IRS assaults on FLPs.

The IRS has increased its attack on the use of family limited partnerships (FLPs) as an estate and gift tax planning tool. Despite these attacks, FLPs continue to be a popular tool for transfer tax planning purposes. An FLP allows a taxpayer to maintain control over property transferred to it, while mitigating the transfer tax consequences normally associated with such transfers.

In a typical FLP, a taxpayer transfers property to a limited partnership in exchange for general and limited partnership interests. For valuation purposes, the fair market value (FMV) of a limited partnership interest in the FLP is usually less than the FMV of the interest's pro rata value of the FLP's underlying assets. This is primarily a result of the significant legal restrictions on the limited partner's right to participate in management, transfer the partnership interest or compel the FLP's liquidation. Another major factor requiring a valuation discount is the lack of a ready market for the partnership interests.

The IRS consistently contends that no discounts are allowable in determining the FMV of FLP interests, arguing that the creation of the FLP is a sham that should be ignored for transfer tax purposes. In addition, the Service contends that Chapter 14 of the Internal Revenue Code allows it to disregard the FLP for valuation purposes.

Letter Ruling (TAM) 9719006 clearly illustrates these arguments. In the ruling, the taxpayer formed an FLP two days before her death and contributed marketable securities and several parcels of real estate to it. At the time, she was terminally ill. Immediately after the formation of the FLP, limited partnership interests in the FLP were transferred to her children. The estate claimed a 48% discount in valuing the FLP interests for estate tax purposes.

The IRS concluded that the FLP should be ignored, because it was created for the sole purpose of reducing estate tax. The Service also concluded that the partnership could be ignored by applying Sec. 2703(a)(2). Although the TAM involves a somewhat abusive factual situation, it provides a good road map for the IRSs current position on FLPs.

The Service has attacked the valuation of interests in FLPs at various levels of the tax controversy process, including examination, appeals and before the Tax Court. Taxpayers have generally been able to settle controversies by convincing the IRS of the FLPs validity, through the existence of a valid business purpose and by negotiating a lower valuation discount.

From a valuation perspective, it is important to remain aware of the developments in this area to ensure that valuations withstand close IRS scrutiny. In addition, it is important that taxpayers document an FLPs business purpose during the planning stage (including in the appraisal); the existence of a valid business purpose is a major factor in defending against the Service's assaults.

From Jeffrey N. Kelm, J.D., and Jeffrey M. Wright, J.D., Houston, Tex.