The planning and formation stage is just part of the process of having a successfully implemented family limited partnership (FLP). Failure to attend to operational details and other factors or mistakes can invalidate the tax advantages of this vehicle. Here are some pitfalls to avoid:
The IRS takes a dim view on death bed or terminally ill transfers. There are many court cases that have invalidated the tax benefits associated with FLPs where decedents implemented this plan on or near their death bed. Planning for and the implementation of FLP should begin well in advance of any medical problems.
The creator’s contribution of substantially all of his or her assets to the FLP, including homes and other personal assets, without retaining sufficient funds for everyday expenses has resulted in many tax cases being decided against taxpayers. This factor has also been coupled with the creator (decedent) using the assets of the FLP to pay personal expenses and not following the terms of the FLP. Merely forming an FLP is not enough; the creator of the FLP must not unilaterally take monies from the FLP whenever he or she decides to do so.
The FLP should not make disproportionate distributions to the transferor to pay for living expenses. Upon the death of the creator of the FLP, the FLP should not pay for estate expenses or estate taxes. Distributions from the FLP need to be made in accordance with the ownership percentages of the partners in the FLP. Selective or disproportionate distributions to selected partners can doom a FLP.
The parties fail to follow partnership formalities. Formally transferring legal title to all property to the FLP needs to be done. For example, if real estate is involved it must be transferred by deed to the FLP and formally recorded with the recorder of deeds in the county where the real estate is located. Failing to keep proper books and records can jeopardize the tax advantages sought by use of the FLP. Failure to set up a separate bank account for the FLP is problematic. The payment of FLP obligations personally and not by the FLP should be avoided and will put the parties in a bad position if the IRS reviews and audits the FLP.
Where there is little or no change in investment and business strategies after the transfer of assets to FLP, the IRS has challenged the validity of the tax benefits associated with the FLP.
The parties commingling of partnership and personal assets has been a significant factor in cases in this area. Once again assets in the FLP should not be used for the personal expenses of the creator of the FLP.
Where younger family members are not actively involved in FLP business decisions and kept in the dark about business operations the tax objectives of setting up the FLP may be jeopardized. Additionally, where the FLP was formed without the other family members having advice from independent counsel and/or failed to retain a valuation expert to make sure their interest was correctly valued, the IRS has challenged the tax benefits associated with the FLP.
The benefits of implementing a family limited partnership can be extremely significant. However, the FLP must be formed and operated in a business like and arm-length manner to insure the estate, gift and income tax benefits. For a discussion of these benefits please see the companion article entitled Family Limited Partnerships.