BY NORMAN G. GRILL
For many individuals, family limited partnerships have become an estate planning basic. But you must be cautious about either establishing or managing one of these arrangements. The IRS frequently challenges their validity in court.
With a typical FLP, you transfer business interests, marketable securities, real estate or other assets to a limited partnership, keeping a small general partnership interest (say, 1 percent) and a large limited partnership interest. Over time, you transfer limited partnership interests to your children, removing the value of those interests from your taxable estate while retaining management control.
Limited partnership interests are relatively unmarketable and give the holder little or no control over partnership affairs. As a result, they enjoy significant valuation discounts (often 30 percent or more) for gift and estate tax purposes.
The IRS, however, is suspicious of FLPs and often rejects them as nothing more than disguised tax-avoidance vehicles. So it”™s critical to have documentation proving a legitimate nontax purpose for setting up the arrangement.
The agency”™s approaches to challenging FLPs are complex and multifold. Just one example is the step transaction theory. Here the IRS argues that gifts of FLP units are essentially equivalent to gifts of the assets originally contributed to the partnership ”“ thus, the FLP should be declared invalid.
The IRS has generally been unsuccessful in court at arguing this theory when an FLP is formed and funded with careful consideration to the rules. But when shortcuts have been taken, the agency has been successful in its challenges. Such shortcuts include gifting FLP units before or on the same day the partnership is formed and funded.
Establishing a legitimate nontax purpose for an FLP is easier when the entity holds a family business or other closely held business. These partnerships offer many nontax business benefits, including:
· Maintaining ownership within the family.
· Allowing the older generation to transfer ownership interests without diluting their control.
· Providing some protection against creditors”™ claims.
It”™s harder to establish a nontax purpose when an FLP holds marketable securities. Courts have denied tax benefits when they concluded that FLPs holding marketable securities were formed for personal reasons ”“ such as tax reduction, estate planning, protection of wealth against dissipation by children or the financial education of children.
On the other hand, families have succeeded in preserving the tax benefits of an FLP when they were able to show legitimate investment objectives, such as coordinating management of family assets to preserve holdings in a particular stock, or pooling assets to reduce investment management expenses or qualify for investment opportunities that require larger positions.
Whether your FLP holds business interests or other assets, your stated nontax purpose must be a real one, not merely a pretext. To convince the IRS or the courts of your motives, it”™s critical to treat the FLP as a legitimate business or investment vehicle. That means ensuring your partnership agreement and other terms of your arrangement are comparable to arm”™s-length transactions, respecting all partnership formalities, and segregating personal funds from partnership funds.
Avoid actions that may raise red flags, such as transferring assets to an FLP when you”™re in poor health, contributing substantially all of your wealth to the FLP, commingling FLP and personal assets or using FLP assets for personal expenses.
Pay particular care to the formation and management of the partnership. Use valid, formal documents vetted by your attorney and financial adviser.
FLPs may seem like more trouble than they”™re worth. But for higher-net-worth families looking to preserve wealth for future generations, these vehicles really can pay off in the long run ”“ if they”™re properly formed and managed.
Norm Grill (N.Grill@GRILL1.com) is managing partner of Grill & Partners L.L.C., certified public accountants and advisers to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien, 203-254-3880.
