John and Kathy own a widget manufacturing
company that they have spent years nurturing and growing and they now wish to
see that it passes on to their children at their death. After examining
their various options, they decide to transfer the business into an FLP.
At the time of the transfer, they also grant their children the majority
ownership of the FLP, but maintain control of the company by making themselves
the general partners responsible for all decision making.
The FLP Advantage
Now, ordinarily a transaction of this type
will simply trigger gift taxes to the parents on the full value of the company when it is
transferred to the children. However, with an FLP set up in the manner
above, the children's ownership interest will be "discounted" because
they are limited partners with no vote in the governance of the company.
It is similar in principle to preferred corporate stock being worth less than
common stock in most instances because the preferred stock has no voting rights.
Since the children's new ownership of the FLP
(and the underlying family business) is deemed to be worth less than a
"voting interest" ownership, the transfer will be subject to lower
taxes than an ordinary ownership transfer would have been.
John and Kathy
of course, have managed to transfer most of the company to their children, but
at the same time, get to continue running their business as they see fit without
concerns about interference from their meddlesome children.
Too Good To Be True?
If the above scenario sounds a little
"convoluted" to you, you're not alone. The IRS thinks so as well
and has challenged FLPs in court stating that they lack economic substance among
However, after some IRS setbacks in U.S.
Tax Court whereby the judges lowered the discount taken, but did not throw out
the FLP, it is anticipated that FLP usage will continue to grow at a fast pace.
Many estate planners now are even setting up
FLPs simply to hold family investments as opposed to conducting a family
business. In 2000, the Clinton administration asked for legislation
barring discounts for non-business interests in FLPs and FLLCs (family limited
liability companies - a similar type entity), but Congress has not addressed the
The IRS Strikes Back?
The IRS, despite the court setbacks, has not
given up the fight on this issue and we strongly urge you to speak with us
before venturing into this potential minefield. You can expect the IRS to
continue challenging both the use of FLPs and the discounts being taken on
In a recent IRS legal paper, the agency argued that the FLP should
be ignored where formed just to hold and transfer family wealth. It argued
once more that a family entity created to get estate tax or gift tax valuation
discounts lacks business purpose and economic substance. We can expect
more court challenges in the near future...