Maintain FLP to   Avoid IRS Problems

A family limited partnership provides a way to transfer assets to family members. Setting up an FLP can also result in lower gift and estate taxes because the assets can be given away at discounted values.

It's critical to be able to demonstrate that an FLP has a valid business purpose and economic substance. Even a properly-worded agreement only goes so far in addressing these concerns. Actions speak louder than words. Make sure required procedures are done on a timely basis and contemporaneously documented to provide evidence of purpose and substance.

For example, delays in opening bank accounts and transferring assets, combined with cash distributions that disregarded an FLP agreement were key pieces of evidence in one recent Tax Court case. (Estate of Morgan B. Harper, TC Memo 2002-121)

The court ruled that the FLP lacked economic substance. There was an implied agreement for the decedent to retain the economic benefit of the transferred property, the court stated. It also determined that the transfers were testamentary in nature and not bona fide sales.

Result: The partnership was disregarded and property transferred to it was included in the decedent's estate, resulting in federal estate and gift tax deficiencies.

To prevent the ball from being dropped after the formation of an FLP, here are some critical steps to take:

Prepare a to-do list for principals and assign each task to a specific person. Designate one person to coordinate the process, issue reminders, verify completion, and collect documents. After the set-up procedures are complete, the focus should shift to ongoing operations.

Give the principals a crash course on what they need to do to operate the FLP properly. Follow-up on a regular basis to see if they are following the instructions and discuss what has happened since your last contact. Consider asking a standard list of questions. 

Record and date the notes of any conversations for your files. If there is an important deadline, contact the principals before to remind them and after to verify the action. 

Meet with the principals, at least annually, to review operations and discuss changes in the family and the tax laws. If necessary, documents and procedures can be updated to reflect these changes.

Making sure that your clients' FLPs are operating properly with these procedures is a valuable service that can generate recurring fees. Consider selling FLP engagements as a package with separate fees for set-up and annual maintenance.

Proper follow up of partnerships can prevent ugly complications later and help ensure that your clients' wishes aren't overturned by the IRS.