FLPs and FLLCs: To save taxes, you need a nontax purpose

It may strike you as illogical, but for a family limited partnership (FLP) or family limited liability company (FLLC) — let’s refer to them collectively as FLPs — to reduce gift and estate taxes, there must be a legitimate nontax reason for forming one. In other words, if you set up an FLP strictly as an estate planning tool, the IRS will disallow the tax benefits. But if you can establish a bona fide business or investment purpose for the entity, tax savings can be a pleasant bonus.

How FLPs save taxes

With a typical FLP, you transfer business interests, marketable securities, real estate or other assets to a limited partnership, retaining a small general partnership interest (say, 1%) and a large limited partnership interest. Over time, you transfer limited partnership interests to your children, removing the value of those interests from your taxable estate while retaining management control.

Limited partnership interests are relatively unmarketable and provide the holder with little or no control over partnership affairs. As a result, they enjoy significant valuation discounts — often 30% or more — for gift and estate tax purposes.

Not surprisingly, the IRS is suspicious of FLPs and often rejects them as nothing more than disguised tax-avoidance vehicles. So it’s critical to have — and be prepared to document — a legitimate nontax purpose for forming an FLP.

Have a good reason

Establishing a legitimate nontax purpose for an FLP isn’t difficult when the entity holds a family business or other closely held business. FLPs offer a variety of business benefits, including maintaining ownership within the family, allowing the older generation to transfer ownership interests without diluting their control and providing some protection against creditors’ claims.

It’s more difficult — but not impossible — to establish a nontax purpose when an FLP holds marketable securities. In recent cases, for example, courts have denied tax benefits when they concluded that FLPs holding marketable securities were formed for personal reasons, such as tax reduction, estate planning, protection of wealth against dissipation by children or the financial education of children.

On the other hand, families have succeeded in preserving the tax benefits of an FLP when they were able to show legitimate investment objectives, such as coordinating management of family assets to preserve holdings in a particular stock, pooling assets to reduce investment management expenses or qualify for investment opportunities that require larger positions, or promoting some other investment strategy or philosophy.

Actions speak louder than words

Whether your FLP holds business interests or other assets, your stated nontax purpose must be a real one, not merely a pretext. To convince the IRS or the courts of your motives, it’s critical to treat the FLP as a legitimate business or investment vehicle. That means ensuring your partnership agreement and other terms of your arrangement are comparable to arm’s-length transactions, respecting all partnership formalities, and segregating personal funds from partnership funds.

Avoid actions that may raise red flags, such as transferring assets to an FLP when you’re in poor health, contributing substantially all of your wealth to the FLP, commingling FLP and personal assets, using FLP assets for personal expenses, or failing to keep proper FLP books and records.

Avoid IRS scrutiny

The IRS has long cast a wary eye on FLPs. To help ensure yours doesn’t draw Uncle Sam’s attention, be sure you have a legitimate nontax reason for forming one. You’re more likely to enjoy an FLP’s tax savings benefits only if you can show the IRS yours has a bona fide business or investment purpose.