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Troubleshooting checklist for family limited partnerships

by Tony Novak, CPA, MBA, MT
, revised 11/28/2011

Family limited partnerships (FLP) were a popular way for family businesses to protect assets and reduce estate taxes over the past two decades. They were especially popular for holding stock and real estate that was intended to pass from parents to children. In recent years the IRS and Tax Court took a tougher stance on these tax shelters. Most financial advisers have modified the format of the FLPs they recommend now to comply with the more conservative legal positions. Many FLPs set up years ago and not recently updated could be held invalid by the IRS, making them useless for reducing taxes after the death of a parent.

Your FLP could be in trouble if any of the following apply:

• The FLP was set up while the parent was terminally ill
• The FLP held ownership of the parent’s principal home
• The FLP owns substantially all of the assets of the parent
• The parent controls the management of assets
• The FLP is funded exclusively with the parent’s assets and not the other partner’s (children’s) assets
• The FLP is used as a checkbook to pay expenses like rent or health care
• There are no regular income distributions paid systematically to all partners
• The FLP was set up years ago and not updated by an attorney within the past few years
• The main purpose of the FLP was to avoid taxes rather than run a legitimate family business venture

While none of these factors is by itself a fatal blow to the tax status of an FLP, the occurrence of any of these is good reason to schedule an overall financial review. The FLP might either be updated or exchanged for a more secure legal format like a family limited liability company.

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