Charitable Family Limited Partnerships
Another scam on the charitable scene involves an entity called the charitable family limited partnership (“CFLP”). Its abusive nature is similar to the split-dollar life insurance ploy, except its purpose is, in addition to giving a large charitable deduction, to save the donor income and estate taxes on highly-appreciated assets, such as real estate or a family-owned business.
It is a derivative of the well-known family limited partnership. A family limited partnership divides a taxpayer’s assets among family members, in an attempt to “freeze” the value of the estate for estate tax purposes. Because the taxpayer owns a fractional interest in the property, a minority discount is applied to reduce the value of the estate by 30%-40% (See my discussion on minority discounts at: http://www.taxprophet.com/hot/dec98.htm).
The CFLP differs from the family limited partnership because a charity becomes the major limited partner. This allows any tax gain from the sale of an appreciated asset to be charged against the charity’s interest, and since the charity does not pay tax, the sale is transformed into a tax-free transaction. Although the gain is taxed to the charity, the money stays in the partnership and the income generated from the investments finds its way into the hands of the donor, usually through management fees. Special clauses are typically inserted into the agreement that allow the taxpayer’s family to repurchase the charity’s limited partnership interest for pennies on the dollar.
The presumed result: a large up-front charitable deduction, sale of appreciated assets tax-free, retention of sale proceeds in the partnership, and repurchase of the charity’s partnership interest for pennies on the dollar.
IRS has announced that it is studying these transactions as potential abusive tax shelters. Expect an announcement shortly.
The CFLP suffers from the same three-prong attack used against the split-dollar life insurance transaction: (1) lack of donative intent; (2) transfer of property with questionable or negligible fair market value (such as a restrictive limited partnership interest) to the charity; and (3) transfer of less than the entire ownership interest. Like the split-dollar life insurance ploy, expect IRS to attack these schemes under the transfer of less than the entire ownership rules.
In essence, a limited partnership is formed and the taxpayer transfers appreciated property, such as a business or real estate, to the partnership in exchange for a 1% general partnership interest and a 98% limited partnership interest. Family members own the other 1% as limited partners. The 98% limited partnership interest is donated to charity and the donor receives a charitable deduction equal to the FMV of the charity’s interest in the partnership.
The partnership sells its asset at a large gain, however since 98% of the partnership is owned by the charity, that portion escapes tax. The money stays in the partnership and is invested in stocks and bonds. The owner, as general partner, draws money out through management fees. There is a buy-out provision enabling the taxpayer’s family to repurchase the charity’s interest at a steep discount. The windup: the taxpayer gets a large up-front tax deduction, the asset escapes taxation, and the family repurchases the assets at a steep discount. In other words, the charity cleanses the transaction of income tax and virtually eliminates estate tax on the asset.
Comparison to Abusive Corporate Tax Shelters
Using a charity as a limited partner within a traditional family limited partnership is fraught with peril. It is similar in structure to the abusive corporate tax shelters discussed in the June and July Hot Topics. In both cases, taxable income is diverted to a non-taxpaying entity and the taxpayer receives the tax benefits from the transaction. Also, apart from the tax benefits, the transaction has little or no economic significance. In other words, apart from the tax advantages, the parties would not have entered into the transaction.
The Fortress Financial Group and Its “Confidential” Legal Theories
The CFLP has all the hallmarks of a classic abusive tax shelter. The self-proclaimed leader in the CFLP field is the Fortress Financial Group, which has trademarked its “technique” as “Charitable Alliance.” Fortress uses strict licensing and confidentiality agreements and takes steps to prevent unauthorized photocopying of its materials. This is similar to the confidentially agreements used by corporate promoters of abusive tax shelters.
Such branding and protecting of their so-called “legal theories” supporting the scheme raises “red flags” as to its legitimacy. If other attorneys are prevented from reviewing the theory, the client cannot get an independent opinion on the subject. Also, there is no such thing as a secret tax plan because the ultimate audience is the IRS. Experienced tax practitioners know the wisdom of testing your tax planning theories within the tax community to expose any weaknesses in your concept and correct them. Otherwise, you run the risk of miscalculating an IRS response. Nevertheless, companies like Fortress are marketing their untested and secret theories to attorneys and accountants, turning these recruits into promoters of the scheme.
Other promoters have jumped on the scene, advertising this hot new tax strategy on the Internet. According to a Wall St. Journal Article dated July 13, 1999, one promoter boasted that the “only loser is the IRS.” That, of course, produced a heated reaction from the tax collector. IRS director of tax-exempt organizations, Marcus Owens, is quoted in the Wall St. Journal article as stating the CFLPs “are under serious scrutiny. Quite possibly we could determine this is an abusive tax shelter. Potentially a lot of money is at stake.”
Although promoters claim their partnerships will withstand IRS scrutiny, they often use the general disclaimer that the partnership must be operated without abuse. But if the advantages of using a CFLP are predicated upon tax abuse, then it cannot operate without abuse. Eliminate the abusive nature of the arrangement and the CFLP loses its appeal.
While promoters put on a brave front, claiming these structures will pass court muster, IRS warns those forming these CFLP that there is considerable risk the CFLP will be considered an abusive tax shelter, which means the taxpayers, promoters and charities could be subject to large penalties.
The CFLP is similar to abusive corporate tax shelters: each is heavily promoted to the client; each is tax-driven with the benefits flowing to the client; there is little business purpose for the transaction outside of the tax breaks, and the nontaxable status of the nominal party participating, whether it is a foreign or tax-exempt entity, is the driving element behind the deal. Taxable income is channeled to the non-taxpaying entity, thereby eliminating the tax that otherwise would be due from the taxpayer.
Unlike the typical corporate tax shelter scam, however, there is an enormous additional risk with the CRLP transaction: the charity that participates could lose its precious tax-exempt status and its managers could be penalized for violating a myriad of restrictions that apply to charities.
Clearly, IRS detests transactions in which a charity’s tax-exempt status is abused to produce a tax benefit to a donor that was unintended by the code. If a donor wants to make a straight gift to charity with no strings attached, then he is entitled to a full deduction. However, structuring a deal where the donor remains in control, either directly or indirectly, or merely gives a portion of the property away, will cause IRS to come after you with all the weapons in its arsenal.
Neither the split-dollar life insurance nor CFLP scheme work and both violate the basic rules for deducting a charitable contribution. Worse, the charity is placed in jeopardy by participating in such programs. Promoters claim they work, but they cannot cite a single case or IRS ruling that supports their position. In fact, the CFLP crowd goes to great lengths to hide its legal justification for these transactions from the legal community, probably because its reasoning is so tenuous. Of course, preventing a client from obtaining an independent opinion as to the tax consequences of a transaction is a tip-off that the client is heading into dangerous territory.
It is just a matter of time before Congress and IRS take steps to shut down the CFLP as an abusive tax shelter. In the meantime, those participating in these scams are headed into shark-invested waters.
**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**