Abstract: The family limited partnership (FLP) has a long tradition of being attacked by the IRS. The attacks have taken many forms, and recent success has given the IRS more reason to continue the fight. The good news is that an FLP can still work for you — as long as you know how to avoid the many pitfalls. This article explains how to properly structure and execute an FLP to keep assets transferred to it out of your estate.
Create an FLP that passes Tax Court scrutiny
A properly structured one can allow you to transfer family business interests and reduce estate taxes
by Charles Epstein, CLU, ChFC, Epstein Financial Services
The family limited partnership (FLP) has a long tradition of being attacked by the IRS. The attacks have taken many forms, and recent success has given the IRS more reason to continue the fight. The good news is that an FLP can still work for you — as long as you know how to avoid the many pitfalls.
As with most financial strategies, careful planning is needed to ensure your FLP is structured and executed properly. Otherwise, you may not be able to keep assets transferred to FLPs out of your taxable estate.
Whether transferring actual business ownership (which you can do for most business entities) or ancillary assets, such as real estate leased to the business, FLPs are effective. A primary reason is because it’s highly likely that the gift tax value will be discounted from the asset’s underlying value. A second, often equally important, reason is the ability to retain control of the assets even though you don’t own them.
Here’s an example of how an FLP typically works: Anne, a family business owner, is getting ready to retire. She decides to transfer interests in her business to an FLP, creating general partnership shares and limited partnership shares. Anne holds on to the general partnership shares and gives the limited shares to her children, who will take over the company. As general partner, Anne is responsible for the management and control of the partnership, while her children, as limited partners, have no say. (FLPs are typically structured with transfer restrictions on the limited partners’ shares.)
Anne reduces her estate tax liability because she has removed these assets from her estate. She claims a discount on the value of the gifts for gift tax purposes because the assets gifted are minority interests in the partnership and therefore represent noncontrolling interests. If Anne structured the FLP with transfer restrictions, the shares would also be discounted for lack of marketability.
The IRS’s attacks
For many years, the IRS disallowed discounts for shares gifted to family members. But after numerous court defeats, in Revenue Ruling 93-12 the IRS accepted such discounts. Revenue Ruling 93-12 was based on a specific case that allowed a 20% discount for each of the gifts that a sole shareholder made to his children. Although the children had 100% control over the company, the discount was allowed because no one child individually retained control. Therefore, the gifts were not gifts of controlling interests. But this change of heart didn’t mean the IRS approved of FLPs overall, and the IRS has been waging a war against them ever since.
Recently the IRS has found new ways to challenge FLPs. The latest concerns Internal Revenue Code Section 2036(a), which specifies that assets transferred to partnerships be treated, for estate tax purposes, as taxable in the estate of the older generation if it has retained the right to use them or designate who shall use them.
The problem with asset control
The principle under Sec. 2036(a) is that you really haven’t given away assets if you retain the right to use them or designate who shall use them. So, the FLP assets should be included in your estate.
Sec. 2036(a) does not, however, apply if assets are transferred in a “bona fide sale for adequate consideration.” But the bona fide sale exception doesn’t work with FLPs when there is no sale.
In the Tax Court’s eyes, many cases boil down to how the decedent and family members used the FLP before the decedent’s death.
2 important cases
The best-known FLP attack may be a series of cases involving the Estate of Strangi. Albert Strangi contributed almost all of his assets to a partnership — even his home — and he treated the FLP assets as if they were still his own. For example, Strangi’s funeral expenses, a specific bequest and his estate tax liability were all borne by the partnership.
The Tax Court found that Sec. 2036(a) applied because there was an implied agreement that Strangi retained the right to enjoy the property and he had the right to designate who else could enjoy it.
This case illustrated that treating the partnership funds as your personal funds, making disproportionate partnership distributions and satisfying personal bequests by using the partnership assets are a misuse of an FLP.
Another important case involving FLPs was the Estate of Stone. In this situation, the IRS’s Sec. 2036(a) argument failed. Why? One reason was that the couple kept enough assets outside the FLPs to support themselves. Another was that the family negotiated the FLP’s terms — in fact, both the taxpayers and their children had independent representation. The Tax Court concluded that the FLPs were legitimate business entities.
The key difference between the Strangi and Stone cases: The Stone family respected the FLP’s formal format by not using FLP assets as their own.
Although the IRS will likely find new ways to challenge FLPs, this vehicle is an important tool for business owners. And taxpayers can pass Tax Court scrutiny if the facts and circumstances warrant. That’s why it’s vital to know what to do — and, more importantly, what not to do — when creating and using an FLP.
Sidebar: Guidelines for success
Although the IRS has been successful in certain circumstances, it has not prevailed across the board. From the Strangi and Stone cases and others, guidelines for passing Tax Court scrutiny emerge:
- The owners should have sufficient assets outside the family limited partnership (FLP) so FLP funds aren’t needed to maintain a lifestyle.
- The partnership should have a clear business purpose.
- The owners should operate the FLP as a business.
- The owners shouldn’t commingle FLP funds and personal funds.
- FLP distributions should be made proportionate to ownership.
The most important factor, indeed, may be whether the taxpayer retained sufficient assets outside the FLP. In recent years, the outcome in many cases seems to have focused on this issue.