In Kerr v. Commissioner of Internal Revenue [113 T.C. No. 30 (12/23/99)], the Tax Court provided guidance on several issues that affect family limited partnerships (FLPs). The case is important because it demonstrates:

• That the IRS’s broad interpretation of an "applicable restriction" under IRC § 2704(b) generally doesn’t apply to a partnership agreement’s liquidation provisions
• The importance of a taxpayer’s strict compliance with the terms and conditions in documents and agreements

Through some complex estate planning, Baine and Mildred Kerr formed two FLPs under Texas law. The Kerrs contributed the capital and were the sole general partners, but they immediately assigned a portion of each FLP to their children. The partnership agreements contained restrictions on dispositions of partnership interests. The agreements also included liquidation provisions stating various conditions upon which the partnerships would dissolve.

The Kerrs then formed two grantor-retained annuity trusts (GRATs) and transferred limited partnership interests in the FLPs to the GRATs and to their children. In their gift tax returns for the year, the Kerrs valued the transferred limited partnership interests by applying discounts for lack of liquidity and minority interest. The IRS alleged that the Kerrs had understated the value of the FLP interests they had transferred.

Applicable Restrictions

The IRS argued that certain restrictions on liquidation found in the partnership agreements constituted "applicable restrictions" within the meaning of IRC § 2704(b). An applicable restriction is any restriction that limits the ability of the corporation or partnership to liquidate, except any restriction imposed, or required to be imposed, by any federal or state law. Section 2704(b) provides that if an interest in a corporation or partnership is transferred to a member of the transferor’s family, and the transferor and family members hold control of the entity immediately before the transfer, then any applicable restriction shall be disregarded in determining the value of the transferred interest. According to the IRS, the restrictions should have been ignored in valuing the FLP interests.

The court found the central question to be whether the liquidation provisions in the partnership agreements were more restrictive than liquidation limitations that would apply to partnerships under Texas law. After determining that they were not, the court ruled that the restrictions on liquidation were not "applicable restrictions" under Section 2704(b) and should not be disregarded.

Assignee Interest

As an alternative argument, the Kerrs claimed that the FLP interests they transferred to the GRATs were assignee interests — as opposed to limited partnership interests — on the grounds that partner consent was required to admit a new limited partner. Under Section 2704(b), if the interests were assignee interests, then they would have few rights under state law and Section 2704(b) would not apply to disregard any restrictions. The court found that the partnership agreement’s consent requirements were not strictly complied with on prior transfers. Also, references made in the transfer agreements were to limited partnership interests. The court therefore held that the Kerrs transferred limited partnership interests to the GRATs.

Significance of Case

Kerr is important because there had been some concern regarding liquidation provisions in partnership agreements, even leading to the formation of partnerships in states that had no right of withdrawal. The case also tells us to carefully comply with partnership or operating agreements in executing transfers and in choosing the wording of transfers.