How Can a Family Limited Partnership Prepare for IRS Scrutiny?

The IRS has often challenged FLPs (Family Limited Partnerships), contending they were created solely for the purpose of avoiding estate tax. The tax courts have generally rejected these challenges, recognizing that most FLPs are formed for legitimate business purposes. But lately, the IRS has had some success in the courts. Although this recent success has been touted as the FLP's death knell, it has in fact provided guidance on how an FLP can survive an IRS challenge.

Here are some tips:

• Have one or more substantial nontax purposes for creating the FLP (this is a requirement for a valid FLP).
• Keep good records.
• Create the FLP while you're still in good health.
• Observe all legal formalities when creating the FLP and while operating the business.
• Hire an independent appraiser to value assets going into the FLP.
• Transfer legal title of assets going into the FLP.
• Put only business assets into the FLP-- don't put any personal assets into the FLP.
• If you do put personal assets, such as your home, into the FLP, pay fair market rental for their use.
• Do not commingle FLP assets and personal assets--keep them separate.
• Never use FLP assets for personal purposes.
• Keep enough assets outside the FLP to pay for personal expenses.
• Distribute income to partners pro rata.