Beware of FLP traps.

• Author: Hollingsworth, Danny P.
• Position: Family limited partnerships; taxation

Think the answer to a client's needs is a family limited partnership? Fine, but be aware that the IRS may be on the warpath, challenging entity formation, business purpose, income allocations, distributions and estate tax valuation. This article explains the IRS attacks in these areas and offers planning guidance.

Recently, the IRS has taken a dim view of using family limited partnerships (FLPs) for tax avoidance, especially in death-bed planning situations.(1) In addition, the Treasury has promulgated anti-abuse regulations in the partnership area that give the IRS additional authority to scrutinize FLPs. When these government initiatives are combined with relatively long-standing tax law restrictions, a host of tax traps arise.

FLPs have become a popular business planning strategy for tax advisers, due to the available income and estate tax savings. FLPs have been used to shift income and property appreciation to younger family members, thereby minimizing both income and estate taxes. With maximum individual income tax rates nearing 40% and estate tax rates as high as 55% (with a 5% surtax on estates over $10 million), an enormous amount of tax can potentially be saved by using a FLP.

In addition to tax savings, FLPs provide several nontax benefits. Often, a wealthy taxpayer who owns all (or substantially all) of a family business wants to keep its assets in the family. Such a taxpayer usually wants to control the business, but transfer a portion of it to a spouse and/or children. A partnership can be used to restrict the transfer of interests in the business to ensure continued management by the family. Moreover, the taxpayer typically wants a business form that limits individual liability and protects business assets from creditors of individual partners. Although the Revised Uniform Limited Partnership Act (RULPA) provides that a creditor can obtain a court order charging a limited partner's interest for unsatisfied claims, such a creditor can obtain only the rights of an assignee.(2) The assignee will be subject to tax on the partner's allocable share of partnership income, even if no partnership distributions are made.(3)

This article focuses on these traps and offers guidance in the areas of FLP formation, business purpose, income allocation, current distributions and estate tax valuation.

Formation

Forming a partnership can be relatively simple or extremely complex, depending on the property contributed, the parties involved and the provisions (e.g., income allocations) included in the partnership agreement. Typically, a partnership agreement consistent with the Revised Uniform Partnership Act or RULPA adopted by the resident state of the partnership is drafted; such an agreement identifies the partners' rights, duties and responsibilities.

A FLP is typically comprised of (1) a general partner (a corporation or limited liability company owned by an older taxpayer) and (2) limited partners (the older taxpayer and perhaps, a spouse and/or children).

Example: F, age 58, owns a working ranch that generates $500,000 in annual income and is worth $6,000,000. F and his wife, W, have two sons and a daughter. After exemptions and deductions, F's and W's joint income tax liability is $160,000. If F forms a FLP and gifts limited partnership interests to his three children (thereby allocating to them a portion of the ranch's income), considerable income tax savings may be realized. In addition, on F's and W's deaths, the appreciation in the limited partnership interests held by the children would escape estate tax.

Although F's plan of forming a limited partnership should work, there are some traps to consider.

Gift vs. Purchase of a Partnership Interest

The method of acquiring a partnership interest is important, especially when family members are involved. In gift or bargain purchase situations involving family members, there is a risk that the transfer will not be recognized for income tax purposes, or that no partnership will be deemed to exist.

If the partnership is one in which capital (as opposed to services) is a material income-producing factor, Sec. 704(e)(1) provides that an individual is a partner as long as he actually owns a capital interest, regardless of whether the transfer was by gift or purchase. Thus, the method (gift vs. purchase) of acquiring a partnership interest is irrelevant for family members under Sec. 704(e). Prior to enactment of that provision, the validity of a partnership interest was determined by judicial doctrines, such as assignment-of-income and business purpose.

For example, in Culbertson,(4) the taxpayer had operated a cattle partnership; his partner wanted to dissolve the partnership because of ill health. All but 1,500 head of cattle were sold. The taxpayer wanted to keep these cattle and approached his partner about buying his share. The partner agreed, but only if the taxpayer would sell an undivided one-half interest to his four sons at the same price. The partner wanted to maintain a particular cattle strain and felt that the taxpayer was too old to carry on the business alone. The taxpayer's sons provided him with a promissory note and a partnership was created.

Parties' intent: The IRS argued that no partnership had been formed, because the taxpayer's sons did not contribute original capital or services for their partnership interests. The Tax Court had agreed with the IRS, but the Fifth Circuit had reversed, holding that a family partnership created with no intention of tax avoidance should be recognized for tax purposes, regardless of whether it was intended that some of the partners contribute either capital or services during the tax year. The Supreme Court, reversing and remanding, stated that the question is whether the parties acted in good faith and with a business purpose to join together in the present conduct of the enterprise.

If Sec. 704(e) does not apply (i.e., capital is not a material income-producing factor), the principles established in Culbertson still apply. However, as can be seen from that case, such principles are more subjective than Sec. 704(e). Determining whether a partner actually owns a capital interest under Sec. 704(e) is also somewhat subjective.

Retained control: A key element in determining whether a partnership interest has been transferred is whether the transferor has...