The Family Limited Partnership (FLP) and “Valuation Planning.”

These are best suited for an estate consisting largely of real estate or a family business, but not a professional practice or firm. (The use of money or capital resources must be a major income producing component of the enterprise-as opposed, for example, to a medical practice, where personal services generate the income.) The FLP is an “ordinary” limited partnership, organized under state law, in which the partners happen to be a small, closely related group.

What are limited partnerships? First, one must understand the general partnership: This is a group of individuals who have agreed to collectively own and manage some form of property or business. No organizational papers need to be filed. Each partner has a share of income and management voting rights proportional to his/her percent ownership. But each partner, personally, is fully liable for 100% of all partnership debts and other liabilities.

General partnerships are not useful for estate planning. Parents want to transfer property to their kids to avoid its inclusion in their taxable estate, but they do not want to give up the control that goes with that transfer of ownership. Also, the unlimited liability of all partners is an unacceptable risk in most families.

How are limited partnerships different from general partnerships? They have two classes of partners-general and limited. General partners run the business, regardless of the percentage they own. They have unlimited liability. That means that if partnership property were insufficient to satisfy creditors, any other, individual property of the general partners could be at risk. In the typical FLP, these are the parents.

Limited partners have no control and limited liability-their amount at risk is limited to their ownership stake. In the FLP, the children are the limited partners. (Note that limited partnerships do have to file papers with the state, and comply with state limited partnership laws.)

What’s so good about the limited partnership? It was designed by law as a form of business organization that any group of investors might use to undertake a business or financial venture. But its structure also happens to facilitate parents’ estate planning. So increasingly, the limited partnership is being used, where appropriate, as a means of holding and distributing family wealth. The operation and benefits of a FLP are best illustrated by example:

Family property (e.g., stock in the family company, and/or real estate) is placed in the name of the partnership, which is divided (on paper) into 100 “units” of 1% each. The parents assume two ownership and management roles. Wearing the hats of general partners, Mom and Dad take 2 units, and hold 98 units as limited partners. At this point, they fully control the partnership business and property in their role as general partners. They also happen to own 100% of everything, anyway-for now.

The parents begin a series of yearly gifts (each worth $12,000 or less) of partnership units to children or grandchildren. The plan is to slowly reduce their taxable estate, by taking advantage of the annual exclusion from federal gift and estate tax of $12,000 per person, to each donee. The making of gifts is simpler using partnership “units,” especially when several different, and difficult to divide assets are owned.

What about the parents losing management control by giving away an increasing share of ownership to the children over time? No problem. The parents remain firmly in control, due to their role as general partners. This has nothing to do with their ownership percentage. To ensure continued family control, the partnership agreement provides that the share of any partner who wants to sell his/her share must sell it to the parents at a fair market price.

When a distribution of FLP property is made to a partner, there is generally no taxable gain recognized at that time by the recipient, even though the property might have increased in value since the FLP acquired it. In contrast, taxable gain would be recognized if a corporation were used to hold appreciated assets distributed to a shareholder.

Protection from creditors and lawsuits is much greater if Mom and Dad’s property is placed in a FLP. Then, the parents own only a “partnership interest”-not the actual property contributed. So that is the maximum a creditor stands to get. In practice, even if he successfully sues, a creditor would generally be entitled only to the rights to future income that go with the parents’ partnership interest. (Note, however, that if property is transferred for the purpose of defeating the rights of an existing creditor, the conveyance can sometimes be “undone” in court.)

The FLP can offer family income tax savings. The total tax paid by all family members on partnership income can be decreased when it is allocated to those in a lower tax bracket than Mom and Dad. This advantage can be enhanced by paying family members reasonable and appropriate salaries, if justified by actual services performed. Remember, however, that if Mom and Dad are truly “running the show” they must pay themselves a reasonable salary. The IRS won’t allow them to forego reasonable compensation so that more income becomes available to allocate to family partners in lower tax brackets.

“VALUATION PLANNING.” The division of property ownership into “units” results in another tremendous advantage of the FLP: The partnership units given away undergo a “magical”decrease in their value-for gift and estate tax calculations. This means that more true wealth can be “squeezed into” every $12,000 gift, and more can be protected by the $1,000,000 (for 2002) credit shelter.

“Value,” as used in tax matters, most commonly means fair market value to the public. For property interests that are not publicly traded every day, as are big company stocks and bonds, the determination of value can be difficult and open to argument.

We can start with the truism that, “the whole is worth more than the sum of the parts.” Conversely, the total value of 100 individual unit “slices” of FLP property is less than that of the whole estate, if appraised as one “pie.” E.g., a 10% stake in a FLP that owns a $100,000 building is worth less than $12,000.

Why? For one thing, minority share owners have 0.0% day to day control over the property and the income it produces. None of them has the power to sell the actual assets and “cash out” the partnership’s stake in that investment in favor of another-only the general partners can make that decision. All the minority owner can do is sit tight, or maybe “cash out” himself, by asking for fair market value for his/her interest. But what is “fair market value”? Go try to offer to the public something called a “partnership unit.”! Would most of the public even know what that is? And even if a prospective buyer understood the operation of a limited partnership, who would want to be in a minority business arrangement with members of another family? In other words, because of all its drawbacks, a minority interest in property is not very “marketable”-which is an independent basis for claiming an additional discount in its value.

For these reasons, “valuation discounts” of 30% to 35%, and even much more are often accepted by the IRS. Indeed, fractional share owners of any form of family-owned property or business have something that is not easily marketable to the general public. This is the essence of “valuation planning.”

The idea of “fractionalizing” family property is an important estate planning concept at the heart of several widely used techniques. This kind of planning is complicated, requiring the help of an accountant and qualified appraiser, as well as a estate planning attorney. But the ultimate estate tax savings can be huge. Because of this, make no mistake: Especially in an intra-family situation, the IRS does not like valuation discounts based on “lack of marketability” or “minority interest.” Never has, never will. This reality must be prudently factored into your planning. In other words, don’t go overboard or be too greedy-whatever you are doing.

TIP: For those daring enough to claim aggressive valuation discounts, one prominent estate planning attorney has suggested a clever strategy to keep the IRS at bay: The estate owner bequeaths a desired share of his “fractionalized” property, knowing that at death his representative will claim a very low value when filing the estate tax return. But the estate owner also directs that all of his wealth above a certain dollar value will go to charity-which would result in an estate tax deduction. So where does this leave the Tax Man? Sure, he can challenge in court the low value claimed for the “fractionalized” estate property, and he might win. But what’s in it for the IRS? Nothing! After all, even if the estate property does end up being valued highly, anything beyond that pre-chosen dollar value goes to charity, not Washington. The estate owner hopes the IRS will quickly recognize the likely outcome of this situation and pick on somebody else.

The FLP can be so attractive a tool, that a cautionary note is in order. The tax law requires a legitimate non-tax, business purpose for the use of a FLP, or it will be ignored by the IRS. The FLP is coming under increasing IRS scrutiny on this very basis.

Putting aside income and estate tax savings, there are certainly valid non-tax motivations for parents to give to their children and grandchildren. The transfer of an ownership interest in the family company, for example, might help provide the younger generation with business savvy and wisdom in handling money. Yet Mom and Dad might not feel comfortable giving an increasingly large percentage of stock ownership to the children. The giving of FLP units does not also give increased management control of the company that the parents might fear would occur with a direct gift of company stock.

Some of the other important non-tax purposes of the FLP include the partial protection against creditors (discussed above) and preventing family assets from being wasted by the younger generation or entangled in a divorce. FLP ownership units given by the parents to a child are not easily converted to cash, or co-mingled with other assets. Since the gifted units remain separate and clearly identifiable as such, they will usually not be “on the table” if the child ends up in divorce court dividing property some day.

Another non-tax advantage of using the FLP to hold family wealth is the convenience and possible cost savings of centralized of asset management. If the family owns real estate in another state, placing it in the FLP can also avoid the need for probate proceedings in that state. (A Will or Trust would still be needed in the family’s home state, however, to dispose of any FLP units still owned by the parents when they died.)

Lifetime gift giving can be made much more convenient with the FLP, and this is a non-tax advantage. When the family estate consists of diverse assets owned by the FLP, Mom and Dad can parcel out gifts of FLP units much more easily than fractional shares in real estate or business interests.

CAVEAT:

Many FLPs have been created solely as repositories for assets like publicly traded stocks, bonds, life insurance or a vacation home. These FLPs appear to lack any valid business purpose. When such FLPs-or any techniques-are used strictly to obtain “valuation discounts,” or other tax advantage, they invite IRS scrutiny or a challenge. From a conservative viewpoint, these FLPs are therefore risky, and are likely to become increasingly so. Certainly, there is plenty of legal authority to support the taxpayer, should the IRS challenge an FLP owning, for example, nothing but publicly traded mutual funds. Indeed, there appear to be few occasions on which the IRS has actually successfully raised such a challenge-yet. But the IRS does not like tax gimmicks, and has a variety of time-honored legal theories on which to rely in fighting them. Moreover, the legal positions and auditing priorities of the IRS are always subject to change. So, only one piece of firm advice can be offered here on the “aggressive” use of the FLP: Discuss the situation in detail with a competent tax attorney.