Several recent court cases bring good news for those who have considered, or are now involved in, a family limited partnership (FLP). These cases resulted in major defeats for the IRS. While a headlong rush to set up or expand existing FLPs may be the knee-jerk reaction, a more cautious approach may prove to result in more lasting savings.

The FLP structure

A family limited partnership typically holds appreciating business or investment properties. It is usually funded largely by senior generation family members who are the general partners. Limited partnership units are subsequently transferred to junior generation family members. At the time of transfer, the limited interest units generally qualify for substantial valuation discounts. Those discounts shield the transfer from significant gift tax while saving the family even more on the estate tax down the road.

The general partnership interest allows the older-generation transferor a continuing voice in the operation of the business despite that interest representing only a small percentage of the business's value. Retention of too much control by the older generation, however, can be fatal to the plan. Recently, the IRS has seized upon the "control" issue and has made it the focal point of FLP litigation.

IRS victories

At the heart of recent IRS court victories is the argument that the taxpayer has not respected the underlying entity, which in turn allows the FLP to be disregarded at the death of the older-generation "transferor."

In one recent Tax Court case, the family tried to have the FLP do too much and ended up having it completely ineffective for tax purposes. In that case, the facts and circumstances supported the conclusion that an implied agreement existed: (1) the decedent transferred nearly all of his wealth to the FLP, leaving him with few liquid assets for living expenses; (2) the decedent continued to occupy his home after it was transferred to the FLP, where accrued rent was not paid for over two years; (3) money from the FLP was used to pay for the needs of the decedent and his estate; and (4) the arrangement resembled an estate plan more than a joint enterprise and did not change substantively the decedent's relationship to the transferred assets.

IRS defeats

Two recent FLP cases -one in the Tax Court and one in the Fifth Circuit Court of Appeals-- have turned back IRS's string of victories and point the way to a formula for creating an FLP that strengthens a family's overall financial health, saves taxes, and avoids trouble with the IRS.

In the recent Tax Court case, the hope that litigation among the decedent's heirs would be minimized was among the reasons that the FLP was set up. According to the court, that purpose was enough to demonstrate a strong non-tax motive for the FLP's creation. The FLP also helped the older generation better manage their assets. Further, the FLP had economic substance as a viable enterprise for profit. The final key to having the FLP work was having the older generation leave sufficient assets out of the FLP sufficient to maintain their accustomed standard of living.

In the recent Fifth Circuit case, the IRS was told that the $2.5 million in FLP assets were successfully removed from the estate of the family matriarch. The initial transfer of assets to the FLP was a bona fide sale for adequate and full consideration. The assets contributed were properly credited to the grandmother's partnership capital account. She retained sufficient assets outside the FLP for her own support and did not commingle FLP and personal assets; partnership formalities were satisfied; credible non-tax business reasons existed for the FLP's formation. The fact that her estate claimed a 49-percent discount in valuing the decedent's partnership interest did not preclude a finding that the FLP interest constituted adequate consideration for the assets transferred.

Conclusions

In matters such as an FLP in which substantial assets are at stake, a conservative approach is generally wise. For an FLP, this means using caution in spite of major IRS defeats. However, it also means that, given the right planning, an FLP can safely save a family business a substantial amount of estate and income tax that otherwise will have to be paid.

The steps that should be taken in establishing a successful family limited partnership include the following:

• Set up the FLP while the older generation was still healthy;
  Only include business assets (Congress is considering a bill that would do just that)

• Limit legally-enforceable older-generation controls of, or day-to-day management responsibilities over, partnership assets

• Have the older-generation member where practicable relinquish any interest income in the FLP prior to death

• Leave the older-generation member with adequate assets to cover all living expense

• Conduct legitimate negotiations between the older and younger generations dealing with the funding and operation of the FLP

• Respect the partnership entity.