Family limited partnerships (FLPs) have become popular estate planning tools. Despite their popularity, however, the IRS has challenged certain FLP arrangements. Recently courts have rejected several IRS attacks on FLPs and have come out with some favorable rulings affecting them.
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 limited partnership interests.
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 the limited partnership interests for gift and estate tax purposes is generally discounted (often by as much as 40 percent 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.
Some recent Tax Court cases have rejected IRS attacks on FLPs. The IRS has argued that the restrictions on liquidation founding partnership agreements constitutes “applicable restrictions” within the meaning of IRC Section 2704(b). An applicable restriction is any restriction that limits the ability of the corporation or partnership to liquidate, unless the restriction is required or imposed by law. Section 2704(b) provides that if an interest in a corporation or partnership is transferred to a member of the transferor’s family, and the transferor and family member hold control of the entity immediately before the transfer, then any applicable restriction shall be disregarded in determining the value of the transferred interest.
For example, in Kerr v. Commissioner of Internal Revenue, the Tax Court ruled that the restrictions on liquidation found in some partnership agreements weren’t “applicable restrictions” under Section 2704(b) and shouldn’t be disregarded. Kerr is important because there had been some concern regarding liquidation provisions in partnership agreements. The case also emphasizes the need to be careful in executing transfers and in choosing the wording of various transfers.
In Harper v. Commissioner, the Tax Court reviewed a partnership agreement’s restrictions on the right to liquidate a partnership. The court applied Kerr and held that the limitations on liquidation contained in the partnership agreement weren’t applicable restrictions and must be taken into account when valuing the limitation the limited partnership interests. The court found that restrictions in the partnership agreement were no more restrictive than the default restrictions of California law, which would apply in the absence of the restrictions.
In another case, Church v. United States, the U.S. District Court (W.D. Texas) ruled in favor of a taxpayer. The government contended that the partnership was a sham transaction because it had been formed two days before death. The court found that if the business purpose can be reasonably explained and the facts can be supported by law, a limited partnership is a valid entity that cannot be disregarded for estate tax purposes.
In Knight v. Commissioner, the Tax Court ruled that a family limited partnership in Texas couldn’t be ignored for valuation purposes and that Section 2704(b) didn’t apply. The IRS had unsuccessfully argued that the 50-year term of the partnership and lack of withdrawal rights for limited partners were applicable restrictions under Section 2704(b). The Tax Court determined that the discounts for lack of control and marketability should be 15 percent.
In Strangi v. Commissioner, the Tax Court dealt with a number of issues, including whether an FLP that lacked business purpose and economic substance should be disregarded for tax purposes. The Tax Court noted that the FLP “…was validly formed under State law. The formalities were followed, and the proverbial i's were dotted and t’s were crossed. The partnership, as a legal matter, changed the relationships between decedent and his heirs and decedent and actual and potential creditors. Regardless of subjective intentions, the partnership had sufficient substance to be recognized by potential purchasers of decdent’s assets, and we do not disregard it in this case.”
Proper planning can reduce the likelihood of an IRS challenge and help support valuation discounts in the event of such a challenge. FLPs facing an IRS challenge are best off by citing legitimate business reasons (other than saving taxes) for forming an FLP. A carefully drafted partnership agreement that properly assigns rights and powers to general and limited partners can also support the FLP’s position.
Trusts are key components of an effective estate plan. To ensure that a trust meets your objectives, it’s important to have trust documents and instructions prepared by experienced, reliable professionals. An equal amount of care should go into selection of the trustee – the person charged with managing the trust and preserving its assets for your loved ones.
Here are several points to consider in choosing a trustee:
