At InKnowVision, we are frequently involved as consultants in Family Limited Partnership and Family LLC estate tax audits. The IRS continues to attack on the basis that there is no business purpose for the entity, and those attacks are winning far too often. More often than not the whole non-tax business purpose issue, which should be easily achieved in most family entities, is merely given lip service and left to be accomplished by boilerplate recitals in the entity agreement.  

So, although we've discussed these issues in the past, let's revisit some key defenses to these IRS attacks so that you can approach any audit with confidence. Of course, the business purposes we identify must be in keeping with the goals and objectives of each individual client.

Surprisingly, all of this can be accomplished with a few client counseling discussions, and the consistent use of a “business purposes checklist.” The checklist we use to help facilitate these discussions can be found at the end of this article.

One of our recent cases involves five children. Three of them are doing well; two are not. The parents do not want to disinherit the children who are deemed financially irresponsible, but they also don't want to risk investment losses or fights between siblings over control of those investments. As the family's advisor, you might conclude that a family investment entity, such as an LLC or LP would be a perfect fit.

The children who are less financially responsible can hold limited partnership interests, while the investment savvy children can be the managers. Additional terms, such as enforceable limits on the sale of LP units, and requirements for distributions of profit not needed to continue business operations, can be drafted into the agreement. Now, when the IRS comes calling and asks for your non-tax business reasons for forming the entity, you have a clear story that provides a satisfactory explanation.

You should be aware that the IRS often develops its offense by talking to the family members involved in the entities. Therefore, you too should be talking with those family members – before, during, and after the implementation of the strategy. Here are some things to talk about:

• Have a family meeting to discuss how and why the entity is being formed in the

first place.

• Explain why the plan is being structured the way it is.

• Share with family members that those with the most successful investment

experience will be running the partnership.

• Explain why the children without the investment acumen will be non-managing

owners, but will still benefit from the success of the business.

• Reduce your discussions with the family to writing. Explain in a letter or a memo

the concerns of the family, and explain why the entity recommended is especially
suited to fit the family goals. When this letter comes to light, which it likely will, it
will serve to answer the IRS's question before they ask it, and it will also serve as
reminder many years later to all of those involved as to why the planning was
recommended. Memories fade. This is a great way to keep them fresh.

• Review the reasons for the entity and its structure at every annual meeting of the

entity. This provides annual reinforcement to the family members as to why the
planning was done.

The key is to make sure that the planning, the implementation, and the maintenance

are more than perfunctory. This will lead to better results, and certainly justifies more

than the token fees that are too often quoted for this complex and serious work.

InKnowVision

www.inknowvision.com

Non-Tax Reasons to Form a limited partnership or LLC

a. To Make a Profit – The primary reason for creating this Entity is to make a profit.

b. To Increase Wealth – This Entity will provide an effective legal vehicle to increase the wealth of the Members and their families.

c. To Provide Centralized Management of Investments – This Entity is designed to hold investment assets and allow for centralized management of those assets.

d. To Manage and Develop Real Estate – This Entity will provide the legal vehicle to effectively manage and/or develop any real estate owned or acquired by the Company.

e. To Avoid Two Layers of Taxation on Profits – This Entity provides flexibility in business planning not available to the Members through trusts, corporations, or other business entities.

f. To Make Gifts Without Fractionalizing Assets – This Entity establishes a method by which annual gifts may be made without fractionalizing family assets.

g. To Make Gifts Without Causing a Loss of Incentive – This Entity provides a method of ownership which allows gifts to be made to children and other beneficiaries without causing a loss of productivity or the incentive to strive to do well.

h. To Control Cash Flow to Members – This Entity provides a structure by which the Manager can control the assets and the cash flow to Members to achieve the legitimate purposes of the Company.

i. To Provide a Buy-Sell Arrangement – This Entity provides an orderly buy-sell arrangement between the members of the families that own membership interests to keep the ownership of Company assets in those families.

j. To Resolve Disputes Privately – This Entity provides for mediation and binding arbitration in disputes by Members that is intended to prevent expensive and embarrassing public litigation of private family business matters.

k. To Require the Losers of Disputes to Pay the Dispute Costs – This Entity requires the loser in any dispute to pay for the costs of the dispute.

l. To Restrict the Right of Non-Members to Acquire Interests – This Entity restricts the right of non-Members to acquire interests in Company assets.

m. To Prevent Transfers of Membership Interests Because of Failed Marriages – This Entity prevents the transfer of a family member's interest in the Company because of a failed marriage.

n. To Prevent Commingling of the Assets of Gift Recipients – This Entity creates a method of ownership that will prevent gifts made to family members from being commingled with assets owned by others.

o. To Make it Difficult to Withdraw – The restrictions in this Operating Agreement make it difficult for any of the parties to withdraw from the Company once they become a Member.

p. To Protect Members from the Company's Creditor Claims – This Entity limits the liability of Members from the Company's creditors and further limits the liability of Members holding particular Series of the Company from liability associated with other Series of the Company.

q. To Provide Asset Protection for Members – This Entity protects the family resource base from the claims of future creditors of Members.

Scott Hamilton, CEO, InKnowVision, LLC

www.InKnowVision.com

Scott@inknowvision.com

 To learn about Scott Hamilton click here!