The family limited partnership has been widely-used in estate planning for years. The benefits are so significant that for almost as long the IRS has been trying to curtail the tax advantages of Family Limited Partnerships.
While some of the IRS efforts have been successful, taxpayers also logged some victories. In addition, the IRS successes were in cases in which the taxpayers were sloppy, to put it mildly. Best of all, the series of cases give a clearer picture of how to create an FLP that will achieve estate planning goals and withstand a challenge.
FLPs are popular because they provide a unique combination of tax savings, control, and flexibility.
In a typical arrangement, the estate owner creates a limited partnership. Often, the owner (or owner and spouse) are the general partners, with an interest valued at 1% of the partnership’s value. The owner then transfers assets to the FLP, and in return receives limited partnership interests that equal 99% of the FLP’s value.
The next step is to transfer all or most of the limited partnership interests to the owner’s children and perhaps the grandchildren, or to trusts for their benefit. There are several ways to make the transfers.
Usually the owner gives the interests to the children. The gifts can be made over a period of years to take advantage of the annual gift tax exclusion. But that usually takes too long. Most often, one large gift is made to each child. This likely incurs gift taxes or uses up part of the owner’s lifetime estate tax credit, but it gets the value of the FLP and future appreciation out of the owner’s estate.
One benefit of the FLP is that under partnership law a general partner has almost all the power; limited partners have little power. The general partner manages the assets, determines distributions, and takes other actions. Many owners like this feature. They can continue to manage a business or real estate while removing the value from their estates. The general partner determines which assets are purchased or sold, when distributions are made to partners, and the amount of the distributions.
Because the limited partners have so little power and the partnership interests are difficult to sell, the FLP can result in significant gift tax discounts when the limited partnership interests are given. Remember, estate and gift taxes are applied to the value of property. The value might be reduced because of lack of control or minority interest, especially if no individual owns more than 50% of the limited partnership votes. There also can be a lack of marketability discount. Most FLP agreements limit the ability of a limited partner to sell an interest to outsiders, ensuring the lack of marketability discount.
Together the discounts often reduce the value of the limited partnership interests by 20% to 60% of the underlying value of their share of the partnership assets. A qualified appraiser determines the value of the partnership and the appropriate discounts. The discounts apply to gifts of limited partnership interests and also to any limited partnership interests held in the estate of the owner.
You can see the attraction of an FLP to an estate owner. The owner can retain significant control of the assets yet remove them from the estate at a reduced tax cost.
Of course, that also is why the IRS has vigorously objected to FLPs and denied the tax benefits in a number of cases. The courts have agreed with the IRS in several cases. But the IRS has not challenged the basic premises of the FLP. Instead, it has attacked the execution or application in particular cases.
Those cases, and some taxpayer victories, show how to set up and manage an FLP to reduce the risk of drawing IRS objections or losing in court. Because of the IRS’s animosity toward the FLP, a taxpayer has to assume that the FLP will be audited. Steps must be taken to help the arrangement survive an audit. Bear in mind that the FLP is likely to be challenged after the owner is gone. The owner must create a record that helps defend the FLP. Here are the key features that help justify the FLP arrangement:
The IRS says it tests these arguments. It looks for actual efficiencies and improved management. It also will interview the adult children who are limited partners to ensure that they have the ability and involvement to satisfy the business purpose.
FLPs can be a good source of tax savings and other estate planning benefits. But they are not for every estate. To be done right, the FLP often costs $15,000 or more to create, and annual expenses are required to maintain the FLP. Anyone who is not willing to follow the formalities of the FLP should not consider using one.