FLP audit triggers: Family limited partnerships raise red flags at IRS.

• Author: Allmon, Michael B.
• Position: Brief Article

The application of gift and estate tax laws to family limited partnerships is in many ways unclear, admits Charles Morris, IRS Western Estate and Gift Tax Territory Manager. Morris discussed the IRS perspective on FLPs at a recent Los Angeles Chapter Estate Planning Committee meeting.

A significant reason that the IRS is aggressively attacking the discounts claimed for interests in FLPs is the lack of consistency. Morris questions the fairness of dramatically different tax results among taxpayers who retain similar benefits from like assets based upon the method of holding those assets.

Further, there is an issue of consistency from region to region in the audit of PLP transfers. As a result, the IRS will aggressively review the claims for discounts for transfers of FLP interests so that the rules can become clear and can be applied consistently

Red Flags

Morris cited three red flags that trigger audits of family limited partnerships:

* An FLP lacking a valid planning purpose.

* A managing partner directly benefiting from assets placed in the FLP.

* Overly generous discounts.

Tax Court Decisions

Morris reviewed significant Tax Court decisions that provide guidance on FLPs.

Valid Purpose

Murphy v. Comr--This case established that an FLP must have a purpose other than tax avoidance. If it exists just to avoid estate taxes, the FLP will be disregarded for estate tax purposes.

Watch Those Controlling Interests

Strangi et al v. Comr--A family member with power of attorney set up an FLP for his invalid father-in-law (Strangi). The FLP was funded with cash and securities. The family corporation was the general partner of the FLP and the son-in-law effectively ran both entities. Within two months, Strangi died.

The IRS stated that there was no business purpose and therefore the FLP should be disregarded. However, the court noted that the FLP's formation had strictly followed Texas state law for FLPs. So it had to be accepted as such.

The IRS further argued that the formation of the FLP resulted in a gift based on a comparison of the value of the assets placed in the FLP and the value of the FLP interest received. The court held that no gift was made.

The court noted the IRS arguments that Strangi effectively retained control of, and benefit from, the property he contributed to the FLP. Under IRC Sec. 2036, such an arrangement might result in inclusion of all the assets in the taxpayer's estate as a retained interest. But since the IRS did not argue...