E. Fifth Fundamental: Both the entering into a limited partnership and the transferring of a limited partnership interest can be designed to comply with the prerequisites of Internal Revenue Code Section 2703.

Consider the following example involving Sam Selfmade as an illustration of the gift and estate tax consequences of a typical family limited partnership.

[Ed. Note: Example 1 appears earlier in the original manuscript. It is included here for context.]

When Sam dies in 2005 leaving his interests to Sonny and Betsy, the partnership net assets are worth $30,000,000. However, if Sam's executor were to sell Sam's general and limited partnership interests, he would receive only $3,500,000 from a hypothetical willing buyer, reflecting a 65% discount from the underlying $10,000,000 asset value attributable to Sam's one-third total interest. This discount results from the low distributable yield on Sam's partnership interests and the fact that any buyer would be a mere assignee of a limited partnership interest with no management rights and no liquidation rights (at least for another 40 years). Contrast a scenario in which Sam's executor has the right to liquidate the partnership, in which case the estate's interests in the partnership would be worth $10,000,000. Is the difference between $3,500,000 and $10,000,000 subject to estate taxes?

Susan serves Sam's executor with a 30-day letter claiming "no discount", instead of the 45% discount claimed by Sam's executor on the estate tax return. Susan (the "Examining Agent") claims the creation of the partnership should be ignored because of Section 2703(a) and that the safe harbor under Section 2703(b) is not available because the partnership is a "device". Sam's executor (the "Taxpayer") hires Pam Planner to write a protest with respect to the 30-day letter (the "Report"). What are Pam's arguments?

With Pam Planner's permission we reproduced part of her protest letter to the District Director of the Internal Revenue Service:

1. Argument and Authorities That Under Section 2703(a) the Internal Revenue Service Cannot Ignore the Creation of the Partnership.

a. The Examining Agent's Use of Section 2703(a) to Disregard the Creation of the Partnership Ignores the Clear Wording of the Relevant Statutes.

Section 7701(a)(2) provides that for estate and gift tax purposes, where not otherwise distinctly expressed or manifestly incompatible with the intent of other provisions of the Code,

"[T]he term ‘partnership' includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term ‘partner' includes a member in such a syndicate, group, pool, joint venture, or organization." (emphasis added)

A limited partnership will be treated as a partnership for federal estate tax purposes rather than an association taxable as a corporation under the current regulations, if it lacks two or more of the following characteristics: (1) continuity of life; (2) free transferability of interests; (3) centralization of management; and (4) limited liability. *44 Failing two or more of these tests is necessary. The facts demonstrate that the Partnership is a partnership for estate tax purposes, for it lacks the characteristics of continuity of life and free transferability of interests.

(i) Continuity of Life. As stated previously, the Partnership was organized and is operated under the TRLPA. Limited partnerships organized and operated under the TRLPA lack the corporate characteristic of continuity of life. *45 Under the TRLPA, an event of withdrawal of the last remaining general partner results in the dissolution of the partnership unless all of the partners agree in writing to continue the business of the partnership. *46

In Revenue Procedure 89-12, 1989-1 C.B. 798, the Service indicated that it would not rule that a limited partnership organized under a state statute corresponding to the Revised Uniform Limited Partnership Act lacks continuity of life if the partnership agreement provides that the consent of only a majority of the partners is needed to continue the partnership business upon the withdrawal of the last remaining general partner. Nonetheless, if local law, as well as the partnership agreement, provide that only a majority in interest of the remaining partners must agree to continue the partnership upon the bankruptcy or removal of a general partner, the Service has said that it will not take the position that the partnership has continuity of life. *47 The provisions of Article X of the Partnership Agreement are consistent with the Section 8.01 of the TRLPA regarding the events upon which the Partnership is to be dissolved and liquidated, except that all remaining general partners must agree to continue the Partnership upon the occurrence of any act or omission by a partner which results in the dissolution of the Partnership under the TRLPA. Therefore the Partnership lacks the corporate characteristic of continuity of life.

(ii) Free Transferability of Interests. The Service has indicated that a limited partnership lacks the corporate characteristic of free transferability of interests "if, throughout the life of the partnership, the partnership agreement expressly restricts (within the meaning of section 301.7701-2(e)(1) of the regulations) the transferability of partnership interests representing more than 20% of all interests in partnership capital, income, gain, loss, deduction, and credit." *48 The Regulations provide that free transferability exists if, without the consent of the other partners, substantially all of the partners can substitute for themselves another person who is not a member of the organization. *49 This characteristic does not exist in a case in which each member can, without the consent of other members, assign only his right to share in profits but cannot so assign his rights to participate in the management of the organization. *50 Under the Partnership Agreement, the transferee of a partner's partnership interest cannot be admitted to the Partnership as a partner unless all of the remaining partners so agree, and, thus, the transferee can participate in the Partnership only as an assignee with no withdrawal rights, management rights, or information rights which are otherwise accorded to partners. Therefore the Partnership lacks the corporate characteristic of free transferability of interests.

Because the Partnership lacks continuity of life and free transferability of interests, at least two of the four corporate characteristics which distinguish a corporation from a partnership, it is accordingly classified as a partnership for estate tax purposes under the test of the Treasury Regulations.

(2) Section 2703(a). Section 2703(a) provides that "the value of any property [i.e., assignee interest in a partnership] shall be determined without regard to --

(1) any option, agreement or other right to acquire or use the [assignee interest in a partnership] at a price less than the fair market value of the [assignee interest in a partnership] (without regard to such option, agreement, or right) or

(2) any restriction on the right to sell or use such [assignee interest in a partnership]."

(3) Taken Together. In the context of Section 2703, Section 7701(a)(2) reads as follows:

"(a) When used in [Section 2703], where not otherwise distinctly expressed [in Section 2703] or manifestly incompatible with the intent [of Section 2703] -

"(2) Partnership and Partner - The term ‘partnership' includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of [Section 2703] a trust or estate or corporation . . ." (emphasis added).

Because of Section 7701(a)(2), Sam Selfmade is clearly to be considered as having transferred an interest in a partnership under Section 2703 at the time of his death.

b. The Examining Agent's Use of Section 2703(a) to Disregard the Creation of the Partnership Ignores Legislative Intent.

The examining agent's interpretation of Section 2703(a) is inconsistent with the intent of Congress, which was that Section 2703(a) was not to be applied to cause the creation of a limited partnership or any other entity to be ignored, but rather to address certain perceived abusive effects of buy-sell agreements and options upon a transferor's interest in an entity.

The examining agent's Report indicates that, in the context of a limited partnership, despite the clear wording of Section 7701(a)(2) and Section 2703, the examining agent considers the transferred property which is subject to the restrictions of Section 2703(a) to be the partnership's property, i.e., the partner's pro rata share of the partnership assets as of the transfer date. Despite the clear wording of the statutes, the Report interprets the intent of Section 2703(a) broadly and as requiring the existence of the limited partnership as an entity to be ignored, so that the transfer is always of an undivided interest in the underlying assets of the entity. Stated differently, the examining agent is taking the position that the intent of Section 2703(a) provides as follows:

"the value of the assets contributed by Sam Selfmade to the Partnership shall be determined without regard to ... (2) any restriction on [Sam Selfmade's] right to sell or use such assets contributed by Sam Selfmade to the Partnership."

It is the Taxpayer's belief, however, that both the wording of the statutes (Sections 7701(a)(2) and 2703(a)) and the intent of the statutes are consistent: the property under Section 2703 being transferred at Sam's death is an assignee interest in a limited partnership, not the partnership's property.

The legislative history of Chapter 14 supports the Taxpayer's interpretation of Section 2703(a). The heading of the Senate Committee Report dealing with Section 2703(a) is entitled "Buy-sell agreements" and in the Conference Committee Report the heading is entitled "Buy-sell agreements and options." It appears from the legislative history that the focus of Congress in Section 2703(a) is restrictions in an agreement on transfers of interests in an entity and not restrictions in agreements concerning liquidation nor the creation of an entity (even if that leads to minority discounts and other discounts) (that is the province of Section 2704), as the following demonstrates:

". . . [T]he committee is aware of the potential of buy-sell agreements for distorting transfer tax value. Therefore, the committee establishes rules that attempt to distinguish between arrangements designed to avoid estate taxes and those with legitimate business agreements. These rules generally disregard a buy-sell agreement that would not have been entered into by unrelated parties acting at arm's length." *51

" . . .The bill does not affect minority discounts or other discounts available under present law" (which would otherwise be applicable to an entity). *52

In the "Explanation of Provisions" accompanying the bill in the Senate Committee Report, the discussion relating to the changes brought by Section 2703(a) are presented under the heading "Buy-sell agreements". It is thus implied that the property discussed in the following explanation is that property which is the subject of the buy-sell agreement, i.e., the interest in the entity to which the restrictions apply, to-wit:

"The bill provides that the value of property for transfer tax purposes is determined without regard to any option, agreement or other right to acquire or use the property at less than fair market value or any restriction on the right to sell or use such property, unless the option, agreement, right or restriction meets three requirements. . . " *53

In a corresponding provision in the Conference Report, under the heading "Buy-sell agreements and options" it is stated:

"The conferees do not intend the provision governing buy-sell agreements to disregard such an agreement merely because its terms differ from those used by another similarly situated [entity]. . ." *54

That the statute is intended only to address objectionable transfer provisions in agreements creating entities (and not the creation of an entity) is further supported by the Senate Report statement that, apart from the restrictions concerning acquisition or use of the property addressed in the bill, "[t]he bill does not otherwise alter the requirements for giving weight to a buy-sell agreement. For example, it leaves intact present law rules requiring that an agreement have lifetime restrictions in order to be binding on death." *55

To adopt the examining agent's interpretation of Section 2703(a) is not only in contradiction to the literal wording of Sections 7701(a)(2) and 2703(a), and the latter statute's legislative history; it is also inconsistent with the statutory structure of Chapter 14. The examining agent's view of Section 2703(a) would totally supplant the need for Section 2704, which covers restrictions in an agreement with respect to liquidation. Under Treas. Regs. § 25.2704-2(b), any option, right to use property, or agreement covered by Section 2703(a) is not covered by Section 2704(b), so to the extent that Section 2703(a) applies to a restriction, Section 2704(b) is to be ignored. Under the examining agent's expanded view of Section 2703(a) (creation of the entity is ignored), there is nothing left to be addressed by Section 2704 (which addresses liquidation restrictions of those entities already ignored). Stated differently, the natural conclusion of the examining agent's position is that Congress passed a meaningless statute when it enacted Section 2704(b). On the other hand, the Taxpayer's position that one reads Sections 7701(a)(2) and 2703(a) literally would not make Section 2704 meaningless and would make it a necessary part of what Congress was trying to do when it passed Chapter 14.

Professor Jerry A. Kasner has pointed out the fallacy in the examining agent's broadly interpreting Section 2703 as determining that "the property" which is subject to the restrictions of Section 2703 is the partnership's property, and not the assignee's rights in a partnership interest. He writes:

"How would the opponents of the valuation discounts seek to use section 2703 to deny them? As I understand it, the argument is that any restriction that affects the rights of limited partners to force a liquidation of the entity or to sell their interests to purchasers who could force liquidation of the entity is a restriction that must be ignored under section 2703, i.e., the transfer is always of an undivided interest in the underlying assets of the entity. Of course, if this statement is true, there was never any reason for Congress to adopt section 2704(a) or (b). I believe it is clearly not true.

"The basic fallacy here is in defining the "property" that is subject to the restrictions. In the typical family partnership (or corporation, or limited liability company), the senior family member transfers assets to the partnership in exchange for general and limited partnership interests. At this point in time, there is of course no taxable event. (I have seen one commentator suggest there is!) Assume senior then transfers limited partnership interests to family members. The property being transferred is the partnership interests, not the underlying partnership assets. The possible application of sections 2703 and 2704 will depend on restrictions placed on the rights of the donees in the partnership interests. The donees never own the partnership assets.

"If section 2703 applied this broadly, then it would apply any time property is transferred to a partnership, corporation, or limited liability company, and interests in those entities are then transferred to family members. In other words, the existence of the entity would always be ignored. I do not find anything in the language of the code, regulations, or legislative history of sections 2703 and 2704 to suggest that result, although the IRS might like it.

"Even if the scope of section 2703 were that broad, the argument of the proponents of the section would come into play -- it obviously makes good business sense in the case of a variety of both active businesses and passive investments to operate and manage property through a separate business entity, whether or not family-owned. This is not to say some of these transactions could be treated as shams, or lacking substance. However, to broadly nullify the existence of all family business or investment entities goes too far." *56

c. The Examining Agent's Use of Section 2703(a) to Disregard the Creation of the Partnership Ignores the Assumption in the Treasury Regulations That Section 2703(a) Only Deals With Transfer Restrictions in Agreements and Does Not Apply to the Creation of Entities.

The literal wording of Section 2703(a) addresses "rights", "restrictions", and "agreements", terms which spring from the agreement or structure affecting the transfer of the subject property and not from the actual creation of an entity. The language of the Treasury Regulations under Section 2703(a) is consistent with the Taxpayer's interpretation of Section 2703(a), as supported by the legislative history.

For example, Treas. Reg. § 25.2703-1(a)(3) provides:

"(3) Agreements, etc., containing rights or restrictions. A right or restriction may be contained in a partnership agreement, articles of incorporation, corporate bylaws, a shareholders' agreement, or any other agreement. A right or restriction may be implicit in the capital structure of an entity."

"(5) Multiple rights or restrictions. If property is subject to more than one right or restriction described in [Section 2703(a)(1) or (2)], the failure of a right or restriction to satisfy the requirements of [Section 2703(b)] does not cause any other right or restriction to fail to satisfy those requirements if the right or restriction otherwise meets those requirements. Whether separate provisions are separate rights or restrictions, or are integral parts of a single right or restriction, depends on all the facts and circumstances."

Under the examining agent's view of Section 2703(a), which would ignore the creation of the entity, this regulation would have no meaning, for if the entity is disregarded, none of the rights or restrictions would otherwise have any application. The Taxpayer believes the only logical interpretation must be to read this regulation as applying the statute within the context of an agreement: any restriction within the agreement which violates the statute will be disregarded; all other rights or restrictions with respect to the creation of the entity will remain.

The current regulations under Treas. Reg. 301.7701-3 made it clear that the joint undertaking by Sam Selfmade and his family will be treated as the creation of a partnership for all federal estate tax purposes and all other federal tax purposes:

"§ 301.7701-3. Partnerships. -- (a) In general. The term "partnership" is broader in scope than the common law meaning of partnership and may include groups not commonly called partnerships. Thus, the term 'partnership' includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not a corporation or a trust or estate within the meaning of the Internal Revenue Code of 1954."

The proposed regulations under Treas. Reg. § 301.7701 also make it clear that the joint undertaking by Sam Selfmade and his family will be treated as the creation of a partnership for all federal estate tax purposes and all other federal tax purposes.

"A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. . . a business entity is any entity recognized for federal tax purposes. . . that is not properly classified as a trust . . . the term partnership means a business entity that is not a corporation . . . and that has at least two members."

d. The Examining Agent's Use of Section 2703(a) to Disregard the Creation of the Partnership is Contrary to the Proposition That Estate Taxation of Assets Owned At Death Must Be Consistent With State Law Property Rights.

Congress has always intended that if a partnership exists for state law purposes, then it is also effective for transfer tax purposes. The chief requirement to be satisfied under state law is that the partnership's activity be one in which the partnership is engaged for profit. Estate and gift tax consequences are determined solely by applying state law to determine ownership rights and encumbrances. *57 As stated previously, the facts of this case support that the Partnership was created and has been operated as a valid, independent legal entity at all times, in accordance with all state and tax law requirements, and no allegations or suggestions to the contrary have been made. Therefore Section 2703 should not change the fact that under state law the Partnership was a validly existing entity at the time of Sam Selfmade's death. The act of creating a limited partnership (or the use of the partnership form of organization) in order to hold financial assets clearly was not affected by Congress' enactment of Section 2703. As stated previously, in the context of Section 2703(a), Section 7701(a)(2) still reads as follows:

"(a) When used in [Section 2703(a)], where not otherwise distinctly expressed [in Section 2703(a)] or manifestly incompatible with the intent [of Section 2703(a)] -

"(2) Partnership and Partner - The term ‘partnership' includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of [IRC Section 2703] a trust or estate or a corporation . . ." (emphasis added)

Clearly what Sam Selfmade transferred at his death under Texas property law and estate and gift tax law *58 was an assignee interest in a limited partnership, and in the context of Section 2703(a) "the value of the assignee interest in a limited partnership interest shall be determined without regard to ... (2) any restriction on the right to sell or use the assignee interest in a limited partnership interest."

The examining agent's position radically ignores Texas property law. Under Texas property law Sam Selfmade did not own any of the assets of the Partnership; he only owned an interest in the Partnership. Texas law does not grant to a partner of a limited partnership any rights to the partnership property, as provided in Section 7.01 of the TRLPA:

"A partnership interest is personal property. A partner has no interest in specific limited partnership property."

Under Texas law neither Sam Selfmade nor his family (prior to or after his death) had any rights to or interests in the assets of the Partnership. Therefore the examining agent's application of Section 2703 requires that this provision of Texas property law be disregarded.

The examining agent's position is also in contradiction to the Tax Court's recognition (to which the Service has acquiesced) *59 , based upon state law property rights, of a partnership as an entity, and not merely an aggregate of assets, in the area concerning the estate taxation of life insurance owned by and payable to a limited partnership of which the insured is the managing partner. Section 2042(2) requires the proceeds of life insurance on a decedent's life to be included in the decedent's gross estate if the decedent possessed at his death any incidents of ownership, exercisable either along or in conjunction with any other person. Both the Tax Court and the Service have previously held that, where a life insurance policy on the life of a partner owned by the partnership is payable to the partnership, Section 2042 should not apply to such insurance proceeds, even if the insured is a managing or controlling partner. In Estate of Knipp v. Commissioner *60 , a decedent at the time of his death was a 50% partner in a partnership which held ten insurance policies on his life. The partnership paid the premiums on all of the policies, and the insurance proceeds were payable to the partnership. The Tax Court examined whether at the time of his death the decedent possessed incidents of ownership over such policies which would subject the insurance proceeds to taxation under Section 2042(2). The Tax Court noted that the insurance policies were assets of the partnership, and that the partnership had complete control over them, holding all of the incidents of ownership: "Decedent, as an individual, had no power to exercise any rights in specific assets of the firm." *61 The Tax Court applied the "entity" theory (as opposed to the "aggregate" theory) in analyzing a partner's rights to partnership assets. Under the Uniform Partnership Act (and the Revised Uniform Partnership Act), a partner has no rights with respect to partnership assets. Accordingly, the Tax Court held that the proceeds of the ten policies were not includible in the insured partner's gross estate. In Rev. Rul. 83-147, *62 the Service acquiesced in the result reached in Estate of Knipp.

Estate of Knipp is not the only case in which the Tax Court applied the "entity" theory to a partnership in determining whether Section 2042(2) is to be applied. In Watson v. Commissioner, *63 36 T.C.M. (CCH) 1084 (1977), the decedent was insured under a policy purchased by a business associate with whom he operated under an oral partnership agreement. After the purchase of the policy, the renewal premiums for the policy were paid out of a partnership account, and were charged on the partnership books as a partnership expense, although the record was unclear as to whether the actual ownership of the policy was held by the business associate/partner or by the partnership. However, the Tax Court held that even if the partnership did become the owner of the policy and remain such until the insured partner's death, "the [insured] would still not be considered as possessing the requisite incidents of ownership merely by virtue of his control as a 50-percent partner." *64 For further examples of the Tax Court's reluctance to ascribe incidents of ownership of an insurance policy owned by a partnership to the partner-insured, see Estate of Fuchs v. Commissioner, 47 T.C. 199 (1966); Estate of Infante v. Commissioner, 29 T.C.M. (CCH) 903 (1970), and Estate of Tompkins v. Commissioner, 13 T.C. 1054 (1949).

e. The Examining Agent's Use of Section 2703(a) to Disregard the Creation of the Partnership Ignores Section 2703(b), Which Provides a Clear Safe Harbor for the Creation of Partnerships and Other Entities.

For purposes of the discussion in this subparagraph e, because of the operation of Section 2703(a), the Taxpayer assumes that the requirement that the Partnership must terminate in 50 years (if it had not already terminated) is removed and that a limited partner can withdraw upon six months' notice (hereinafter the Partnership Agreement as so modified will be referred to as the "Modified Partnership Agreement"). *65 The Taxpayer believes that the Modified Partnership Agreement and the creation of the Partnership with that modification (the "Modified Partnership") is clearly protected by the safe harbor provided in Section 2703(b). For purposes of the discussion of this paragraph, the Taxpayer is assuming Section 2703(a) to be construed as giving the Service the potential power to disregard the creation of the Partnership, because the courts ignore (i) the literal wording of Sections 7701(a)(2) and 2703(a), (ii) the legislative history of Chapter 14 under which, clearly, Congress meant for taxpayers to be able to create "pro rata" corporations and partnerships, (iii) Treasury Regs. § § 25.2703-1(a)(3), 25.2703-1(b)(5), and 301.7701-3 and Proposed Teas. Reg. 301.7701-1, 2 and 3 which strongly imply that Section 2703(a) is only meant to apply to partnership agreements or articles of incorporation abuses, not to the creation of a pro-rata partnership, and (iv) Texas law property rights. However, even if the courts ignore the above arguments, the courts will not ignore Sam Selfmade's (and the other partners') creation of the Modified Partnership and use of the partnership form of ownership because of the safe harbor exception under Section 2703(b). This exception provides that the Modified Partnership Agreement and the creation of the Modified Partnership will not be disregarded for valuation purposes, if the following three requirements are met:

(i) The right or restriction is a bona fide business arrangement ("bona fide arrangement" test);

(ii) The right or restriction is not a device to transfer property to members of the family for less than full and adequate consideration in money or money's worth ("device" test); and

(iii) At the time the right or restriction is created, the terms of the right or restriction are comparable to similar arrangements entered into by persons in an arm's-length transaction ("comparables" test).

According to Treas. Reg. § 25.2703-1(b)(2), each of these three requirements must be independently satisfied before a right or restriction will meet this exception.

Bona Fide Arrangement Test. Sam Selfmade's investment in the Modified Partnership should meet the "bona fide arrangement" test. If a group or syndicate wishes to conduct a trade or business or a nonbusiness financial operation, Congress has always assumed that the most prevalent (and logical) way to conduct the group's affairs would be to use the partnership form of ownership. See Section 7701(a)(2). Assuming a group's pooling of resources makes financial sense, using a partnership to pool those resources is almost always the most advantageous arrangement for that "pooling." The flexibility advantage and income tax advantage of the partnership "arrangement" clearly make it the preferred form of ownership for many business and/or financial transactions. Thus, using the partnership form of ownership for business or financial assets is bona fide and common.

In light of the property management and family considerations of the Selfmade family, it is clear that at the time of the formation of the Modified Partnership there existed a number of compelling nontax business and financial reasons which supported the Modified Partnership as an advantageous vehicle for, and as being in the best interests of, the members of the Selfmade family.

[Pam Planner incorporated in this part of her Protest Letter much of the discussion which appears under paragraph F of this outline and is described as the "Sixth Fundamental".]

The examining agent questions Sam Selfmade's investment in the Modified Partnership as a bona fide arrangement, given the fact that a large portion of the assets contributed by relatively passive investments, i.e., stocks and bonds.

The nontax and financial reasons for and advantages to an investment in the Modified Partnership have been realized, not only with respect to Sam's real estate interests but also with respect to his portfolio of stocks and bonds. The Taxpayer does not concede Sam Selfmade's securities holdings did not require the same level of "active" management of assets that his real estate and mineral interests holdings did. Even if stocks require less "active" management, prior to the formation of the Modified Partnership they constituted a significant portion of Sam Selfmade's estate, and it was to his advantage to include them and thus make them available to all of the management and administrative features of the Modified Partnership. The fact that such securities are fairly passive investments does not cause the Modified Partnership to be less of a bona fide arrangement with respect to these assets as evidenced by the following rulings, code sections and regulations:

(i) The Internal Revenue Service, because of Section 7701(a)(2), has always recognized that "passive investment clubs", through which investors engage in passive investment activities, may be conducted in the partnership form of ownership for all federal tax purposes. See Rev. Rul. 75-523, 1975-1 C.B. 257 (because of Section 7701(a)(2), a partnership was recognized for tax purposes even though the only purpose of the partnership was to invest in certificates of deposit) and Rev. Rul. 75-525, 1975-1 C.B. 350 (because of Section 7701(a)(2), a partnership form of ownership was recognized for tax purposes even though the only purpose of the partnership was to invest in marketable stocks and bonds).

(ii) The Code defines the term "partnership" in Sections 761(a), 6231(a), and 7701(a). Under the Code, Congress clearly provides that unless it is "manifestly incompatible" with Congress' intent, a group or syndicate that carries on business or financial operations and is neither a corporation, nor a trust, nor an estate is a partnership for purposes of Chapters 1, 11, 12, 13, and 14. Congress clearly intended that an individual would always be treated as a partner of a partnership for purposes of Chapters 1, 11, 12, 13, and 14 of the Code, if that individual was a member of a group that conducted a financial operation, unless that group was a trust, an estate, or a corporation.

(iii) Specific rules that apply only to partnerships holding passive investment assets appear in the Code and the Regulations. Under Section 721, taxpayers contributing assets to a partnership that is deemed an "investment company" (generally, one made up of over 80% marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts) will recognize gain or loss on contribution unless that stock portfolio is substantially diversified (see the new regulations under Section 368). New Section 731(c)(3)A(iii) addresses the favorable tax treatment of distributions of marketable securities made to partners of "investment" partnerships (which is defined under Section 731(c)(3)(C)(i) as a partnership which has never engaged in a trade or business and substantially all of its assets are passive securities). Treasury Reg. § 1.704-3T(e)(3) contains a special aggregation rule for "securities" partnerships (at least 90% of the partnership's non-cash assets consist of stocks, securities and similar instruments tradable on an established securities market). Furthermore, Treas. Reg. § 1.761-2(a) expressly confirms that investment partnerships are to be treated as partnerships under subchapter K (unless a contrary election is made). Finally and significantly, the final anti-abuse regulation acknowledges that the "business" activity of a partnership may be investing assets: "Subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax." *66

In formulating these laws, regulations, and rulings Congress and the Treasury have clearly recognized and approved the common existence of partnerships holding primarily passive investment assets (including marketable stocks and bonds), and unlike the examining agent's position, Congress and the Treasury have obviously assumed for all federal tax purposes that it is very normal to hold such assets in that form.

As the above discussion demonstrates, there is no shortage of business and financial reasons for the Selfmade family, including Sam's interests through the trust, to have considered the formation of the Modified Partnership to be advantageous to their many, diverse interests. As a result, the Modified Partnership should not be disregarded for tax purposes, even if one consequence of the Modified Partnership was the reduction of estate taxes attributable to Sam Selfmade's transfer of his partnership interest at the time of his death. Long established judicial authority holds that the Internal Revenue Service cannot disregard the existence of a partnership, if the partnership was formed for a business, financial, or investment reason or in fact did engage in a business, financial, or investment activity. *67 Where either of these tests has been met, the courts have not ignored the effect of partnership agreements on valuation, even when valuation discounts approach 85%. *68 Accordingly, the Partnership has sufficient independent purpose to be recognized as a bona fide arrangement.

Device Test. The facts of this case easily demonstrate that the creation of the Modified Partnership was not a "device" for Sam Selfmade to transfer property he contributed to the Modified Partnership to her family for less than full and adequate consideration. For the examining agent to win on this "test", with respect to the creation of the partnership, she has to establish that the taxpayer has not met its burden as to both *69 of the following: (i) the creation of the partnership is a "device" and (ii) Sam Selfmade's family received the assets Sam contributed to the partnership.

The taxpayer clearly meets its burden with the second part of the device test. Under the Modified Partnership Agreement Sam Selfmade's family has no rights to receive, possess or use those contributed partnership properties, either before his death or after his death. Sam Selfmade's family after his death only has rights to use and enjoy his partnership interest. Sam Selfmade's family does not have nor will they have the right to receive or use the assets Sam Selfmade contributed to the Modified Partnership. The fact that Sam Selfmade's family cannot possess or use the property of the Modified Partnership and can only possess or use his partnership interest clearly means that the Modified Partnership is not a device to transfer to them the property Sam Selfmade originally contributed to the Modified Partnership. For instance, a shareholder of General Motors does not have the right to use a General Motors factory in Detroit -- that shareholder has the right only to current and future General Motors dividends and other rights consistent with the use and ownership of corporate stock. If Sam Selfmade had transferred General Motors stock to his family, they would not have the right to receive or use any factory (even if he had contributed that factory to General Motors, Inc. in exchange for the stock). In this instance, partnership law is exactly like corporate law. *70 Thus, the Modified Partnership cannot be a "device" to transfer contributed partnership properties to Sam Selfmade's family, when those contributed properties are not and cannot be transferred to Sam Selfmade's family because of partnership law. *71

Although it is not necessary for the taxpayer to meet its burden on the first part of the "device" test, since the second part is clearly not applicable, the first part of the "device" test should not apply to the creation of the Modified Partnership, which is a pro rata partnership, because that creation is far removed from the facts of St. Louis County Bank v. U.S., 647 F.2d 1207 (8th Cir. 1982). *72 That case led the Eighth Circuit to conclude that while a valid business purpose may exist for buy-sell agreements, the buy-sell agreement under the facts of St. Louis County Bank may constitute an estate tax avoidance device and refused to grant summary judgment on the issue as the District Court had:

"The government's principal argument for reversal is that the District Court erred in granting summary judgment because there were genuine issues of fact left unresolved.. . .

"We have no problem with the District Court's findings that the stock-purchase agreement provided for a reasonable price at the time of its adoption, and that the agreement had a bona fide business purpose -- the maintenance of family ownership and control of the business. Courts have recognized the validity of such a purpose. See Estate of Bischoff v. Commissioner, 69 T.C. 32 (1977); Estate of Reynolds v. Commissioner, 55 T.C. 172 (1970); Slocum v. United States, 256 F. Supp. 753 (S.D.N.Y. 1966). Here the District Court concluded that the existence of a valid business purpose necessarily excluded the possibility that the agreement was a tax-avoidance testamentary device. 511 F.Supp. at 654-55. We disagree. The fact of a valid business purpose could, in some circumstances, completely negate the alleged existence of a tax-avoidance testamentary device as a matter of law, but those circumstances are not necessarily presented here." (emphasis added)

The Taxpayer believes in this instance the valid financial and business purposes of creating the Modified Partnership are so overwhelming that it, in the words of the St. Louis County Bank opinion, "completely negate[s] the alleged existence of a tax-avoidance testamentary device" (see the discussion of the "bona fide arrangement" test on pages 32 to 35 above). Even if it does not, the facts in St. Louis County Bank that led the Eighth Circuit to conclude that tax-motivated testamentary reasons were not necessarily excluded as a matter of law, contrast sharply with the creation of the Modified Partnership:

1. In St. Louis County Bank the buy-sell agreement restrictions were ignored by the taxpayer's family with respect to transfers to family members. The partners of the Modified Partnership carried out its activities as partners and did not treat the Modified Partnership as its alter ego, thus, the creation of the Modified Partnership, in contrast to the St. Louis County Bank buy-sell agreement, was a "restriction" that was recognized by the partners of the Modified Partnership.

2. The buy-sell agreement formula in St. Louis County Bank resulted in a value of "0" and was not the normal formula for an asset-holding corporation (the formula was based on a multiple of earnings approach). In clear contrast, the Modified Partnership is a "normal" way for unrelated parties to hold business and nonbusiness financial assets (see the discussion below under the "comparables" test).

Thirdly, neither part of the "device" test should not apply to the creation of the Modified Partnership, because of case law precedent. This was the chief argument the IRS used in Estate of Harrison and Estate of McLendon (the "device" test is also in the regulations under Section 2031). In both cases the Tax Court rejected the Service's argument, because it found unrelated parties in similar circumstances would create a limited partnership.

Comparables Test. The terms to which Sam Selfmade's interest in the Modified Partnership was subject at her death were comparable to similar arrangements entered into by persons in an arm's-length transaction. The Regulations define a similar arrangement as one that could have been obtained at a fair bargain among unrelated parties in the same business dealing with each other at arm's-length. A right or restriction is considered a fair bargain if it conforms with the general practice of unrelated parties under negotiated agreements in the same business. The "comparables" test is satisfied by the contribution of Sam Selfmade's investment assets to the Modified Partnership. Many partnerships exist in which purely financial or investment activities take place (e.g., the holding of only lease properties, oil and gas royalties, stocks, bonds, and cash). According to recent estimates, there are over 17,000 passive investment clubs in the United States. *73 Almost all of those investment clubs are organized as partnerships with terms exactly like the Modified Partnership. The Internal Revenue Service has always recognized that "passive investment clubs", through which investors engage in passive investment activities, may be conducted in partnership form. *74 Congress has many provisions in the Internal Revenue Code which assume that there are many partnerships that hold only investment assets (see the discussion above). Therefore it is apparent that unrelated individuals use the partnership form of ownership for their investment clubs. This choice of entity should not be prohibited to related individuals. The partnership form of doing business is as attractive to families as it is to unrelated parties because of its potential lower "per unit" administration expenses and its greater potential for diversification.

2. Arguments and Authorities That for Estate Tax Valuation Purposes, the Value of Sam Selfmade's Assignee Interest in the Modified Partnership is the Same as the Value of Sam Selfmade's Assignee Interest in the Partnership.

Assuming Section 2703(a) does not affect the creation of the Modified Partnership, the statute should not have an impact upon the valuation of Sam Selfmade's Partnership Interest for federal estate tax purposes, as reported on the Estate Tax Return. For these purposes assume Sam Selfmade transferred an interest in the Modified Partnership. The key component to the discount in the value of Sam Selfmade's interest in the Modified Partnership transferred at his death is its nature as an assignee interest, which is recognized by the Eleventh and Fifth Circuits.

In Estate of Watts v. Comm., 823 F.2d 483 (11th Cir. 1987), aff'g 51 T.C.M. 60, the inherent restrictions attendant to the general partnership interest transferred by a decedent persuaded both the Tax Court and the Eleventh Circuit to allow a substantial discount to the partnership interest's liquidation value, even though under applicable state law, the decedent had held during lifetime full dissolution rights. The courts reasoned that the transfer value of the partnership interest was what a hypothetical willing buyer would pay for the interest actually being transferred, rather than the interest held by the decedent before death. Both courts reasoned that an assignee would assume that the partnership would continue. The key parts of the Eleventh Circuit's opinion are as follows:

". . . However, this error [by the Tax Court] does not require a reversal, because the tax court's decision to value decedent's interest as part of a going concern is amply supported by the law governing Oregon partnerships, and the contractual restrictions placed upon Ms. Watts' partnership interest by the partnership agreement governing Rosboro Lumber Company.

"First, we note that, ‘because the estate tax is a tax on the privilege of transferring property upon one's death, the property to be valued for estate tax purposes is that which the decedent actually transfers at his death, rather than the interest held by the decedent before death, or that held by the legatee after death.' Propstra, 680 F.2d at 1250. [Additional citations omitted]. The Commissioner's argument rests entirely on the notion that the interest transferred at the time of Martha Watts' death was an interest which entitled its holder to dissolve the partnership, and liquidate the company. This is not the case.

". . . No dissolution occurred here. Thus, the interest held by Ms. Watts' estate did not carry with it the liquidation right of Ore. Rev. Stat. § 68.600. We therefore conclude that the tax court was correct, as a matter of law, in determining that the value of Ms. Watts' interest in Rosboro could not be ascertained by reference to the value of that interest upon the lumber company's liquidation. This is true not because of the partner's current intent, but because of the legal restrictions placed upon the partner's interest by contract, fully commensurate with Oregon law. Cf. Hunter v. Straube, 273 Or. 720, 543 P.2d 278 (1975) (suit to dissolve a three-man partnership by two partners did not entitle them to dissolution where partnership agreement expressly provided that the retirement of any partner would not dissolve the partnership of the remaining partners).

". . .The Commissioner's argument seems to rest on the additional assumption that once the hypothetical purchaser has bought the interest, he can then act to dissolve the partnership, and subsequently require liquidation. However, this contravenes the rule that the interest being valued is that interest passed by the estate, not the subsequent value of that interest in the hands of the purchaser. See Bright, 658 F.2d at 1002. Moreover a conveyance or assignment of an interest in a partnership does not cause dissolution. Ore.Rev.Stat. § 68.440." *75

In the recent Fifth Circuit opinion in Estate of McLendon v. Comm., 96-1 USTC 18,545 (5th Cir. 1996), the Fifth Circuit confirmed that the price a willing buyer would pay for a limited partnership interest is based upon the assumption that the willing buyer will only be an assignee, instead of a limited partner. Therefore the transfer tax value of a limited partnership interest to a willing buyer is its "assignee" value, i.e. the value of that which is actually being transferred: *76

"Both the gift tax and estate tax issues turn on categorization of partnership interests Gordon transferred. The Estate suggests that the interests transferred could only be remainders in ‘assignees' interests' in the partnerships, not the actual partnership interests themselves. Texas law, relied on by the Estate, prohibits the transfer of partnership interests without agreement by the other partners. See, e.g. TEX. REV. CIV. STAT. ANN. Art. 6132b, § § 18(g) and 27(1) (Vernon 1970).

". . .Viewing the transaction at face value, it is evident that the Tax Court's neglect of Texas law was unfortunate. The Tax Court does not sit to create its own rules of business organization governance. Where the Internal Revenue Code has not superseded state law, the tax consequences of a transaction must depend on the nature of the deal under state law. Accordingly, we look to Texas law as well as the various agreements to evaluate the transactions executed among Gordon, Bart and the Trust.

". . . First, neither partnership agreement permitted sale or transfer of partnership interests without consent of the partners. No person could demand admission to the partnership unless consent was granted by all the partners, in the case of Tri-State, § 7.04 of the partnership agreement, or by the partners of the McLendon Company, § 6. Texas law reinforced this right of exclusivity, born of the intimate nature of the partnership relationship and the apparent authority of each partner to conduct partnership business. Thomas v. American Nat'l Bank, 704 S.W.2d 321, 323 (Tex. 1966). The Commissioner agrees that if, under Texas law, a partner attempts to transfer a general partnership interest without the other partners' consent, the transferred interest is an assignee interest, limited to the non-control right to receive distributions from the partnership. IRS Brief at 17, n. 16, and 29-30 citing Thomas, supra; TEX. REV. CIV. STAT. ANN. Art. 6132b § 27(1); Art. 6132a § 2(c)."

When examined against the inherent nature of an assignee's interest in a limited partnership under state law, and when examined against the restrictions required by Treas. Reg. § 301.7701-2(e)(1), there should be no difference in a willing buyer's valuation of the transferred interest in the Partnership and the Modified Partnership for federal estate tax purposes. Application of Section 2703(a) would not change the value of the Partnership Interest as determined by the Appraisal and as reported on the Estate Tax Return. For transfer tax purposes, the inherent nature of the interest in the Modified Partnership transferred by Sam Selfmade at her death pursuant to the Modified Partnership Agreement was not a limited partnership interest but rather merely an assignee interest. The fact that a limited partner has certain rights is irrelevant to a willing buyer -- what is relevant to the willing buyer is the assignee rights. Under the Modified Partnership, because of the inherent nature of an assignee interest, value is not measurably affected by the absence of such contractual restrictions.

Under Texas law, the inherent characteristics of an assignee of a limited partnership interest are found in the TRLPA. Texas law prohibits the transfer of a partnership interest without the prior consent by the other partners. *77 If under Texas law a partner attempts to transfer a partnership interest without the other partners' consent, the transferred interest is an assignee interest, limited to the non-control right to receive distributions from the partnership. *78 A limited partnership will not be dissolved until an event of withdrawal of a general partner with the remaining general partners electing not to continue the partnership, or all of the partners agree to a dissolution. *79 An assignee of a partnership interest is not entitled to withdraw his or her interest until the partnership is dissolved. *80 An assignee of a limited partnership interest is not entitled to inspect the books and records of the partnership. *81

In conclusion, if it is determined that Section 2703(a) requires certain restrictions imposed by the Partnership Agreement to be disregarded, an examination of the inherent nature of what was transferred by Sam Selfmade (an assignee interest), in the Modified Partnership Agreement provisions, indicates that the value of the transfer at Sam Selfmade's death does not change because of the following:

(i) If the transferability restrictions imposed by Article VIII of the Partnership Agreement are no longer applicable, so that the Partnership Agreement is silent as to transferability restrictions, then the inherent nature of the Partnership Interest under state law prohibits the transfer of a partnership interest without the consent of the partners. As under the Partnership Agreement, Sam Selfmade would be limited to only being able to transfer an assignee interest in the Modified Partnership. This should not change the determination of the value. Chapter 14 of the Code did not repeal the willing buyer - willing seller standard of Treas. Reg. § 20.2031-1(b). *82 The inherent nature of an assignee interest in a limited partnership is that a holder of an assignee interest would not be entitled to become, or to exercise the rights or powers of, a partner, without the consent of the other partners. *83

(ii) If the Partnership Agreement were silent as to the duration of the Partnership, so that the 50 year term under the Partnership Agreement does not exist, then there would be no requirement, as well as no assurance to the partners, that the Modified Partnership must terminate at any time. Under state law the Modified Partnership could continue as long as the general partners desire to continue the partnership. Given the relatively young age of the current general partners of the Partnership, their actuarial life expectancies could equal 50 years. Therefore a willing buyer of an assignee interest in the Modified Partnership must take into account that the Partnership could be continued for a term in excess of that period. Although state law and the Modified Partnership Agreement would permit a limited partner to withdraw from the Partnership upon six months' written notice, this right is not extended to an assignee holder of Sam Selfmade's Partnership Interest. Therefore although the Partnership Agreement would at least guarantee the assignee holder of Sam Selfmade's Partnership Interest the right to withdraw from the Partnership at the end of its stated year term, under the Modified Partnership, Sam Selfmade's transferee, as an assignee, must expect to hold his or her interest indefinitely.

3. No Other Grounds Exist for Ignoring the Creation of the Partnership (Nor Has the Examining Agent Indicated Any Other Grounds for Ignoring the Partnership).

In order for the creation of the Partnership to be ignored (assuming Section 2703 does not apply), one of two arguments must prevail:

(i) The Partnership is a sham and as such must be disregarded for transfer tax purposes. The facts of this case support that the Partnership was created and has been operated as a valid, independent legal entity at all times, in accordance with all state and tax law requirements. No allegations or suggestions have been made to the contrary. Therefore the facts do not support that the creation or operation of the Partnership has been a sham in any respect; or

(ii) Under the step transaction doctrine, Sam Selfmade's contribution of property to the Partnership, coupled with his subsequent transfer of a limited partnership interest, is actually one transaction, that of a transfer of an undivided interest in partnership assets. The step transaction analysis applies to collapse the creation of the partnership "step" with the transfer of the partnership interest "step". Upon the collapse, Section 2703(a) would become applicable. Under this theory, the restrictions in the partnership agreement affect the value of the contributed partnership property and therefore should be disregarded for valuation purposes.

It is the Taxpayer's position, however, that the step transaction doctrine is not an appropriate analysis for transfer tax law (it is only an income tax doctrine). If the creation of the Partnership is not voidable under applicable state law, then Sam Selfmade's transfer at death was a transfer of a partnership interest under state law and, thus, transfer tax law. *84 Also, even if the step transaction analysis is appropriate for transfer tax law, it has no application under the facts of this case. First of all, the analysis requires the presence of three steps. The first step is the creation of the entity; the second step is the transfer of the interest in the entity, and the third step is the termination of the entity. The third step clearly has not (and did not) taken place. Secondly, case law indicates that if the first step of creating the entity is not subject to attack as a sham or illusory, has independent economic significance, and was undertaken to "minimize" and not "avoid" taxes, then the steps cannot be collapsed. This is true, according to case law and the Service's own rulings, even if the steps were part of an overall plan. In the present case, valid business and financial reasons existed to support the creation of the Partnership (see discussion above), and there has been no suggestion or allegation that the creation of the Partnership was a sham. See Rev. Rul. 79-250, 1979-1 C.B. 156; GCM 37652 ("The Service has indicated on several occasions that threshold steps, even when undertaken to tailor transactions so as to generate favorable tax results with respect to the transaction as a whole, will not be disregarded under a step transaction analysis when such preliminary activity demonstrates independent economic significance"); Penrod v. Comm., 88 USTC 1415, 1429-1430 (1987). There is therefore no basis for claiming that what Sam Selfmade transferred was any asset at the time of her death other than an interest in the Partnership.

F. Sixth fundamental: Even if substantial transfer taxes are saved because of the use of a family limited partnership, the Internal Revenue Service cannot disregard the entity if either business or financial reasons exist for its creation.

It does not matter if a principal purpose for utilizing a partnership structure is to reduce aggregate tax liability as long as there exists a business, investment, or financial reason for using that form of organization. Long established judicial authority holds that the IRS cannot disregard the existence of a partnership if the partnership was formed for a business, financial, or investment reason or in fact did engage in a business, financial, or investment activity. *85 Where either of these tests has been met, the courts have not ignored the effect of partnership agreements on valuation, even when valuation discounts approach 85%. *86 There is no shortage of business, financial, or investment reasons for creating a family partnership:

1. The Ability to Transfer Wealth Without Killing the Transferee's Productivity and Initiative.

Many successful clients fear that substantial gifts to descendants may hinder their productivity and initiative. In particular, clients with a substantial portfolio of stocks and bonds feel that giving a child or grandchild a readily marketable asset would not be doing that child any developmental favors. Most clients feel that no one understands their children better than they do. By creating a family limited partnership and transferring only a limited partnership interest to a descendant, a donor controls the amount of wealth transferred because the interest effectively cannot be sold and because the donor can reinvest cash flow rather than making distributions to the partners. This retained, indirect power to affect the cash income of the partners does not subject the transferred interest to estate taxes on the donor's death. *87 By contrast, a retained power as trustee to determine the amount of distributions to trust beneficiaries may subject the trust assets to estate tax on the donor's death.

2. While in the Short Run the Partnership Interest Will Be Worth Less Than the Contributed Assets, Over the Long Run, the Partnership Investment Should be Worth More Because the Pooling of Partnership Assets Will Lower Operating Costs and Increase Diversity.

Families often have many members, and often several trusts have been created over time in conjunction with prior gifts. Keeping up with investments for multiple parties can be frustrating and expensive. By consolidating assets into one partnership, however, these problems over the long term are solved. It is easier and cheaper for a partnership to diversify investments because the size of the portfolio is larger. Likewise, it is easier and cheaper to diversify across several money managers because larger accounts generally are less expensive on percentage basis and because minimum size requirements are more easily met. This is why unrelated individuals have used the partnership form of ownership for their investment clubs. See Rev. Rul. 75-523, 1975-1 C.B. 257; Rev. Rul. 75-525, 1975-1 C.B. 350. Related individuals also like forming "investment clubs." The partnership form of doing business is as attractive to families as it is to unrelated parties because of its potential lower "per unit" administration expenses and its greater potential for diversification.

3. Simplified Annual Giving.

Many assets are extremely difficult to value and are not prone to gifts of undivided fractional interests. Good examples of such assets are rural land and closely held unincorporated businesses. Contributing those assets to a family limited partnership, however, allows a donor to assign partnership interests to a descendant with the use of a simple form. A fractional interest is given away, yet there is no immediate risk of partition, and management of the asset remains consolidated.

4. Keeping Assets in the Family.

Family partnership agreements often are drafted with certain buy-sell provisions to ensure that the partnership's assets will stay in the family. Under such provisions, if any partner attempts to assign his or her interest in the partnership to a person outside of the family, the other partners or the partnership itself may acquire that interest on the same terms, or, in the case of a gratuitous transfer, at its fair market value.

5. Creditor Protection.

A family partnership can be a flexible vehicle to provide some protection of an individual's assets from future creditors. The principal remedy of a partner's "outside" creditors, as distinguished from the partnership's "inside" creditors, is to receive a "charging order" against the partner's interest in the partnership. Under many states' limited partnership laws, unless a partner has made a fraudulent conveyance to the partnership or a conveyance deemed to be fraudulent, his or her creditors cannot reach the partnership's assets. Instead, a creditor may be given a charging order against the partner's interest in the partnership which does not give the creditor any management rights but entitles the creditor only to the partner's share of partnership distributions (i.e., an assignee's interest). In addition, the partnership agreement can be drafted so that an involuntary transfer of a partnership interest to a creditor or any other third party triggers buy-sell provisions which allow the other partners or the partnership itself to purchase that interest at its fair market value. Since the fair market value of a limited partnership interest is usually much less than the underlying asset value, the creditor effectively is paid with less money, and the family assets are more likely to survive the creditor's claims. Furthermore, partnership agreements can be drafted to prohibit the pledging of partnership interests for the debts of a partner.

6. Assets Protected Against Failed Marriages.

The risk of a gift to a descendant being awarded to his or her spouse on divorce can affect an estate plan, and prenuptial or postnuptial agreements may be distasteful or impractical in many situations. In particular, stocks and bonds are very prone to being commingled with assets of the marriage and in community property states effectively might become community property. Limited partnership agreements, however, can be drafted so that gifts of limited partnership interests are protected from the risk of divorce. Consider that many jurisdictions will not award separate property to a divorced spouse. A partnership provides a convenient means of segregating a descendant's separate property so that commingling is avoided. In addition, a partnership agreement can provide that an involuntary transfer of a partnership interest required by a divorce court will trigger buy-sell provisions under which the other partners or the divorced partner can buy that interest at its fair market value. Because the fair market value of the limited partnership interest is usually less than the underlying asset values, a divorced partner is protected even if a court awards his or her interest to a former spouse.

7. Flexibility of Partnership Agreements.

In comparison to an irrevocable, unamendable trust, a limited partnership agreement is a very flexible document. If all of the partners agree, the partnership agreement may be amended or the partnership may be terminated, and usually all of the partners are family members. By contrast, an irrevocable trust generally may not be amended or terminated without court participation and participation by a guardian or an attorney ad litem for certain beneficiaries. As compared to corporations, a partnership requires fewer formalities and may be terminated without the potential adverse tax consequences associated with the termination of a corporation.

8. Business Judgment Rule Offers Flexibility in Management.

The prudent man rule applicable to trustees is a stricter standard than the business judgment rule applicable to the managing partners of a partnership. Many financial investments, such as options and commodities, and many business decisions, such as wildcat oil drilling, may be reasonable but could be considered imprudent under trust law. Most families want to protect the family member who is charged with the responsibility of making investment decisions. In particular, families often want that family member to be protected from the "20/20 hindsight" of a court or jury.

9. Arbitration of Family Disputes Rather than Litigation.

Recent history is replete with examples of highly publicized intrafamily litigation involving the management of family assets. It is extremely difficult to replace a trust beneficiary's right to sue his trustee with a commitment to binding arbitration: the state law right of a beneficiary to sue his or her trustee in many jurisdictions may not be removed by a trust agreement. Because a partnership agreement is a mere contract, however, it can be written so that all of the partners agree to settle disputes by arbitration. When compared to a jury trial, arbitration is usually preferable, especially in the family context. The publicity associated with family disputes can provide an unfair advantage to the person bringing a lawsuit against the family's decision maker. With a well-drafted partnership agreement, such publicity can be avoided through the arbitration process and enforced by a confidentiality provision. In addition, an experienced business person or financial advisor may serve as arbitrator and fact finder.

10. Applying the "English" Rule to Disputes (Loser Pays).

Under trust law, frivolous actions can be difficult to prevent and may be brought by beneficiaries just to provoke a resignation or distribution by the trustee. It is difficult to surcharge a trust beneficiary with the costs associated with legal action. Furthermore, even though a trustee may be reimbursed for legal costs out of the trust's properties, the other beneficiaries of the trust suffer because of that reimbursement. By contrast, a partnership agreement can require a partner who brings an unsuccessful arbitration action against the management of the partnership to pay all of the costs associated with the arbitration. A family limited partnership thus more easily avoids frivolous claims and harassment actions.

11. Institutionalizing Communication on Financial Matters.

One of the more enjoyable aspects of a family limited partnership is that it can serve to institutionalize the education of younger family members on the family's wealth management philosophies. Many people see nothing wrong with wealth per se but fear that it can be abused and therefore want to oversee the financial experiences of younger family members. In addition, prudent investment can generate employment and serve other altruistic purposes. The collectivism provided by a partnership agreement institutionalizes this education process.

12. Lower Probate Costs Out of State.

Many people in our mobile society own passive real estate investments, including vacation property, outside of their home state. Contributing that property to a family limited partnership avoids the costs associated with out of state probate of those assets. Also, if the home state jurisdiction does not have a basic inheritance tax, the basic inheritance tax of the ancillary jurisdiction may be avoided in certain instances through the use of a family limited partnership.

13. Indirectly Allows Trustee Partners to Follow Modern Portfolio Theory.

A trustee may have difficulty following modern portfolio theory because there is a natural conflict between the investment philosophies of income beneficiaries, who prefer current income to growth, and remainder beneficiaries, who prefer growth to current income. In general, modern portfolio or asset allocation theory teaches that rational investors should seek to achieve the highest rate of return consistent with their tolerance for risk, from whatever source. For example, sometimes stocks may be preferred to bonds, and at other times the reverse is true. Although there is one type of trust known as a "unitrust" which pays current beneficiaries a percentage of the value of the unitrust's properties, allowing the trustee to follow modern portfolio theory, most trusts are not unitrusts. A limited partnership, on the other hand, can serve as a "wrapper" around family assets and allows those assets to be managed like a unitrust. The managing partner can invest in a way that produces the highest rate of return consistent with his or her tolerance for risk, whether the source of that return is appreciation or current income. The managing partner then may distribute the percentage of the partnership's assets that he or she deems appropriate to the current "beneficiaries" (i.e., partners) of the partnership.

44. Treas. Reg. § 301.7701-2, -3; Rev. Proc. 92-88, 1992-42 I.R.B. 39; Priv. Ltr. Rul. 9239014; Zuckman v. United States, 524 F.2d 729, 744 (Ct. Cl. 1975); Larson v. Commissioner, 66 T.C. 159, 185 (1976), acq., 1979-1 C.B. 1.

45. Treas. Regs. § 301.7701-2(b)(3); Priv. Ltr. Rul. 8753006 (Sept. 30, 1987).

46. TRLPA § § 8.01, 8.03.

47. Rev. Proc. 92-35, 1992-18 I.R.B. 21, 22; Rev. Proc. 92-88, 1992-42 I.R.B. 39.

48. Rev. Proc. 92-33, 1992-17 I.R.B. 28 (supplementing Rev. Proc. 89-12, 1989-1 C.B. 798).

49. Treas. Reg. § 301.7701-2(e)(1).

50. Id.

51. 136 Cong. Rec. S15681 (10/18/90).

52. Id.

53. Id. at S15683.

54. H.R. Rep. 964, 101st Cong., 2d Sess. 1137 (1990).

55. 136 Cong. Rec. S15683 (10/18/90).

56. "Family Partnerships: Focus Shifts to Section 2703," Tax Notes 610-11 (July 31, 1995).

57. See H. Rep No. 2543, 83d Cong., 2d Sess., 58-67 (1954). Indeed, to the extent that there is evidence of Congressional intent, that evidence strongly suggests that Congress intends that transfer tax consequences are to be determined solely by applying state law to determine ownership rights and encumbrances. See H. Rep. No. 1274, 80th Cong., 2d Sess., p. 4 (1948-1 Cum. Bull. 241, 243), and S. Rep. No. 1013, 80th Cong., 2d Sess., p. 5 [U.S. Code Cong. Service 1948, pp. 1167, 1260] (1948-1 Cum. Bull. 285, 288), where the Committee Reports on the 1948 changes in the estate taxation of community property state "Generally, this restores the rule by which estate and gift tax liabilities are dependent upon the ownership of property under state law." See also Aldrich v. United States, 346 F.2d 37 (5th Cir. 1965).

58. For purposes of Chapters 11 and 12, because of Section 7701(a)(2), Sam Selfmade will be considered as having transferred an interest in a partnership.

59. Rev. Rul. 83-147, 1983-2 C.B. 158.

60. 25 T.C. 153 (1955), aff'd, on another issue, 244 F.2d 436 (4th Cir. 1957), cert. denied 355 U.S. 827 (1957), acq. in result, 1959-1 C.B. 4.

61. Estate of Knipp, 25 T.C. at 169.

62. 1983-2 C.B. 158.

63. 36 T.C.M. (CCH) 1084 (1977).

64. Id. at 1088.

65. The Taxpayer does not consider that these restrictions should be disregarded because they fail to satisfy the safe harbor provided in Section 2703(b). However, for purposes of the argument in this subparagraph 5 and the argument under paragraph B below these "restrictions" are ignored. The remaining partnership provisions do not fail under section 2703 because these "restrictions" may fail. See Treas. Reg. 25.2703-1(b)(5).

66. Treas. Reg. § 1.701-2(a) (emphasis added). The parenthetical language referring to investment as a business activity was added after the release of the proposed regulation. Compare Prop. Reg. § 1.701-2(a).

67. See Frank G. Lyon Co. v. U.S., 435 U.S. 561, 583-584 (1978); Estate of McLendon, 66 T.C.M. (CCH) 946, 962 (where amendments to a family limited partnership agreement which limited the partners' ability to liquidate the partnership were adopted shortly after the decedent partner's diagnosis of cancer and 15-1/2 months and 13 months, respectively, prior to the decedent partner's death); Sparks Farm, Inc. v. Commissioner, 56 T.C.M. (CCH) 464, 472-473 (1988); Estate of Harrison, 52 T.C.M. (CCH) 1306, 1309 (where the subject partnership interest was acquired under the authority of a durable power of attorney on behalf of an infirm, incompetent principal who died 5-1/2 months after the family limited partnership was created); Estate of Bischoff v. Commissioner, 69 T.C. 32, 39-41 (1977).

68. See Estate of Watts v. Commissioner, 51 T.C.M. (CCH) 60 (1985), aff'd, 823 F.2d 483 (11th Cir. 1987); John R. Moore v. Commissioner, 62 T.C.M. (CCH) 1128 (1991); Estate of Harrison, 52 T.C.M. (CCH) 1306; Harwood v. Comm., 82 United States Tax Court Reports 239 (1984).

69. If the taxpayer meets its burden on either part of the test, the creation of the partnership is not a device to transfer assets contributed to the partnership to Sam's family.

70. TRLPA § 7.01: ". . . A partner has no interest in specific limited partnership property."

71. See the discussion on pages 30 to 31 above concerning Estate of Knipp and the Tax Court's recognition of a partnership as an entity, in which partners, even controlling partners, do not have any right to or interest in insurance policies, which are owned as specific partnership assets, on the lives of partners.

72. The Senate Finance Committee Report on Section 2703 makes it clear that the "device" test follows the reasoning of the Eighth Circuit in St. Louis County Bank.

73. See New York Times, Section 3, Page 1, Our Portfolio, Ourselves (October 15, 1995)(referencing 17,004 investment clubs that belong to the National Association of Investors Corporation).

74. See Rev. Rul. 75-523, 1975-2 C.B. 257 (a partnership was recognized for tax purposes even though the only purpose of the partnership was to invest in certificates of deposit); Rev. Rul. 75-525, 1975-2 C.B. 350 (a partnership form of ownership was recognized for tax purposes even though the only purpose of the partnership was to invest in marketable stocks and bonds).

75. See also Estate of McCormick v. Commissioner, 70 T.C.M. 318 (1995).

76. It should be noted that the Fifth Circuit designated the opinion in McLendon as not for publication because, according to the Court, it had no precedential value, merely deciding a particular case on the basis of well-settled principles of law.

77. TRLPA § 7.04(a).

78. Id. at § 7.02(a).

79. Id. at § 8.01.

80. Id. at § 7.02.

81. Id.

82. "The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts."

83. The Internal Revenue Service has indicated through its own regulations that this lack of free transferability is inherent in transferred partnership interests and is a key factor in distinguishing an entity as a limited partnership as opposed to a corporation. See Treas. Regs. § 301.7701-2(e).

84. Estate and gift tax consequences are to be determined solely by applying state law to determine ownership rights and encumbrances, not federal income tax law. See FN 15.

85. See Frank G. Lyon Co. v. U.S., 435 U.S. 561, 583-584 (1978); Estate of McLendon v. Commissioner, 66 T.C.M. (CCH) 946, 962 (1993); Sparks Farm, Inc. v. Commissioner, 56 T.C.M. (CCH) 464, 472-473 (1988); Estate of Harrison v. Commissioner, 52 T.C.M. (CCH) 1306, 1309 (1987); Estate of Bischoff v. Commissioner, 69 T.C. 32, 39-41 (1977).

86. See Estate of Watts v. Commissioner, 51 T.C.M. (CCH) 60 (1985), aff'd, 823 F.2d 483 (11 Cir. 1987); John R. Moore v. Commissioner, 62 T.C.M. (CCH) 1128 (1991); Estate of Harrison v. Commissioner, 52 T.C.M. (CCH) 1306 (1987); Harwood v. Comm., 82 United States Tax Court Reports 239 (1984).

87. See United States v. Byrum, 408 U.S. 125 (1972). The Service held in Technical Advice Memorandum 9131006, citing Byrum, that in a typical family limited partnership, the managing partner will not be considered as having retained an IRC Section 2036(a)(2) or IRC Section 2038 power over the transferred limited partnership interest. See also Rev. Rul. 81-15, 1981-1 C.B. 457; Ltr. Rul. TAM 9415007, 9332006, 9310039, and 9026021; GCMs 38984 and 38375.

Copyright 1996 S. Stacy Eastland. All rights reserved.