Focus

The U.S. government has increased the amount of assets from $1.5 million to $2 million you can pass to your heirs tax-free, but it hasn't made it any easier for you to execute "deathbed transfers," or family limited partnerships (FLPs).

FLPs can be risky propositions for family businesses because the Internal Revenue Service (IRS) is almost certain to initiate an audit when one is formed. In an FLP, a parent—before dying—transfers his assets (which can include real estate, securities or a family business) into a partnership formed with his children. The advantage of an FLP is that once formed, its assets are more difficult to sell, thereby decreasing its taxable value by as much as 40 percent. Once the parent dies, the children then can disband the partnership and sell its assets.

Of course, the IRS sees FLPs as yet another ploy for business owners to avoid paying significant estate taxes. In fact, in a July 2005 ruling against the FLP of Albert Strangi, his family was forced to pay the IRS $2.6 million. Strangi had formed his FLP two months before he died and included his house in the FLP; he continued to live in the house rent-free for the remaining two months of his life. In addition, during the two-month period, Strangi took money from the FLP when he needed it for personal expenses, defeating the idea that what he formed was an equal "partnership."

To successfully form an FLP, make sure the reason is not to avoid the estate tax. You'll have to document in writing meetings you have had with your children to prove you intend to transfer your business to them. In addition, don't allow any partner to contribute to or take distributions from the FLP unless done so according to a set schedule. Also, no partner (such as the parent) should contribute all his wealth to the FLP; each partner should have enough assets on which to survive without counting on taking distributions from the FLP.

If you think an FLP would work for you and your family, make sure you consult an attorney before forming one. Proper documentation is key to surviving an inevitable audit.

Ambika Puniani Bailey is editor of Professional Roofing magazine and NRCA's director of communications.