Has the IRS nailed the coffin shut on family limited partnerships (FLP)? The IRS has been challenging FLPs in courts for years, until recently with little success. Two recent court decisions, however, disallowed some FLPs and caused at least a few Estate Planning advisors to caution taxpayers against setting up new FLPs at least until the rules are clearer.
The case causing the most concern is Estate of Strangi (T.C. Memo 2003-145), which is now on appeal. Clearly, the Strangi family abused the FLP concept and did not follow estate planning guidelines set out in past issues of Retirement Watch and available on the web site Archive.
The Strangi patriarch donated 98% of his assets to the FLP, including his personal residence. He technically had to pay rent for continuing to live in the residence, but he never did. In addition, he retained control over the assets as general partner, used them as his own, and distributed income as he desired instead of in some proportion of partnership interests. The Tax Court ruled that, in effect, Strangi never changed his control over the assets and had no intention of doing so. The court ruled that the full value of the partnership assets was included in his estate.
I think Strangi is an extreme case and should not affect a properly executed FLP.
For an FLP to work, you have to show reasons other than tax reduction for setting it up. Do not transfer personal assets to the FLP. An operating business is the best asset for an FLP. Real estate properties also can be good. Estate planners differ over whether it is appropriate to contribute an investment portfolio in an FLP. Do not contribute a residence or other personal assets if you plan to continue using them. Do not pay personal expenses from the FLP checkbook. You should not keep all income for yourself. It also would be helpful if the children could contribute assets of their own to the FLP.
An attractive feature of the FLP is that the parents can be general partners and exert a lot of control over how the FLP assets are managed. The Tax Court did not rule that this is not allowed. But if someone else serves as general partner, the IRS’s arguments against the FLP clearly would be weakened.
The FLP is not dead as an estate planning tool. The Tax Court has drawn some lines that taxpayers cannot cross. The original owner cannot continue to treat partnership assets as his own and must respect both the formalities of the partnership and the rights of other partners. It helps to regularly distribute income to all the partners. Review your processes with an experienced estate planner and there should be no problem with your FLP.