A Brief History Lesson

If the IRS does not like FLPs-and it does not-it has no one to blame but itself. The agency invented the "FLP era" in 1993 when it issued Revenue Ruling 93-12, which ruled that minority discounts could be appropriate even for interests in a family controlled entity. Not surprisingly, taxpayers and their advisors scooped up Revenue Ruling 93-12 and ran with it as far and fast as they could. Taxpayers contributed property to FLPs, then gave away, sold or otherwise transferred the FLP interests, often claiming discounts of 35%, 45% or even 55% or more.
The IRS responded initially by attacking the concept of discounts. However, it was not on solid footing because, almost inherently, a minority interest in an FLP lacks both liquidity and control. In these early cases, the IRS took a repeated body slam to the mat.

In recent years, however, the IRS has started attacking FLPs with different theories, particularly its favorite weapon, Code Section 2036-the brass knuckles in the IRS' arsenal. The IRS developed two distinct arguments under this provision. First, it argued successfully in several cases that FLP assets were properly included in a decedent's estate because, while the ownership of the assets had been transferred to the FLP, the original owner retained the enjoyment of the assets, either directly or through the tacit cooperation of the family. In effect, if mom and dad gave ownership of an FLP to the children, but then continued to use the partnership assets and to receive all the income from the partnership, the property could be included in the estate.

The second IRS argument, successfully asserted in an instantly infamous case called Estate of Strangi v. Commissioner, was that if a transferor of assets retained the ability to control distributions from the FLP (for example, by directly or indirectly controlling the general partner managing the FLP), then the FLP assets could be included in the transferor's estate. This is a far broader and more controversial interpretation of the law than earlier cases.

Taxpayers and their advisors are nervous about the Strangi case, but so far it is the only case on this point. Further litigation is all but certain.

Withstanding An IRS Half Nelson

An FLP is formed under the limited partnership statute of a particular state. People might choose a state for a variety of factors, but they often pick Delaware because it is very favorable on a number of legal issues. However, if asset protection is a principal objective of the FLP, look for a state (such as Florida) that makes a "charging order" the exclusive remedy for a creditor of a partner. (A charging order gives a creditor certain economic rights, notably the right to receive the partner's share of any partnership distributions, but the creditor does not take legal possession of the partnership interest or become a partner in the partnership.)

An FLP is comprised of one or more limited partners who have no right to participate in the management and at least one general partner who has all management power and authority. Structuring the entity that will act as general partner is an interesting and complicated issue, especially after the Strangi case, because many senior family members who are willing to put assets in an FLP and give away the interests nevertheless want to retain control over the assets (and thus the children).

n general, it is considered bad form to have a property transferor retain direct ownership or control over the general partner (which is often an LLC). A "middle" strategy is to make the general partner of the FLP a single-member LLC owned by an irrevocable trust. The transferor can be a trustee of this trust. The argument is that the fiduciary duties imposed on the senior family member as a trustee may help mitigate the IRS's argument that control has been retained. There is case law that may help support this position. However, a more conservative position (and the one we recommend) would be for the trustee to be someone other than the senior family member/transferor. This family member could then be given the right to remove the trustee and appoint an "independent trustee," to allow for at least some degree of retained control over the trust.

A key issue in structuring an FLP is to identify (and document) the nontax purposes for forming the partnership. Recent case law indicates that there must be a "significant and legitimate nontax purpose" in order for the partnership to be respected (and for the discounts to be permitted). (Some of these common non-tax purposes have already been mentioned.)