Proper planning and formation of the FLP is critical, but there are certain events that must be avoided or you could risk invalidating the FLP. If the person or persons transferring assets to an FLP are terminally ill, the IRS may invalidate the FLP as it is seen as a way for the transferor to hide assets rather than protect them.
It is equally important not to transfer all of your assets to an FLP. A person must maintain sufficient funds to handle daily expenses. Failure to do so could have adverse tax effects. Also, one cannot use FLP assets to pay personal expenses without following the FLP terms. Of course, this refers to FLP distributions to the owner. An owner cannot simply take money anytime he chooses to do so. There are specific circumstances in which distributions may be taken and these must be listed in the FLP agreement.
The FLP must not make excessive distributions to an owner to pay living expenses. Upon the death of the owner, the FLP does not have to pay estate expenses or estate taxes. That must be handled with the owner’s personal funds or through a life insurance policy. Distributions to certain partners and not others can spell tragedy for an FLP.
An FLP is a legal business entity and should be treated as such. The proper transfer of assets must be handled legally. If a home is being transferred, then a real estate deed must be drawn up and filed with the appropriate government entity. The same is true for a vehicle. Title and registration must be transferred through the Department of Motor Vehicles. The other assets that have property title must be alienated in the same way. Other assets can be transferred by means of a deed of sale stating the date, the name of the assignor and what was transferred. A nominal purchase price must be made. In addition, the FLP must keep proper books and records as any business would. If there are no changes to FLP’s business or investment strategies, the IRS can challenge the validity of the business.
No active participation of younger family members
When any of the limited partners are not actively involved in business decisions and unaware of the operations, then the FLP may be in jeopardy. All family members should be able to obtain independent legal advice or hire an appraisal expert; otherwise, the IRS may not allow tax benefits.