In the last several years, the family limited partnership (FLP) has become a popular estate planning tool. Recently, however, the IRS has challenged certain FLP arrangements. This doesn’t mean estate planners should avoid FLPs, but it heightens the need for careful planning to ensure that an FLP achieves its goals and withstands IRS scrutiny.
In a typical FLP arrangement, senior family members transfer business interests, real estate, securities, or other assets to a limited partnership. One or more senior family members act as general partners, and younger family members receive.
An FLP allows the senior generation to transfer assets to the younger generation while retaining control. It can also produce substantial tax savings because the value of limited partnership interests for gift and estate tax purposes is generally discounted (by up to 40% or more) to reflect lack of control and lack of marketability. In addition, future appreciation of the transferred limited partnership interests is shielded from estate taxes.
In a number of recent rulings, the IRS has challenged FLPs as tax avoidance schemes. Many of these rulings involved terminally ill donors who formed FLPs just prior to death and, therefore, appeared to be motivated by tax concerns. But the IRS’s reasoning, which was based on a novel interpretation of estate tax valuation rules, was broad enough to encompass FLPs as well.
Many financial experts believe the IRS position in these rulings is not valid. Nevertheless, proper planning can reduce the likelihood of an IRS challenge and can help support valuation discounts in the event of such a challenge.
One of the strongest arguments an FLP can make in the face of an IRS challenge is to show legitimate business reasons (other than saving taxes) for forming an FLP. Examples include:
By identifying and documenting legitimate business or investment purposes, an FLP can protect itself against IRS attack. A carefully drafted partnership agreement that properly assigns rights and powers to general and limited partners can also support the FLP’s position.
