Savvy taxpayers have long recognized the advantages of family limited partnerships (FLPs) in limiting estate tax liability. Unfortunately, so has the Internal Revenue Service (IRS). Recent developments in the IRS battle against FLPs should have investors paying close attention to how they structure their partnerships.
Using audits of gift and estate tax returns, the IRS has fought to eliminate or reduce the estate tax advantages afforded by FLPs. In selected estate tax cases, the agency has even taken its campaign to the courts. In a much publicized estate tax case decided in 2000 – Strangi v. Commissioner – the Fifth Circuit Court affirmed a tax court decision that applied estate taxes to some assets that Strangi, through his agent, had transferred to an FLP shortly before his death.
The court found that an “implied agreement” existed between Strangi and his family for Strangi’s retained use of the transferred assets (which included virtually all of his property, including his residence), thus subjecting them to estate tax.
Key in the decision was the court’s holding that even though Strangi may have received full value for the transferred assets (in the form of partnership interests), his transfer was not a “bona fide” sale due to the absence of a “substantial nontax purpose.”
What do Strangi and other cases involving estate – and not gift – taxes mean to FLP investors? The holdings in these cases may be followed in litigated gift tax cases, so they provide us with a blueprint for successful use of FLPs as part of a gift program. As long as there are significant or substantial nontax purposes for using an FLP, taxpayers should be able to use this blueprint to construct their FLPs. Owners of multifamily real estate may be among those best suited to demonstrate such purposes.
Benefits for real estate FLPs
So what exactly is a “significant or substantial nontax purpose?” Let’s consider 60-year-old Donald, a successful, healthy real estate entrepreneur. Donald’s activities include development and construction. He has two children who work and own small interests in the business. Donald wants to remain active for now and eventually have his children take over. He expects that the business will increase in value and worries that the estate tax burden will make its transfer to his children difficult. Donald has heard that an FLP might provide him with the means to transfer to his children interests in the business at discounted gift tax values – thereby reducing the size of his estate and the amount of the estate tax – and achieve other benefits as well. Can Donald demonstrate “significant or substantial non-tax purpose(s)” for use of an FLP?
Donald and his children might consider pooling their assets by contributing them to an FLP in exchange for partnership interests. The FLP would operate the family real estate business and be constructed and operated as a “pro rata” partnership (all distributions would be made on a proportionate basis). A limited liability company owned by Donald and the children would be general partner. (Donald should consider avoiding retaining outright control of the company or limiting his control to veto powers over major decisions.)
The FLP would provide centralized business management and financial economy by owning all of the interests (while preserving liability protection through ownership of interests through individual limited liability companies) and creditor protection for the partners. It would also facilitate the reinvestment of FLP assets, as well as a change of investment approaches and increased involvement of the children in the business in preparation for the transfer of the business to them.
At some point, Donald would consider transferring to his children portions of his interest in the FLP utilizing one or more techniques. The value of such transferred interests would be determined by an appraisal and should reflect valuation discounts.
Proper planning does not end with the formation and funding of the FLP.
It is critical that all of the formalities entailed in the operation of an FLP be strictly observed. There should be no commingling of individual and partnership assets. The general partner must perform its functions for the sole and exclusive benefit of the partnership and its limited partners in accordance with the partnership agreement. No distributions should be made to partners for a reasonable period after any transfers are made (and when made, must be made on a pro-rata basis). Regular meetings of partners should be held.
Finally, assets (including all personal-use assets) adequate to meet the needs of the partners should be retained by them outside the FLP.
Properly structured and operated, an FLP can lead to substantial estate tax savings, especially for owners of multifamily real estate.
Herbert B. Fixler is a partner in the Private Client Services Group at WolfBlock in New York City. He can be reached ator (212) 297-2670.