Family limited partnerships have been a key element in many estate plans, and that is why they have been targets of the IRS for years. The tax law regarding FLPs has fluctuated, but there now are enough court cases decided to develop a road map for securing the benefits of an FLP.
An FLP is flexible and the details can vary with the needs of each estate owner and family. In the standard FLP, the estate owner creates the FLP and transfers assets to it in return for the limited partnership shares. In the past it was common for the estate owner also to be the general partner and run the partnership.
All or a portion of the limited partnership interests then are transferred to others, usually the estate owner’s children. The transfers can be by gift or sale.
The tax advantage to the FLP is known as the minority or control discount. The general partner controls most actions of the FLP; limited partners have few rights. As a result, the value of a minority interest is less than its proportionate share of the value of all the assets held by the FLP. Discounts range from 30% to over 50%, depending on the types of assets held by the FLP.
The discount means that the estate owner can give limited partnership interests to the children at a lower gift tax cost than by giving straight shares in the underlying assets. It also means that any limited partnership interests held at death receive a discount when the estate tax is computed. By holding the general partnership interest, which usually has only 1% ownership in the FLP, the estate owner also is able to retain control over the assets.
It is easy to see why the FLP is a popular estate planning tool and why the IRS is opposed to it. The IRS has had some success in the courts, but it also has lost some cases. The recent court cases give us a checklist of how to secure the benefits of the FLP. Ensure that your FLP meets these requirements, and it likely will pass muster with the IRS and the courts.
Economic purpose. The key requirement is that there must be one or more substantive nontax reasons for creating the FLP. If the only reason for creating the FLP is to use the minority or control discount to reduce taxes, all the assets in the FLP will be included in the owner’s estate.
Most of the cases the IRS won involved very elderly people who were either terminally ill or mentally impaired. The FLPs were established within months or less of their demise, and often the actions to create the FLP were taken by an adult child exercising a power of attorney. The only reason the courts saw for the creation of these FLPs was to reduce taxes.
There are nontax reasons for creating an FLP the courts will recognize. Providing asset protection from either creditors or potential divorces of the children is a good reason. An FLP also can be an efficient way to shift ownership and management of assets to the next generation. Putting family assets in one entity also can result in more efficient and lower cost management.
These all are nontax reasons that are accepted by the courts. Some estate planners now recommend stating the nontax reasons in either the documents creating the FLP or in the minutes of the initial partners meeting.
Proportionate contributions. Some FLPs were established by simply creating limited partnership interests for the children. The children contributed little or nothing for their interests. A partner must contribute property roughly equal in value to the ownership interest received. That is why the standard arrangement is for the parents to contribute property in return for all the limited partnership interests. Then, the parents give or sell limited partnership interests to the children. Estate planners now prefer to have the children contribute assets in return for partnership interests. This also bolsters the case that a nontax reason for creating the FLP was to consolidate management of family assets.
Respect the entity. Some FLP creators had the paperwork setting up the FLP completed but afterwards did not follow the legal formalities. They continued to treat the assets as their own, did not hold partnership meetings, and did not establish ownership of assets in the FLP’s name. If you do not follow the formalities of the FLP, the IRS and the courts will not recognize it either.
Proportionate distributions. Related to respecting the entity is to treat all owners equally. Some FLP general partners distribute assets and cash to themselves as they need the wealth. The limited partners receive little or nothing during the general partner’s lifetime. The court cases make clear that any distributions should be proportionate to the ownership interests of the partners.
Retain personal assets. In the court cases lost by the taxpayers, the parents contributed everything to the FLPs, including their personal residences and checking accounts. Thus, they used partnership assets to pay for their day to day living expenses. For the FLP to be respected, the creators must retain their personal residences and enough assets to pay living expenses. Partnership assets must be used to benefit all partners.
Limit control. The early FLPs allowed the parents to be general partners and exercise complete discretion in management of the assets. The courts now frown on that arrangement. Some estate planners believe the parents should have no control or at least no greater voting rights than the other partners. Alternatives to having the parents be general partners include a sibling, adult child, business colleague, or a trustee of the family trust. Another option is to have one spouse transfer most of the assets to the FLP while the other is the general partner. Because of this, FLPs are more appealing to retiring business owners than those who still plan to be active.