Wrestle Mania

The following are some further ideas for structuring an FLP to better withstand IRS challenge: (i) Include assets other than marketable securities, particularly real estate or closely held business entities (but note that if S corporation stock is contributed, the S election is terminated because partnerships are not eligible shareholders of S corporations); (ii) Pool the assets of family members other than the senior family member/transferor; and (iii) Maintain sufficient assets outside of the FLP to provide for the daily living expenses of the senior family member/transferor and enough to pay estate taxes following his or her death.

How to Administer an FLP

The IRS has been particularly successful in "taking down" FLPs when the senior family members signed documents transferring FLP interests to children but then went back to "business as usual," with the transferor effectively controlling the partnership and enjoying the benefit of the assets. The key is to operate the FLP in a manner that demonstrates a serious intention to pursue the business purposes identified in the partnership agreement. Regular meetings should be held, distributions should be made in strict conformity with the partnership interests, and far more than lip service should be paid to the intent and spirit of the agreement. Probably the single biggest weakness that the IRS picks on is not the technical structure of the FLP but the actual administration by the family members.

Finding A Victory In The Ring

FLPs can also be combined with other successful estate planning strategies, and the valuation discounts applicable to FLPs can significantly increase the effectiveness of these strategies. For example, interests can be contributed to a grantor retained annuity trust ("GRAT"). Basically, a GRAT is established for a period of years (say five), and during that period the GRAT must pay back to the grantor/creator of the trust a predetermined annuity amount. Any appreciation in the GRAT assets above a statutorily determined interest rate (the so-called "7520 rate") can be passed on to the beneficiaries (such as the children of the grantor) without triggering any gift or estate tax. The 7520 rate for April 2008 is 3.4%, which is extremely low by historical standards.

Another sophisticated alternative is to use FLP interests in connection with an installment sale to an intentionally defective grantor trust (IDGT). FLP interests may be eligible for discounts, and the use of the IDGT may allow a substantial wealth transfer for estate and gift tax purposes. However, because the trust is a type of trust referred to as a "grantor trust," the sale would not be recognized for income tax purposes, and therefore there would be no current income tax consequences on the "sale." The advantages of this technique include the following:

1. The partnership interests may be correctly and fairly valued at a discount to the underlying partnership property.
2. The interest rate that must be charged (the so-called "applicable federal rate") is generally lower than the 7520 rate, allowing enhanced ability to transfer value to successor generations.
3. The "purchase" of the FLP interest has the effect of freezing the value, and any future appreciation above the applicable federal rate will pass to the IDGT and its beneficiaries free of estate and gift taxes.

The more detailed requirements for structuring a GRAT or IDGT are beyond the scope of this article, but the point is that the ability to conveniently fragment and transfer property ownership through FLP interests creates many kinds of planning opportunities, and the potential availability of valuation discounts may significantly enhance the effectiveness of those strategies.

The IRS clearly has antipathy toward FLPs, and when it looks at one, it sees a red flag, a smoking gun, and an obnoxious Yankees fan, all rolled into one. In short, anytime you combine the letters I-R-S and F-L-P in the same sentence, the result is likely to be anything but D-U-L-L.