Family limited partnerships (FLPs) havebecome an increasingly popular vehiclefor managing and controlling familyassets and for transferring wealth toyounger generations. The ever-increasinginterest in FLPs is due, in substantial part,to the availability of discounts to decreasethe taxable value of property being transferredby 1 generation to the next. FLPsare also popular because they allowsenior-generation family members totransfer wealth to the younger generationwhile retaining control over thetransferred assets.
The IRS has a history of attempting tocurtail the use of FLPs as a wealth transfertechnique, often challenging their technicalstructure as well as the valuation discountstaken when FLP interests are transferredto younger-generation familymembers. The IRS is most likely to attackan FLP upon the creator's death when itbelieves that the FLP lacks a legitimatebusiness purpose and is merely an attemptto disguise testamentary transfers. The IRSattacks on FLP transfers clearly suggestthat the failure to follow the proper formalitiesin organizing and operating theFLP may negate the tax benefits sought.
For instance, it is important that all theproper legal formalities be adhered toboth when forming and when transferringtitle of assets to the FLP. This wouldinclude, among other things, filing a certificateof limited partnership with thestate, obtaining a federal taxpayer identi-fication number for the FLP, and signingan appropriate partnership agreement.
Care must also be taken in selectingboth the type and amount of assets to becontributed to the FLP. For instance, S-corporationstock should never be transferredto an FLP (as it will result in a terminationof the corporation's subchapterS status with associated adverse tax consequences),and it is generally unwise totransfer personal use assets, such as avacation home or a boat, to an FLP. Also,transferring substantially all of one'sassets to an FLP can be problematic.
Even after the FLP has been properlyformed and the appropriate assets transferredto the FLP, it remains critical thatthe FLP thereafter be operated in theproper manner. Most important is that theform and function of the FLP be respectedas an entity separate and apart from itscreator. In most cases when IRS attacks onFLP transfers have been successful, the creatorof the FLP was found guilty of treatingthe FLP as a proverbial "personal piggybank" (ie, depositing income of the FLPinto a personal checking account, usingFLP income to pay personal expenses anddebts, using FLP assets such as real estatewithout paying adequate rent, etc).
Respecting the FLP as a separate entityalso entails keeping proper books andrecords, filing annual income tax returns,and making sure that all distributions topartners are consistent with the partnershipagreement, which in most cases willrequire that cash distributions be made ona pro rata basis.
In most cases, FLP transfers will requirethat the value of the FLP interests, giftedor sold, be documented in a qualifiedappraisal and that the gifts of FLP units bereported on a US gift tax return.
The IRS continues to attack questionableFLPs, and based on several recentdecisions, it appears that its position mayhave started to find favor with the courts.Nonetheless, through careful planningand implementation of the FLP from itsinception and throughout its life, oneshould be able to reap the benefits.
Andrew Wolfe is the partner-inchargeof the Estate Planningand Wealth Preservation Groupat JH Cohn, LLP, the largestaccounting and consulting firmin the Northeast. He has recentlycompleted a practical, in-depth FLP User'sManual for those who are setting up FLPs.He welcomes questions or comments at 800-879-2571 or www.jhcohn.com.