For the past fifteen to twenty years or so, a popular business and estate planning technique has been the use of family limited partnerships (“FLIPS”) for the purpose of management of real estate and investment assets and the wealth from one generation to the next. For nearly as long, the IRS has tried a number of theories to attack the tax and financial planning benefits of FLIPS. Although the IRS has achieved some success in challenging the use of FLIPS under certain circumstances, for the most part, the attacks have been unsuccessful. A recent decision by the Fifth Circuit Court of Appeals further bolsters the position that a well-structured FLIP remains a very important business planning technique.
By way of background, a FLIP is simply a limited partnership created by family members. The family members contribute property, including stock, bonds, cash or real estate, and in return, receive partnership interests. The FLIP, just as a general partnership, is managed by the general partners. The limited partners are essentially passive investors with few, if any, management rights. Similar to general partnerships, the general partners of a limited partnership remain liable for the debts and liabilities of the partnership, unless the partnership is registered with the Missouri Secretary of State as a “Registered Limited Liability Limited Partnership.” This registration will afford limited liability to all of the limited partnership’s partners, including the general partners.
There are numerous tax and non-tax reasons for establishing FLIPS. These reasons include (i) establishing a method by which annual gifts may be made without dividing a particular asset, (ii) continuing the ownership and operation of family assets, (iii) restricting the right of non-family members to acquire interests in family assets, (iv) providing protection from creditors of family members and (v) providing flexibility and continuity of business planning.
The IRS has attacked the use of the FLIP as an estate planning technique on several grounds. The first involves use of the annual gift tax exclusion with respect to gifts of FLIP interests. Where the FLIP restricts the ability of limited partners to transfer their interests, the IRS argues that the individual who receives a limited partnership interest as an annual exclusion gift does not have the “immediate use, possession or enjoyment of the property”, an element required for a gift to be eligible for the annual exclusion exemption.
In addition, in the Hackl v. Comm (118 T.C. No. 14 (March 2002)) case, gifts of limited liability company interests were deemed to be taxable gifts because the members of the limited liability company in question could not (1) unilaterally withdraw their capital accounts, (2) independently effect a dissolution of the L.L.C., or (3) sell their interests without the consent of the manager. The Court also found the fact that the L.L.C. was not expected to produce immediate income, and that any income generated would only be distributed at the manager’s discretion, as further support for the proposition that the donors did not have the immediate use, possession or enjoyment of the property. This case is currently on appeal. However, until the case is reversed, review of FLIPS should be undertaken to ensure that gifts made of limited partnership interests or limited liability company interests qualify for the annual exclusion.
The second area in which the IRS has attacked FLIPS is through the use of IRC.§2036, to include the assets a decedent used to fund the FLIP in the decedent’s estate. The IRS has enjoyed some success in these cases. However, the cases in which the IRS has triumphed have involved bad facts. A recent Fifth Circuit Court of Appeals decision in Kimbell v. U.S., 2004 W.L. III 9598 (5th Cir. (Tex) May 20, 2004) calms some fears regarding the utility of FLIPS in light of the §2036 argument, as well as establishing helpful guidelines for the organization and operation of a FLIP.
In Kimbell, shortly before the taxpayer’s death, the taxpayer (a ninety-six year old), transferred assets to a FLIP in exchange for a limited partnership interest. The IRS required the taxpayer’s estate to include the entire value of the assets transferred to the FLIP in the taxpayer’s estate rather than the discounted value afforded to the FLIP interest owned by the taxpayer. The District Court agreed with the IRS. The Court of Appeals, however, reversed the decision, holding that the transfer by the taxpayer was, in fact, a bona fide sale and thereby successfully removed the assets from her estate, for purposes of §2036.
This decision is helpful to those who have utilized, or who plan to, utilize a FLIP as an estate and business planning technique. However, it is still important to organize and operate a FLIP in accordance with the numerous guideposts set forth in Kimbell and other cases discussing FLIPS.
Adopting the following guidelines and incorporating them into the operation of a FLIP may help forestall an IRS attack:
- The partners should respect the separate existence of the partnership. If a distribution is to be made out of the partnership, it should be made pro rata to all the partners in accordance with their respective ownership percentages. Disproportionate distributions from a FLIP will be troublesome to the IRS, and ultimately, to the partners. Also, distributions should probably be made on an established periodic basis. It would appear that pro rata distributions, while necessary, are not enough if they are made irregularly in response to the perceived cash needs of the donor.
- The partners should act in a manner that is consistent with the partnership agreement. The partnership should not pay an individual partner’s bills, nor should an individual partner utilize partnership property for personal reasons. The individual partners should also not commingle their personal assets with FLIP assets.
- Sound accounting principles and practices must be maintained.
- FLIP documents should expressly hold the general partner or manager to a fiduciary standard in their dealings with the FLIP.
- Establish the FLIP as soon as possible. The partnership should be formed while the donor has a reasonable life expectancy. Don’t wait to make it a deathbed partnership.
- It is likely more advantageous to fund the partnership with capital contributions of assets by each of the partners to constitute a “pooling” of family assets.
- The partnership should be established and continued for a valid business purpose, which should be documented in the limited partnership agreement. RUN THE PARTNERSHIP LIKE A BUSINESS.
- The General Partners should maintain excellent partnership records, including records of annual partnership meetings, income tax returns, partnership tax returns and valid assignments of partnership assets to the partnership.
- The IRS seems to be interested in whether a FLIP is continued after the death of a donor decedent. As a practical matter, it is probably advisable to maintain a FLIP at least until after the completion of any audit of a FLIP.
- The IRS will look at the proximity of gifts in partnership interests relative to a decedent’s death. In other words, was the partnership established, or were gifts made, in anticipation of a decedent’s death?
- The IRS looks askance at the transfer of a majority of a decedent’s assets to a FLIP. We would recommend staying away from conveying personal assets, such as residences, cars and vacation homes to a FLIP.
- The limited partners or the members should have the right to convey their partnership or membership interest. If a limited partner does not have the right to sell or assign his interests, it may not be a “present gift” and therefore, the annual gift tax exclusion may not be available. However, a limited partnership can place restrictions on the right of transfer – for instance, a right of first refusal in the partnership and other partners.
When structured properly, Family Limited Partnerships offer an excellent vehicle for owning and managing of assets, especially investment assets, allowing younger generations to become exposed to good stewardship and growth of family wealth, while yet protecting younger generations from themselves, divorce, and creditors, as well as providing valuable estate planning technique.