Revisiting Family Limited Partnerships

This ALERT is captioned “revisiting” because I have previously offered some observations about these interesting estate planning tools about 18 months ago. If you missed that article and would be interested in reviewing it, just shoot me an e-mail and I will forward to your inbox ASAP.

A number of years ago, an enterprising estate planner postulated that the value of an asset could be diminished if the ownership of the asset was broken into component parts. The inspiration for this “revelation” was the situation that arises in closely held corporations, when two stockholders are involved in the business, but one of their positions is greatly diminished if he lacks control of the business. For example, if a corporation was worth $1,000,000 and there were two, 50-50, shareholders, each with the same rights to manage the business, each person’s interest would be worth $500,000. But, if one of them owned just one percent more, so that the ownership percentage was 51-49, the person with the 51 percent interest would control the business and would have the right to make all management decisions. Theoretically, the 49 percent shareholder’s interest should be worth $490,000, but the real world market place tells us that it is not, because of the inability of the minority shareholder to make management decisions. Therefore, whatever the minority shareholder gets for that 49 percent interest is a “discounted amount” reflecting the lack of control of the business. For purposes of this hypothetical, say a third party would pay $300,000 for that 49 percent minority interest. The difference between the theoretical value of that interest ($490,000) and the amount for which it sold ($300,000) is $190,000. That sum is the amount placed on the lack of control in the management affairs of the business because it represents a minority position in the company.

Keep in mind that when one dies, governmental entities collecting taxes on the transfer of wealth want to know the total value of the decedent’s assets. So, this approach can be very valuable in family estate planning. Assume in the above hypothetical that the “majority owner” is the husband, and the “minority owner” is the wife. Does the discounted value have any real practical effect? No, but for purposes of wealth transfer taxation it has a very real effect, as the value of each spouse’s interest together totals $810,000 – not $1,000,000. Presto! The asset’s value for estate tax purposes has been discounted by $190,000.

The enterprising estate planner argued that, due to lack of control, the ownership of almost asset could be fractionalized in a way that the sum of the components of an asset would be worth less than the total asset. The ownership vehicle of choice that emerged to implement this strategy was the limited partnership; but as the above example illustrates, this technique can be utilized with corporations, as well as limited liability companies. The Family Limited Partnership (FLP) became the hottest technique in estate planning. Additional theories of discounting emerged, with the leading one being a discount for lack of marketability.

The standard (if such an animal exists) structure of a Family Limited Partnership formulated for estate planning purposes works like this: A parent sets up the FLP, transfers assets to it (publically traded securities, or real estate, or an interest in a closely held corporation) and retains the general partnership interest, which includes the right to manage and control the assets. Various limited partnership interest are created which are either given to other family members at once (spouse); over time (children utilizing annual gift exclusions); or sold (spouse, children or others). The FLP operating document prohibits the owners of the limited partnerships interest from managing or otherwise controlling the assets of the partnership, so the value of those interests is heavily discounted for gift and estate tax purposes.

As one might guess, the Internal Revenue Service went ballistic when this estate planning device started to become utilized and contested its use at just about every turn. The arguments against them were primarily twofold:

That agency’s first argument was that the entire FLP was nothing but a tax-avoidance sham, so it would be disallowed for estate and gift tax valuation purposes. The IRS had success with this argument in cases in which the FLP was set up shortly before the taxpayer’s death, because it was able to argue that the FLP had no business purpose (no purpose really) other than to minimize the size of the decedent’s estate for estate tax purposes.

The other argument the IRS advanced in the “early days” of contest over FLPs was that in a FLP where the general partner has the right to control distributions to the limited partners (a typical FLP provision), then gifts of limited partnership interests were really gifts of future interests. Stated “in English,” what the IRS argued was that a limited partner had no real interest in the entity until the general partner died, that death triggering the distributions to the limited partners. Under the gift tax law, in order for a gift to qualify for the annual gift tax exclusion (currently $13,000 per year), the transaction has to involve the gift of a present interest. Accordingly, the establishment of interests in a FLP by gift often did not qualify and were void, or so argued the IRS. This argument was successful in cases in which the FLP document was very draconian. But if the FLP document provided for at least the possibility of management changes and different distribution schemes (even if the family never planned to implement them), the IRS lost the argument.

Today, with proper planning, a Family Limited Partnership can be used to achieve significant transfer tax savings. With properly drafted documents, the IRS now routinely accepts valuation discounts for lack of control and for lack of marketability. However, the points of which you MUST be mindful include:

Do Not Wait Until the Last Minute. In the words of Chico Marx, when the parent is on his or her death bed . . . itsa toooo late!! As long as the FLP has been inexistence well before the parent’s death and has been in operation, then the IRS cannot (and will not) make the argument that the arrangement is a sham transaction.
Selling Limited Partnership Interests is a “Better” Course of Conduct.
Assuming the children have some money, then selling interests in the partnership (at big discounts, of course) guts just about any argument the IRS could ever advance against the arrangement. First, a present value for the limited partnership interest is established that the IRS will have a hard time contesting down the road at the time of the parent’s death. Therefore, the possibility of a challenge on the decedent’s estate tax return is minimized. (Note: for decedents dying in 2010, there is no Federal Estate Tax; but long-term, all tax professionals expect it to return. In light of the huge federal deficit, its return may be with a vengeance!) If the children do not have money, the limited partnership interests can be obtained via an installment sale. Just be careful to ensure that an adequate interest rate is charged on the obligation.
The Family Limited Partnership MUST be a Separate Entity. Not just in name only! The general partner can have control over whether to buy or sell assets held by the partnership, but he or she must transact business within the FLP. For example, the general partner should NEVER deposit partnership checks into a non-partnership bank account.
The Family Limited Partnership MUST be an Actual Functioning Entity.
Not only should the FLP be treated as a separate entity, it must actually operate AND have some purpose. The only way to avoid the ability of the IRS to successfully argue that there is no business purpose to the FLP is to make sure it HAS a business purpose. Accounts should be set-up in the name of the FLP and it should transact business as a FLP. If it is doing business, the IRS cannot say otherwise!

In summary, the Family Limited Partnership as an estate planning tool can be dramatically effective. But it also illustrates yet another area in which it is so important to get good, competent, advice. This is an exceptionally complex area, and certainly not one you should attempt to navigate on your own.

Work with a competent professional!!