Family Limited Partnerships Being Probed by the IRS

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Family limited partnerships (FLPs) are the target of increased scrutiny by the Internal Revenue Service (IRS). These vehicles are apparently a popular technique for reducing estate and gift taxes. The IRS is increasing the number of audits it performs, focusing on those taxpayers with incomes of $100,000 or greater, according to the Wall Street Journal.

The IRS is concerned FLPs are being set up for other than legitimate business purposes. Audit interviews are focusing on how these partnerships are set up and run, according to the Wall Street Journal. In some cases, the IRS is examining medical records and interviewing doctors to discover if the partnerships were created to save the taxes of those about to die.

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An FLP is created under state law and the partnership agreement documents the rights of the two parties. The interests of the partnership are divided generally into general partner (GP) and limited partners (LPs) interests, according to

Usually one general partner (GP) is empowered to administer the partnership and its assets according to the partnership agreement. The GP, usually a parent, controls any assets or businesses held by the FLP, according to They also determine the timing, amount, and distribution of any profits. The limited partners (LPs), usually the children, maintain no management rights.

The LPs cannot sell their interests in the partnership per the FLP agreement and simply have the right to receive authorized distributions from the GP, according to They also have no liability for the debts of the partnership as the GP has the only management rights.

A common FLP scenario is two parents creating an FLP. Together they hold a single GP interest and 99 LP interests, according to The stock of their business, the real estate on which the business is located, and other investments like marketable securities, are transferred into the partnership. At the proper time, the 99 LP interests are gifted to their children, below market value.

The discounted valuation is attributed to the Lack of Marketability Discount (the inability to sell your interest when you want) and the Minority Discount (the lack of management rights in the partnership), according to The combined discount can reach between 20 and 50 percent or higher in some cases. The Annual Gift Tax Exclusion and the one-time Million Dollar Gift Tax Exclusion enable the older generation to pass on their assets at far below market value, without paying any gift tax.

Aileen Condon, chief of the estate and gift-tax program in the IRS's small business/self-employed division, told the Wall Street Journal, “We think it's a significant area of abuse.” The IRS is encouraged by a string of tax court victories involving FLPs. She said that these victories have helped make the IRS “more effective in identifying and challenging noncompliance and abuse.”

The IRS's aggressive stance has tax attorneys advising their clients wanting to set up a FLP “to plan on their gift-tax or estate-tax returns being audited,” according to David Handler, a partner at Kirkland & Ellis LLP in Chicago, speaking to the Wall Street Journal. Handler has seen a reduction in the number of FLPs created in recent months. Two IRS tax attorneys, Martin E. Basson and James L. Gulley, said that one area of interest is whether the discount applied in valuing partnership interests is reasonable?

With all the scrutiny and focus on FLPs, several points must be understood when creating an FLP, according to Most importantly, it must have a business purpose. It should not be a vehicle established only to avoid taxes. Transferring of assets, other than business assets to the FLP, is not recommended. Also the partnership agreement must also have a provision for the GP(s) to receive only their proportional distribution of profits. The GP(s) must show they possess enough assets on which to live after gifting partnership LP interests.

Bruce Friedland, IRS spokesman, told the Wall Street Journal, “The IRS may be checking that those children who are limited and general partners have the business knowledge, expertise and involvement that establish a valid business purpose” for the FLP.

Additionally, partnership and personal accounts and paperwork should never be co-mingled. GP(s) should never divert partnership assets for their own uses. To avoid an IRS audit, FLPs should always be established when you are in good health. The IRS has won tax court cases because a partnership was established before a partnership GP passed on, but not far enough in advance for the IRS, according to Keeping these points in mind will be helpful as the IRS has indicated that 100 percent of FLPs will be audited.

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