Flip-Flopping on FLPs

Unraveling the IRS's stance on family limited partnerships (FLPs) is harder than tracking the marital status of Britney Spears. In 2003, the tax court disallowed an FLP created by one Albert Strangi only a couple of months before his own death a ruling that sent estate planners scurrying from FLPs. Then in May 2004, the revenuers blessed the intentions of one Ruth Beyer, and the technique was back

Unraveling the IRS's stance on family limited partnerships (FLPs) is harder than tracking the marital status of Britney Spears.

In 2003, the tax court disallowed an FLP created by one Albert Strangi only a couple of months before his own death — a ruling that sent estate planners scurrying from FLPs. Then in May 2004, the revenuers blessed the intentions of one Ruth Beyer, and the technique was back in favor. Then, last fall, the Third Circuit Court poked a bunch of holes into the FLP efforts of the late Theodore Thompson, sending high-net-worth clients and their advisors running for the Prozac once again.

Positive or negative, each decision has presented some clues advisors can use to help the wealthier members of a book design a family limited partnership that will cut taxes, maintain some flexibility and still skate through an IRS review without a hitch.

It might take some effort, but FLPs are still worth the trouble.

The Case in Favor

In the right situation, the FLP is unrivaled among estate-planning strategies. No other tactic provides a tax reduction at such low cost yet still gives owners some of the control needed to face business, personal and tax-law uncertainties.

Don't tell the government, but one of the reasons many people choose to set up FLPs is to transfer assets without incurring big gift- or estate-tax bills. The benefit of these structures is that because the shares are illiquid, they qualify for valuation discounts — anywhere from 10 percent to 50 percent, depending on the type of asset.

As a result, the estate-tax savings can be astounding. Say you have an older couple with a business worth $5 million, and their descendants are three married adult children and six grandchildren. If the mom and dad die owning the business outright, the estate-tax bill could run into seven figures without stopping to take a breath.

But if they instead transfer the business to a family limited partnership and begin making annual gifts of shares in the FLP to their children and grandchildren, the parents should be able to pass more than $2 million in value to the next generation over a decade or so. The family will pay no gift taxes, as long as the shares gifted per person per year are valued under the excludable amount ($11,000 right now).

When the parents die, whatever partnership shares they still own can also be slashed in value — maybe even enough to limbo under the maximum amount that can be passed free from estate taxes ($1.5 million in 2004 and 2005).

But it's not just avoiding “death taxes.” The family's overall income tax bill can be cut, too. If the older generation takes any cash out of an asset they own outright, it's likely to be taxed at the maximum rate. But if income is instead distributed among all shareholders in the FLP, the receiving children and grandchildren are likely to be in lower brackets and pay much less in taxes on the distributions.

The P's and Q's of an FLP

Clients can avoid a negative IRS inquiry by having a well-written partnership agreement and then meticulously adhering to the terms of the document. Here are the rules:

It's strictly business.

The partnership must be created with a specific business purpose in mind. Running a farm? Great. Managing a store or factory? OK. But plopping the parents' home into an FLP and then letting the old folks continue to live there rent-free? Don't try it.

An ATM it ain't.

Don't allow your older clients to keep dipping back into the partnership for living expenses and support. Reserving enough liquid assets in their name will show the IRS that the FLP isn't just a stab at eliminating estate taxes.

Pay fair.

Keep cash distributions from the partnership spread proportionately among the shareholders. Mom and Dad shouldn't get the lion's share of any payouts unless they have the lion's share of the, um, shares.

Deathbeds are for dying…

…Not for transferring wealth. The sooner your clients begin the process of establishing an FLP, retitling ownership of their assets and gifting partnership shares, the more likely the procedures will stand up to scrutiny.

Keep it neat and clean.

Document all decisions and actions relating to the partnership assets and you'll have the necessary paperwork to prove your clients' noble objectives — not to mention avoiding the ignominy of having their names forever associated with a landmark tax ruling costing their fellow Americans millions in legal expenses and billions in back taxes.

Writer's BIO: Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. kevinmckinley.com

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