For the past fifteen to twenty years or so, a popular business and estate planning technique has been the use of family limited partnerships (“FLIPS”) for the purpose of management of real estate and investment assets. They have also been used as an estate planning technique, allowing families to transfer wealth from one generation to the next. For nearly as long, the IRS has tried a number of theories to attack the tax and financial planning benefits of FLIPS. The question is whether FLIPS will survive the continued intense scrutiny of the IRS in light of recent
By way of background, a FLIP is simply a limited partnership created by family members. The family members contribute property, including stock, bonds, cash or real estate, and in return, receive partnership interests. The FLIP, just as a general partnership, is managed by the general partners. The limited partners are essentially passive investors with few, if any, management rights. Similar to general partnerships, the general partners of
a limited partnership remain liable for the debts and liabilities of the partnership, unless the partnership is registered with the Missouri Secretary of State as a “Registered Limited Liability Limited Partnership.” This registration will afford limited liability to all of the limited partnership’s partners, including the general partners.
There are numerous tax and non-tax reasons for establishing FLIPS. These reasons include (i) establishing a method by which annual gifts may be made without dividing a particular asset, (ii) continuing the ownership and operation of family assets, (iii) restricting the right of non-family members to acquire interests in family assets, (iv) providing protection from creditors of family members and (v) providing flexibility and continuity of business planning.
The IRS has attacked the use of the FLIP as an estate planning technique on several grounds. In recent years, the IRS has scored some key victories using IRC §2036. In several cases, the IRS has persuaded the Tax Court to disregard the FLIP, forcing the taxpayer to include the partnership’s assets in the donor’s gross estate so that the donor or his estate loses the benefit of valuation discounts. The cases tend to focus on whether property was
transferred legitimately and at arms length, and whether the transfer constitutes a “recycling” of value. These cases provide us with guidance regarding the structure of FLIPS. To protect against a Section 2036 attack, FLIPS
should adopt the following guidelines and incorporate them into the operation of the FLIP:
- The partners should respect the separate existence of the partnership. If a distribution is to be made out of the partnership, it should be made pro rata to all the partners in accordance with their respective ownership percentages. Disproportionate distributions from a FLIP will be troublesome to the IRS, and ultimately, to the partners. Also, distributions should be made on an established periodic basis. It would appear that pro rata distributions, while necessary, are not enough if they are made irregularly in response to the perceived cash needs of the donor.
- The partners should act in a manner that is consistent with the partnership agreement. The partnership should not pay an individual partner’s bills, nor should an individual partner utilize partnership property for personal reasons. The individual partners should also not commingle their personal assets with FLIP assets.
- Sound accounting principles and practices must be maintained.
- FLIP documents should expressly hold the general partner or manager to a fiduciary standard in their dealings with the FLIP.
- Establish the FLIP as soon as possible. The partnership should be formed while the donor has a reasonable life expectancy. Don’t wait to make it a deathbed partnership.
- It is likely more advantageous to fund the partnership with capital contributions of assets by each of the partners to constitute a “pooling” of family assets.
- The partnership should be established and continued for a valid business purpose, which should be documented in the limited partnership agreement. RUN THE PARTNERSHIP LIKE A BUSINESS.
- The General Partners should maintain excellent partnership records, including records of annual partnership meetings, income tax returns, partnership tax returns and valid assignments of partnership assets to the partnership.
- The IRS seems to be interested in whether a FLIP is continued after the death of a donor decedent.
- The IRS will look at the proximity of gifts in partnership interests relative to a decedent’s death. In other words, was the partnership established, or were gifts made, in anticipation of a decedent’s death?
- The IRS looks askance at the transfer of a majority of a decedent’s assets to a FLIP. We would recommend staying away from conveying personal assets, such as residences, cars and vacation homes to a FLIP.
- The limited partners or the members should have the right to convey their partnership or membership interest. If a limited partner does not have the right to sell or assign his interests, it may not be a “present gift” and therefore, the annual gift tax exclusion may not be available. However, a limited partnership can place restrictions on the right of transfer – for instance, a right of first refusal in the partnership and other partners.
When structured properly, Family Limited Partnerships offer an excellent vehicle for owning and managing of assets, especially investment assets, allowing younger generations to become exposed to good stewardship and growth of family wealth, while yet protecting younger generations from themselves, divorce, and creditors, as well as providing valuable estate planning technique. However, care should be taken in the structure and operation of the FLIP to avoid an IRS attack.