Virtually all investments lost value during 2008, and 2009 did not herald the end of the recession, or begin the economic recovery, that many hoped would occur. Appetites for taking risk, including the risk of potential tax audits associated with complex estate planning, have remained restrained. However, recent tax court decisions could re-ignite interest in utilizing Family Limited Partnerships (FLPs) or similar entities as part of asset protection and estate planning.
Abide by the rules
A number of recent rulings regarding tax cases (Estate of Shurtz1, Estate of Black2, and Murphy v. U.S.3, for example) offer lessons about what to do right regarding an FLP. Begin by following the formalities of creating, funding and maintaining the FLP. Hold annual meetings and keep minutes, books and records. Make sure the founder has enough wealth outside the FLP to maintain his or her lifestyle. Keep personal and FLP accounts separate.
You have to work at it to earn your just rewards
The managers or general partners should actively oversee the affairs of the entity and treat it as an ongoing enterprise, not just a passive shell. Establish and follow an investment policy. For those who choose to turn over the day-to-day management of their investments, maintain strategic oversight at the entity level. Have director or partner meetings and routinely review policy and performance.
Don’t put off until tomorrow what you can do today
Other cases (Estate of Jorgensen4, Estate of Bigelow5, for example) offer lessons about what can go wrong with an FLP. Form and fund the FLP well before executing transfers of interests. Have business activities prior to and between transfers; show that the entity has a bona fide business purpose. When using promissory notes, treat the notes as you would treat notes to a third party- be sure to establish and respect repayment terms. You may amend notes as needed, but don’t ignore them.
Why we ask for things that appear to have nothing to do with value
Estate of Malkin6 offers a great example of what not to do. The taxpayer never properly set up the FLP, co-mingled assets and generally did not respect the process. This is why it is important to provide appraisers documentation of the legal and tax recognition of the FLP, minutes of annual meetings and proper tax returns with accounting for fund transfers to and from partners’ accounts. A professional valuation report cannot compensate for poor circumstances if the IRS challenges the legitimacy of the FLP or shows that adequate and full consideration were never given in exchange for the FLP interests. However, a well-documented valuation report can preemptively provide evidence that formalities have been followed and possibly deter a challenge based strictly on business purpose or process.
Help others to help you
Estate of Keller7 offers a great example of how powerful this advice can be. By following proper procedures, showing an active involvement in the creation and ongoing direction of the entity and properly executing documents, the taxpayer was awarded a significant valuation discount in tax court despite having died after forming the FLP but prior to completing the funding process.
Don’t wait to get it right. By following the formalities of the FLP formation and operation process and keeping the appropriate records, one can set the stage for a well-documented professional appraisal to be the last piece of a well-crafted planning strategy.
1Estate of Shurtz v. Commissioner, 2010 WL 374528 (U.S. Tax Ct.)
2Estate of Black v. Comm’r, 133 T.C. 15
3Murphy v. U.S., 2009 WL 3366099 (W.D. Ark.)
4Estate of Jorgensen v. Commissioner, 2009 WL 7920771 (U.S. Tax Ct.)
5Estate of Bigelow v. Comm’r, 2007 U.S. App. LEXIS 22030
6Estate of Malkin v. Commissioner, 2009 WL 2958661 (U.S. Tax Ct.)
7Keller v. United States, 2009 WL 2601611 (S.D.Tex.)