Fundamentals of Family Limited Partnerships
 
July 15, 2003
 
Alvin Geske - Washington

A family limited partnership (FLP) is a limited partnership composed of a general partner and limited partners. The general partner, who has the power to make virtually all decisions on behalf of the partnership, is generally an entity (an S corporation or limited liability company (LLC)) controlled by family members. The general partner ordinarily has a very small percentage interest in the partnership (usually one percent). The initial limited partners are the members of the older generation, who have a very large percentage interest in the partnership (usually 99 percent). Under the partnership agreement, the limited partners have no rights to participate in the day-to-day management of the partnership. The partners contribute investment assets, and profits and losses are allocated pro-rata to the partners. The limited partners may, and frequently do, make gifts of limited partnership interests to the younger generation during their lifetimes.

Tax Advantages

The principal tax advantage is a valuation discount, usually of from 30 to 48 percent on the value of the transfer subject to tax. Discounts may exceed 50 percent in appropriate circumstances, but there is penalty exposure if such a discount is completely disallowed. The transfer tax savings is generally a highly important reason for a client to utilize a limited partnership. The discount is generally greater for real estate and less for publicly traded securities. It is also generally greater when the property does not produce cash flow.

Valuation Discount. The valuation discount arises because non-controlling ownership interests in business or investment entities are not valued at the value of a proportionate interest in the underlying assets (net asset value). Recognized valuation methodology provides that such interests are entitled to discounts for lack of marketability and control. These discounts recognize the economic realities that such interests cannot be sold for net asset value because they are not marketable — that is, they cannot be readily sold like shares of stock in a publicly traded corporation — and they do not permit the transferee to exercise control over the activities of the business or investment entity, thus resulting in the owners’ subjection to the discretion and business judgment of another party both for operating results and the timing of distributions (if any).

Trying to quantify the expected tax savings involves determining when property is likely to be sold as well as determining effective transfer tax and income tax rates. In general, the transfer tax savings must be offset against the present value (as of the time the transfer tax would have been paid) of the income tax cost resulting from the reduced basis step-up (which applies only if the estate tax applies because the limited partnership interest is included in the decedent’s estate). If property is expected to be retained in the family for many years, the income tax offset can be ignored. Also, when the property is sold there will be cash proceeds to pay the tax, which is not the case with the transfer tax.

Example 1. Taxpayer owns raw land worth $5 million with a zero basis that will be sold five years after the taxpayer’s death. The discount is assumed to be 50 percent. The estate/gift-tax rate is 49 percent. The combined federal and state income tax rate on the sale is estimated to be 25 percent. The estate tax savings will be roughly $1,225,000 [49 percent of $2,500,000]. The loss of a full basis step-up will mean that the capital gains taxes on sale would be $625,000 [25 percent of $2,500,000] greater, but that figure would have to be reduced to the present value as of the due date of the tax return to reflect that the tax has been deferred by about five years. Stated another way, the savings would be $600,000, plus the time value of having $625,000 for five years. Even at an assumed‑discount rate of four percent this deferral is worth about $111,000.

Example 2. Taxpayer owns publicly traded stock worth $5 million with a zero basis that will be sold five years after the taxpayer’s death. The discount is assumed to be 40 percent. The estate/gift-tax rate is 49 percent. The combined federal and state income-tax rate on the sale is estimated to be 20 percent. The estate tax savings will be roughly $980,000 [49 percent of $2,000,000]. The loss of a full basis step-up will mean that the capital gains taxes on sale would be $400,000 [20 percent of $2,000,000] greater, but that figure would have to be reduced to the present value as of the due date of the tax return to reflect that the tax has been deferred by about five years. Stated another way, the savings would be $580,000, plus the time value of having $400,000 for five years. Even at an assumed discount rate of four percent, this deferral is worth about $72,000.

Example 3. The facts are the same as Example 2 except there are two separate blocks of stock – Stock A, with a basis of $2,500,000 and a fair market value of 2,500,000 and Stock B, with a basis of zero and a fair market value of $2,500,000. For simplicity, it is assumed that decedent retained a 90-percent limited partnership interest at death, with respect to which the net asset value in the partnership was $4,500,000. As a result of the 40-percent valuation discount, the interest is included in decedent’s estate at a value of $2,700,000. The donor’s spouse receives a 45-percent interest in the limited partnership and the other 45 percent is left to decedent’s children. Stock B is distributed to the spouse in liquidation of the spouse’s partnership interest within two years of the transfer of the interest to the spouse. The adjustment should increase the basis in Stock B to $1,350,000 – the basis is the spouse’s inherited partnership interest under Section 732(d) of the Internal Revenue Code. Note that this is better than an election under Section 754, which would result in a basis step-up of only $450,000 [$2,700,000 – 2,250,000 (2,500,000 x 90%)].

Example 4. Taxpayer owns a family business corporation worth $5 million with a zero basis that will be not be sold for many years. The discount obtained by placing the corporate stock in a family limited partnership is assumed to be 50 percent. The estate/gift-tax rate is 49 percent. In this situation, the potential income tax offset can be ignored. The estate/gift tax savings will be roughly $1,225,000 [49% x $2,500,000].

Non-Tax Advantages

The non-tax reasons to form a family limited partnership include:

• Transfer a group of assets into a form of ownership that is simpler to transfer (to facilitate annual and other gift-giving programs).

• Centralize management and obtain the benefit of continuity of management over the partnership’s assets.

• Provide protection to partnership assets from claims of future creditors of the limited partners and to limit the limited partners’ liabilities for partnership debts.

• Provide unified control (through the general partner) over distributions of cash derived from earnings on the partnership’s assets.

• Provide flexibility in business planning not available through trusts, corporations or other business entities.

• Conduct investment and business activities in an entity that is not itself subject to federal or state income taxes.

• Avoid the delay, publicity, inconvenience and expense associated with probate administration of multiple separate investments of the partners upon their respective deaths or liquidation.

Disadvantages

• Locks assets in the partnership for a period of time, generally not ending until the expiration of the statute of limitations for the last year during which transfers were made.

• Records must be kept, and annual tax returns must be filed, for the partnership and the corporate or LLC general partner. Appraisals must be made to establish the value of the gifted limited partnership interest. The investment in legal, accounting and appraisal fees for formation and administration of a FLP are significant, but the savings achieved often exceed costs by a multiple of 20 or more.

• Use of FLP clearly enhances the chance of gift or estate tax return being examined, and perhaps contested in court. Many “traps for the unwary” if partnership form is not respected.

• Could create or increase liquidity problems of estate by locking up assets that could otherwise be used to pay estate tax.

• Could be problems if highly leveraged real estate is being transferred to the partnership.

• Could be income tax problems if property is distributed to donees within seven years of contribution (see disguised sales rules of Sections 731(c) and 737 of Internal Revenue Code).

For Whom Is this a Good Strategy?

• Estate of at least $2.0 million for single individuals and $3.0 million for married couples.

• Generally requires ability to put at least $1.5 million of securities or “non-personal use” real estate in a partnership and be supported by non-partnership assets. There are situations in which personal use property may be used effectively, but donor must not be put in a situation where he or she must rely on invasion of partnership principal for support.

• Donor must have a toleration for complexity of maintaining assets of partnership separate from personal assets and for filing separate tax returns for partnership and corporate or LLC general partner.

• Usually works best with marketable securities or real estate, although limited partnerships have been used successfully to hold interest in closely held businesses, personal use property, or certain types of tangible personal property (e.g., horses or cattle).

• For greater estate tax savings, donor must not control general partner at the time of death.

Comparison with other Estate Planning Techniques Like Gifts or Family Sales

There is no requirement of surviving a particular period to obtain benefits (as long as it is not a true “deathbed” transfer). Also, there is an immediate reduction in the value of property, which will apply to lifetime transfers and death time transfers.

The benefits do not require interest rate plays or that property appreciate at a greater rate than an assumed interest rate.

Although FLP issues have been litigated frequently and taxpayers win these decisions far more often than not, the availability of benefits is less secure than benefits with specific statutory sanction, such as Grantor Retained Annuity Trusts (GRATs).

When compared with use of undivided fractional interests in real property, the advantages are often as follows: (1) the discounts generally are higher (especially in cases where the property yields current income); and (2) the FLP is much easier to use for periodic transfers because interests are more easily assigned. A disadvantage of the FLP is that the undivided property approach may make it somewhat easier to avoid IRS challenges to the structure of the transaction. The IRS could still argue that there was no transfer in substance if the donor retained all of the income from the property, even though valuation of the interests may create a dispute.

Special Considerations

Gift on Formation. The IRS may argue that diminution in value on formation of partnership results in an immediate gift. So far this argument has been unsuccessful where documents are properly done. Exposure is greatest where other parties control general partner at formation.

Qualification for Annual Exclusion. Gifts of limited partnership interests qualify for the $11,000 per donee annual exclusion only if they are gifts of present interests. If the recipients have no rights to transfer the interests or to receive distributions, the gifted interests may not qualify.

Retained Control Pulls Back Gifted Interests into Donor’s Estate. Code Section 2036(a) generally requires inclusion in the decedent’s estate of property transferred during lifetime if he retained sufficient control over the gifted property. The IRS has argued, with some degree of success that this provision applies when the decedent controlled the general partner or had the power to remove the general partner and the general partner’s power over distribution and transfers of interests are sufficient to conclude that the interests were not completely transferred.

For more information, contact Alvin J. Geske via e-mail at alvin.geske@hklaw.com or call toll free 1-888-688-8500.