Failure to Follow Family Partnership Formalities May Negate Tax Benefits
Family limited partnerships ("FLPs") and family limited liability companies ("LLCs") are an effective estate planning tool. Here's how they work: You form either an FLP or an LLC and contribute real estate or marketable securities to it in exchange for FLP/LLC interests. You also enter into a partnership or an operating agreement which places substantial restrictions on your ability to transfer your FLP/LLC interests and to manage the FLP/LLC. These substantial restrictions plus the general lack of a market for the FLP/LLC interests can give rise to valuation discounts on the FLP/LLC interests retained by you, as well as on the FLP/LLC interests you give to, for example, your children.
The IRS has, however, successfully argued in certain instances that all of the assets transferred to an FLP/LLC are included in the transferor's estate (and without any valuation discounts) even though part of those interests have been transferred to children or others. The IRS position applies Section 2036 of the Internal Revenue Code, which provides that assets transferred during your lifetime are included in your estate if you retain the right to continue to possess or enjoy the transferred asset.
In determining whether you have retained the right to possess or enjoy the transferred assets, the IRS looks for evidence that you continued to treat the FLP/LLC assets as your own. For example:
- Did you commingle personal assets with FLP/LLC assets?
- Were FLP/LLC assets and earnings used to satisfy your personal debts and expenses?
- Were there any irregularities in the formal transfer of title of assets from you to the FLP/LLC?
- Were almost all of your personal assets transferred to the FLP/LLC (implying that you will need to look to the transferred assets to maintain your standard of living)?
- Were disproportionate distributions made to you?
The IRS attacks on FLP/LLC transfers make it critical to observe partnership/LLC formalities. The FLP/LLC should maintain separate accounts and keep good books and records. All distributions should be made at the same time to all participants, and in exact proportion to their interests. Personal expenses should not be paid directly by the FLP/LLC. And you should retain sufficient assets outside the FLP/LLC to sustain your lifestyle. Personal assets (cars, personal residence, etc.) have no place in such an entity. If these guidelines are not followed, you may lose all of the gift and estate tax benefits you hoped to obtain in creating the FLP/LLC.
If you have created an FLP/LLC for estate planning purposes, check with your attorney for ongoing guidance in following all of these rules.