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Updated Estate Planning for Family Limited Partnerships

Last update on: Aug 10 2020
estate planning

Soon after I updated the tax status of family limited partnerships for our July visit, the Tax Court ruled in another FLP case. The decision went against the taxpayers and again dimmed the enthusiasm of many tax advisors for FLPs. I’m not as pessimistic about the decision, but it does add some uncertainty and should make most people wait for additional decisions before deciding to use an FLP for Estate Planning.

In Senda v. IRS (T.C. Memo 2004-160; July 12, 2004), the taxpayers created two FLPs over time and later transferred publicly-traded stock to them. Their minor children initially had very small limited partnership interests for which they supposedly contributed accounts receivable. But there was no writing to support the accounts receivable. Their interests were listed as being held in trust with the parents as trustees. But no trust agreements ever were written; the trusts did not file tax returns; and all gains and losses from the FLP were reported on the children’s tax returns.

Other paperwork related to the FLPs was not done. No partnership meetings were held, as required by the FLP documents. There were no accounting records for the FLPs. The father used personal funds to pay all legal and professional fees of the FLPs and was not reimbursed by the partnerships.

After the parents transferred stock to an FLP, there was no record of how the value of the stock was allocated to the partner’s capital accounts. The parents transferred additional limited partnership interests to the children. The stock was transferred to the FLP, and the FLP interests to the children on the same day. But the lack of records made it impossible to determine the order in which these transfers took place.

Unlike in many past FLP cases, the IRS did not challenge the economic substance of the FLPs. Instead, the focus was on the gifts of the FLP interests to the children.

The taxpayers claimed that the transfers were gifts to the children. They also claimed that the gifts should be valued at less than the market value of the underlying assets. The parents claimed that the gifts should get discounts for lack of marketability and for being minority interests.

The IRS said that the FLPs should be ignored for purposes of valuing the gifts. It view is that the FLPs simply were a way of making indirect gifts to the children. The IRS said that the gifts of stock to the FLPs coupled with FLP gifts to the children should be viewed together as gifts of stock to the children. Direct gifts would not qualify for marketability or minority interest discounts.

The Tax Court agreed with the IRS. It found the testimony of the taxpayers to be evasive on key issues about partnership details. It also pointed out that the taxpayers were not too concerned with the formalities of the FLP but with transferring the stock to the children at a discount. It didn’t help that the taxpayers first learned about FLPs at a seminar on estate tax reduction.

Therefore, the Tax Court said that there would be no discounts for minority interests or lack of marketability.

In this case, the taxpayers ignored key estate planning advice I’ve given in the past. All formalities of the FLP need to be respected and followed. In addition, I’ve cautioned in the past that using an FLP solely to hold publicly-traded securities might not qualify for the valuation discounts, especially as in this case when a large amount of one stock is used. Small businesses and real estate are better choices. A diversified portfolio which has significant contributions from each partner also could qualify.

The IRS argued that the transfers of stock to the FLP followed by the transfers of FLP interests to the children were integrated transactions, so the partnership should be ignored. The court did not directly address this argument. It essentially found that the taxpayers ignored the partnership, so the court would, too. The court said it was likely that the stock was contributed after the FLP interests were given to the children. The court found that the parents’ contributions enhanced the children’s interests.

But the same result would have been reached if the “integrated transaction” argument were followed. That’s why many tax advisors are worried and want to wait for more guidance.

A conservative taxpayer should wait for another case or two before deciding about FLPs. Others should follow our advice about FLPs from past issues. Establish a business purpose for the FLP, respect the formalities, and consider using an independent general partner.

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