Things to Consider When Using a Family Limited Partnership
This FLP Alert is directed at clients and their advisors who have already
established Family Limited Partnerships (“FLP’s”) and those clients who are considering
a partnership as part of their estate plan.
With all the attacks the IRS has made on FLP’s over the past few years, culminating
at the Strangi III decision in July 2005, many have inquired as to the continued
viability of FLP’s, particularly with respect to estate tax valuation discounts.
The Strangi cases (I, II and III) were extreme cases involving a fact pattern that
weighed heavily against the taxpayer and should be used to clarify how to structure
an FLP in order to minimize tax consequences.
Background – In the Strangi case, Mr. Strangi’s son-in-law, acting
as his agent under a durable power of attorney, created an FLP two months before
his death in 1994. Approximately 98% of Mr. Strangi’s net worth was transferred
to the FLP and he became the 99% limited partner; however, he also retained a small
percentage of the 1% general partnership interest.
On Mr. Strangi’s estate tax return, the executor reported the value of Mr. Strangi’s
partnership interest at a discount from the value of the underlying partnership
assets using the “estate tax valuation discount.” In claiming this discount
the executor asserted that the FLP agreement created restrictions that would cause
a third party to value the limited partnership interest lower than the value of
the underlying assets held by the partnership. On audit, the IRS disagreed
and informed the executor that it was seeking an additional $2.5 million in estate
taxes. Litigation has continued since then, with the most recent decision in favor
of the IRS, referred to a Strangi III. It is unknown at this time whether
the Estate will appeal this decision to the U.S. Supreme Court.
§ 2036(a) of the Internal Revenue Code provides that transferred assets can still
be included in the taxable estate if prior to death the decedent retained (1) possession
or enjoyment of the assets or (2) the right to designate persons who shall possess
or enjoy the assets. In Strangi II, which was upheld by Strangi III, the courts
determined that § 2036(a) applied to the assets held by the Strangi FLP, thereby
increasing the estate’s tax liability considerably.
Lessons from Strangi III – Here is what we have learned as far as
what to avoid in the formation of FLP’s, and things to look for in the operation
and management of FLP’s.
• Don’t put all your assets in the partnership. The partnership
should be viewed as a business or investment vehicle, not a tax planning vehicle
or account. Reserve an amount of assets outside of the partnership sufficient
to allow you to live in your desired standard of living for the remainder of your
anticipated life expectancy. In addition, in the Strangi case, the IRS was
highly critical that the FLP paid estate administration expenses following Mr. Strangi’s
death. Therefore, it is probably a good idea to include anticipated expenses
in the reserve described above, perhaps even considering a reserve for estimated
estate and inheritance taxes, or providing for those taxes through a life insurance
• Don’t put “personal use” assets in the partnership. One of the
many facts that caught the IRS's attention was Mr. Strangi’s occupying his home
rent-free after it had become a partnership asset. Personal use assets include
vacation homes, boats, airplanes, art collections and similar items. It’s
just not a good idea to put these in a Family Limited Partnership.
• Don’t make any distribution that fails to follow the terms of the partnership
agreement. Most FLP agreements require that when the general partner
makes distributions to the partners, the distributions must be made pro-rata based
on each partner's proportionate interest in the partnership. Distributions
to only one limited partner implies to the IRS that there is some sort of agreement
among the partners to benefit one partner over others This can provide the
IRS with significant ammunition against the valuation discounts.
• Don’t make too many distributions. The IRS is consistently arguing
that most FLP’s have no business purpose, and in certain situations is finding success
with that argument in the courts. Treat the partnership like a business and
have a business purpose for the FLP. Most well run businesses do not distribute
every dollar - they assess their opportunities and first seek to reinvest in the
business. If adequate reserves have been identified, the partnership cash
flow should not be necessary to support the lifestyle of the limited partners. The
retained funds should then be invested for the benefit of all the partners.
• Don’t fail to re-title assets that belong to the partnership.
Once it is determined what assets will be transferred to the partnership, be sure
to change their title. For example, if an investment account is to be a partnership
asset, then change the account title to the name of the partnership, even if this
requires opening a new account and closing the old. A very clear line needs
to be maintained between which assets belong to the partnership and which assets
belong to the limited partners as individuals.
• Don’t think that once the partnership document is signed you can rest easy.
Be cautious in the operation of the partnership entity. Keep accurate
books and records. Do not use partnership assets for non-partnership purposes
and do not co-mingle partnership funds or expenses with personal funds or expenses.
• Don’t concentrate control in a limited partner. Be aware of retained
voting rights, the right to remove general partners, and rights to amend the agreement.
It’s not just about the percentages. Pay attention to control held in
different capacities, for example, individually and as trustee.
• Don’t have the senior family member (who in many cases contributes most of
the assets) serve as the general partner or have control over the general partners.
This has to do with control over partnership assets, and the IRS is looking
at who ultimately determines who gets to enjoy those assets. When the IRS perceives
that the person who contributed those assets also has the right to make these determinations,
it may seek to include the partnership assets in that person's estate, thereby ignoring
the discounts. Because of this, it is essential that the person contributing
the bulk of the assets is comfortable with that loss of control.
• Don’t procrastinate. If you are interested in this type of planning
and have not done so, make your decision. Many FLP’s have successfully been
attacked by the IRS in situations that involved the death of the founder closely
after the creation of the partnership. One of the many non-tax reasons to
form as FLP is the potential asset protection features a limited partner may enjoy.
• Don’t assume that your existing partnership has been adequately managed simply
because the partnership tax return has been filed every year. The idea
of FLPs generating valuation discounts has been a popular estate planning tool since
the late 1980's. Many partnerships have been created and have operated since
that time. As any advisor will tell you, what may have seemed an appropriate
design feature in 1990 may not be a good idea today. Similarly, income tax
returns alone typically will not identify and expose problems in the management
of the partnership. Failure to address these issues in many older partnerships
will simply provide ample ammunition to the IRS.
• Don’t try to do it alone. Hire competent advisors, including
an attorney, CPAs and valuation specialists. While the professional fees are sometimes
expensive, failure to properly plan and carry out the operation of the partnership
properly can have expensive consequences.
If you are considering an FLP, consider reviewing these points with your advisors
to insure they are covered. If you, or a family member, have an existing FLP,
you may want to consider a "checkup" to ensure your structure and operations will
have a better chance of withstanding the potential for IRS scrutiny.