FLiPs Flop in Court
â€œBut, theyâ€™re all that way!â€ exclaimed a major law firmâ€™s lead estate planning attorney. â€œIf so, youâ€™d better hope that your clients donâ€™t get audited,â€ I replied.
This exchange happened just months ago while discussing the significance of two mid-2002 Tax Court decisions. The Court ignored the existence of two family limited partnerships (FLPs, but sometimes pronounced â€œFLiPsâ€) and taxed their assets in the creatorsâ€™ estates. The attorney was flipping out.
FLPs came into vogue in the early to mid-1990s after Congress outlawed the sexier, more potent partnership freeze technique. After initial skepticism in the typically avant-garde estate planning community, FLPs quickly became the rage. I actually overhear people discussing them in cocktail parties! Given their popularity and these recent cases, the attorney anticipates an estate tax disaster of unprecedented proportions.
A Quick Primer
Just in case youâ€™ve spent the past decade in Siberia, here is how a typical FLP works. A senior generation family member who weâ€™ll call â€œDadâ€ creates and funds a partnership, receiving a 1% general partnership (GP) interest and a 99% limited partnership (LP) interest. Dad then gives the LP interest to the kids.
The LP interest lacks marketability and control. So, its gift tax value is reduced by a substantial discount, typically 30% - 50% of the underlying assets value. As GP, Dad controls the partnershipâ€™s investment activities. Plus, Dad determines whether and when cash is distributed to the partners (aka the kids), which typically is an estate planning no-no. No wonder the IRS hates this estate planning nirvana.
It often takes about 10 years for IRS to identify an alleged abuse, challenge it, and get test cases through the judicial system. So, the results of its vigilant efforts have become evident only over the last few years. Upon discovering an FLP, an agent issues a thick report asserting numerous legal theories, alleging dastardly acts and seeking restitution of gazillions of dollars of unpaid gift and estate taxes.
Despite the initial bluster, I am aware of hundreds of FLP challenges where Dads (and Moms) settled these disputes without going to court by conceding to a modest reduction of the valuation discount. Why?
The Facts Rule
The law simply does not support the IRSâ€™ legal theories. A handful of cases have proven that point because taxpayers have soundly defeated the IRS in virtually all of them based on the law. However, the taxpayers in the recent and a few earlier cases lost on the â€œfacts.â€ The odd thing is that taxpayers can control their facts, so these families did not have to lose.
My lawyer friend was agonizing because she only controls an FLPâ€™s formation, which is relevant to most of the IRSâ€™ legal challenges. Unfortunately, after clients leave her office to celebrate their estate planning cunning, they proceed to mess up their FLPsâ€™ operations. Those operations are highly relevant to the factual issues upon which the IRS has been successful.
The law assesses an estate tax on the date-of-death value of any property that you give away during life if you retain the right to the income from or the use of the property. Obviously, a legally binding document stating that you retained that right would cement the IRSâ€™ case, but most advisors are clever enough not to create such a smoking gun. Given that reality, the law says that retention can be implied and is determined based upon the facts and circumstances. So, when Dad dies, the IRS looks for facts that suggest he retained the prohibited right to income or use of the property.
In one case, Mr. Thompson and his kids set up an FLP through an insurance agent who marketed the technique using glossy literature that called it a â€œFortress Plan.â€ (By the way, glossy sales literature extolling tax savings and a clever name do not tend to get you off on the right foot with either the IRS or a judge. The technique might be valid, but please steer clear of the glitz.)
The children received the 1% GP interest and a portion of the LP interest for the assets they contributed. Mr. Thompson received the balance of the LP interest for his contributed assets. Note the role reversal from the typical FLP described above. Mr. Thompson was over 90 years old, so I suppose control was not too important to him. Apparently, the plan was for him to give away his LP interest over time at discounted values. If he died before giving it all away, his estate could claim a discount on the balance since his kids controlled the partnership. Indeed, he died owning part of the LP interest.
So, why did the judge huff and puff and blow down Mr. Thompsonâ€™s Fortress Plan?
Mr. Thompson contributed virtually all of his assets to the FLP, retaining almost nothing to live on. (Well, duh! That would certainly imply some understanding with his kids that he could get money whenever he needed it!)
When he actually needed money, the FLP magically gave it to him, totally ignoring the partnership agreement distribution provisions.
The IRS discovered letters written by the kids to various advisors asking how Dad could get money to make Christmas gifts. (You guessed it, the partnership distributed money to Dad for that purpose.)
When the kids needed money, the FLP loaned it to them, just as Mr. Thompson had done before the FLP was created.
One kid contributed a â€œranchâ€ and the other contributed a personal residence. They each continued to use them much as they had before the FLP was created. The court concluded that the family members did not really come together as partners; they kept on using their assets just as before the FLP.
So, the judge concluded that Mr. Thompson transferred his assets, but retained the right to the income and use. The result was that all of the assets he had contributed to the FLP were taxed in his estate.
So, we are now all on notice of what we advisors already knew. If you set up an FLP, or any other estate planning structure for that matter, and you do not â€œrespectâ€ their integrity, disaster can and will occur.
Stay tuned for practical guidance concerning the dos and donâ€™ts of the operation of your FLP, trusts and other commonly used estate planning entities.
Ross Nager is Senior Managing Director and Principal
Sentinel Trust Co. LBA, Houston, TX