Handle This Tax Dodge With Care

With mom hooked up to a life-support system, her grown children had to act fast.

They stood to inherit millions of dollars, but unless they took immediate action, most of the money would go to Uncle Sam in the form of estate taxes. So the siblings did what hundreds of thousands of American families who fear the dreaded "death tax" are doing: They transferred their ailing mother's assets--real estate and securities--into a family limited partnership, or FLP, leading to a potential tax savings of around 48%. Two days after the partnership was created, the plug was pulled, and their mother died.

BLATANT CASE. Inappropriate? The Internal Revenue Service sure thinks so. The episode may sound like a bad TV-movie, but this real-life drama has caught the attention of the IRS, which in a March memo declared the partnership invalid. Tax experts say that it took such a blatant case for the IRS to publicly denounce what it views as an increasingly widespread problem: the abusive use of FLPs to avoid estate taxes. Traditionally, such limited partnerships have been created to hold real estate assets, or to operate family businesses. But lately, families with sophisticated legal counsel have figured out that FLPs can shelter even marketable securities from the full impact of estate taxes, says Kenneth P. Brier, a partner and tax attorney at Sherburne, Powers & Needham in Boston.

Now, tax attorneys across the country are worried that the IRS is planning a full-scale crackdown on all family limited partnerships, says Santa Clara University law professor Jerry A. Kasner. If so, the impact will be far-reaching, even affecting folks with less than $1 million in assets who are using FLPs to protect assets from creditors or former spouses. If your FLP is not properly structured, expect to find yourself in tax court. Done right, on the other hand, FLPs can be a valuable estate planning tool, offering more than just tax advantages.

Here's how they work: The donor, usually a parent, transfers the assets to the FLP and becomes the general partner, thus maintaining a controlling stake in the partnership. The spouse and/or children become limited partners and receive interests in the FLP through gifts. It's up to the general partner to determine whether any earned income is reinvested or distributed to the kids.

Since the limited partners have no control over the assets, they receive shares at a discounted value. A lawyer will recommend an appraiser who will determine what an appropriate discount would be. Depending upon the type of assets, discounts will run from 25% to 60%, allowing the children to inherit more after estate taxes are paid than if the parent had given them the assets outright, says Jerome A. Deener, a senior partner at Deener, Feingold & Stern in Hackensack, N.J.

HOARD PAPER. If you are currently using or considering creating an FLP, there are several ways to protect yourself from IRS scrutiny. First, make sure the partnership is well-drafted. Ask your attorney for a copy of the filing certificate. The partnership agreement should clearly state your nontax reasons for creating it, such as protecting assets from future creditors or ex-spouses. Save any supporting documents that prove tax-avoidance was not your sole motive. Establish a separate bank account for the partnership and save all records.

More important, parents need to treat the children as real limited partners. "Make sure the children receive distributions that are proportionate to their share of the partnership," says Owen Fiore, a principal of the Fiore Law Group in San Jose, Calif., which specializes in estate planning. The general partner must file IRS form 1065.

You shouldn't skip a qualified business appraisal, either. If you should face an audit, such an appraisal will help you prove that the discounted value of the shares was reasonable. Even marketable securities must be appraised because the discount is based upon the value of partnership interests. Expect to pay from $12,000 to $15,000 in legal and appraisal fees. "The burden of proof is on the taxpayer," says Fiore. If you're not willing to invest the requisite time and money setting up the partnership, don't be surprised if Uncle Sam comes along and pulls the plug.

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