How to Build a Foolproof Family Limited Partnership

The court casually dismissed the three general and nine specific purposes for creating the Turner FLP, saying that they were “taken from a form partnership agreement” and did not necessarily reflect the couple’s  actual reasons for transferring the assets to the FLP.

Clyde Sr.’s estate countered that the FLP was formed for three legitimate and significant nontax reasons: “(1) to consolidate their assets for management purposes and allow someone other than themselves or their children to maintain and manage the family’s assets for future growth pursuant to more active and formal investment management strategy; (2) to facilitate resolution of family disputes through equal sharing of information; and (3) to protect the family assets and Jewell from Rory” (a drug-addicted grandchild).

Consolidated Asset Management

The court acknowledged that the first reason, consolidated asset management, can be a legitimate nontax purpose for forming an FLP, but said that consolidated asset management is not a significant nontax purpose where an FLP is “a mere asset container.”

In most cases holding that consolidated asset management was a legitimate nontax reason for funding the FLP, the assets held by the FLP required active management. Also, where the FLP owns stock in a closely held corporation, consolidated asset management often is a legitimate justification. For instance, an FLP may legitimately be formed to ensure that family members cannot transfer stock to an outsider or to keep the stock together in a voting block.

Here, the Turners’ FLP held passive investments, including publicly traded bank stocks. Clyde Sr. did not have a personal investing philosophy that he hoped to perpetuate. And the court found that the Tuner’s portfolio didn’t “change in a meaningful way” after creation of the FLP and that giving management authority over the FLP to their sons didn’t have a “material impact on the profit potential of the portfolio.” As a result, the court dismissed consolidated asset management.

Resolution of Family Discord

Similarly, the court dismissed the family’s second claimed reason for funding the FLP. Although resolution of family discord can be a legitimate nontax reason for forming an FLP, the court found that the Turner children didn’t fight over their parent’s assets and never expressed any interest in managing the assets. In fact, creation of the FLP created some discord between the siblings rather than resolving it.

Protection of the Assets from the Drug-Addicted Grandchild

Although asset protection can be a legitimate reason for forming an FLP, the court dismissed that reasoning here because, in its view, Jewell had shown that she was capable of protecting herself from her son; there was no evidence that any gifts she gave her son were other than voluntary. Also, the court found that a trust that had been created for Rory adequately protected him from himself and that the FLP didn’t add any additional protection.

Factors Showing that the Transfers Were Not Bona Fide Sales

The court felt that there were several other factors indicating that the transfers to Turner & Co. were not bona fide sales. First, Clyde Sr. was on both sides of the transaction, and there was no meaningful bargain struck between him and his wife or any of the children and grandchildren who were to become partners in the FLP. Also, Clyde Sr. “co-mingled personal and partnership funds” to make personal gifts, to make life insurance premium payments, and to pay estate planning legal fees.

Conclusion

Because the court found that the transfer to the FLP was not a bona fide sale, it held that the bona fide sale exception did not apply. The court then considered whether Clyde Sr. retained enjoyment of the property that had been transferred to the FLP. According to the court, “a transferor retains the enjoyment of property if there is an express or implied agreement at the time of the transfer that the transferor will retain the present economic benefits of the property.”

The court viewed the $2,000 management fee paid to Mr. and Mrs. Turner as unreasonable because they did nothing to manage the partnership. According to the court, that fact showed that the FLP was not a business conducted for profit. They viewed it as more akin to an investment account. Also, the court believes that the FLP was testamentary in nature. As a result, the court held that Clyde Sr. retained a life interest in the transferred property.  Because Clyde Sr. had retained an interest in the FLP’s assets during his lifetime, the value of the property was included in his gross estate.

This was not a case where the family and its attorneys could not have formed a bulletproof FLP under any circumstances. There is a very good change that, with proper counsel, the family could have funded its FLP in such a way that the Tax Court, and maybe even the IRS, would have respected the entity.

The focus of the court’s analysis seemed to be on the “off-the-shelf” nature of the FLP. They apparently believed that if the FLP were intended for a business or other nontax purpose, more care would have been put into drafting it. Although the Turners provided a laundry list of nontax reasons for forming and funding the FLP, the structure of the partnership and the Clyde Sr.’s relationship with the FLP did not bear out those purposes.

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s partner, AdvisorFX, for a free trial.

See also The Law Professor’s blog at AdvisorFYI.