Family Limited Partnerships

The Family Limited Partnership (FLP) is an entity which can be used to great advantage in passing on family-owned businesses and business assets. In addition to moving funds outside the probate process, this element of your estate plan can insure the gradual and orderly transition of power and wealth, reducing conflict and providing a vision for future generations, while providing substantial tax savings. With the increased use of this tool has come increased IRS scrutiny and challenge. This doesn’t mean estate planners should avoid FLPs, but it heightens the need for careful planning to ensure that an FLP achieves its goals and withstands IRS scrutiny.

Background

In a typical FLP arrangement, senior family members transfer business interests, real estate, securities, or other assets to a limited partnership. One or more senior family members act as general partners, and younger family members take on ownership of the business interest as their business skills mature.

An FLP allows the senior generation to transfer assets to the younger generation without totally stepping out of the picture. It can also produce substantial tax savings because the value of limited partnership interests for gift and estate tax purposes is generally discounted (by up to 40% or more) to reflect lack of control and lack of marketability. In addition, future appreciation of the transferred limited partnership interests is shielded from estate taxes.

IRS challenges

In a number of recent rulings, the IRS has challenged FLPs as tax avoidance schemes. Many of these rulings involved terminally ill donors who formed FLPs just prior to death and, therefore, appeared to be motivated by tax concerns. But the IRS’s reasoning, which was based on a novel interpretation of estate tax valuation rules, was broad enough to encompass FLPs as well.

Many financial experts believe the IRS position in these rulings is not valid. Nevertheless, proper planning can reduce the likelihood of an IRS challenge and can help support valuation discounts in the event of such a challenge.

Planning is Critical

One of the strongest arguments an FLP can make in the face of an IRS challenge is to show legitimate business reasons (other than saving taxes) for forming an FLP. Examples include:

By identifying and documenting legitimate business or investment purposes, an FLP can protect itself against IRS attack. A carefully drafted partnership agreement that properly assigns rights and powers to general and limited partners can also support the FLP’s position.

Applicable Restrictions

Some recent Tax Court cases have rejected IRS attacks on FLPs. The IRS has argued that the restrictions on liquidation founding partnership agreements constitutes “applicable restrictions” within the meaning of IRC Section 2704(b). An applicable restriction is any restriction that limits the ability of the corporation or partnership to liquidate, unless the restriction is required or imposed by law. Section 2704(b) provides that if an interest in a corporation or partnership is transferred to a member of the transferor’s family, and the transferor and family member hold control of the entity immediately before the transfer, then any applicable restriction shall be disregarded in determining the value of the transferred interest.

Review of Cases

For example, in Kerr v. Commissioner of Internal Revenue, the Tax Court ruled that the restrictions on liquidation found in some partnership agreements weren’t “applicable restrictions” under Section 2704(b) and shouldn’t be disregarded. Kerr is important because there had been some concern regarding liquidation provisions in partnership agreements. The case also emphasizes the need to be careful in executing transfers and in choosing the wording of various transfers.

In Harper v. Commissioner, the Tax Court reviewed a partnership agreement’s restrictions on the right to liquidate a partnership. The court applied Kerr and held that the limitations on liquidation contained in the partnership agreement weren’t applicable restrictions and must be taken into account when valuing the limitation the limited partnership interests. The court found that restrictions in the partnership agreement were no more restrictive than the default restrictions of California law, which would apply in the absence of the restrictions.

In another case, Church v. United States, the U.S. District Court (W.D. Texas) ruled in favor of a taxpayer. The government contended that the partnership was a sham transaction because it had been formed two days before death. The court found that if the business purpose can be reasonably explained and the facts can be supported by law, a limited partnership is a valid entity that cannot be disregarded for estate tax purposes.

In Knight v. Commissioner, the Tax Court ruled that a family limited partnership in Texas couldn’t be ignored for valuation purposes and that Section 2704(b) didn’t apply. The IRS had unsuccessfully argued that the 50-year term of the partnership and lack of withdrawal rights for limited partners were applicable restrictions under Section 2704(b). The Tax Court determined that the discounts for lack of control and marketability should be 15 percent.

In Strangi v. Commissioner, the Tax Court dealt with a number of issues, including whether an FLP that lacked business purpose and economic substance should be disregarded for tax purposes. The Tax Court noted that the FLP “…was validly formed under State law. The formalities were followed, and the proverbial i's were dotted and t’s were crossed. The partnership, as a legal matter, changed the relationships between decedent and his heirs and decedent and actual and potential creditors. Regardless of subjective intentions, the partnership had sufficient substance to be recognized by potential purchasers of decdent’s assets, and we do not disregard it in this case.”