 2009, appropriate documentation had to be filed with the Tennessee Secretary of State by October 1, 2009. On November 10, 2009, the Department of Revenue imposed an additional requirement to qualify for the OME exemption for 2009.

Each entity that switched to the OME exemption must file a new Application for Exemption with the Department of Revenue on or before November 30, 2009. If the entity does not file an Application for Exemption by November 30, 2009, it will not be exempt for 2009.

The Department of Revenue has discretion to allow a late filing of the application. However, if they permit the late filing, they must charge a $1,000 penalty.

If the entity failed to convert to an OME prior to October 1, 2009, it has the option of converting to an OME prior to December 31, 2009 if the entity wants to be exempt from franchise and excise taxes for 2010 and future years.

If you are an owner of an OME and are concerned about your potential exposure to liabilities of the entity, you should consider transferring a portion of your assets to an asset protection trust.
 

When you own a business with one or more other persons, it is advisable to enter into a written agreement with the other owners. These agreements have different names depending upon the type of entity: shareholder agreements for corporations, partnership agreements for limited partnerships and general partnerships; and operating agreements for limited liability companies. These agreements are sometimes generically referred to as “Buy-Sell Agreements”.

Buy-Sell Agreements typically restrict transfers to third parties and specify rights of the parties under certain circumstances such as death, divorce and disability. It is not uncommon for these agreements to give the company and/or the other owners an option to buy your interest in the company for a predetermined price in the event that you die, or become disabled, or transfer your stock to any other person, including your spouse upon divorce. The price is generally less than a proportionate share of the value of the entire business.

If a divorce court awards a portion of your interest in the company to your spouse, your spouse may contend that he or she is not bound by the Buy-Sell Agreement. Alternatively, your spouse may argue that your interest in the company should be valued based upon the different method than that contained in the Buy-Sell Agreement.

Customarily, spouses do not sign Buy-Sell Agreements unless they own an interest in the company. However, a recent case decided by the Tennessee Court of Appeals provides a good reason for asking your spouse to sign the Buy-Sell Agreement.

In the Inzer (pdf) case, the wife argued that her husband’s stock in his company should not be valued in accordance with a formula contained in the Buy-Sell Agreement. The Court indicated that the wife’s argument would have been meritorious if she had not signed the Buy-Sell Agreement. Because she signed the Agreement, the Court ruled that she was bound by the valuation formula.

For purposes of valuing the couples’ marital estate, the stock was valued significantly below its pro rata share of the total value of the company. Because the husband was awarded the stock, this meant that the wife received a smaller share of the other assets. As a result of this case, I plan to recommend that my clients ask their spouses to sign their Buy-Sell Agreements.
 

Family limited partnerships (or LLCs) are often used to obtain valuation discounts for estate and gift tax purposes. Appraisers typically conclude that the fair market value of an interest in a family limited partnership (“FLP”) is at least 35% less than the value of the assets owned by the FLP.

The IRS dislikes these discounts and has successfully challenged the discounts in several court decisions. As a general rule, the taxpayers were "sloppy" in the cases that the IRS has won. Errors were made either in funding, distributions, or record keeping.

When the FLP is properly funded and administered, taxpayers are able to substantiate the discounts. For every case in which the IRS has successfully disallowed discounts, there are many others where the court approved a discount or the IRS agreed to a discount without going to trial.

A case in point is the recent Rayford L. Keller et al v. United States decision. Mrs. Williams was in the hospital, dying from cancer. Six days before her death, she signed documents to establish an FLP to be funded with $240 million of bonds and $10 million cash.

The assets were not transferred to the FLP until one year after she died. Nevertheless, the Court ruled that her family was entitled to a 47.5% discount on the value of the bonds and cash that were transferred to the FLP.

I do not recommend waiting until death is imminent to establish an FLP. It is far better to establish the FLP when you have several years to live, and then to make gifts or sales of FLP interests when that is appropriate.

Detailed summary of Keller case by Steve Akers of Bessemer Trust Company, N.A.

Your family LLC or limited partnership might be hit with a large tax bill from the Tennessee Department of Revenue for 2009 and future years. The law was recently changed to remove the exemption from Franchise and Excise taxes for certain family LLCs and limited partnerships that own commercial real estate.

Under prior law, rent income from commercial properties was defined as passive, which allowed family-owned entities to avoid paying the tax. The new law changes the definition of passive income to exclude rental income from commercial properties and residential properties containing more than four units.

The result of this change is to make entities owning such property subject to franchise tax on the value of the entity’s property ($2,500 per million dollars of value) and an excise tax of 6.5% on the net income earned by the entity.

If the owners of the entity do not want to pay the tax, they can waive liability protection prior to October 1, 2009. This means that if the entity suffers a judgment that exceeds the value of the entity’s assets, the owners would be personally liable for the judgment. A lot of my clients are choosing this option and purchasing additional liability insurance.

Another change concerns the registration requirements for all entities that claim an exemption from Tennessee Franchise and Excise taxes. Each such entity must notify the Tennessee Department of Revenue of its exemption within sixty (60) days after creation and then each following year no later than April 15. If you are late, the Department of Revenue will either eliminate your exemption or charge you a $1,000 penalty.

Questions and answers regarding franchise and excise taxes.