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David B. Gollin

David B. Gollin Trusts & Estates

dgollin@fredlaw.com
612.492.7159
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An Update on Family Limited Partnerships: Forming, Operating, and Fixing FLPs Following Recent Successful IRS Challenges

By: DAVID B. GOLLIN

May 2007

The IRS Has Had Some Success in Attacking FLPs

In February of 2005, we updated you on recent cases involving family limited partnerships (FLPs). In particular, we highlighted the watershed victory by the IRS in the Strangi case in which the service successfully claimed that the assets contributed by Mr. Strangi, the decedent, to his FLP (rather than the discountable partnership interests he owned) should be included in his estate on a non-discounted basis. The IRS determined, and the Tax Court and 5th Circuit Court of Appeals agreed, that Mr. Strangi had retained not only the right to the income from, but also the possession and enjoyment of, the property he transferred to the FLP. As a result, such property was includible in his estate and subject to estate tax.

The IRS has won most subsequent FLP cases, including the Estate of Edna Korby and the Estate of Austin Korby. The original decisions favoring the IRS in Korby were recently affirmed by the 8th Circuit Court of Appeals, which covers Minnesota, North Dakota, South Dakota, Iowa, Arkansas, Missouri, and Nebraska. Not surprisingly, a significant number of so-called “bad facts” were present in most of these cases (including Korby), making it very easy for the courts to side with the IRS. In reality, the Service was only litigating the cases it knew it could win.

Benefits of Using FLPs

Families have long used FLPs for a variety of non-tax related reasons. These include limited liability, orderly management of family assets, succession planning, investment diversification and flexibility, simplification and/or minimization of probate, easier and less costly dispute resolution, and creditor protection, including in the event of divorce. FLPs are also a good tool for simplifying the gift-giving process while providing an educational opportunity for junior family members. As might be expected, there are also significant tax-related benefits. These are available due to certain discounts (for lack of control and marketability) that might apply to partnership interests that are gifted during lifetime or transferred upon death.

Should Clients Still Establish FLPs?

Given the recent success the IRS has had attacking FLPs in court, one must ask if it is still appropriate to create them. While there is reason for concern, I believe the answer is still an unmitigated YES. Those who heed the proper advice of counsel can still reap significant benefits from FLPs.

Issues Regarding Formation

There are a number of issues that should be addressed and precautions taken when establishing an FLP. Failure to be cognizant of these matters may result in adverse estate tax consequences.

  1. There must be at least one significant and legitimate non-tax reason for creating the FLP. This should be evident in the correspondence between attorney and client, and spelled out in the partnership agreement.
  1. All formalities required by state law should be complied with in establishing the FLP. In other words, make sure the FLP is legally established under state law.
  1. Assets must actually be transferred to the FLP in exchange for FLP interests. Furthermore, the FLP should be funded before transfers of FLP interests are made. As a general matter, funding should take place soon after the FLP is legally established.
  1. Respect partnership rules when funding the FLP. Each partner’s ownership interest should be proportionate to the value of his or her contribution relative to all partners’ contributions. The value of the assets contributed by a partner should be reflected in his or her capital account. And, upon dissolution, each partner should be entitled to the value of his or her capital account.
  1. The primary transferor should maintain sufficient assets outside the FLP to maintain his/her standard of living and pay regular living expenses. Under no circumstance should all or nearly all of a person’s assets be transferred into the FLP.
  1. Personal-use assets (e.g., a primary residence) should not be transferred to the FLP.
  1. Avoid establishing FLPs when the primary transferor is very old or ill. Be wary of using powers of attorney to establish an FLP for a primary transferor who might otherwise lack capacity.
  1. Other family members (and perhaps non-family members) should contribute to the FLP to create a true “pooling of assets.” These contributions should be more than de minimus.
  1. The primary transferor of property to the FLP should not control the general partner.
  1. Fiduciary duties of the general partner should not be waived.

Issues Regarding Operation

There are also issues concerning the operation of an FLP. Again, failure to address these may produce negative tax consequences.

  1. Operate the FLP like any other business. Periodic meetings should be held,  FLP and partner actions documented, and an FLP record book maintained.
  1. FLP assets should not be commingled with the assets of any individual partner, especially the primary transferor. The FLP should not be used as the primary transferor’s personal checkbook.
  1. Do not make non-pro-rata distributions to the primary transferor. This is clear evidence that the primary transferor did not part with the right to the income from, or the possession and enjoyment of, the transferred property.
  1. The FLP should be operated in a manner that is both consistent with, and in furtherance of, its stated legitimate and significant non-tax purposes.
  1. The FLP’s assets should be actively managed. It is best if at least some operating (rather than solely passive) assets are transferred to the FLP. Asset management should be through the FLP and not the individual transferor.
  1. The primary transferor should not control the general partner. Neither the primary transferor nor his/her power of attorney or trustee should have the power to control FLP distributions.
  1. It might be wise to wait between establishing and funding the FLP and gifting FLP interests. Gifts of FLP interests to a trust with an independent trustee also may be helpful.

What Can You Do With Existing FLPs

What do you do if you have established an FLP and one or more of the “bad facts” discussed above might be present? Do not panic. The mere existence of a couple of bad facts (other than putting most or all of your assets in the FLP while incompetent and near death) will not necessarily doom your FLP. Consult with competent legal counsel as soon as possible; the following remedies might be applicable.

  1. Consider eliminating the senior family member(s) as general partner(s). This might be accomplished by a gift or sale of the general partnership interests to junior family members and/or trusts. If there are other general partners, the FLP might simply redeem the senior member’s general partnership interests.
  1. Consider eliminating the senior family member(s) as limited partner(s). Again, this might be accomplished through gifts or sales.
  1. Consider separating investment from distribution authority. If Dad contributed all of the assets, amend the FLP agreement to give Mom authority over distributions while Dad retains the authority over investments.
  1. Consider adding non-family members as general or limited partners. This can be accomplished by using trusts with independent trustees.
  1. Diversify the FLP’s assets. If the FLP consists solely of marketable securities, consider real estate investments and/or operational businesses.
  1. Distribute partnership assets to senior members if too large a portion of their net worth was transferred to the FLP. The goal is to make sure that the senior family member has an independent source of financial support. Remember to consult with your tax attorney as such distributions may have income tax consequences.
  1. Amend the FLP agreement to eliminate any waiver of the general partner’s fiduciary obligations. A provision should be added that articulates the general partner’s fiduciary obligations to the FLP and the partners.
  1. Get rid of personal-use assets held by the FLP. Execute fair-market-value leases for assets that are used by any individual partner for personal reasons.
  1. Consider doing an accounting of partnership expenditures and distributions. Require reimbursement for personal use of FLP assets and/or distributions of a personal nature (e.g., to pay personal medical bills).
  1. If disproportionate distributions have been made, consider reimbursement with interest. (As a practical matter this may not be possible, as disproportionate distributions typically occur when the senior family member contributes too much to the FLP and does not retain sufficient assets to support himself/herself.)
  1. If all of the limited-partnership interests have been gifted to junior family members, consideration might be given to liquidating the FLP.

In summary, what we have learned over the last several years is that, despite many potential pitfalls, FLPs that are properly structured and operated will be respected and will continue to provide an efficient means for transferring wealth to younger generations. Furthermore, it is still possible to fix potential problems before they become (upon death) real issues.

If you have an existing FLP (or other family entity), or wish to discuss the creation and implementation of an FLP, contact your current estate planning attorney or any of us in the Trusts & Estates Group at Fredrikson & Byron to answer your questions.