An Illuminating Look at Closely Held Entities: Series Overview (Pt. 1 of 4)

Jan 3, 2023 | Business Planning, General Estate Planning, IRS / Tax Guidance, Podcasts, T&E Administration

An Illuminating Look at Closely Held Entities

“An Illuminating Look at Closely Held Entities,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Stacy Singer, ACTEC Fellow from Chicago. There are three main phases of the closely held entity: formation, administration, and possible liquidation. We will tackle each phase in the series of podcasts. ACTEC Fellows Todd Angkatavanich from New York and Stephanie Loomis-Price from The Woodlands, Texas, will give us an overview of this topic in the upcoming podcast. Welcome, Todd and Stephanie.

Todd: Well, thanks so much for having us today. We are going to “kick off,” if you will, a little overview of the “Friday Night Lights” presentation that we recently did at the ACTEC conference in San Francisco. Stephanie Loomis Price did double duty serving as the moderator as well as one of the two Monday morning quarterbacks along with me as another quarterback, providing commentary on the three different sessions that we went through with really an all-star team here. We had “pregame” entity formation with Miriam Henry and Kevin Matz. “Game time” administration of a closely held entity with David Handler and Ann O’Brien. And then to wrap it up overtime considerations with the possible liquidation of a closely held entity with Ann Burns and Lou Harrison.

So, in terms of the overall program, it was a very interesting program that talked about these three different stages, starting obviously with the pregame or formation of the family partnership or closely held entity. Stephanie, the discussion was really a riveting one and it started with the selection of jurisdiction and reasons for creation of the partnership. What were your observations?

Pre-game: Planning and Formation of Entities

Stephanie: I think the most important thing that we heard throughout all three sessions was the importance of tailoring the governing agreement and the purposes stated in that agreement to the family’s needs and goals. And not just taking your template document off the shelf, putting the family name on it, and hitting the go button. So, making sure that you’ve talked with the clients about what their goals are, ensuring that their goals are realistic. In other words, if they say, I just want my family to work together forever, for years and years–kind of talking through with them about how realistic that goal is. And if that goal is feasible, making sure that that goal is highlighted in the governing agreements and is lived by once the entity is up and running.

Todd: I couldn’t agree more, Stephanie. That was really something that came across loud and clear. Not only in the first session, but in the other sessions as well. And that is really sort of – reflects the tenor of the messaging from the tax court where they’ve looked at a number of situations. And what’s clear from these cases is that there’s no one size fits all kind of structure where this necessarily satisfies the requirements of the bonafide sale exception to Section 2036 and this one does not.

Rather the court, in these cases, they take a look at the purported reasons for the creation of the partnership or the entity and the actual family circumstances. And what that court has made clear is they’re not working for the “theoretical justification” but rather really trying to look for the non-tax reasons for the creation of the partnership. So, one of the other things that were an important issue that was discussed throughout, but certainly discussed with respect to the pregame entity formation, was trying to make sure that the reasons are properly documented and that those are reflected in the file and that it’s consistent with what’s in the agreement itself.

And I think that’s something that you’ll hear throughout these other podcasts. The other thing is really thinking through the Section 2036(a)(1), so-called bad facts or good facts, and Section 2036(a)(2), retain control issue at the formation stage as well as managerial roles. What were your observations about that, Stephanie?

Closely Held Entities: Lessons from Powell, Cahill, and Levine Decisions

Stephanie: Well, we know that at least until the early 2000s that issue had not yet been highlighted. We saw it highlighted in the Strangi case and really thought that the control issue between 2036(a)(2) was an outlier. It’s kind of an offhand comment in a decision by Judge Cohen in the Strangi case. And then, of course, we had Powell and Cahill come fast on each other’s heels just a few years ago.

And those two cases have really changed the landscape in terms of the concerns about the right to control and the fact that we don’t necessarily have to be a general partner for the IRS to focus in on 2036(a)(2), but even in limited partner has strong retention as a service. And I know, Todd, that is something you have explored in great depth. Do you want to explain that a little bit more extensively?

Todd: Sure. Well, I think this rewinds back 20 years to the Strangi case and then as you said more recently, the Powell case over the past few years. And it’s really sort of become perhaps the main issue of concern because, after Strangi there was a feeling that, well, okay, that was one case and that the issue of retained control is one that was just not really addressed for a long time after Strangi and then now, in the Powell case a few years ago, then more recently, Cahill, it’s more front and center.

And, I think from the formation stage of things, it’s very important to think about who is going to be in that role. Is the matriarch or patriarch going to serve as the general partner or one of the general partners or the manager in the case of an LLC? The other thing that was explored is, well, sometimes you might consider bifurcating those roles between sort of an investment manager, which seems to be a more acceptable role for the matriarch or patriarch to play, versus let’s say, a distribution manager, which seems to be the more tainted kind of function that many would prefer the clients not to serve with respect to that role.

I think the other thing that was important was the Levine case – a very recent Levine case was discussed. And that provides a little bit of sort of pushback, if you will, with respect to the possible breadth of the application of 2036(a)(2) in the case of closely held family entities. Even though the Levine case was not a closely held entity case at all but was rather a multigenerational split dollar case.

Game Time: Administration and Operations of Closely Held Entities

Stephanie: That, I think, wraps up the quick points on formation. What about the administration of a partnership? What are your thoughts – main takeaways – one or two, from the administration session?

Todd: I think the administration session with David Handler and Ann O’Brien is a great session. And there was certainly a continuation of the topics that we talked about in the first session, but I think one of the things that are so important is to make sure that you administer your partnership or your entity properly. So, where these things are destined to fail in many cases is when it’s a set it but forget it kind of situation and they set up the entity and then they just put it in the drawer and they never look at it again.

If you’re going to do that, and I think this is clear from the discussions, that if your clients are not sort of equipped to administer and respect the formalities of this partnership or this entity correctly, they just shouldn’t set it up, right. Because that’s so many places where those things fail. The other thing that I think was an important clarification is that under 2036(a)(1) and 2036(a)(2), those are two separate ways that assets can be pulled back into a parent’s estate, right? So, as we know from the Strangi case, it can be pulled back in the state under both theories, but it only takes one theory for those assets to be pulled back into the estate.

Stephanie: And Todd, what I’m hearing based on our summaries, is that “creation” tends to be a 2036(a)(2) consideration. That whether or not you have control. And “operation” tends to be a 2036(a)(1), kind of bad facts consideration. So, you can start out with something that’s clean and have it go bad, i.e. no control but bad facts, or you can start out with something that’s bad because you have control issues, but perhaps operate it cleanly. Either way, you may have a 2036 issue at best, and as we know, the service even in gift tax cases is asking questions about 2036 issues even though 2036 only applies in estate tax cases. I think that’s very interesting.

Overtime Part 1: Liquidation and Control of Entities

Todd: Yeah, I think it’s such an important distinction. The other analogy that we talked about is, and in keeping with our sort of “Friday Night Lights” theme, is sort of the playing field analogy with respect to a valuation of an entity for 2036 purposes. And the way I like to sometimes sort of envision this is that if you envision a field and the field, you know, 75% of the field is the bonafide sale exception. And that takes up so much of the field because, as Steve Akers will say correctly, probably in over 95% of the cases on 2036, where the estate has either won or lost, that battle or that game has been sort of won on the bonafide sale exception.

Now, if the bonafide sale exception is not satisfied then, in most cases, that’s where you go to the evaluation of whether there was sort of the administrative bad facts under 2036(a)(1) and/or if there was control under 2036(a)(2). But like you said Stephanie, either one of those can cause the assets to come tumbling back into the estate. Now, that also sort of relates to the discussion that was had with respect to de-control of the matriarch or the patriarch of their role as a general partner and/or manager. And the distinction that we made was: Look, de-control is a very important thing to think about, okay? But, don’t just rush into doing de-controlling because you could possibly trip over Section 2704A, and run into a deemed gift to a more immediate problem in your quest to try to solve things from a 2036(a)(2) de-control standpoint.

And then I think importantly, and similarly, you don’t want to just rush or make a knee-jerk reaction to de-control to get parents out of the general partner or managerial interests unless and until you’ve done an honest assessment from a 2036(a)(1) administrative bad facts standpoint. Because keep in mind that de-controlling will only address 2036(a)(2), but if your partnership or entity is already infected of a 2036(a)(1) bad facts administration standpoint. You’re still going to have inclusion in the estate in any case. And you could actually make the situation worse because now maybe you’ve threatened the extent to which you can get the marital deduction and how much the marital deduction you can get. And so, I think these things are all interconnected.

Stephanie:  I think that’s been – I think we’re headed the same place. I think that takes us to the potential termination of an entity. And considering when either your facts are so bad that you’ve got that hole in the pit of your stomach that tells you we’ve got a problem, or you’ve got family members who say, okay, mom and dad’s goal was accomplished, mom and dad are now gone and, so, we’d like to close down the partnership.

Overtime Part 2: Termination of an Entity

Stephanie: So, Todd, I’m going to turn to you for the pit of your stomach considerations, but I think I just want to mention that in that latter situation where you’ve got the kids saying, okay, mom and dad are gone, we don’t want to do this anymore, my caution is: beware because you now have a what I call “2036 protected partnership or entity.” Because in order for 2036 to apply in the children’s estate, they would have had to transfer assets or contribute to the entity. If they have not, there is no situation in which Section 2036 can apply in their estates. And so, you now have something that can pass and live free of the sector of Section 2036. Thoughts on that, Todd, and/or the pit of your stomach situation?

Todd: Well, I couldn’t agree more with that sentiment. We sometimes like to refer to that as a “dynastic partnership.” And again, the notion being that while the knee-jerk reaction by the family members might be, “okay, mom and dad are passed, we’ve gone through the audit, how long before we can take the assets out and get the cash?” While that might be the knee-jerk reaction, okay, from a multigenerational planning standpoint–really hit the pause button before doing that.

Because now, you have the next generation with assets that are inherently subject to discount, perhaps, but the biggest argument that the service has had with respect to family entities, wouldn’t apply in the next-gen situation because, as you said, they never put the assets in the partnership in the first place. So, you didn’t have that sort of capital contribution as a prerequisite.

I think, from a pit of the stomach situation, right, I think the most important takeaway from all these things is you really want to be proactive as advisors with your clients to do the stress test. Do it now. Do it from time to time, right? Because we often hear situations, well, this partnership is 20 years old. It’s old and cold and we should be good. Well, just because it’s old doesn’t mean that it’s good. You could have something that’s been in place for 20 years with 20 years of bad facts. Keep in mind, the triggering an event doesn’t happen until the matriarch and/or patriarch passes on. So, in many cases, an old and cold partnership might just be essentially a ticking time bomb.

So, I think the proactive stress test now, from a 2036(a)(1) and 2036(a)(2) standpoint, as well as an evaluation of your sort of – the strength of your argument from a bonafide sale exception standpoint — is really critical. If after you do that stress test, you determine that maybe it’s still viable, but there are things that you can do to fortify the structure, now is a good time to do that. In some cases, however, Stephanie, your valuation of the partnership may show that there’s probably just too many bad factors at play here and it may be better to think about unwinding it now – liquidating it.

Having the different parties take their share of the partnership or the entity and sort of going their separate ways. But I think, as the third session really stressed upon, there are a number of partnership tax issues that have to be taken into consideration very carefully before just rushing to liquidate. Mixing bowl issues, hot assets issues, disguised sale issues. All the partnership tax issues that need to be thought about before you unwind.

Stephanie: You’ve hit the nail on the head and with that, I would suggest that we have won the field goal kick in overtime and we probably ought to shut off the lights.

Todd:  Well, it’s going to be hard to top that analogy, so I’ll leave it with that.

Stacy: Thank you Todd and Stephanie for giving us a hit list of focus issues on entity formation, administration, and possible liquidation. And stay tuned for the next podcast, in this 4-part series, “Formation of a Closely Held Entity.”

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