IRS Challenges to FLPs

Substantiation and documentation are key.
BY NICHOLAS FIORE

s tools for saving estate and gift taxes and, at the same time, retaining family control over assets, family limited partnerships are extremely popular. These partnerships enable older family members to maintain control over property and provide them with estate and gift tax savings through the use of discounts and valuation adjustments when their interests in an FLP ultimately are transferred.

FLPs are subject to very strict and complicated rules. The IRS views many FLPs as shams and will challenge taxpayers that try to use them solely to avoid taxes.

FLP ISSUES

The taxpayer’s ability to discount the value of the underlying assets when FLP interests are transferred (either as gifts or as part of an estate) is the key to obtaining tax savings. In general, when property is transferred, its taxable value is determined based on its fair market value (FMV), which is the price a willing buyer and a willing seller would agree upon. However, making this determination for a privately owned partnership interest with no active market in which such an interest can be bought and sold (as opposed, for example, to a publicly traded company’s interest on a stock exchange) is more art than science and requires consideration of many factors.

This determination ultimately centers on control (or the lack thereof). If the individual receiving the FLP interest is a minority interest partner (and thus cannot control the FLP’s underlying assets), the person making the gift can claim that partnership interests transferred should be discounted, for tax purposes, to an amount less than the total value of the underlying assets, based on a lack of marketability and/or a lack of control. IRS challenges to the values claimed on transfers of FLP interests (and to the validity of the FLPs themselves) focus on:

Business purpose. The service initially may argue that the FLP is not bona fide. It will claim that the property rights transferred are interests not in a valid FLP but in the underlying assets and that the FLP does not have a valid business purpose. However, the courts have held that, if an FLP is properly created and operated under state law (that is, all steps necessary have been taken) and would be recognized for estate and gift tax purposes (even if its business purposes are not valid), it would have economic substance for transfer tax purposes.

Liquidation restrictions. Many FLP agreements include provisions restricting liquidations, which can lower the value of FLP interests. However, in certain instances, the estate or gift tax value of any FLP interest is determined without regard to “applicable restrictions” if the transferor and members of his or her family control the FLP immediately before and after the transfer. An applicable restriction is one that effectively limits the ability of the entity to liquidate and that lapses after a transfer. Limits imposed by state or federal law are not applicable restrictions.

Gift on formation. The IRS also will argue that a taxpayer made a gift of an FLP interest when the partnership was first formed. If, however, on formation of the FLP, no partner receives a benefit beyond his actual contribution (rather than pro rata), there was no gift made at that point.

Appropriateness of the specific discounts. Taxpayers claiming discounts on the transferred interests must properly determine and substantiate them. The valuation methods used should be supported by expert testimony.

For a discussion of FLPs and their role in estate, gift and generation-skipping transfer tax planning, see “Significant Recent Developments in Estate Planning (Parts I and II),” by Brian Whitlock and Jill McNamara, in the August and September issues of The Tax Adviser.

—Nicholas Fiore, editor
The Tax Adviser

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