Over the years, decisions from the U.S. Tax Court have developed guidelines for when family limited partnerships will be recognized for tax purposes and when they won‛t. Those guidelines apply as well to family LLCs. The current leading case for what NOT TO DO is the 1997 decision of the Tax Court involving a Salt Lake-area family and business–the Schauerhamer family who owned Economy Builders Supply. [Cite to court decision is T.C.Memo. 1997-242]
In 1990, Mrs. Schauerhamer was diagnosed with colon cancer (she died on December 13, 1991). Shortly after being diagnosed with colon cancer, she had an estate plan prepared and on December 31, 1990, formed three family limited partnerships, with two general partners in each–one of her three children (and herself). Her investment and business assets were transferred to the three limited partnerships by transfers on December 31, 1990 and also again in November, 1991.
On December 31, 1990, and again eleven months later, Mrs. Schauerhamer transferred a total of 66 limited partnership interests to her family members as gifts ($10,000 at each transfer).
Unfortunately, Mrs. Schauerhamer did not respect the partnerships as separate entities, but retained and used all income from the partnerships as if it was her own. She deposited partnership income directly into her personal checking account where it was commingled with her income from other sources.
She continued to treat the limited partnerships as her personal investment accounts. At the same time, no distributions were made to the limited partners in the partnerships and the other general partners in the partnerships acquiesced in Mrs. Schauerhamer‛s diversion of partnership income to her personal use.
Under those circumstances, the Tax Court held that the limited partnerships should be ignored for estate tax purposes and the value of the assets of the limited partnerships should be included in Mrs. Schauerhamer‛s gross estate for estate tax purposes. Since the value of those assets exceeded $2,000,000, this caused additional estate tax to the Schauerhamer family of about $950,000.
Our point in mentioning the Schauerhamer case is to indicate that there are court-imposed guidelines on what to do and what not to do with regard to family limited partnerships and family limited liability companies. Some of those guidelines include the following:
- Assets of a partnership or LLC should not be commingled with personal assets of the general partner or manager or controlling person–or any other partner. Partnership or LLC receipts should be deposited directly and exclusively to each entity’s bank account–not to the account of any partner or member.
- Assets of the partnership or LLC should not be used to pay personal expenses of the general partner or manager (or any members).
- Separate records and accounting should be kept for each partnership or LLC.
- Financial reports on each partnership or LLC should be furnished on a regular basis to all partners or members of the entity.
- If monies are to be taken out of the partnership or LLC, they should pay the debts or bills of the partnership or LLC, or be disbursed as compensation for services rendered (at reasonable levels) for the partnership or LLC, or should be disbursed as distributions of profits or as draws and appropriately charged against distribution accounts or drawing accounts of the partners or members.
- Assets and income of a partnership or LLC should not benefit only one partner or member.
- Voting and approval rights of the partners or members should be respected.
- The entity should be respected and treated as a separate entity just as much as if the entity included non-family members or other commercial entities as partners or members.
- Formalities required by the governing documents for the entity should be followed–not ignored.
We bring these items to your attention for the purpose of helping you fortify the operations of your family entities so that they will be largely immune from any IRS attack.
After all of the effort, trouble and cost you have invested (and will invest) to establish and maintain separate entities, we think it advisable to focus on any operational issues that need improvement in order to strengthen these various entities as truly independent entities which could withstand an IRS attack.