Key Administrative Practices
Ideally,
the family office should be involved from the inception of the FLP to
become familiar with its structure and how it should be operated. The
attorneys responsible for forming the FLP generally run the show during
formation, but the family office can help by doing the following:
1.
Facilitate discussions among family members and trustees who will be
involved in the FLP to discuss valid, non-tax related business
purposes. For instance, some family members may want to pool assets to
invest in a hedge fund or private equity fund.
2. Ensure that not
only the parents, but also junior family members (or trusts created for
their benefit) participate in the creation of the FLP and have an
opportunity to contribute their own assets, as opposed to assets that
have been recently gifted to them for the purpose of contribution to
the FLP.
3. Encourage clients to consider the long-term financial
and interpersonal implications of FLP planning. The FLP will probably
be kept in place well after the death of the matriarch or patriarch, so
clients should consider whether they are able to tie up these assets
for a period of years.
4. Facilitate negotiations among the various
partners on the terms of the partnership agreement and act as a liaison
between family members and their respective counsel.
5. Offer to
serve as the general partner or the manager (in the case of an LLC) of
the FLP. This makes it far more difficult for the IRS to argue that a
deceased general partner maintained control over the assets prior to
his or her death and that the assets should be put back into the
deceased general partner's estate at full value.
6. Ensure all of
the partners have properly executed the formation documents and
transferred their individual assets into the partnership accounts or
into the name of the FLP. A common defect of many FLPs is the failure
of the parties to properly transfer assets.
7. Ensure that FLP accounts have been opened in a timely manner and that a tax identification number has been obtained.
8. Ensure that the partnership tax "diversification" rules are not violated in connection with the formation of the FLP.
9.
Communicate with counsel and the various partners to create protocols
that will be necessary to properly administer the FLP on a day-to-day
basis and ensure that these protocols are understood and strictly
followed.
Limiting The 'Bad Facts'
Once the FLP has been
formed, the family office can add enormous value to the legitimacy of
the entity by paying attention to and complying with its protocols. It
is, for example, important to maximize "good facts" and minimize "bad
facts" in FLP administration. This refers to the unofficial rubric that
the IRS typically uses to determine whether the FLP should be respected
or disregarded as a tax avoidance structure. The IRS will make a
decision based on whether the formalities of the FLP were respected and
whether the partners treated the FLP as an operating business between
non-related third parties. Building a record of the FLP's activities
can go a long way toward improving the credibility of the FLP in an IRS
audit.
The harsh reality is that there are likely many FLPs that have been neglected by their partners and are "time bombs" waiting to explode upon the death of the matriarch or patriarch. "Bad facts" FLPs are not in short supply. The typical IRS agent is investigating numerous flawed entities at any given time. Ongoing administration by a family office, however, can improve the appearance of an FLP so its facts are much stronger than other FLP cases lying on the IRS agent's desk. This should give the FLP credibility and strengthen its case in the event of an audit.
What follows are ways family offices can maximize good facts and minimize bad facts in FLP administration:
1.
Respect the formalities of the FLP's partnership agreement. Prepare a
list of the administrative requirements under the partnership agreement
(e.g., requirement to provide annual financial statements to all
partners, notice and consent requirements with respect to transfer of
partnership interests, etc.) and make sure the list is followed.
2.
Hold routine partnership meetings to review investment performance and
make investment decisions. Prepare and maintain minutes documenting the
discussions to memorialize any decisions.
3. Change the investment makeup of the FLP after contribution of assets.
4.
Confirm that assets have been properly contributed to the FLP promptly
upon formation before any transfers of partnership interests.
5.
Maintain FLP stationery for the partnership. Memos or correspondence
on such stationery should document any partnership decisions.
6. Do
not allow family members to contribute all or even most of their assets
to the FLP. Instead, instruct family members to maintain, in their own
names, a significant amount of assets outside of the FLP. The family
members should not look to the FLP to make distributions for their own
financial support.
7. Do not allow the FLP to make distributions
that are not pro rata to all partners. No family member should
continue to receive income or other distributions from the FLP unless
all of the other partners are receiving similar pro rata distributions.
8.
Do not allow family members to treat the FLP assets as if they are
their own. The family office should ensure that estate taxes resulting
from the death of a partner are not paid out of FLP assets. Tax court
has made examples of owners of FLPs that were essentially the alter ego
of the taxpayer.
9. Do not allow family members to contribute
personal residences to the FLP. If this is unavoidable, occupying
partners should at minimum pay fair market rent to the FLP for their
occupancy.
10. Do not allow the commingling of partnership assets with other independent assets of any partner.
An FLP that is properly administered and has few bad facts-the typical FLP will always have some bad facts-will have a much greater chance of withstanding IRS scrutiny. Indeed, in a recent tax court case the taxpayers prevailed over an attempt by the IRS to undo an FLP, despite a significant number of bad facts. In upholding the FLP, the court noted that the parties intended to treat the partnership as a collective investment vehicle in order to provide a means for the management of the family's assets, the taxpayer maintained significant assets outside of the FLP, the partners held partnership meetings in which they discussed investments and the partners maintained the partnership after the taxpayer's death.
To the extent that it can properly administer an FLP and limit bad facts, the family office can play a large role in determining whether an FLP can withstand an IRS challenge. In short, the FLP structure and the family office are a perfect union. With little additional effort and expense, family offices can ensure that the benefits of this powerful estate planning tool are preserved, thereby adding tremendous value to their representation of wealthy families.
Edward
A. Renn and N. Todd Angkatavanich are partners of Withers Bergman LLP,
an international private client law firm with several offices
worldwide. They practice out of the firm's Greenwich and New Haven,
Conn., and New York offices. The authors would like to thank Hallie
Aronson, an associate at Withers Bergman LLP, for her valuable
contribution to this article.