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‘Substance over form’ in family limited partnership

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in Small Business Tax,Small Business Tax Deduction Strategies

A family limited partnership (FLP) may be used to protect business interests from creditors. Assuming no ready market for the shares transferred to the FLP, the value can be discounted for estate and gift tax purposes. The IRS often challenges these discounts.

In a new case, the IRS questioned the legitimacy of a transfer to a FLP shortly before the grantor’s death. However, the District Court approved the transfer, even though certain formalities had not been met. (Keller, DC-Tex, 8/20/09)

Key facts: Based on the advice of her advisors, Mrs. Williams decided to utilize an FLP. They determined that the FLP should be funded with bonds in two trusts created at her husband’s death. On May 9, 2000, Mrs. Williams reviewed and signed the FLP agreement as the trustee of the two trusts and the general partner of the FLP. But the initial capital contributions portion remained blank because her advisors had not completed the valuation calculations for the bonds.

Mrs. Williams died on May 15, 2000, before the FLP was formally funded, but after appropriate documents had been filed with the state. Because the FLP was not formally completed, the estate paid almost $148 million in federal estate taxes. Subsequently, the estate filed for a refund.

Under applicable state law in Texas, property intended to be a partnership asset is determined by intent, rather than legal title. The District Court was convinced by the testimony of the financial advisors, along with their written documents, that Williams intended to fund the FLP with the bonds.

The court ruled the bonds were FLP property at the decedent’s death. It also said the interest was properly discounted. Furthermore, the estate is able to deduct $30 million in interest payments made to the FLP to satisfy the federal estate tax liability and various other debts.

Icing on the cake:
The court granted deductions for administrative expenses and attorneys’ fees.

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