Bulletproofing your FLP

During the last decade, family limited partnerships (FLPs) have come under fire from the IRS. That doesn’t mean an FLP has lost any of its muscle as an estate and succession planning tool. What it does mean is that the IRS may attempt to shoot down an FLP it believes is nothing more than a tax-avoidance scheme.

Fortunately, with careful planning, you can create an FLP that’s bulletproof — or at least bullet resistant. There are no guarantees when it comes to tax law, but designing and operating an FLP as a legitimate business rather than merely a tax-saving vehicle can help deflect an IRS challenge.

A high-caliber planning tool

FLPs offer several benefits, including the ability to:

• Consolidate ownership and management of securities, real estate or other investments,
• Transfer large amounts of wealth to children or other family members without giving up management control,
• Keep a business or other assets in the family,
• Ensure a smooth transition of business ownership from one generation to the next,
• Provide a mechanism for resolving disputes over the disposition of assets,
• Shield assets against personal creditors’ claims, and
• Reduce gift and estate taxes through valuation discounts available to limited partnership interests (typically between 30% and 40%).

The key to preserving an FLP’s tax benefits is to ensure that the partnership is designed to also meet one or more nontax objectives.

The IRS’s target

If you’ve followed recent court cases involving FLPs, you might think that the string of IRS victories signals the death of the FLP as a viable planning strategy. But most of these cases involved taxpayers who failed to follow partnership formalities and were unable to demonstrate a legitimate, nontax purpose for forming the FLP.

Fortunately, the courts’ opinions provide a roadmap for helping you structure and operate an FLP that will likely survive an IRS challenge. (See “FLP red flags” on page 5.)

Consider the Tax Court’s decision in Erickson v. Commissioner in 2007. The decedent, Hilda Erickson — who was suffering from advanced Alzheimer’s disease — formed an FLP on the advice of counsel and largely through the efforts of her daughter, Karen. The partnership was designed to hold several million dollars worth of real estate, marketable securities and other assets. Karen and her younger sister, Sigrid, were general as well as limited partners, and Karen’s husband was a limited partner.

Contrary to the partnership agreement’s terms, the FLP wasn’t fully funded until Mrs. Erickson was on her deathbed. Two days before she died, Karen, acting as her mother’s attorney-in-fact, transferred more than $2 million in assets to the FLP. Karen also gifted substantial limited partnership interests to Mrs. Erickson’s grandchildren. After Mrs. Erickson’s death, the FLP purchased her home and gave her estate more than $100,000 to help pay estate taxes.

Ammunition

The IRS successfully challenged the FLP under Internal Revenue Code Section 2036(a), which allows the IRS to disregard an FLP under certain circumstances and treat assets contributed during the person’s lifetime as part of his or her estate. Sec. 2036(a) applies if, by express or implied agreement, the transferor retains “possession or enjoyment of, or the right to the income from, the property,” or the right to determine who can do so. There’s an exception for assets transferred as part of a “bona fide sale for adequate and full consideration.”

The Tax Court pointed to several factors indicating that Mrs. Erickson retained the right to possess or enjoy the assets she contributed to the FLP:

• The delay in funding the FLP until two days before Mrs. Erickson died suggested that the parties did not respect partnership formalities.
• The FLP provided the estate with funds to meet its liabilities — the court wasn’t convinced by the estate’s argument that this was merely a redemption of Mrs. Erickson’s partnership units.
• The FLP had little practical effect during Mrs. Erickson’s life — the court said it was “mainly an alternate method through which Mrs. Erickson could provide for her heirs.”

According to the court, the transaction represented the daughters’ “last-minute efforts to reduce their mother’s estate’s tax liability while retaining for decedent the ability to use the assets if she needed them.”

The court also found that the FLP transactions didn’t fall within the bona fide sale exception. That exception applies when an FLP is formed for a legitimate and significant nontax reason and each partner receives a partnership interest that’s proportionate to the fair market value of the property he or she contributes.

In this case, several factors belied the existence of a legitimate and significant nontax purpose:

• The parties stood on both sides of the transaction — Karen, for the most part, acted unilaterally and the other parties were not represented by independent counsel, nor did they appear to understand the transaction.
• Mrs. Erickson and her estate were financially dependent on distributions from the FLP.
• The partners commingled partnership funds with their own.
• The parties didn’t transfer assets to the FLP until Mrs. Erickson was on her deathbed.

The court found that the FLP was nothing more than an “asset container.” It didn’t serve to centralize management of family assets, as the estate claimed, because there was virtually no change in management responsibilities or investment strategies after the FLP was formed.

Protect yourself

An FLP remains one of the most powerful estate planning tools available, but you must exercise caution. Be sure to have a qualified tax professional and attorney to oversee every step of the process. Otherwise, it will be very difficult to ensure your FLP saves taxes and fulfills other goals while meeting tax code requirements. •