Family LP and LLCs: The Devil is in the Detail
The “devil is in the details” is one of the most critical aspects in any business and tax planning strategy.  I have recently finished an audit with the Internal Revenue Service (“IRS”) for estate tax purposes dealing with a family limited partnership (“FLPs”). The outcome was very favorable for my client in receiving a 35% discount on the FLP’s assets because he paid attention the details in maintaining the FLP properly given the victories that the IRS has had in this area.  

I have been called by a number of people asking whether or not FLPs” or LLCs are still valid, based upon recent the IRS victories in the tax court and stressed in its most recent audit settlement policies.  These calls stem from the IRS’s successful use of IRC Code Section 2036 and the “retained interest” by the taxpayer.

A retained interest is an interest that was supposed to be transferred by an individual, but more often than not had some string attached (usually money back to them for personal living expenses) that cause the interest to be included in their estate.  However, sale of an interest is acceptable to the IRS, if it is bona FIDE and for valid consideration.
The starting point to remember when creating either an FLP or LLC is to have a valid business reason to establish it in the first place.  For example, a family residence or IRA will not be the type of assets that you would typically use for business purposes.  Also, someone in their late 80’s or early 90’s, starting a business at that point in their life, will generally fail the “smell test”.
Paul Hood of Leimberg Information Services wrote an article for planners a couple of years ago that illustrates what needs to be done.  Although he discussed 10 items, the two I want to stress are discussed below.

1. FISCAL FITNESS: Make sure the FLP/LLC is the right fit in your situation! Most mistakes that are made in the FLP/LLC arena are due to the inappropriate evaluation of the suitability of that entity technique in a particular situation. Simply put, many FLP's/LLC's fail due to improper "fit."
2. Is your client too old or unhealthy for the FLP/LLC?
3. Will your clients follow the rules for FLP's/LLC's? Do your clients understand the importance of following the rules?
4. A perfectly formed and funded FLP/LLC that is imperfectly administered (e.g., non pro rata distributions, commingling, etc.) probably will not work for estate tax purposes. Will your clients pay for follow-up advice?
5. What have you done to educate your clients as to the rules and the risks, and what written proof do you have of your efforts in this regard?
6. Do your clients need or require this level of complex planning? Can they handle that complexity? Do they understand the tax risks inherent with FLP's/LLC/s? Did you consider/offer alternate estate planning techniques to them?
7. 2. THE SUBJECT MATTERS! The type of assets placed into an FLP/LLC make a difference. The assets contributed to FLP's/LLC's can have both tax and non-tax implications. Many clients are drawn to the FLP/LLC for its asset protection qualities. However, people sometimes put liability-prone property into an FLP/LLC with other valuable property, and, by so doing, fail to achieve the asset protection that could have been available had the assets been placed into separate entities to minimize cross exposure.
8. On the tax side, the wrong mix of marketable securities could cause the entity to be treated as an "investment company". The contribution of appreciated property to an FLP/LL could give rise to considerations of allocation of built-in gain.
9. Not only can the financial nature of FLP/LLC property matter, but the percentage of a client's property that is put into an FLP/LLC seems to matter, as well as the nature of that property. In Harper Est. v. Comr., supra. and Thompson Est. v. Comr., supra, the Tax Court applied IRC Sec. 2036 where the decedent had placed virtually all of his or her property into the partnership.

Many practitioners believe that the IRS has a bias against FLP's/LLC's that are entirely or heavily capitalized with marketable securities.
Conclusion.  I have been in many audits with the IRS over many of the 2 rules mentioned above.  If you follow them you should be able to successfully defend the FLPs/LLCs with the IRS.