FAMILY LIMITED PARTNERSHIPS DRAW IRS SCRUTIY
A family limited partnership (FLP), like other limited partnerships, is a form of business consisting of one general partner and one or more limited partners. In an FLP, however, the individuals involved usually are members of different generations of the same family. One of the advantages of a well-executed FLP is a reduction in federal estate and gift taxes. Instead of transferring assets directly to beneficiaries, an individual may transfer interests in a limited partnership. Since interest in an FLP is not marketable and since a limited partner does not control management of the enterprise, the value of interests in an FLP usually can be discounted by anywhere from 25% to 50%, with a corresponding reduction in tax liability.

As with many transactions among family members, the IRS has a history of casting a skeptical eye on FLPs. Essentially, the IRS is intent on assuring that the tax advantages of any particular FLP are not the be-all and end-all for its existence. If the FLP is deemed to be a sham, the IRS may challenge the valuation discount and perhaps even the very existence of the partnership.

In one recent case, a federal appeals court found an FLP to be legitimate despite some circumstances that had aroused IRS suspicion. A 96-year-old woman put about $2.5 million into an FLP, keeping $450,000 for her personal expenses. She died two months later. The fact that the transfer included interests requiring active management and that no personal assets, such as a house or car, were involved weighed in favor of the FLP. Also, the person making the transfer into the FLP did not manage the FLP. Perhaps most importantly, oil and gas operations provided an essential legitimate business purpose for the FLP.

In another case that was similar in many respects, including the age of the individual transferring the assets to the FLP, the assets were found to be subject to the estate tax because the FLP had not been formed for a valid business purpose. Transactions made by the FLP never went outside the family circle and amounted to financing the needs of individual family members.

Emerging from the cases are a few rules of thumb for setting up and running an FLP so as to realize its tax benefits without attracting the attention of the IRS:

» Articulate real business reasons for the FLP that can be substantiated by persons outside the FLP;

» Do not let the person transferring assets into the FLP transfer all of his or her assets or use the FLP to pay personal expenses;

» Assign control over the FLP to a general partner who is not the same person who funded the FLP. Often the general partner is an entity, such as a limited liability company;

» Have some "actively" managed assets in the FLP; and

» Follow the formalities for setting up and operating the FLP, including separate accounts and scrupulous adherence to formal accounting practices.