Avoid FLiP Flops:: Focus on the FLiPing Facts!
Last month, I promised practical guidance to keep the IRS from blowing up your family limited partnership (FLiP or FLP) and other estate planning entities.
Several taxpayers have needlessly lost family limited partnership cases. They blew facts that were under their control, so their FLPs assets were taxed in the senior generation's estates. You can avoid their fate if you'll focus on your unique facts.
The law says that an asset is taxed in your estate if you (a) transfer it for less than full consideration and (b) retain the right to the income from or the use of the asset. Typically, there is little doubt that whatever you transfer, the kids get it for less than full value. But, what asset is at issue in (b)?
These taxpayers gave partnership interests to their kids and did not retain either the income from or the use of those interests. The IRS successfully argued in the court cases that the partnership entity should be ignored and the law should be applied as if the parents transferred the partnership assets and retained the prohibited income and use rights in them. Depending upon the facts, the IRS can make and win a similar argument based upon the judicial doctrine of substance over form.
I have long said, If you don t respect your entities, the IRS won't either. So, how can you gain respect for your FLP?
My suggestions below are couched in FLP terms, but the concepts also are relevant to trusts and other structures that are used in estate planning. Observing these suggestions in your family business activities also can reduce tax risks associated with it.
Here are ways to control your facts and dramatically increase the odds that your FLP will accomplish the desired gift and estate tax reduction.
Upon creation, observe the formalities that you would observe if you were entering into a partnership with an unrelated person. Open checking and other appropriate accounts in the partnership's name and have all partners promptly transfer the agreed assets to those accounts. Make sure that all FLP assets are properly titled in the partnership's name.
Family members and advisors discussions and documentation preceding the FLP's creation should focus on the business, investment and cashflow implications rather than on tax savings potential. If the IRS or a judge believes (correctly or incorrectly) that your primary motivation is ripping off the fisc, your odds of success go down dramatically. Documentation and family member testimony concerning the reasons for the FLP and the rights of the parties can be extremely damaging or highly beneficial. I'm not suggesting that people lie about motivations. Tax savings are ok; they simply should not be the primary drivers and, therefore, should not be the primary topic of discussions or documentation at any time.
Do not put all of your assets in the FLP. Doing so may imply an understanding with the kids that you can access FLP funds when needed. Keep a reasonable amount for your and your spouse's support and maintenance. Only put excess assets into the FLP.
Do not have formal or informal understandings with the kids that the partnership assets are really yours to use whenever and however you want. Avoid written documents and oral discussions that might in any way be interpreted to suggest that any partner has rights to partnership funds or other assets. A partner only owns a partnership interest, with rights only as granted under the partnership agreement. A partner does not own or have the right to use partnership assets.
Avoid putting any personal use property (e.g., personal residences, vacation homes, art work, etc.) in an FLP. It can create an implication that the contributing partner retained use rights. Even some personal use property can taint the other business and investment property that you contribute. A partnership is a business or investment entity and partners typically pool their interests in contributed assets. Personal property, especially if it continues to be used by the contributing partner, is inconsistent with normal partnership concepts. If you insist on contributing personal use property, the FLP should charge arms-length rent for your use of it.
Create and maintain a formal set of books and records for the FLP. Keep these records current. Do not wait until after yearend or when an IRS agent comes knocking on your door.
Hold and document annual and other meetings that are required by the governing agreement.
Deposit FLP revenues in partnership accounts and do not pay partners personal expenses from FLP accounts.
Do not commingle FLP assets with those of other family members or entities.
Avoid the use of so-called open or draw accounts. Make distributions to partners only as provided in the partnership agreement (e.g., proportionately to all partners based upon their sharing percentages). Don't tailor distributions to the exact amounts or timing of partners needs. If the partnership agreement specifies conditions under which distributions may be made, make sure that the conditions are met before making the distributions. Document decisions and actions accordingly.
Try to avoid having the FLP make loans to the partners. If loans are necessary, document them with formal promissory notes.
Respect and comply with the management and voting provisions in the partnership agreement.
FLP agreements often restrict transfers of partnership interests and require approvals before transfers occur. Be sure to comply with these provisions if a transfer is planned or occurs.
Try to fix any violations as soon as possible and avoid future violations. Fixes can include loan documentation and repayments, truing up disparities between actual distributions and those permitted by the governing documents, updating the books, etc.
If you are contemplating creating an FLP, think ahead about whether you can comply with these suggestions. If not, you probably should change the planned structure and/or asset composition.
You can avoid being the Rodney Dangerfield of estate planning. But, you must respect your entities and control your facts.
Ross Nager is Senior Managing Director and Principal, Sentinel Trust Company, Houston, TX,
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