Family Limited Partnerships

Family limited partnerships (FLPs) are established estate planning vehicles that are a legitimate wealth-preservation and asset-protection strategy. Over the past few years FLPs have been the target of IRS scrutiny in investigations targeting abusive tax shelters. The IRS took the position that the FLP was not a legitimate family partnership, but rather a guised attempt to dodge taxes. The IRS even went so far as to send out “advisory notices” warning people that the IRS could invoke a section of the Tax Code allowing it to disregard FLPs due to the potential for abuse. However, the IRS has not taken any further action to invalidate FLPs, and most estate planning practitioners still believe the FLP is a valid tax and estate planning strategy.

Structure of a Family Limited Partnership

A family limited partnership is basically a limited partnership where the partners are family members. A limited partnership consists of a general partner, who runs the partnership, and one or more limited partners. By law, limited partners do not have any control over how the partnership is run, or any voice in the management of the partnership. Only the general partner has control over the assets of the partnership. Thus, a general partner may only own 1% of the FLP, but controls 100% of the assets in the FLP.

The usual scenario involving an FLP involves a family member who holds significant assets (usually investments or real estate) that can be centrally managed. The family member is usually from an older generation, typically the parents. The parents place certain assets into FLP, and initially serve as both general and limited partners. Eventually, they begin to gift limited partnership interests to their children.

Although the parents are gifting away interests in the FLP, as general partners they still retain full control over the assets in the FLP. Thus, the parents are giving up ownership of the assets in the FLP, but still maintain control.

Tax Advantages of a FLP

Except for the 1% interest of the parents in the FLP, the other assets are moved out of the parents’ taxable estate, as a completed gift has been made to the children. There may be gift tax consequences to the transfer, but the parents can use their unified credit for estate and gift tax to pay any gift tax owed. Presently, the parents have a $ 4 million credit for estate and gift tax ($ 2 million each x 2). In 2009, the amount of this credit is due to increase to $ 7 million ($ 3.5 million x2). The amount of this credit is unlimited in the year 2010, but unless Congress votes to make this tax repeal permanent, in 2011 the amount of the credit drops to $ 2 million ($ 1 million x 2).

Once the gift is complete, all appreciation on the assets in the FLP is moved out of the parents’ estate. Depending on the life expectancy of the parents and the amount of assets contributed to the FLP, the potential tax savings on this appreciation can be significant.

In addition to the foregoing advantages, one of the greatest savings features of the FLP is with regard to valuation discounts. Since the parents have gifted a limited partnership interest, not the assets themselves, they are entitled to take a valuation discount on the gift, because while the limited partners own most of the assets in the partnership, they don’t have any control over the FLP. If you were to offer to sell a limited partnership in an FLP to a third party, you would have to discount the sale price because no one will pay market value for an asset over which they have no control. This lack of control results in a valuation discount for the value of the limited partnership interest gifted. Usually discounts of 35-40% are allowed by the IRS, depending on the assets transferred and other factors.

Since the children own 99 percent of the FLP, 99 percent of the income from the FLP will be taxable to them. Typically, parents are in a higher tax bracket than their children. If this is the case, the income tax savings on the income generated by the FLP assets may be significant.

Asset Protection Benefits of an FLP

A FLP offers asset protection to the parents; before the creation of the FLP, 100 percent of the assets were exposed to the creditors of the parents. After creating the FLP, only 1 percent of the assets in the FLP are exposed to the parents’ creditors.

If the children are sued, their creditor will only be able to obtain a “charging order” against their limited partnership interest. A charging order entitles the creditor to the same rights and benefits as a limited partner; essentially, a charging order entitles the creditor to “stand in the shoes” of the limited partner/debtor. Since the limited partner doesn’t have the right to force a distribution from the FLP, but is taxed on the income from the FLP, the parents/general partner can decide not to distribute any cash to the limited partners. As a result, the creditor would be on the hook for the tax on the income from the FLP, but wouldn’t receive any cash from the FLP. This often provides strong incentive for the creditor to settle with the limited partner.

Strategy for a Successful FLP

The definitive case on what not to do when utilizing a FLP is the Strangi case. Albert Strangi established a FLP using most of his assets, including his personal residence. He then proceeded to act as if the transferred assets were still his own personal assets. In invalidating the FLP, the court determined that there was an implied agreement that Strangi still owned the assets, and Strangi retained the right to designate who would enjoy the property. The partnership form appeared to be completely disregarded by Strangi’s family, who treated the assets as if they still belonged to Strangi.

The IRS has had the most success in invalidating FLPs by invoking Internal Revenue Code Section 2036(a). In a successful challenge to the validity of the FLP, the IRS is able to treat the assets transferred to the FLP as includable in the estate of the person or persons establishing the FLP.

In establishing a successful FLP, here are a few key points to keep in mind:

• Don’t fund all of your assets into the FLP. Make sure there are sufficient assets outside of the FLP to maintain your standard of living.

• Treat the FLP as a business, and operate it as such. Don’t mix FLP and personal assets and keep clear records on the FLP assets.

• Have a clearly defined business purpose for the FLP. If your motivation is to protect your assets from potential creditors and/or manage your assets more effectively, make sure you document these purposes.

• In creating the FLP agreement, individual family members should negotiate as to the terms of the agreement. Parties who are in negotiation should be represented by separate counsel.

• Respect the structure of the FLP agreement. Don’t use the assets of the FLP to supplement your living expenses. Use the assets you kept out of the FLP to maintain your lifestyle.

• Don’t get greedy by attempting to claim outrageous discounts. Attempting to claim a 90% valuation discount will most likely result in an audit.

Seek Experienced Legal Advice

A family limited partnership is a powerful estate planning tool that offers significant transfer tax and asset protection benefits. Family limited partnerships are often used in combination with other advanced estate planning techniques, such as sales to intentionally defective grantor trusts (IDGTs). However, the FLP must be correctly structured in order to survive scrutiny by the IRS. It is important to consult with legal counsel experienced in this type of estate planning. If you are interested in reducing your tax burden, while protecting your assets from potential creditors, call us to schedule an appointment to learn if the FLP is an appropriate estate planning strategy for you.