Question

1. You moved to the United States in 2017 and became a US citizen in early 2019. You have two adult children. Your son is a citizen and resident of Japan. Your daughter is a citizen and resident of Canada. Both children are in need of immediate cash. You own 100% of the stock and serve as President of a very profitable family business which operates as a C-corp. In order to put immediate cash in your childrens’ hands you decide to transfer a 10% ownership interest in the family business to each of your children and declare a substantial dividend. At the same time, you require both children to sign an agreement that they will make a gift of their 10% ownership interest back to you at a time to be selected independently by each child, as long as the gift to you is completed by no later than December 31, 2025. Would you expect the Internal Revenue Service to challenge the validity of the original gift from you to the children? Name and describe as many as possible of the tools (or weapons) you think the IRS might use to challenge the validity of the gifts to your children?

Answer 1

Transferring family wealth from one generation to other results in levying estate and gift taxes. However, by using Family Limited Partnership (FLP) parents can minimize transfer tax through valuation discount and can also maintain control over the assets when serving as general partners of FLP.
How FLP reduces transfer taxes
Let us discuss the functioning of FLP with the help of following examples:
FLP must have at least one General partner and one limited partner and typically the limited partners will be family members, while the general partner is a corporation.

Here, in first instance, tax payer creates a FLP and a corporation by transferring assets worth RS $ 10 million as follows
$100000 to the corporation for 100%controle,and $9.9million to FLP and get 99% control and the corporation then transfers its cash to FLP to get 1% interest.
In second instance, TP transfers all his limited partnership interest to family members. But they have no controlling power. Hence their owner ship interest is reduced to reflect this limited control by the use of valuation discount, hence $ 9.9million reduced to $5.9 million at a discount of 40%.Thus saving nearly 4 million in wealth from transfer taxes.
By aggressively using valuation discounts to reduce transfer taxes, taxpayers now face IRS challenges in audit and in court. The IRS has attacked FLPs using the following arguments
• Economic substance (business purpose)
• Sec. 2703
• Sec. 2704
• Gift on formation
• Sec. 2036
The first four arguments support attempts by the IRS to ignore the FLP’s legal existence, which would make the full FMV of assets transferred subject to gift or estate taxes. However, the courts have overwhelmingly held against the IRS on these arguments. In particularly, the Tax Court has indicated that a FLP validly formed under applicable state law will not be ignored, despite lack of business purpose.
   However, Sec. 2036 remains the one area where the IRS has enjoyed and continues to enjoy success in court.
How Section 2036 Operates
Sec. 2036(a) operates to ignore certain asset transfers, subjecting them to estate taxes, if the taxpayer retains possession, enjoyment, or income rights to the property or has the ability to designate others who may hold such rights. For example, if a taxpayer transfers her home to a FLP but continues to live there rent-free until death, Sec. 2036 ignores the transfer and includes the home in the taxable estate. Thus, Sec. 2036 negates any valuation discounts, since the transfer of the property to the FLP is voided. Bona fide sales of property do not fall under Sec. 2036.6 Transfers of wealth as gifts during a taxpayer’s lifetime do not fall under Sec. 2036, since the section deals only with estate taxes. Taxpayer Carelessness Ensures IRS Victories
Here are the elements of carelessness that contribute to the taxpayers’ FLPs being subjected to Sec. 2036 attack:
• Commingling of FLP and personal funds
• Not dealing at arm’s-length with the FLP
• Making disproportionate, or non-pro-rata distributions to taxpayer
• Leaving taxpayer with insufficient personal assets after FLP transfer
• General partner does not manage FLP
When taxpayers commingled FLP funds with their personal cash, they act to ignore the FLP’s existence.
When assets are transferred to the FLP, taxpayers must respect the changed ownership over those assets. This element has been increasingly violated by taxpayers who transfer their personal residences to their FLPs, yet continue to reside there without paying rent to the owner of the house—the FLP
Making disproportionate, or non-pro-rata distributions to taxpayer When the taxpayer, as a limited partner in the FLP, receives more than his pro-rata share of distributions, this strengthens the IRS case that the taxpayer has retained control over the FLP assets and hence, Sec. 2036 should apply. All distributions to limited partners should follow the guidelines set down in the FLP partnership agreement, which will generally require pro-rata, or proportionate distribution of assets at the direction of the general partner. Distributions to partners should be make at the same time and should be proportionate in amount, based on the limited partners’ ownership interests in the FLP. Further, the business reasons for all FLP distributions should be carefully documented in FLP minutes.
When all or substantially all of the taxpayer’s assets are transferred to the FLP, the IRS will argue that an implied agreement exists among the remaining family limited partners for the transferor to continue using the assets as he did before the transfer.
   The general partner has a fiduciary duty under state law to manage the partnership and to ensure that distributions to limited partners are made on a pro-rate basis. If the general partner’s actions benefit one, but not all limited partners, the IRS may argue the benefited partner has control over the assets and the FLP should be ignored. The limited partners should conduct no management functions, since this violates the partnership agreement.