Should Your Clients Consider a Family Limited Partnership (FLP)?
A family limited partnership (FLP) can be a valuable estate-planning vehicle for clients who want to limit their tax liability when transferring assets to their heirs but also retain some control over the assets. Although the IRS has a long history of challenging such arrangements as invalid, the agency’s record of success is mixed. But the many court cases that have resulted from IRS challenges can provide valuable insight into how to craft an FLP that withstands scrutiny.
The value of limited partner interests in an FLP, even those that are held by family members, is typically discounted from the net asset value of the partnership’s underlying assets to account for the interests’ lack of marketability and lack of control. The discounted value translates to lower gift taxes (but the amount of discounts varies significantly). Moreover, upon the death of the general partner who established the FLP, his or her taxable estate may be smaller because it includes only the value of the general partnership interest and any untransferred limited partnership interests, not the value of all of the FLP’s assets.
When challenging an FLP, the IRS might assert that its underlying assets are includable in the general partner’s taxable estate under Internal Revenue Code Section 2036(a). Under Sec. 2036(a), the fair market value of assets transferred by a decedent during his or her lifetime generally must be included in the taxable gross estate if the decedent retains the (actual or implied) possession or enjoyment of the assets or the right to designate who will benefit from the assets.
A transferor retains the enjoyment of assets if an actual or implied agreement exists at the time of the transfer that the transferor will retain the assets’ present economic benefits. Factors that suggest a retained interest include: transfer of most of the transferor’s assets or the transferor’s primary residence; the transferor’s continued use of the assets; commingled personal and FLP assets; disproportionate distributions to the transferor; and the use of FLP funds for the transferor’s personal expenses or the estate’s expenses.
Estates can avoid Sec. 2036(a) by showing that assets were transferred in a bona fide sale for adequate and full consideration. The bona fide sale exception applies if the transferor has a legitimate and significant nontax reason for creating the FLP. Legitimate nontax reasons recognized by courts include effective asset management, asset protection and resolution of family disputes. Whatever your client’s nontax reason for establishing an FLP, it’s important to formally document it in the operating agreement.
Conversely, transfers weren’t bona fide sales where FLP funds were used to make personal gifts to grandchildren, fund life insurance premiums for the benefit of the transferor’s children, and pay legal fees related to the transferor’s estate planning. The IRS has also argued that transfers weren’t bona fide sales because the FLP failed to observe partnership formalities.
In general, an FLP will be deemed to observe partnership formalities if it operates according to the terms of its operating agreement and follows certain precautions. For example, the FLP should keep separate bank accounts (as opposed to depositing income in partner accounts or paying partners’ personal expenses with FLP funds), keep detailed accounting records, prepare annual financial statements and file partnership federal and state income tax returns. The FLP also should:
- Hold partner meetings with formal minutes taken at least once a year,
- Execute documents in the name of the FLP,
- Make distributions on a pro rata basis and at the same time to all partners,
- Use letterhead in the FLP’s legal name for business operations,
- Avoid commingling partners’ personal assets and FLP assets,
- Execute agreements for all transactions, and
- Record any real estate transfers.
Failure to adhere to such formalities could severely undermine the validity of an FLP and the tax benefits available.
Despite many IRS challenges over the years, FLPs remain a useful estate planning tool in certain circumstances. As long as an FLP is properly drafted and implemented, your clients and their family members could benefit greatly.