As previously discussed in this column, creating and funding a family limited partnership or limited liability company (both types are referred to herein as an “FLP”) may well result in substantial estate gift tax savings. Recent cases involving FLPs have provided fresh guidance as to the “do's” and “don'ts” of forming and operating such entities. For years, courts have upheld the validity of properly structured and funded FLPs and have ruled that, because of lack of control and marketability, discounts can be taken when valuing non-controlling interests in FLPs for estate and gift tax purposes. The greater the discount, the less there is to tax. Usually, the discounts range anywhere from 15 percent to 50 percent. The new cases have shown that to obtain such discounts, it is essential that the formalities of the creation, as well as the funding and operation of an FLP be respected. What the courts have made clear is that a person may not simply establish an FLP and then be done with it or, worse, manage the FLP in a manner that allows the person funding it unfettered access to the FLP's income or its assets. When examining estates with FLPs, the IRS will generally investigate all the circumstances surrounding the formation of the FLP, as well as how it was run to determine which valuation discount, if any, is warranted. The more rules you follow, the greater the likelihood that a substantial discount will be allowed by the IRS (or, absent an agreement with the IRS, by the court).
Recent court cases, as well as audits in which attorneys at our firm have represented clients have revealed a clear list of both “do's” and “don'ts.”
Do establish valid, supportable reasons for establishing the FLP — in addition to its tax savings. Non-tax purposes for creating an FLP include liability limitations (e.g., in real estate), protection from creditors (including ex-spouses), avoidance of ancillary probate (as to property located other than in one's home state), providing for the unified management of assets, and creating a relatively simple mechanism to use to make gifts to family members which really are undivided interests in property.
Do carefully respect the formalities of the FLP agreement. Read the agreement (or get a summary of the applicable provisions), do what it says is to be done and keep contemporaneous records showing that you did.
Do prepare and execute resolutions memorializing all significant FLP decisions, the election of officers and, if applicable, directors or managers.
Do maintain minutes of all meetings of the partners.
Do transfer assets to the FLP promptly after its formation, and in a legally valid manner.
Do make sure to transfer assets from its account to the FLP's account to pay for its interest in the FLP, if there is a corporate general partner or manager. And be certain that the corporate general partner or manager also complies with all applicable procedures.
Do establish and maintain FLP accounts and be sure that all receipts and disbursements of the FLP flow through them. Any income generated by assets transferred to the FLP (e.g., rents, dividends and interest from marketable securities and distributions from interests in closely-held businesses) must be deposited into the FLP's accounts and managed in accordance with the partnership agreement or operating agreement, as appropriate.
Do make sure all actions taken by the FLP are taken in the name of the FLP. If its general partner or manager takes action, the correct person or entity must take it.
Do make sure that all required consents to FLP actions and to transfers of FLP interests are obtained and properly memorialized.
On the other hand:
Don't contribute all or almost all of the client's assets to the FLP. Make sure to keep sufficient assets to live on, to pay projected expenses, and so forth. In no event should your client have to look to the FLP for support on a regular basis.
Don't make distributions from the FLP unless they are pro rata to all partners/managers.
Don't regularly distribute all or even substantially all of the FLP's income.
Don't treat the FLP as if it is the client's personal bank account; don't pay bills from the FLP's accounts; don't deposit income or non-FLP assets into the FLP's accounts.
Don't skip the FLP (e.g., don't pay income earned by any FLP asset directly to an owner of the FLP).
Don't forget to confirm the existence of all of the appropriate assets and property contributed to the FLP. In other words, carefully document when property or securities enter the FLP and make sure that proper assignment, documents and required consents have been duly executed. Be sure to keep copies.
Don't liquidate the FLP until long after any estate or gift tax audit period ends.
Don't permit any partner to utilize any FLP asset for personal use, unless a fair market value is properly paid to the FLP.
One can never guarantee what the IRS or a court will do. But we have seen that clients with “bad facts” (ones who did not follow these dos and don'ts) have had valuation discounts reduced to 10 percent — or totally disallowed, depending upon the facts of the case. For “good fact” FLPs, however, the results are usually far more favorable, varying according to the facts and the type of assets held by the FLP. For instance, an FLP holding only marketable securities may yield a discount of 15 percent to 35 percent, whereas an FLP holding an interest in income-producing real property or a minority interest in family business may achieve a discount of 30 percent to 50 percent, or even more.
There are also important do's and don'ts for advisors running money for FLPs:
Do have an investment allocation strategy responsive to the partnership purposes and reflective of partnership interests.
Don't allocate in a manner which appears to (or in fact, does) favor the creator of the partnership, for example by tilting toward income at the expense of growth.
Do get your investment goals and directions in writing from the proper partners (the partnership agreement will tell you who they are) and be certain your normal investment advisory contract is with the partnership, and not with the individual partners or the creator of the partnership.
Don't disrespect the lines of partnership authority, and do not follow what the creator alone says to do when it contradicts those with authority under the partnership agreement.
Remember, liability runs silent and runs deep.
Wrier's BIO: Roy M. Adams is a partner in Sonnenschein Nath & Rosenthal in New York, where he server as senior chairman of its trusts and estates practice group.