This is the second of a four-part series of tax-related columns presented as a service to our readers as we approach the 2006 tax season.

Recently, the IRS won another Family Limited Partnership (FLP) case (Estate of Rector v. Commissioner). That win adds another notch on its belt in its battle to curb FLPs as a once-popular estate planning tool to avoid taxes. For those dying in 2008, the estate tax exclusion is $2 million per individual, and twice that for a married couple, $4 million. Clearly, those with estates in excess of $2 million have a strong incentive to reduce their estate tax through tax efficient estate planning.

The IRS has challenged FLPs as a “tax avoidance technique” to avoid substantial estate and gift taxes. Their recent string of victories has left estate planners wondering if the FLP is still a viable estate planning technique. And for many individuals who currently have FLPs in place, some may want to evaluate whether they are set up properly.

What is an FLP?

An FLP is an estate planning tool used by wealthy parents to transfer their assets to their children with reduced estate tax. With estate tax rates peaking at 55 percent, there is an incentive for individuals to pass their wealth on to their children with as little estate and gift tax consequence as possible. 

Transfer of assets

In a typical arrangement, a parent will transfer business or investment assets, such as a family business, real estate or securities, to a partnership formed where the children are also partners. Most of the shares of the partnership are then transferred to the children through a series of annual gifts of partnership interests, which are discounted for “lack of control” and “lack of marketability.” The gifts of partnership interests are not gifts in the underlying assets, but are gifts of interests in the partnership where both the parents and the children co-own the partnership’s assets. The gifts of partnership interests without market value (rather than gifts of the asset) can be used to support the accelerated giving of the assets at discounted, gift-tax free rates.

Control over Assets

In most FLP arrangements, the parents typically retain some semblance of control over the assets. Whether this is done either expressly as a general partner in the partnership, or impliedly as a limited partnership, there is an understanding that the parents will control the partnership assets during their lifetime. The parents typically make all management decisions concerning the partnership’s assets and distributions to the partners. In the most abusive FLP arrangements, the parents treat the partnership’s assets as their own, utilizing the partnership’s funds to pay the parents’ personal expenses during their lifetime.

Under the federal tax code, if parents contribute assets to the partnership, and continue to possess or use the assets during their lifetime, the property once placed in the partnership will be included in the parents’ gross estate, and subject to an estate tax upon the parents’ death. If this provision is triggered, and the IRS is successful in challenging the FLP, the assets that the parents gave to their children during their lifetime will be brought back into the gross estate to be taxed as high as 55 percent. 

The IRS has stated publicly that it will audit all estate tax returns where an FLP is reported. Those that have no “significant nontax purpose” (other than to avoid estate taxes) will fail under the judicial precedent and the tax code. This means that business arrangements involving family members will be highly scrutinized for estate and gift tax consequences.

What qualifies as a “significant nontax purpose”?

The partnership must include a real, ongoing active family business with significant day-to-day activity. Passive investment assets owned by a family will not qualify as an asset that should be properly placed in an FLP. Many of the cases have argued that FLPs were formed as an asset protection tool against creditors. This argument has been rejected repeatedly when it could not be shown that there was a real threat of creditors when the FLP was formed. Asset protection arguments have failed where the FLP assets were passive, such as rental property investments, securities and cash. Ongoing businesses operated by a family unit, however, clearly need asset protection against creditors to protect the business and partners’ assets. 

Tips for forming an FLP

• Form your FLP when you’re in good health. FLPs should not be formed if a parent’s life expectancy is short, or if a parent is suffering from a terminal illness. In all cases where the parent died shortly after the partnership was formed, the courts ruled that the FLP had been formed to avoid estate taxes. The IRS has actually probed into the medical records of the decedent, and has interviewed doctors, family members and friends to prove that the FLP was formed merely to avoid taxes. When the medical health of the parent becomes the focus of the IRS’s audit, it is often traumatic for the surviving family members. Therefore, it is important that FLPs should have “significant nontax reasons” for being formed because they will not withstand IRS scrutiny if the only purpose was to save estate taxes.

• Don’t put all of your assets into your FLP. Another common failure in the FLP arrangement is when parents place substantially all of their assets into the FLP. If the parents do not have sufficient assets and income outside of those in the FLP, and the parents need income from the partnership to support their life expenses, the courts will find that there was an “implied agreement” that the parents could continue to use the assets transferred into the partnership. Thus, families with FLPs should ensure that the parents who transferred substantially all their assets into the FLP have retained sufficient assets separate from it to maintain all their life expenses. FLP income should not be relied on for living expenses.

• Operate your FLP like a business. The legal precedent has required the FLP to operate more like a business entity. The courts have found that those FLPs that failed to keep separate books and records, did not hold monthly meetings with written minutes, and did not maintain separate financial accounts, were no more than a partnership “wrapper” designed to avoid estate taxes. FLPs should be formed and managed day-to-day like an operating business.

• Consult with professionals. If you have an FLP, or are intending to form one, consider consulting with a qualified tax or estate planning practitioner regarding the proper arrangement you and your family should follow. Ideally, all members of the partnership should have separate legal representation. FLPs have been a popular wealth planning tool for decades, and their many promoters still tout its viability, sometimes without full understanding of the judicial precedent, thereby failing to provide proper advice to their clients. The gift and estate tax consequences on a poorly structured and sloppily managed FLP are dire, given the judicial precedent the IRS has on its side, so take the time to ensure your FLP is formed and operating properly.