Family limited partnerships (FLPs) are a tool that can be used by dealership owners to accomplish a wide range of financial, succession and estate planning objectives. But care should be taken when establishing these arrangements, because the IRS has taken a particular interest in them in recent years.
Specifically, the IRS has challenged the validity of some FLPs by claiming in court that the owners are using them solely to avoid paying federal gift and estate taxes. So it’s critical to have a legitimate non-tax purpose for forming an FLP, as well as documentation that will support that purpose.
How does an FLP work?
An FLP is a limited partnership controlled by family members. It consists of two types of partners: general partners and limited partners. The general partners control management and investment decisions for the FLP and assume full liability. The limited partners, meanwhile, aren’t allowed to participate in management, and their liability for the outcome of decisions is limited.
In a typical scenario, owners will transfer dealership interests, marketable securities, real estate and other assets to the FLP in exchange for a small general partnership interest and a large limited partnership interest. Owners can continue to gift additional partnership interest annually to their children and grandchildren using their annual gift tax exclusion.
This strategy enables owners to retain management control of the dealership while lowering the value of their taxable estate and, thus, the amount of gift and estate taxes due upon death. In addition, the limited partnership interests are relatively unmarketable since the holders have little or no control over the partnership. Therefore, these interests may qualify for valuation discounts of up to 30% or more, further reducing gift and estate taxes.
These tax benefits are legitimate. But, as mentioned, the IRS is on the lookout for FLPs it believes have been established solely for the purpose of tax avoidance. This is why it’s so important to establish legitimate non-tax reasons for creating and maintaining the arrangement.
What are some non-tax purposes?
The good news is that FLPs can serve a variety of different purposes besides lowering gift and estate taxes. These include:
- Keeping ownership of a family-owned dealership within the family after the current owners have moved on or retired,
- Enabling current owners to gradually transfer ownership interests to the next generation of leaders without giving up management control,
- Protecting assets from the claims of future dealership creditors, and
- Providing a high degree of flexibility so that the partnership agreement can be amended if the family’s circumstances change.
Another strategy is to place ownership of dealership real estate in an FLP, which would then lease the real estate to the dealership. Doing so would shift the rental income to the FLP partners, who could be taxed at a lower rate.
The strategy of placing dealership real estate in an FLP offers another benefit specific to dealerships: The transfer of ownership wouldn’t have to be approved by the automobile manufacturer, which would usually need to approve the transfer of limited partnership interests to an FLP.
Should it hold the business or securities?
It’s usually easier to establish a legitimate non-tax FLP purpose when the FLP holds the business entity rather than when it holds marketable securities. In several cases, U.S. Tax Courts have denied tax benefits for FLPs holding marketable securities when they determined that the FLPs were formed for personal reasons such as tax reduction and estate planning.
Conversely, the tax benefits of some FLPs have been preserved when families were able to demonstrate legitimate investment purposes for the FLP. These might include moves such as pooling assets to reduce investment management expenses and qualifying for investment opportunities that require large minimums.
Are they worth it?
Given the increased IRS scrutiny of FLPs, these arrangements may not seem like they’re worth the trouble. But they can be beneficial for dealership owners who want to keep ownership in the family after they retire, transfer ownership interests to the next generation gradually, and reduce gift and estate taxes. Again, the key is to make sure to establish an FLP for legitimate non-tax purposes — and to be able to document this if the IRS comes calling.
