09 April 2020 - Article
Family Limited Partnerships and Family Limited Liability Companies (“FLPs”) have grown in popularity over the last decade and, as a result, have come under IRS scrutiny. One of the keys to withstanding this scrutiny, however, may be a resource that’s already at the disposal of many wealthy families: the family office.
Recent tax court cases have shown that the ongoing administration of FLPs is as important as making sure the transaction was properly structured at the outset. The family office is a natural fit for ensuring such administration because of its day-today involvement with family members and their assets, businesses and investments.
Using a family office for FLP administration may be for some a relatively new concept, partly because FLPs are considered to be the domain of tax lawyers. Yet while it’s true that family offices may lack the legal expertise to set up an FLP, they can be valuable resources in both the formation and administrative stages.
The Importance Of Active FLP Maintenance
FLPs have become popular because of their ability to provide a structure to manage family assets, protect against creditor claims and reduce estate and gift taxes through valuation discounts.
Simply stated, if a parent contributes assets into an FLP in exchange for partnership interests, the partnership interests may be worth less than the assets for gift or estate tax purposes. This is due to the fact that a buyer would likely not pay as much for partnership interests in an FLP as he would for unrestricted assets.
There was little guidance or case law on how to create or administer an FLP until about 10 years ago. Before then, practitioners relied on cases that acknowledged the possibility of a valuation discount upon the transfer of minority interests in closely held entities. As FLPs became more popular, however, estate planners, clients and family offices were often at a loss as to how to operate these vehicles so the IRS would respect the transaction and honor the valuation discounts.
What can a family office do in order to improve the odds, or possibly ensure, that an FLP will be respected for estate and gift tax purposes? Thankfully, FLP jurisprudence has come a long way over the past decade and we now have numerous court opinions that provide a “roadmap” to properly administer these vehicles. Family offices bring intimate understanding of the interpersonal dynamics, businesses and investments of their family clients, putting them in an excellent position to guide clients through the FLP maze of “do’s” and “don’ts.”
Recent case law provides other compelling reasons to bring family offices into FLP administration.
Many FLP practitioners used to believe the magic of the FLP was in its formation documents. Numerous “bad facts” cases, however, have since made it clear that the FLP is not a “set it and forget it” estate planning technique. Proper FLP formation is still essential, but the partners must actively maintain these vehicles if they are to achieve the desired results.
As a common practice, FLP practitioners send out correspondence to clients explaining the importance of maintaining and properly administering the FLP. The advice, unfortunately, often goes unheeded. Clients get on with their busy and complex lives and often neglect their fledgling FLP structures – a mistake that can lead to IRS scrutiny and significant estate tax exposure. Family offices can fill this administrative void because they are equipped to handle day-to-day FLP maintenance. Family offices can often administer an FLP more efficiently than the family or the attorney who put the structure in place because they are organized, staffed and trained to engage in exactly this kind of oversight.
Key Administrative Practices
Ideally, the family office should be involved from the inception of the FLP to become familiar with its structure and how it should be operated. The attorneys responsible for forming the FLP generally run the show during formation, but the family office can help by doing the following:
1. Facilitate discussions among family members and trustees who will be involved in the FLP to discuss valid, non-tax related business purposes. For instance, some family members may want to pool assets to invest in a hedge fund or private equity fund.
2. Ensure that not only the parents, but also junior family members (or trusts created for their benefit) participate in the creation of the FLP and have an opportunity to contribute their own assets, as opposed to assets that have been recently gifted to them for the purpose of contribution to the FLP.
3. Encourage clients to consider the long-term financial and interpersonal implications of FLP planning. The FLP will probably be kept in place well after the death of the matriarch or patriarch, so clients should consider whether they are able to tie up these assets for a period of years.
4. Facilitate negotiations among the various partners on the terms of the partnership agreement and act as a liaison between family members and their respective counsel.
5. Offer to serve as the general partner or the manager (in the case of an LLC) of the FLP. This makes it far more difficult for the IRS to argue that a deceased general partner maintained control over the assets prior to his or her death and that the assets should be put back into the deceased general partner’s estate at full value.
6. Ensure all of the partners have properly executed the formation documents and transferred their individual assets into the partnership accounts or into the name of the FLP. A common defect of many FLPs is the failure of the parties to properly transfer assets.
7. Ensure that FLP accounts have been opened in a timely manner and that a tax identification number has been obtained.
8. Ensure that the partnership tax “diversification” rules are not violated in connection with the formation of the FLP.
9. Communicate with counsel and the various partners to create protocols that will be necessary to properly administer the FLP on a day-to-day basis and ensure that these protocols are understood and strictly followed.
Limiting the ‘Bad Facts’
Once the FLP has been formed, the family office can add enormous value to the legitimacy of the entity by paying attention to and complying with its protocols. It is, for example, important to maximize “good facts” and minimize “bad facts” in FLP administration. This refers to the unofficial rubric that the IRS typically uses to determine whether the FLP should be respected or disregarded as a tax avoidance structure. The IRS will make a decision based on whether the formalities of the FLP were respected and whether the partners treated the FLP as an operating business between non-related third parties. Building a record of the FLP’s activities can go a long way toward improving the credibility of the FLP in an IRS audit.
The harsh reality is that there are likely many FLPs that have been neglected by their partners and are “time bombs” waiting to explode upon the death of the matriarch or patriarch. “Bad facts” FLPs are not in short supply. The typical IRS agent is investigating numerous flawed entities at any given time. Ongoing administration by a family office, however, can improve the appearance of an FLP so its facts are much stronger than other FLP cases lying on the IRS agent’s desk. This should give the FLP credibility and strengthen its case in the event of an audit.
What follows are ways family offices can maximize good facts and minimize bad facts in FLP administration:
1. Respect the formalities of the FLP’s partnership agreement. Prepare a list of the administrative requirements under the partnership agreement (e.g., requirement to provide annual financial statements to all partners, notice and consent requirements with respect to transfer of partnership interests, etc.) and make sure the list is followed.
2. Hold routine partnership meetings to review investment performance and make investment decisions. Prepare and maintain minutes documenting the discussions to memorialize any decisions.
3. Change the investment makeup of the FLP after contribution of assets.
4. Confirm that assets have been properly contributed to the FLP promptly upon formation before any transfers of partnership interests.
5. Maintain FLP stationery for the partnership. Memos or correspondence on such stationery should document any partnership decisions.
6. Do not allow family members to contribute all or even most of their assets to the FLP. Instead, instruct family members to maintain, in their own names, a significant amount of assets outside of the FLP. The family members should not look to the FLP to make distributions for their own financial support.
7. Do not allow the FLP to make distributions that are not pro rata to all partners. No family member should continue to receive income or other distributions from the FLP unless all of the other partners are receiving similar pro rata distributions.
8. Do not allow family members to treat the FLP assets as if they are their own. The family office should ensure that estate taxes resulting from the death of a partner are not paid out of FLP assets. Tax court has made examples of owners of FLPs that were essentially the alter ego of the taxpayer.
9. Do not allow family members to contribute personal residences to the FLP. If this is unavoidable, occupying partners should at minimum pay fair market rent to the FLP for their occupancy.
10. Do not allow the commingling of partnership assets with other independent assets of any partner.
An FLP that is properly administered and has few bad facts – the typical FLP will always have some bad facts – will have a much greater chance of withstanding IRS scrutiny. Indeed, in a recent tax court case the taxpayers prevailed over an attempt by the IRS to undo an FLP, despite a significant number of bad facts. In upholding the FLP, the court noted that the parties intended to treat the partnership as a collective investment vehicle in order to provide a means for the management of the family’s assets, the taxpayer maintained significant assets outside of the FLP, the partners held partnership meetings in which they discussed investments and the partners maintained the partnership after the taxpayer’s death.
To the extent that it can properly administer an FLP and limit bad facts, the family office can play a large role in determining whether an FLP can withstand an IRS challenge. In short, the FLP structure and the family office are a perfect union. With little additional effort and expense, family offices can ensure that the benefits of this powerful estate planning tool are preserved, thereby adding tremendous value to their representation of wealthy families.