A family limited partnership (“FLP”) can be a valuable estate planning tool for wealthy individuals and families. When structured properly, a FLP allows a taxpayer to make gifts while retaining control over the transferred assets. Equally important, taxpayers who transfer their interests in FLPs can avail themselves of certain lack-of-marketability and minority interest discounts that would not be available if the assets were transferred outright. This can result in significant estate and gift tax savings. For these reasons, it is no secret in the estate planning community that the Internal Revenue Service (the “IRS”) is not fond of FLPs. In a series of recent cases, the IRS has been successful in challenging gifts of FLP interests such that the interests were includible in the donor’s estate.
On March 17, 2016, the United States Tax Court resolved yet another FLP dispute in favor of the IRS. In S.D. Holliday Estate v. Commissioner, the decedent, acting on the advice of her two children and attorney, created an FLP and a limited liability company (“LLC”) to serve as the FLP’s general partner. The decedent then transferred marketable securities to the FLP. In consideration for her contribution, the decedent took back a 99.9% interest as a limited partner, and the LLC received a 0.1% general partnership interest. That same day, the decedent sold the general partnership interest to her children and gifted a 10% limited partnership interest in the FLP to an irrevocable trust. On the decedent’s federal estate tax return, her executor reported the 89.9% limited partnership interest owned by the decedent at the time of her death but listed such interest at a discounted value.
The IRS challenged the transaction, and the matter was brought before the Tax Court. The Court first addressed the issue of whether the decedent retained possession and enjoyment of the transferred property. In accordance with the FLP operating agreement, if the FLP had cash in excess of its operating needs, distributions could be made to the partners on a regular basis. The Court was skeptical that an FLP that held only marketable securities would have “operating needs,” and interpreted this provision to mean that the decedent was entitled to receive distributions from the FLP. In addition, the decedent’s son testified that distributions would be made to the decedent if required. Under these facts, the Court had no trouble concluding that an implied agreement existed that the decedent retained the right to the possession and enjoyment of the transferred property.
Also at issue was whether the decedent had a legitimate nontax reason for creating the FLP. The Court first rejected the argument that the FLP was created to protect the decedent’s assets from litigators’ claims, on grounds that the decedent had never been sued. Equally unpersuasive was the argument that the FLP was designed to protect the decedent from abusive caregivers, since she had no caregivers but her own two children. Considering all available facts, the Court deemed the reasons for the FLP offered by the estate “theoretical justifications” and not legitimate and significant nontax reasons to create the FLP. As such, the entire value of the FLP’s assets was included in the decedent’s estate, without discount, even though the decedent lacked legal control over the FLP assets.
So does Holliday mean that an FLP is an invitation for disaster? Absolutely not. Holliday and its predecessors merely illustrate how an FLP should not be used. To avoid the outcome in Holliday, taxpayers should be sure to observe appropriate formalities and respect the existence of the FLP as an entity separate from its owners. As a starting point, partners should avoid comingling personal funds with FLP assets. In addition, when property is transferred to an FLP, partners must respect the changed ownership of the assets. For example, if a vacation home is transferred to an FLP, fair-market rent should be paid to the FLP if the home is used for personal purposes.
Distributions should always be made pro rata in accordance with the partnership agreement. To avoid the argument that an implied agreement exists for the transferor to continue using partnership assets in the same manner as before the transfer, a taxpayer should retain sufficient assets outside the FLP to meet his or her personal needs and living expenses. Finally, proper books and records should be kept, and the FLP should maintain proper capital accounts and observe all applicable state law formalities.
FLPs can be an excellent estate planning technique provided the proper safeguards are observed. It is important to remember that, while these safeguards can protect against a successful IRS attack, there is never an absolute guarantee that a particular FLP arrangement will withstand challenge. Accordingly, taxpayers are strongly recommended to consult with an experienced estate planning professional to determine if an FLP is appropriate for their unique circumstances.
S.D. Holliday Estate v. Commissioner, T.C. Memo 2016-51.
Estate of Jorgenson v. Commissioner, T.C. Memo 2009-66.
Estate of Turner v. Commissioner, T.C. Memo 2011-209.
Estate of Liljestrand v. Commissioner, T.C. Memo 2011-259.