American jails are bulging with "criminals" guilty of nothing more than indulging in their favored herbal remedy, seeking privacy in their financial affairs, or building on their own property. In certain circumstances, you can also be imprisoned for trying to protect your assets. And now, your legal advisors—and by extension, perhaps you as well—may be committing tax fraud if you form a limited partnership to reduce estate taxes.
On June 9, in a Manhattan federal courtroom, the Department of Justice unveiled a tax fraud indictment against several prominent tax attorneys and tax planners. They stand accused of marketing "tax shelters" that lacked economic substance and had little chance of withstanding an IRS challenge.
The indicted attorneys created opinion letters stating that clients would "more likely than not" prevail in claiming the tax benefits from the tax shelters if challenged by the IRS. Since the IRS believes the opinion letters contained false statements, the indictment claims the attorneys made false representations to the IRS.
The essence of these alleged false representations was that the tax shelters—which generally involved complex investment strategies involving hedges and options—had a non-tax purpose. For instance, a legal opinion one of the indicted attorneys prepared stated:
"You entered into the purchase and sale of the options for substantial non-tax business reasons, including (i) to produce overall economic profits because of your belief that the [foreign currency]/U.S. dollar exchange rate and the [second foreign currency]/U.S. dollar exchange rate relationships would change; and (ii) your belief that the most direct way, with the most leverage, to realize gain from expected changes in currency prices was the purchase and sale of the options."
However, the indictment alleges that:
“In truth and fact, the clients entered into the purchase and sale of the options in order to obtain the desired tax benefits, and had no substantial non-tax business reasons for entering into them…the clients took that step because the conspirators directed them to do so in order to achieve the tax losses or benefits they purchased.”
If the Feds win this case, you can expect a major crackdown against any tax planning strategy in which non-tax benefits are alleged, but can't be proven. And limited partnerships—along with those who create them—will be one of the prime targets.
Estate planning with a limited partnership typically involves forming the partnership, funding it with a substantial portion of your estate, and then making periodic gifts of minority partnership interests to your heirs. Planners often discount the value of such gifts for gift and estate tax purposes. Discounts vary from 10% to 50% or more, although 25% is a typical adjustment. The discount exists because it's often not possible to sell partnership interests—particularly minority interests—for the full value of the underlying assets.
However, even though the courts have repeatedly upheld the validity of valuation discounts, the IRS has continued to challenge them. And if prosecutors succeed in convicting the indicted attorneys in New York, the agency will have one more arrow in its quiver--the threat of prison. In addition, the Obama administration is sponsoring legislation that would eliminate most valuation discounts.
How might the IRS equate estate planning using valuation discounts with tax fraud? Because the planning documents for limited partnerships usually contain the same type of language that the prosecutors in New York are trying to prove is fraudulent. Some of the non-tax justifications used for limited partnerships include:
- Discouraging frivolous lawsuits
- Combining family assets for streamlined management and superior investment options
- Reducing the likelihood of disputes between over family assets.
These are all legitimate goals. But if the IRS audits your estate, and your heirs can't prove that the partnership was used primarily or at least substantially for non-tax purposes, it might not just invalidate the valuation discount. It might also threaten to indict your heirs for tax fraud.
This may seem like an extreme interpretation of the implications of the New York litigation. And in reality, what the IRS is most likely to do is to tell your heirs that if they forget about the valuation discount, they won't be indicted.
The handwriting is definitely on the wall: estate planning with limited partnerships will become an increasingly risky affair. Fortunately, there are numerous alternative strategies—life insurance, various types of trusts, lifetime gifts—that I'll discuss in future blog entries.
Copyright © 2009 by Mark Nestmann
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