family limited partnership (FLP)

The dos and don’ts of FLPs

A family limited partnership (FLP) can be a powerful tool for managing and transferring family wealth. As long as it’s designed and operated properly, this arrangement allows you to transfer a business or other assets to the younger generation at a minimal tax cost — without giving up management control.

In recent years, however, the IRS has taken a tough stance on FLPs in audits, questioning whether partnerships were set up for legitimate business reasons and, in many cases, denying claimed tax benefits. Many of these disputes have ended up in court, and the IRS has pulled off an impressive string of victories.

But this doesn’t mean it’s time to throw in the towel. Most of the taxpayers who lost to the IRS had structured or operated their FLPs carelessly. And examining what they did wrong provides a valuable lesson on how to do it right.

How FLPs work

In a typical FLP, you form a limited partnership with your children or other family members and transfer a business, real estate, investments or other assets to the partnership. Your children might contribute cash or other assets of their own in exchange for limited partnership interests, but it’s more common for them to receive their interests by gift.

Eventually, your children will own most of the partnership shares, but you can continue to manage the business or other assets indefinitely by retaining a small ownership interest and acting as general partner. The shares you give away are subject to gift tax, but, because limited partners have minimal control over partnership affairs, the value of their interests is discounted substantially for tax purposes.

By taking advantage of the $1 million lifetime gift tax exemption and the annual gift tax exclusion, you can transfer a significant amount of wealth with little or no tax cost. And because the assets are removed from your estate, their future appreciation in value escapes estate taxes.

What concerns the IRS The FLP remains a workable planning technique, but there’s a good chance the IRS will audit your gift or estate tax returns if you create one. It’s concerned about taxpayers using FLPs as nothing more than a tax avoidance device. So, to survive an IRS challenge, you need to show that you had a substantial non tax business purpose for forming the partnership and that you’re operating it as a legitimate business.

There are plenty of acceptable reasons for setting up an FLP. One is to facilitate the transfer of a business to the younger generation without giving up management control. Another is to simplify your life a bit by consolidating ownership and management of real estate and other investments.

Yet another common and viable purpose for creating an FLP is to provide a means to keep the family business in the family — and out of the hands of creditors — by having the business owned by the FLP rather than the individual family members.

What the courts have said having legitimate reasons on paper, however, isn’t enough. The IRS and the courts may disregard an FLP for tax purposes if the facts are inconsistent with those reasons. In one case, Estate of Strangi v. Commissioner, the Fifth U.S. Circuit Court of Appeals ruled that assets Mr. Strangi had transferred to an FLP should be included in his estate and subject to estate taxes.

Several facts convinced the court that Mr. Strangi hadn’t truly given up possession and enjoyment of his assets after signing them over to the partnership. For example, he transferred virtually everything he owned (including his home) to the FLP, but continued to live in the home rent-free. And he used partnership funds to pay his medical bills and other expenses.

In another case, Senda v. Commissioner, the IRS disregarded an FLP, resulting in almost $500,000 in additional gift tax liability — and the Tax Court agreed.

Here the FLP may very well have been legitimate, but the taxpayers’ informal treatment of the partnership made it difficult for them to defend their position. Their failure to observe partnership formalities, such as documenting partnership transactions, caused them to lose significant tax benefits. This is especially disconcerting given that the Court accepted the discounts claimed on the gifts of the FLP interests.

How to stay in the clear Recent cases tend to focus on the “don’ts” of FLP planning. But an examination of the courts’ reasoning provides valuable guidance on the “dos” of forming and operating such a partnership as well. These include:

• Do have a legitimate non tax business purpose for the FLP, and be prepared to substantiate it,
• Do observe all partnership formalities, including keeping books and records and properly documenting all partnership transactions,
• Do transfer legal title to property to the partnership,
• Do create the FLP while you’re in good health — if you establish it on your deathbed, the IRS will suspect that your motives are tax-related,
• Do keep enough liquid assets outside the partnership to support yourself,
• Do distribute partnership income to partners in accordance with their relative partnership interests, and
• Do have family members contribute assets in exchange for their interests, if possible, as doing so will eliminate the gifting issues that accompany many FLP challenges.
• Then again, there are of course things you need to avoid. For example:
• Don’t transfer your home to the FLP and continue to live there without paying fair market rent,
• Don’t commingle personal and partnership assets,
• Don’t use partnership funds to pay your personal expenses, and
• Don’t retain too much control over who possesses and enjoys the partnership’s assets.

The IRS and the courts are leery of FLPs that give the transferor too much power over the possession and enjoyment of the partnership’s property. One effective way to ease this concern is to bring in an independent third party as a general partner.

Why you shouldn’t give up

Despite the risks of an IRS challenge, don’t give up on the FLP. It remains a viable business and wealth management strategy. Although a number of taxpayers have lost challenges in court, many properly structured and operated FLPs have succeeded.

Find out how our expertise in Tax Services can add value to your business. Email us or call us at 1 (888) 875-9770.

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