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Home / Special Report / FLPs: Is it time now?
Never? Or now or never?

FLPs: Is it time now?
Never? Or now or never?

Family limited partnerships have been the planning rage of the ’90s, and, for some of us, of years long before.
Every major newspaper and business magazine has featured articles on how these FLPs reduce or eliminate the estate-tax burden. At the heart of the strategy is valuation-discount planning. When a partnership interest is transferred to the heirs it is valued at a discount to the full fair-market value of the partnership assets. Let’s set the stage with a simple example:
Mom and Pop own an apartment building appraised at $2 million. With the latest magazine article in hand, they create a limited partnership. Mom and Pop each own a 1 percent general-partnership interest and a 49 percent limited-partnership interest. They deed the apartment building to the partnership. Ten days later they transfer their entire limited-partnership interest (98 percent) to their three children and seven grandchildren, retaining their 2 percent general-partnership interest.
In the Wall Street Journal they read that limited-partnership interests frequently are valued at only 70 percent of the value of partnership assets due to the restrictions on limited partners, so they file a gift-tax return valuing the limited- partnership interests at $1.372 million (70 percent of $1.96 million).
They both use their unified transfer credits to eliminate federal gift tax on the first $1.2 million of partnership interest transferred, and each uses the $10,000 annual exclusion to cover the tax on the remaining $172,000. Since they recently moved their residence from New York to Florida, they avoid $51,000 of New York gift tax. The gift-tax return shows no tax due; Mom and Pop still own the 2 percent general-partner interest. Plus, 98 percent of all future appreciation and cash flow will be taxed to their children and grandchildren.
Twenty years later, Mom, having survived Pop, dies. The apartment building still is owned by the partnership, but now is worth $10 million. At that time, Mom has no interest in the partnership, and the children have given their interest to the grandchildren. The grandchildren, as a group, have a 50-year life expectancy, and already are starting to transfer limited-partnership interests to their children–all, in this example, without a single dollar of transfer tax.
This scenario is not unique. There are tens of thousands of these partnerships in operation today (some say there are this many in Texas alone). FLPs have always harbored some risk, some more than others depending on how skillfully they are put together. That is true of most high-leverage, cutting-edge tax strategies, and most clients engaged in this planning understand and accept this risk. Unfortunately, the strategy became too popular: The Internal Revenue Service now is trying to retard the pace of partnership planning while a permanent solution is pondered. Is it any wonder that the IRS is sitting up and taking notice? In Mom and Pop’s case, the IRS saw $5 million in transfer tax slip through its hands, perhaps for perpetuity.
Sitting up and taking notice is one thing–being a family actively pursued by the IRS is quite another. On Jan. 14, 1997, the IRS issued an unpublished Technical Advice Memorandum (legal advice to a field auditor) stating that in its view, the entity structure of the FLP should be entirely disregarded in the valuation process. In the context of our example, the IRS would compact the multiple steps into a single transaction, treating it as though Mom and Pop conveyed a 98 percent interest in the real estate directly to their decedents with complete disregard for the entity.
In a further development, the IRS recently completed litigating a Tax Court case. In its brief, the IRS raised the exact same legal arguments outlined in the earlier Technical Advice Memorandum.
Thus, the battle lines are drawn, and all that remains is for the wheels of justice to grind up the legal issues. It is anticipated that a decision will be handed down in this case later this year. That decision should give FLPs and their owners a clear signal on whether the FLP entity will be respected, and whether the anticipated discounts will be available.
Will the IRS be successful in the legal arguments that it is advancing? Many scholars and practitioners believe the arguments are not supported by the Internal Revenue Code, the regulations and the legislative history. Professor Jerry Kasner, of the University of Santa ClaraLaw School, concluded that the reasoning of the IRS “is clearly an unwarranted extension of the law.”
If the IRS is successful in its efforts, it could be a long and rough ride for FLPs. If the IRS suffers defeat, it likely will conclude, as many practitioners already have, that the Internal Revenue Code does not say “disregard an entity and value the assets.”
The IRS then likely will turn to Congress and request legislative relief. This will not be the first time the IRS has asked Congress to give it a “disregard the entity” statute. To its credit, Congress has been reluctant to act, due to the broad policy implications of such a rule as well as both political and constitutional considerations.
Assume that Congress passes legislation adversely affecting FLPs. If history is a guide, all FLP transactions before the effective date of the legislation should be grandfathered under existing law. So, for those taxpayers who are still thinking about forming FLPs, see the title of this article: Is it now, never, or now or never?
If you have an FLP, you should be doing more than sitting around waiting for the other shoe to drop. Now is the time to give your FLP a checkup. Even a favorable decision for FLP owners won’t cure fundamental problems in the planning or implementation of the FLP.
Among the things to look for:
–unsigned partnership agreements;
–failure to file partnership certificates;
–failure to complete all asset transfers to the partnership with proper documentation;
–assignments of limited-partnership interest not properly documented;
–decisions on whether transferees are to be assignees or substitute limited partners;
–establishment of partnership bank and brokerage accounts;
–separate EIN numbers for the partnership;
–filing partnership tax returns and sending partners K-1s;
–making sure that partnership distributions to partners follow partnership interest and are properly authorized;
–changing insurance policies insuring partnership assets and getting correct beneficiary designations; and
–if you have an entity general partner, making sure you are observing the necessary formalities for that entity.
It also is not a bad time to review your partnership agreement to make sure that it is structured in a manner so as to maximize your opportunity for valuation discounts, and that restrictions on transfer of the limited partnership do not involve violations of Chapter 14 of the code. If there are problems, there still may be time to amend or restructure the agreement to minimize or eliminate the risk.
(Michael McEvoy is a partner in the law firm of Harter, Secrest & Emery, where he concentrates his practice on tax matters. His partner, Thomas Solberg, assisted with this article. The firm’s tax home page is at www.hsetax.com.)

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