The Art of Speaking out of Both Sides of Your Mouth
As with other attorneys, tax attorneys often find themselves taking contrary positions on the same law in different cases. These situations can be difficult. The professional rules governing attorneys’ conduct help to spell out the attorneys’ duties in these instances. The more challenging situations for tax attorneys arise when the attorney is called upon to take contrary positions on the same law in the same case. This often arises when the tax attorney does tax planning which includes the creation of various legal entities. I will discuss the example of creating a family limited partnership to highlight the problem.
A family limited partnership is a structure that is established with the aim of passing a family business to the next generation. Family limited partnerships often have estate and gift tax benefits. During the lifetime of the business owner shares of the partnership can be given away at substantial tax valuation discounts (thus saving the unified credit and gift taxes). Similarly, the estate of the original owner of the family limited partnership is reduced by lifetime transfers and the shares of the partnership owned by the decedent upon his or her demise often qualify for substantial tax valuation discounts (thus saving estate taxes).
The IRS often attacks family limited partnerships by arguing that the transaction lacks a valid business purpose. In some cases the family limited partnership may consist of nothing more a group of stocks that are all publicly traded. In response tax attorneys often argue that the family limited partnership has a valid business purpose. They argue that the business purpose is not merely tax savings, it is creditor protection (i.e., or to put the business assets in an entity that contains restrictions so that lower generations creditors or spendthrift habits will not deplete the business assets).
But, if the business owner has an outstanding liability with a creditor at the time that the entity was established or if such a creditor materializes within a certain period after the formation of the entity (usually four years), then the attorney must argue that the transfer was not for creditor protection, it was for tax savings. This (hopefully, but not always) allows the business owner to avoid civil and even criminal liability for making a fraudulent transfer and, by extension, allows the tax attorney to avoid the same liability for aiding and abetting the business owner. The state and federal fraudulent transfer rules have a number of requirements, such as evidence of certain badges of fraud or constructive fraud. The laws really are a fascinating read, but such a discussion is beyond the scope of this blog posting (I will save that one for later).
What I wanted to point out is that in these cases the tax attorney has to speak out of both sides of his or her mouth. I often wonder if the IRS realizes that they are creditors of the taxpayer business owner and that they may have the right to challenge these types of transactions by arguing fraudulent transfer. This situation could arise where the business owner set up the family limited partnership and then passed away within the fraudulent transfer time period or even in cases where lifetime gifts were made a few years prior to the business owner's demise. Raising the fraudulent transfer issue could put business owners and tax attorneys in a no-win situation.
The tax attorney could argue either creditor protection or tax savings or both or neither. The creditor protection argument would subject the business owner and the attorney to civil and possibly criminal liability. On the other hand the tax savings argument could destroy the business purpose argument and nullify the tax savings. This second option would probably result in an increased tax liability for the business owner and it would subject the attorney to a malpractice claim by the client. Making both arguments would result in the business owner and tax attorney facing the problems arising from each and not arguing either would have an equally unacceptable result.
This situation would probably result in the tax attorney not speaking out of either side of his or her mouth...
A family limited partnership is a structure that is established with the aim of passing a family business to the next generation. Family limited partnerships often have estate and gift tax benefits. During the lifetime of the business owner shares of the partnership can be given away at substantial tax valuation discounts (thus saving the unified credit and gift taxes). Similarly, the estate of the original owner of the family limited partnership is reduced by lifetime transfers and the shares of the partnership owned by the decedent upon his or her demise often qualify for substantial tax valuation discounts (thus saving estate taxes).
The IRS often attacks family limited partnerships by arguing that the transaction lacks a valid business purpose. In some cases the family limited partnership may consist of nothing more a group of stocks that are all publicly traded. In response tax attorneys often argue that the family limited partnership has a valid business purpose. They argue that the business purpose is not merely tax savings, it is creditor protection (i.e., or to put the business assets in an entity that contains restrictions so that lower generations creditors or spendthrift habits will not deplete the business assets).
But, if the business owner has an outstanding liability with a creditor at the time that the entity was established or if such a creditor materializes within a certain period after the formation of the entity (usually four years), then the attorney must argue that the transfer was not for creditor protection, it was for tax savings. This (hopefully, but not always) allows the business owner to avoid civil and even criminal liability for making a fraudulent transfer and, by extension, allows the tax attorney to avoid the same liability for aiding and abetting the business owner. The state and federal fraudulent transfer rules have a number of requirements, such as evidence of certain badges of fraud or constructive fraud. The laws really are a fascinating read, but such a discussion is beyond the scope of this blog posting (I will save that one for later).
What I wanted to point out is that in these cases the tax attorney has to speak out of both sides of his or her mouth. I often wonder if the IRS realizes that they are creditors of the taxpayer business owner and that they may have the right to challenge these types of transactions by arguing fraudulent transfer. This situation could arise where the business owner set up the family limited partnership and then passed away within the fraudulent transfer time period or even in cases where lifetime gifts were made a few years prior to the business owner's demise. Raising the fraudulent transfer issue could put business owners and tax attorneys in a no-win situation.
The tax attorney could argue either creditor protection or tax savings or both or neither. The creditor protection argument would subject the business owner and the attorney to civil and possibly criminal liability. On the other hand the tax savings argument could destroy the business purpose argument and nullify the tax savings. This second option would probably result in an increased tax liability for the business owner and it would subject the attorney to a malpractice claim by the client. Making both arguments would result in the business owner and tax attorney facing the problems arising from each and not arguing either would have an equally unacceptable result.
This situation would probably result in the tax attorney not speaking out of either side of his or her mouth...
 
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