Anticipated Treasury Regulations to Target Family Limited Partnerships

For decades, the Family Limited Partnership (FLP) has been one of the most widely used and successful estate planning techniques for wealthy taxpayers to transfer significant wealth to future generations. However, the Department of the Treasury may soon issue regulations that severely limit the effectiveness of FLPs going forward. We strongly recommend proactive planning, and Wipfli tax and valuation professionals can help you determine whether action should be taken.

Background

A typical FLP begins when senior generations contribute assets to a partnership (or similar entity, including a limited liability company) in exchange for general and/or limited partnership interests. Younger generations may also contribute property to the FLP in exchange for partnership interests. The creation of and initial contributions to the FLP are often tax-free events. Later during life (or at death), the senior generations transfer their FLP interests to younger generations. 

Here is the rub: Valuation discounts typically apply to the transferred FLP interests and effectively reduce the cost of transferring the interests to younger generations. These include discounts for lack of marketability and lack of control, both of which can be significant (e.g., 20%-40% in some cases), and these discounts effectively create leverage by transferring true value above the discounted value (and all future appreciation) outside of the senior generation’s estate. 

Challenges to FLPs

The IRS views FLPs with particular scrutiny, as evidenced by dozens of published court opinions for cases in which the IRS challenged (successfully and unsuccessfully) FLP discounts, business validity, and use as an estate tax planning tool. In 1990, Congress gave the IRS ammunition (Chapter 14 of the Internal Revenue Code) to challenge FLPs and similar techniques by disregarding certain “applicable restrictions” in the case of family-controlled entity transfers. Chapter 14 effectively increases the value of transferred assets by disregarding certain discounts. Changes in various state laws and creative tax planning, however, have permitted FLPs to remain viable despite Chapter 14. 

More recently, the Obama administration has also voiced its distain for FLPs via proposed tax law changes in the budget process. These proposals have consistently called for expanding the restrictions to be disregarded under Chapter 14 (i.e., increasing the ammunition plot previously provided by Congress). In 2014 and 2015, though, the Obama administration omitted these proposals. Tax practitioners believed the omissions indicated that a different attack route would be taken. 

This summer, IRS personnel and leading tax practitioners noted that the Treasury may release proposed regulations aimed at limiting the effectiveness of FLPs in 2015, similar to the prior Obama proposals.  Notably, Chapter 14 specifically authorizes the Treasury to issue regulations that will carry the force and effect of law. As a result, taxpayer challenges to any newly issued regulations could be difficult to sustain.

Please remember that any changes are purely speculative, since the Treasury has not yet officially stated it will release any such regulations. Given recent history, however, we strongly recommend proactive planning to be prepared for change when it does come. If you have questions, please contact Rick Taylor, Ryan Laughlin, or your Wipfli relationship executive.