2. The Estate Planning Implications
The fiduciary duty owed by a partner to the partnership and the other partners has great utility in the family partnership arena: (i) the existence of the duty avoids estate tax inclusion of pre-death gifts of non-controlling partnership interests, (ii) the fiduciary duty owed by the general partner or managing member supports the “present interest” requirement for annual exclusion purposes, and (iii) it provides that the relationship among the partners (who are generally family members) will be governed by a standard of fairness in the operation of the partnership instead of being governed by a narrowly defined agreement.
I.R.C. § 2036(a)(2) includes in the value of a decedent’s gross estate any property transferred during life by the decedent over which he or she retains the right (alone or with others) “to designate the persons who shall possess or enjoy the property or the income therefrom.” The Supreme Court decided the possession of management control, including the power to determine dividends, did not constitute the rights described by I.R.C. § 2036(a)(2) because of the fiduciary doctrine regulating the business relationship:
A majority shareholder has a fiduciary duty not to misuse his power (to control the board of directors) by promoting his personal interests at the expense of the corporate interests.
Although Byrum involved closely held corporations and has been subsequently reversed by statute (I.R.C. § 2036(b)), the analysis for partnerships still remains potent for I.R.C. § 2036 purposes. The Bryum reasoning also supports that a gift of a limited partnership interest is a “present interest” gift for I.R.C. § 2503 purposes.
In the early 1990â€²s, the IRS issued a series of rulings using a Byrum analysis to avoid the operation of I.R.C. § 2036(a)(2) and to give the gifted share “present interest” status for I.R.C. § 2503. TAM 9131006 is representative:
“The general partners had the right under the partnership agreement to determine the timing and method of the partnership distributions similar to the right of a corporate board of directors to declare and pay dividends. The general partners are also bound to a high standard of conduct toward limited partners similar to that of corporate boards of directors to shareholders… In the instant case, the powers possessed by the general partners under the partnership agreement, including control over partnership distributions, are common to most limited partnership agreements. The decedent, as general partner, possessed no powers that are not otherwise contained in the standard limited partnership agreement, regardless of whether the partners are related or not… In the instant case, the gifts of the partnership interests constituted outright gifts of ownership interests in a business entity. Each donee received the immediate use, possession and enjoyment of the subject matter of the gifts, the interests in the partnership. These interests entitled the donees to any current economic benefits generate by the property. In addition, the donees had the right at any time to sell or assign the interests (subject to a right of first refusal). Management and control of the partnership assets were vested in an individual, the general partner.
Since the 1990â€²s, the I.R.S. has ceased issuing these useful, pro-taxpayer rulings. Indeed, the I.R.S. pressed an I.R.C. § 2036(a)(2) argument before the Tax Court in Strangi v. Comm. when it was argued on remand. The Tax Court on remand in Strangi distinguished Byrum because of the level of pervasive control that Mr. Strangi exercised (through his agent) and it dismissed the various I.R.S. rulings (including P.L.R. 9331006) as being a “cursory exposition in limited factual circumstances” as well as generally being without precedential force. The current focus by the I.R.S. on family partnerships tends to be on other grounds.
In 2002, the I.R.S. successfully attacked the gifts of a limited partnership unit as not being a present interest because the parent, or general partner, could control whether distributions of available cash would, in fact, ever be distributed. The lesson of the Hackl case is that the partnership or LLC agreement can reverse the general rule that a limited partnership interest is a present interest gift. In Hackl, the father was manager of the LLC for life and no transfer of an interest could take place without his consent. In addition, he retained complete control over distributions and no member could compel a distribution. The Tax Court held that no present interest gift occurred because the donees failed to receive a substantial present economic benefit. It seems clear that to preserve the present economic benefit of a non-controlling interest in a partnership or LLC it is important (i) to give the donees the ability to sell their interests (subject to a right of first refusal) and (ii) that the distributions be dictated by a Byrum-type standard and not at the unfettered discretion of the general partner or managing member.
In the family setting, the fiduciary relationship is important for reasons beyond the estate and gift tax implications. Limited partnerships or limited liability companies are used as a device to manage family relationships over many years, perhaps involving several generations. Thus, it would seem, that the primacy of the fiduciary relationship among partners would be a key attribute of these entities in the estate planning arena.
The fiduciary character of the partnership relationship was unchallenged until recently:
If nothing else could have been said with confidence about partnerships on the eve of promulgation of the UPA in 1914, it was that the relationship was fiduciary in character. Thus, regardless of the contractual structure to which the partners agreed, the foundation of the relationship was a matter of status, not contract. Simply by virtue of being partners, the participants owed each other certain general obligations of conduct: “The duty of each partner to exercise toward the others the highest integrity and good faith is the very basis of their mutual rights in all partnership matters.” Because the obligations were seen as arising by virtue of the status of the partners as partners, and not by their agreement, the remedy for breach of the basic obligations was in tort, not in contract.
The movement in modern partnership law away from its fiduciary duty roots has serious implications for use by estate planners.