People make FLP's for many "business reasons," because in the eyes of the government, you have to have a "business reason" for them to recognize the FLP. The real reason most people make an FLP is that you can use it to discount the value of your assets, keep them in the family, and easily and effectively transfer these to your next generation.
Here is the basic model:
The Smith family are farmers. Simple folk, but they have done well, and own their own 10000 acre farm with a thriving cattle and ranching business on it. It's now worth $100 million, and Ole' man Smith is on his last legs. Ole' man Smith transfers the business into an FLP. Nothing changes, it is a non-event for tax purposes. He now does not own the farm though: the FLP does. He owns 100% of the FLP. Now we can go to work. Ole' man Smith transfers 40% to his spouse, Granny Smith. No tax, as it is between spouses. Then, he uses he and Granny's gift tax lifetime exclusion amount (~$10 million) to transfer an additional 10% each to his children, Steve and Kevin Smith.
If Ole' man Smith died now, what did he own? A $100 million farm? Well yes, obviously, right? Wrong. He had a 40% interest in a FLP. That's it. What's that worth? Good question, to which the government lets you ask more questions: could he sell it? Did he have control? Was there a market for this type of thing? The answer to all of those before the FLP was yes, and if he died he would have paid tax on a $100 million business. Now, after the FLP, the answers have changed. He can't really sell it, he doesn't own it all. He can only sell what he owns. No, he doesn't have control, he has less than half. Is there a market for partial interests in partnerships? I don't know of one. All of these add up to a $100 thing now being worth something a lot less, usually around 30% less.
And that is just the valuation discount for the underlying assets. Further, each gift of a "percentage" of the FLP is discounted in and of itself, so that 10% gift to the kids is really worth 30% more than a straight cash gift would have been, allowing you to leverage your gift tax credit and annual exclusion amounts.
So a couple pieces of paper just saved Ole' man Smith's estate millions, you can use the FLP to legally and easily transfer more to the kids, and as a plan for the business in the future. Easy right?
It gets better. The 5th Circuit Court of Appeals just upheld a case, Keller v. United States (S.D. Tex. 2009), where a wealthy Texas widow who formed a FLP but failed to fund it with the $250 million in corporate bonds she owned before she died. Her estate then paid $147 million in taxes. Big hit. A wise advisor then attended a Continuing Legal Education course, where they learned that intent to fund is enough to show evidence of a completed FLP. The estate then funded the FLP, and took out a "loan" to pay the taxes, and sued for a refund.
At trial, the court held that the intent to form and fund the FLP effectively established the partnership, as intent is good enough under Texas law. It also found she created the FLP for business purposes, not just for tax and valuation uses. Here is where it gets really good: the court upheld a total of 47.5% in discounts on the value of the FLP assets. 47.5%! They also got a refund for the interest they had to pay out on their "loan."
Take away: FLP's can be amazing things. They are one of the last, great, IRS approved vehicles to use to your advantage. However, they can and will be disallowed if you do not do it right.
Does the use of an FLP increase the likelihood of audit?
Historically, yes. There was a time when just about every FLP was getting audited, as the IRS wanted to lay down the law on just how far these discounts were going to go. Now it is a little better, but it definitely does not decrease your likelihood of audit.
Hopefully you have nothing to hide.
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