Family Limited Partnerships (FLPs) are powerful tools for transferring wealth and reducing the size of an estate.  But when misused or used incorrectly, no tool can fulfill its purpose, and FLPs fall under this rule all too often.

For example, in a recent case before the Tax Court, a decedent’s property, which had been transferred to a FLP, had to be brought back into his estate despite the fact that he had made gifts of partnership interests to his children.  Why?  Because the decedent failed to follow the rules.

After being diagnosed with terminal cancer in 1993, the decedent created a revocable living trust and a FLP with the help of his accountant.  The decedent and his two children were trustees of the trust, which was the FLPs sole general partner.  The trust held 98% of the decedent’s property and transferred it all to the partnership.  The decedent then made gifts of 30.4% interests in the FLP to each of his children.

However, even after transferring his property to the FLP and gifting his children’s interests, he continued to treat all property as his own.  He failed to pay rent for the use of his residence (which was owned by the partnership), and he used the FLP’s property to pay his personal expenses.

The estate tax return claimed that the decedent owned only a 36.46% limited partnership interest and a 1% general partnership interest, but the IRS  contended that the entire value of the FLP must be included in his estate.  The Tax Court sided with the IRS.

According to §2036(a), a decedent’s gross estate must include transferred property if the decedent retains the use, possession, right to income, or other enjoyment of the transferred property.  The Tax Court explained that since the decedent continued to enjoy the use of the property within the meaning of §2036(a), the property must be included in his estate despite the transfer of the property to the partnership.