Tax stuff I think is interesting. It is either copied from my primary blog on forbes.com http://www.forbes.com/sites/peterjreilly/ or stuff that I did not put there because being on forbes is a good gig and they have, you know, standards. Also some guest posts.
Sunday, August 24, 2014
Family Limited Partnerships Require Good Planning and Execution
Originally Published on forbes.com on November 12th,2011
There are times when the Forbes contributor guidelines frustrate me. My discussion of the Estate of Paul H. Liljestrand v. Commissioner is one of those times. To fully appreciate my reaction to this case you need to add a common intensifier (ci) when I write something like “You never told your (ci) accountant that you were planning on transferring 5,000,000 of real estate into a family limited partnership.” or “You never told your accountant that you actually did (ci) transfer the real estate into a family limited partnership.” or “The only (ci) way that your (ci) acccountant ever (ci) found out about the (ci) transfer was when she saw the (ci) lawyer’s (ci) bill two (ci) years later !!!” Also I’m SHOUTING.
Like many estate cases this one starts out with the makings of a novel:
Dr. Liljestrand was born in Iowa in 1911. He obtainedan undergraduate degree from Ohio Wesleyan University and amedical degree from Harvard Medical School. Upon completing medical school, Dr. Liljestrand accepted a residency at Queens Hospital in Honolulu, Hawaii. In 1939, after his residency, Dr. Liljestrand went to work at the plantation hospital in Aiea, Hawaii (hospital), where he practiced medicine as a general practitioner and surgeon.
The plantation hospital was a small community hospital that served the plantation’s workers and the surrounding area’s residents. Some time after Dr. Liljestrand began working at the hospital, the plantation closed and the decision was made to close the hospital. Dr. Liljestrand entered into an agreement with the plantation’s owners to lease the hospital building. Dr. Liljestrand opened a medical practice in the building and organized a not-for-profit group to operate the hospital. A few years later Dr. Liljestrand purchased the hospital property.
The ending of the idyllic story is on the mundane side. The good doctorretired and found that rising malpractice costs required him to sell the hospital. The funds did not go to a foundation to send the grandchildren of cane cutters to Harvard. There was a like kind exchange into a diversified portfolio of commercial properties mostly on the mainland. The doctor’s son Robert went from being a hospital administrator to a real estate manager. The real estate was owned by a revocable trust of which the doctor was the sole beneficiary. Robert was paid a salary of $100,000. He hired Annie Au to serve as the trust’s accountant. He must have spoken to Ms. Au from time to time but not nearly enough. In 1996 there was some estate andbusiness planning done:
In April 1996 Dr. Liljestrand and Robert met with Dr. Liljestrand’sestate planningattorney, Mr. Ota. According to Mr. Ota and Robert, Dr. Liljestrand wanted to leave his property to his four children equally, but he wanted to ensure Robert’s continued employment as manager of the real estate. Robert had taken on more and more responsibility with regards to the real estate business, and the other children wanted nothing to do with the business. Mr. Ota suggested that Dr. Liljestrand form a limited partnership and transfer the real estate held by the trust to the partnership.
So far so good. This is a perfect fact pattern for a solid family limited partnership. Document drafting and execution was less than ideal, although not fatal:
In 1997 Dr. Liljestrand, in consultation with Mr. Ota, decided to form the Paul H. Liljestrand Partners Limited Partnership (PLP). Mr. Ota, unfamiliar with drafting partnership agreements, engaged a former colleague, Mickey Rosenthal, to draft the PLP agreement. It is unclear whether Mr. Rosenthal and Dr. Liljestrand had any contact before Mr. Rosenthal drafted the agreement. In order to draft the partnership agreement, Mr. Rosenthal had Dr. Liljestrand fill out a checklist. The checklist was sent to Mr. Ota, who forwarded it on to Dr. Liljestrand. Mr. Ota structured PLP on the basis of his general understanding of what Dr. Liljestrand wanted. Mr. Rosenthal met with Mr. Ota and drafted the PLP agreement in accordance with his instructions. Though Dr. Liljestrand intended his children to become partners in PLP, no child, other than Robert, participated in any discussions regarding PLP’s formation.
There was another front end problem with the planning, that caused the Court to question the scheme. Mr. Ota had indicated that one of the reasons that he had encouraged a partnership was because of concerns that the children might try to exercise a right of partition that existed under Hawaii law. This was sound reasoning, were it not for the fact that most of the real estate was not in Hawaii:
The estate’s argument is unconvincing. First, most of Dr. Liljestrand’s real estate was outside of Hawaii and therefore was not subject to the partition statute. Of the thirteen properties contributed to PLP, only three properties were in Hawaii, two lots of land and the Hawaii condominium. The remaining 10 properties contributed to the partnership were in Oregon, Florida, and California. Dr. Liljestrand’s estate planning attorney, Mr. Ota, understood that the nonHawaii properties were not subject to the Hawaii partition statute. Though Mr. Ota understood that the Hawaii statute was not applicable to these properties, he decided not to research the law of partition in Oregon, Florida, and California. The lack of such basic legal research is telling as to the significance of partition in the decision to form PLP.
The other front end problem is extremely frustating. In order to have a partnership you have to have partners – plural. This partnership was formed with the trust putting in all the properties worth $5,915,167 for a 99.98% interest. The point o.02% balance went to Robert who was supposed to contribute $362. Robert never contributed the $362. There would have been some difficulty with that, because, despite requirements of the partnership agreement, the partnership did not open a bank account. Of course if they had tried to open a bank account for the partnership, they would have realized they needed an EIN, which might have clued them in to the fact that partnerships are supposed to file returns. We call them partnership returns but if we want to be fancy we say Form 1065.
Mrs. Au just continued to report all the real estate activity on the doctor’s individual return. She had a really good excuse. Nobody told her about the partnership. After a couple of years, though, she figured it out:
The failure to treat the real estate as a partnership asset was discovered in 1999 when Mrs. Au, while preparing Dr. Liljestrand’s Federal income tax returns, discovered invoices for attorney’s fees relating to the formation of PLP. At this point, the parties applied for an employer identification number for PLP and opened a bank account in the partnership’s name. Mrs. Au also began keeping books and filing Federal tax returns for the partnership in 1999. Rather than file amended Federal income tax returns for the years 1997 and 1998, Dr. Liljestrand and his advisers decided to treat the partnership as having commenced business on January 1, 1999, even though legal title to the real property had been transferred to the partnership by December 1997.
Excecution did not improve that much in the subsequent years:
Dr. Liljestrand contributed almost all of his income- producing assets to PLP. ……….. Dr. Liljestrand’s retained assets were insufficient to pay his living expenses.In order to offset the shortfall in Dr. Liljestrand’s income, the partnership made disproportionate distributions to the trust and directly paid a number of Dr. Liljestrand’s personal expenses.
Mrs. Au set up a general ledger for PLP to categorize and account for all transactions affecting the partnership assets and Capital accounts 10 as well as ledger income beginning in 1999. accounts were established for each partner to show distributions to each partner, income received by the partnership, and expenses incurred by the partnership. In addition, Mrs. Au set up accounts to keep track of disproportionate distributions to each partner and payment of personal expenses with partnership funds. These accounts had various titles such as: Property tax paid, grandchildren’s gifts, and account for household employees. …….. The partnership needed to properly maintain capital accounts because the partnership agreement called for liquidating distributions in accordance with the partners’ capital accounts. account of Robert’s distribution of funds to the trust without regard for the partnership agreement. The balance in these accounts were treated as draws against each partner’s capital account.
In June 2004 after Dr. Liljestrand’s death Mrs. Au requested a meeting with Mr. Rosenthal to discuss PLP’s accounting. During that meeting Mrs. Au learned that she had incorrectly accounted for the disproportionate distributions and payment of partner personal expenses. Mr. Rosenthal explained to Mrs. Au that these amounts should be treated as partnership receivables which the partners should repay. The record does not contain any evidence of partners repaying personal expense payments or disproportionate distributions they had received.
The estate attempts to downplay the significance of the direct use of PLP funds to pay Dr. Liljestrand’s personal expenses by claiming that such distributions were properly accounted for as draws against Dr. Liljestrand’s capital account. To the extent that the estate’s arguments focus on accounting manipulations, they are unavailing. Robert and Annie Au, PLP’s accountant, each testified that accounting adjustments were made at yearend after monies had actually been distributed. Accounting entries made by Mrs. Au were a belated attempt to undo Dr. Liljestrand’s receipt of disproportionate distributions. After-the-fact paperwork by Dr. Liljestrand’s accountant does not refute the implied understanding that Dr. Liljestrand could continue to use and control the partnership property during his life.
“Accounting manipulations” – One of the most important lessons of failed limited partnership that I emphasize in my piece Devil is in the Details is that judges do not respect journal entries. I have almost come to believe that nobody thinks journal entries mean anything other than the accountant’s who make them. This is from my discussion of the Gore case:
I have learned a hard lesson that many accountants never quite get. When it comes to this “everything’s in balance” routine, almost nobody else cares. Here is some of what the court had to say about Ms. Bower’s efforts:
“The GFLP accounting records prepared by Ms. Bowers purport to show that decedent transferred ….”
“The accounting records also purport to show that after decedent executed the assignment, decedent allegedly sold the Commercial Federal CD, the savings bonds, a Valley National CD, and one of the Treasury notes to GFLP in exchange for a note payable to her from GFLP …”
The word “purport” or one of its forms (e.g. “purporting”) occurs six times. Here is the problem. You can get into law school with a liberal arts degree. They don’t teach double entry accounting in law school. If it’s taught in high school, it’s to kids not on the college track. You certainly don’t need it for a liberal arts degree. Judges are lawyers. It all balances and they don’t care.
Much as I hate to repeat myself my conclusion on this case is pretty much the same as on the Gore and previous cases:
This is nothing new. If you study the cases where taxpayers lose FLP cases, you will, almost always, if not inevitably, find that the failure was not one of a flawed plan. The failure was not following the steps transaction by transaction. If somebody is entitled to a distribution and has bills to pay, you distribute to them and let them pay their own bills. All entities have accounts and the payments in and out are the ones that belong to that entity. If a mistake is made it is fixed by a transfer of funds, not a journal entry that creates an indefinite “Due to”. The moral of the story is that in order for the plan to work you must have coordination between the attorney who prepares the plan and the accountant who will be preparing the relevant returns. If you don’t want to trouble yourself with what entity should pay what bill or accept what deposit, etc, let that piece be handled by your professionals, also, but again in an integrated manner. There has to be somebody who cares what account is used, because that is their job.