The IRS often examines family limited partnerships (FLPs) to ensure that they are not merely tax avoidance schemes (see box below). But that doesn’t mean you should dismiss the idea. For your FLP to withstand the scrutiny, you can’t maintain too much control over the assets transferred to the partnership. Create it, and run it like a real partnership, not as your private piggy bank.
Strategy: Stick to your guns if the FLP is legit. If things are handled correctly, you can give away limited partnership interests at a discount for gift tax valuation purposes, thereby reducing the size of your taxable estate.
Here’s the whole story: With an FLP, you transfer assets—typically, an interest in a closely held business or investment real estate—to a limited partnership. You may act as the general partner while other family members, such as adult children, are named as limited partners. The older generation can then give shares to younger family members.
Of course, these transfers are potentially subject to the federal gift tax, but you can take advantage of the annual gift tax exclusion. For 2011, the gift-tax exclusion covers transfers of up to $13,000 per recipient ($26,000 for joint gifts by a married couple). Any remainder may be sheltered by the lifetime $5 million federal gift tax exemption. (The lifetime gift tax exemption is scheduled to drop to $1 million after 2012.)
This tax-saving device may be especially beneficial for small business owners. Reason: The owner can remain involved in daily operations while establishing a future succession plan. In addition, the assets transferred to the FLP are protected from business creditors.
Icing on the cake: The value of the limited partnership shares may be discounted for estate tax purposes because there’s no ready and available market for those shares. Based on past case history, the discount might be as high as 30%. As a result, even more assets can be transferred to other family members without adverse gift tax consequences.
Surviving an IRS challenge
To minimize the likelihood of an IRS audit, take the following precautions:
- The FLP should be treated like a legitimate partnership. Hold regular meetings with the other partners to discuss issues.
- Have the partnership agreement drafted to avoid potential abuses by the general partner.
- Administer the FLP properly. Set up a bank account that makes distributions in accordance with the partnership agreement, not just for your personal convenience.
- Don’t go overboard. The IRS is likely to become suspicious if all, or virtually all, of your assets are transferred to the FLP. Don’t transfer personal assets such as your home and leave yourself plenty of money to live on.
Tip: The more the FLP looks and acts like a legitimate business partnership, the better its chances of surviving any IRS challenge.