Estate Tax Reduction Strategy Fails IRS Scrutiny

Family Limited Partnerships (FLPs) can be powerful estate planning tools. They allow business owners to transfer wealth to the next generation while retaining control. However, a new Tax Court case, Estate of Fields (TC Memo 2024-90, 9/26/24), proves that these structures must serve a legitimate business purpose—not just tax avoidance.

The court ruled that a $17 million business asset transfer into an FLP was invalid for estate tax purposes. The IRS successfully argued that the taxpayer retained control over the assets, leading to a full estate tax liability plus penalties.

How Family Limited Partnerships (FLPs) Work

A Family Limited Partnership (FLP) is often used to:

1. Transfer business interests to heirs while maintaining control.
2. Reduce estate tax liability through valuation discounts.
3. Protect assets from creditors or legal disputes.

Typically, a business owner forms an FLP and acts as the general partner, managing operations. Family members, such as children or grandchildren, become limited partners with ownership but no decision-making authority.

By gifting shares over time—often using the annual gift tax exclusion—the owner gradually transfers wealth while lowering the taxable estate value. Valuation discounts, often as high as 30% or more, further reduce tax liability.

However, the IRS closely scrutinizes FLPs, especially if they appear to exist only for tax reduction.

The Estate of Fields Case: A Failed FLP Strategy

Case Facts:

1. The taxpayer owned a profitable Texas oil business inherited from her late husband.
2. She had Alzheimer’s Disease and was in declining health.
3. Using a durable power of attorney, her great-nephew transferred $17 million in business assets into an FLP.
4. In return, she received a 99.99% limited partner interest with a discounted value of $10.8 million.
5. Despite the transfer, the FLP paid for her living expenses.
6. She passed away within a month of the FLP’s creation.
7. The estate claimed the discounted $10.8 million value, reducing estate tax liability.

IRS & Tax Court Ruling:

The IRS challenged the transaction, arguing that the taxpayer never truly gave up control over the transferred assets. The Tax Court agreed, highlighting several key issues:

1. Timing: The taxpayer died within a month of forming the FLP.
2. Retained Control: The FLP was used to pay her personal expenses.
3. Lack of Separation: The FLP operated like a personal bank account.
4. Estate Tax Payment: FLP funds were used to pay estate taxes.
5. High Valuation Discounts: The estate applied steep discounts despite the taxpayer’s majority interest.
6. Limited Involvement: The taxpayer did not actively participate in the planning—her great-nephew controlled the process.

Because the taxpayer continued to benefit from the assets, the court ruled that the full $17 million value was taxable. The estate also faced IRS penalties for improper tax reduction attempts.

Key Takeaways: Avoiding FLP Pitfalls

If you’re considering an FLP for estate planning, take these precautions:

1. Ensure a Legitimate Business Purpose – The FLP should serve an actual business function, not just tax savings.
2. Do Not Use FLP Funds for Personal Expenses – Keep FLP finances separate from personal accounts.
3. Plan Early – Transfers should be made well before health declines to avoid IRS scrutiny.
4. Retain Cash Reserves Outside the FLP – Ensure personal expenses can be covered without FLP withdrawals.
5. Be Cautious with Valuation Discounts – Overly aggressive discounts raise red flags with the IRS.
6. Avoid Excessive Control – The original owner should reduce involvement to demonstrate a real transfer of ownership.

Bottom Line:

FLPs can be effective estate planning tools—when structured correctly. However, if they lack a legitimate purpose and merely serve as a tax avoidance scheme, the IRS will challenge them.

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