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Practically IRS proof: preserving the tax benefits of family limited partnerships. (Planning).

Article Excerpt
A family limited partnership can reduce or eliminate a client's estate taxes, especially when combined with defective income trusts and gifts. The estate and gift tax benefits of FLPs have most recently been confirmed in Charles T. McCord Jr. [120 TC 13 (decided May 13, 2003)] where the Tax Court again recognized minority and lack of marketability discounts for gifted FLP interests.

Recent IRS actions on FLPs have only been successful when the partnership fails to follow certain basic tax rules. Accordingly, clients should verify that their partnership agreement and partnership operations comply with tax rules as discussed in recent court decisions.

These guidelines will help keep your FLPs IRS-proof.

1. Clients should not retain the economic benefits of the gifted or sold FLP interest.

If the client retains the economic benefit of the property transferred to the FLP, the IRS will attempt to include that property in the client's taxable estate under Subsection 2036(a)(1).

In the recent Strangi case, [TC Memo 2003-45 rem'd by 293 F. 3d 279 (5th Cir. 2002)] the IRS was successful with this Sec. 2036 argument where the FLP paid the decedent's personal expenses and made disproportionate partnership distributions. The IRS also has been successful in making this argument in Reichardt, 114 TC 144 (2000); Harper, TC Memo 2002-121; and Thompson, TC Memo 2002-246, where the FLP's partnership formalities were not observed.

To avoid this adverse tax result, the FLP should make distributions each year to the partners in proportion to their percentage interests, and should not make preferential distributions to the client. It is also advisable to show that the client is not the sole beneficiary or distributee of the FLP's assets. Rather, other family members should become substantial partners by way of gifts, sales of partnership interests, or by investing their own capital in the FLP. Furthermore, clients should not co-mingle their personal assets with the FLP's assets, and no FLP monies or assets should be used to pay the client's personal expenses. Finally, no personal residence of the client should be owned by the FLP.

2. Do not allow FLP to pay the client's estate's expenses or estate taxes.

If the FLP...