IRS continues to challenge family limited partnerships.

• Author: Schafer, Frances W.

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IRS Continues to Challenge Family Limited Partnerships

As the IRS continues to litigate family limited partnership (FLP) cases, it has formulated two broad-based arguments-one argument rooted in estate tax and one in gift tax--that the courts now routinely recognize to negate the estate planning benefits of FLPs. Whether the IRS will be successful in challenging a particular FLP structure depends upon the facts of the case.

IRS Strategies

For estate tax purposes, the IRS uses Sec. 2036 to pull assets transferred to an FLP back into a decedent's gross estate. Pursuant to Sec. 2036(a), a decedent's gross estate includes the value of any interest in property of which the decedent had made a transfer during life to the extent the decedent retained certain rights in that property unless the transfer is a bona fide sale for full and adequate consideration (the bona fide sale exception). If the IRS is successful in arguing the applicability of Sec. 2036, the asset transferred to the FLP will be valued for estate tax purposes as if it had never been transferred to the FLP.

For gift tax purposes, the IRS uses Sec. 2511 to argue that transfers to an FLP are indirect gifts when a taxpayer creates, funds, and transfers interests in an FLP in a relatively short period of time (e.g., all on the same day). Specifically, the IRS contends that Regs. Sec. 25.2511-1 (h)(1) provides that an indirect gift occurs on the transfer of assets to an entity (e.g., an FLP) in which the transferor does not receive a proportionate interest in the entity in return for the transfer. The difference between the value of the assets transferred and the value of the interest received results in a gift to the other members of the entity. If the IRS is successful in arguing that a transfer is an indirect gift, the asset transferred to the FLP is valued for gift tax purposes as if it had been transferred to the FLP after the interests in the FLP had been transferred.

Malkin

Estate of Malkin, decided September 16, 2009, illustrates the IRS's success with these two arguments. The decedent created two FLPs and four trusts. The decedent was the general partner of each FLP, and he and two of the trusts were the limited partners. The beneficiaries of the trusts were his two children. The decedent transferred family business stock to one FLP (FLP1) and family business stock as well as interests in four limited liability companies (LLCs) to the other FLP (FLP2).

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