ABUSES OF ESTATE VEHICLE RAISE IRS IRE: FAMILY FRIENDLY? NOT THESE FEDS

The Internal Revenue Service is taking aim at a popular estate-planning technique.

Long used as a vehicle to pass on the family business, family limited partnerships have recently become popular cure-alls for everything from estate taxes to angry creditors. And the IRS isn’t happy about it.

So it has recently begun mailing lengthy questionnaires to some of the taxpayers who have benefited from family limited partnerships, gathering detailed information on everything from the purpose of the partnership to the names of those involved in setting it up. The inquiry is the start of an IRS campaign to crack down on abuses of the privilege.

“We’re starting to see cases where people are putting things like the family car or mom’s house into a family limited partnership,” says an IRS lawyer who spoke on the condition of anonymity. “People are using these partnerships to take discounts on assets they would otherwise receive as gifts. The supposed loss of value is more illusory than practical.”

Targeting terminally ill

The IRS, with limited success, is also increasingly challenging a number of partnerships, particularly ones in which the family members were terminally ill and on life support at the time the partnership was formed.

“The IRS is definitely on the warpath,” says Gideon Rothschild, a lawyer with Moses & Singer in New York.

Even the White House is getting in on the act. In his new budget proposal, President Clinton asked for legislation that would withhold the allowable discount from those family limited partnerships where the property is a non-operating business. That would include stocks, bonds and personal real estate.

more and more popular

The offensive comes at a time when the IRS is attempting to portray itself as “kinder and gentler,” and the popularity of family limited partnerships is at an all-time high. Seminars extolling the virtues of such partnerships — which create a structure for owning and managing assets that are discounted to their value outside the partnership — are big draws on the conference circuit. And the Internet is rife with sites touting huge tax savings realized by family limited partnerships.

“We’re using them as often as we can,” says Larry C. Rabun, national director of estate planning services for Deloitte & Touche. “They are very appropriate devices, not just for tax savings but for control and economic reasons.”

The main benefit of a family limited partnership is control. They allow a parent or grandparent to continue to manage his or her property and limit gift and estate taxes by heavily discounting the value of property transferred to heirs. Meanwhile, the family members co-own the assets as limited partners, which means they are protected from creditors if one of them gets into financial difficulty.

It works like this. The owner of real estate, a small business or a stock portfolio puts that property into a family limited partnership. He or she keeps an ownership interest, often only 1% or 2%, and becomes the general partner. The rest of the ownership interests then can be conveyed to the limited partners as gifts.

no voice in management

Under the partnership structure, the general partner retains management control and may draw a management fee. The limited partners have no say in day-to-day operations.

Because the limited partners have no control over the partnership assets, the value of those assets may be decreased. The typical discount is about 35% to 40%, although some taxpayers have taken discounts of as much as 70%.

The tax savings from the discount can be substantial. With a 40% discount, for example, a partnership with stock and real estate worth $1 million would be valued at only $600,000 — below the $625,000 trigger for federal estate taxes.

Lured by the promise of such tax savings, wealthy taxpayers and their advisers are latching on to the family limited partnership with gusto. An increasing number of such partnerships are being formed with no underlying business purpose other than tax avoidance, say wary experts.

And the IRS aims to put an end to it. Since early 1997, the service has issued more than half a dozen so-called private letter rulings challenging the use of family limited partnerships. It’s also taking a growing number of partnerships into tax court — or at least threatening to.

In one recent case, the IRS challenged a partnership discount of more than 50% reported on the estate tax return of woman in Texas.

In that case, the woman’s son (acting on her behalf) transferred mainly stock assets into a family limited partnership a little more than a year before her death. The IRS disallowed the discount, arguing that the partnership was entered into purely for tax-savings purposes.

sudden reversal

Two days before the deadline for setting a trial date, however, the IRS backed down, allowing the discount.

While many were quick to interpret the concession as a sign that the IRS is backing off in its attack against family limited partnerships, such a reading is likely to prove optimistic.

“The IRS is not going away,” says Stacy Eastland, the Houston lawyer who represented the woman’s family in that case. “They are just waiting for a better case.”

One thing is clear: Those who have been utilizing family limited partnerships for years aren’t happy about their newfound popularity.

“I wish people never even heard of family limited partnerships,” says Roy C. Ballentine. He’s a fee-only financial planner at Wolfeboro, N.H.-based Ballentine & Co. Inc., which caters to high-net-worth clients. “The IRS is going to jump all over these things and kill the whole idea. It’s classic.”