Protecting assets, avoiding scrutiny

A family limited partnership (FLP) is usually established specifically to reduce income or estate taxes or to provide limited protection of assets.

Here's how they work: The donor as general partner-typically a parent or grandparent-transfers family assets (such as rent-producing real estate, stocks, or other investments) into the FLP. The general partner retains control over the assets and bears the liability.

Lately, FLPs have come under increasing scrutiny by the IRS because of abuse. One recent case involved a man who, just two years before he died, transferred $2.8 million of assets to two newly created FLPs. Because he hadn't retained enough assets outside the partnerships to support himself, he ended up dipping into the FLPs to pay his personal expenses. The IRS argued that the FLPs be disregarded for tax purposes, and discounted assets be included in the decedent's gross estate. The assets in the FLP were ruled part of the man's taxable estate.

So far, the scrutiny has been directed toward estate reduction only. "There haven't been any IRS cases challenging an FLP for providing asset protection or for reducing income taxes," says Alan R. Eber, an estate-planning attorney in Encino, CA. Still, to stay on the safe side, follow these rules:

If you have an established FLP, meet with your attorney to review the partnership to make sure yours will stand up to IRS scrutiny. Warns Eber, "If the partnership doesn't treat its assets like a business, the IRS won't either."