FLPs and the indirect gift trap.

• Author: Satchit, Vinu
• Position: Family limited partnerships

Over the years, the IRS has used various theories to attack family limited partnerships (FLPs); the courts have overwhelmingly rejected most of these. The taxpayer victories, however, have turned out to be a double-edged sword, because taxpayers and their advisers have gotten increasingly careless about following the proper creation and administration procedures for FLPs. This failure to respect the form of the transaction has led to IRS victories on many fronts, including the successful application of the indirect gift rule to asset transfers to a FLP.

Background

According to Regs. Sec. 25.2511-1(h)(1), a shareholder's property transfer (for less than full and adequate consideration) to a corporation is a gift by the taxpayer to the corporation's other shareholders, to the extent of their proportionate corporate interests. It is well established that the same principle can apply to transfers to partnerships made for less than full and adequate consideration. For contributions to partnerships in exchange for partnership interests, the courts have held that if the contributing partner's capital account is increased for the contributed property's fair market value (FMV), the transfer will be for full and adequate consideration, because the partner will be able to recoup such amounts if the partnership liquidates; see Est. of Jones II, 116 TC 121 (2001). Thus, to avoid the indirect gift rule, taxpayers must be able to prove that (1) the contributing partner received partnership interests in exchange for his or her contribution, (2) his or her capital account was credited for the transfers' FMV and (3) crediting of the capital account preceded the gifting of the partnership interests.

Shepard

Shepard, 283 F3d 1258 (11th Cir. 2002), aff'g 115 TC 336 (2000), was the first case to which the IRS successfully applied the indirect gift rule. In that case, the Eleventh Circuit affirmed the Tax Court's holding that transfers of land and stock to a partnership formed under Alabama law were indirect gifts to the taxpayer's sons, who were also partners. The taxpayer signed the FLP agreement on Aug. 1, 1991 and executed deeds transferring land to it on the same date. The sons, however, did not sign the partnership agreement until August 2; thus, under Alabama law, the partnership did not exist until then.

The Tax Court had reasoned that because the partnership was nonexistent under Alabama law when the land transfer took place, the transfer was not...