FLPs
WITH BUSINESS PURPOSE MORE LIKELY TO PASS IRS MUSTER
Wealthy families thinking of
establishing a Family Limited Partnership (FLP) in order to save
gift and estate taxes need to keep one key point in mind: a FLP
is more likely to pass IRS muster if it can demonstrate a bona fide
business purpose and operate in a business-like manner.
As FLPs (and the family limited
liability company where credit protection is a concern) seem to
have grown in popularity in recent years, taxpayers and the IRS
have been engaged in a tug of war over whether a FLP is a legitimate
vehicle for the reduction of gift and estate taxes. Sometimes the
IRS wins; sometimes the taxpayers win, but out of the tussle, informal
guidelines are emerging that may clarify the issue for taxpayers.
The intent behind most typical
family limited partnerships is straightforward, even if the FLP
itself is complex. A parent transfers assets, such as a family business,
stock, or real estate to a FLP and then gifts most of the shares
of the FLP to the children. The parent typically retains one or
two percent ownership as general partner, effectively controlling
management of the FLP.
Because the children's management
control and marketability of their shares are severely limited,
the value of their shares is treated as less than the shares proportional
net asset value of the FLP. Thus, the value of the gifted shares
is discounted for tax purposes, sometimes as much as 40 percent
or more. That saves the parent potential gift taxes and, because
the assets have been moved out of the parent's estate, it saves
potential estate taxes.
The IRS has generally lost the
gift-tax issue on appeal to tax courts, but it seemingly has had
more success in arguing that a parent never effectively relinquished
control or use of the assets, and thus the assets should be included
at an undiscounted value in the parent's taxable estate upon the
parent's death.
A string of recent court cases
appear to suggest some informal guidelines that families and their
financial and legal advisors may consider when deciding whether
and how to establish a FLP that may pass the IRS challenge for both
gift and estate taxes. The key often turns on whether the facts
suggest that the FLP is a "sham"
whose intent is merely to avoid taxes, or whether it was established
for legitimate business reasons, with a side benefit of saving taxes.
As a result of the dilemma, some tentative guidelines suggested
by these cases include:
Is a FLP appropriate? FLPs generally
are for people likely to face gift and estate taxes. But even they
may find other tax-saving strategies that have the potential of
being more cost effective, less complex, and less vulnerable to
an IRS challenge.
Have a valid business purpose.
This is still a gray area. Many commentators seem to argue that
you'll be on safest ground if the FLP includes an active
family business or investments that requires active management
by the FLP's partners, such as rental property. While one ruling
may go against a taxpayer in part because the FLP mainly holds mostly
marketable securities with no apparent business purpose for holding
them, courts may rule in favor of the taxpayer because the FLP provide
such valid business purposes, such as protection against creditors.
Spell out the business purpose.
The partnership documents should spell out in detail the FLP's business
purposes, and the family should operate it as a business.
Don't commingle personal property.
One certain way to draw IRS scrutiny is to stuff an FLP with personal
assets such as a primary residence or vacation property. A taxpayer
may lose a case because the primary residence was gifted to the
FLP, yet he/she continues to live in it rent free. This has the
potential to work (such as paying fair-market rent to the FLP),
but there may be a challenge.
Don't use the FLP as your personal
piggy bank. It may be beneficial to retain sufficient personal assets
outside the FLP to live on and try to avoid drawing on FLP assets
for living expenses.
Avoid death-bed formations of
FLPs. There have been allowable exceptions to this practice, but
it definitely invites IRS attention.
Maintain the general partner's
fiduciary responsibility. Waiving the responsibility in the agreement
may raise questions about the partnership's validity.
Tax
credit programs are subject to market risk and other special risks
(the risk of losing or recapturing tax credits), for real estate
tax credit programs, the risk that the real estate does not qualify
for the tax credits and the risk that properties will have mortgage
indebtedness which will cause their value to fluctuate.
Furthermore, the illquidity of the tax credit programs may
adversely affect the value of the investment.
This type of investment is not suitable for all investors.
This article
was produced by the Consumer Affairs Dept. of The Financial Planning
Association and provided to you courtesy of Terry P. Welsh, CFP,
Ketchikan, Alaska. If you have any questions or concerns regarding
this, or any other financial topic, please call me at 1-907-225-0619,
or click on the "CONTACT US" button to arrange for a free initial
consultation.
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