Family Limited Partnerships: Having Your Cake and Eating It Too

THE PRACTICAL ACCOUNTANT OCTOBER 1994
ESTATE PLANNING STRATEGIES

It is the client's desire to keep control, rather than the actual need for the asset, that often impedes effective estate planning. Through the use of a family limited partnership (FLP). a client's concerns can be as-suaged. fostering annual giving and later-life estate planning.

All FLPs share some common characteristics. They are recognized by all states except Louisiana and must conform to state statute. An FLP must have at least two partners, and at least one general partner, which may be an individual, trust or corporation. The general partner must own a minimum of 1 % of the partnership. The general partner can also continue to own limited partnership interests, if income is desired. Typ-ically, the donor is the general partner. As the general partner, the donor retains control by directing how the assets are invested or man-aged, and determining when, and if, distributions of income will be made to the limited partners. The general partner can also take a reasonable management fee from the partner-ship. The limited partners cannot make investment decisions, remove assets from the partnership while it is in existence or force the liquidation of the partnership)¹

Of course, any partnership inter-ests owned at death by the general partner would be included in the general partner's estate. However, the general partner's managerial pow-ers are not considered a retained power to control the beneficial enjoyment over limited partnership inter-ests under Sections 2036 or 2038. Thus, any limited partnership inter-ests not owned by the general partner are not included in the general part-ner's estate, the rationale being that a general partner's control over part-nership distributions is subject to fiduciary obligations.²

Recently, the IRS confirmed that transfers of limited partnership inter-ests are gifts of present interests that qualify for the annual exclusion. The general partner's discretion to deter-mine the amount and timing of distri-butions is not a problem. However, a trustee's discretionary authority to I distribute or withhold trust income or property generally makes a gift to such a trust a future interest. The IRS also concluded that Section 2701 anti-freeze valuation rules do not come into play to increase the value of gifts of limited partnership inter-ests. Where the general partners' rights to distributions are the same as those that are transferred, they would not constitute retained distribution rights under Section 2701.³

Best of Both Worlds

Two examples from our files show the versatility of family partnerships for both older and younger clients. Mr. Z is an 85-year-old who has more than enough income, but felt uncom-fortable making major gifts to his three adult children. The recent death of his wife has prompted him to develop an estate plan immediately to try to minimize the hefty estate taxes that will otherwise be due on his estate of $2 million. He formed an FLP with $1,010,100 in assets, retain-ing a 1 % interest as the general part-ner, and gifts out a 33% limited part-nership interest to each child. The FLP appeals to Mr. Z because only he, as general partner, has authority over management. and his children, the limited partners, have no say.

There are two other advantages. Although Mr. Z will incur gift taxes now (to the extent the value of the gift exceeds his available unified credit exemption), he is able to re-duce the value of the gifts, taking dis-counts for lack of marketability and minority interests. After years of liti-gation, the IRS has announced it will allow donors to take discounts for lack of marketability (the inability of the limited partner to trigger liquida-tion of the partnership, which in turn limits the marketability of the inter-est) and the related discount for mi-nority interest (the lack of control that accompanies co-ownership) in the context of intra-family gifts.⁴

These discounts, which have ranged from 10% up to more than 50%, are responsible for the mush-rooming of FLPs. Some commenta-tors have suggested that such dis-counts can even be taken with gifts of partnership interests with underlying assets consisting of marketable secu-rities as well as of real estate and fam-ily businesses. In determining the ap-propriate discount, an appraisal should be obtained to support the discount in case of an IRS challenge.

Lastly, the limited partnership may enable Mr. Z to reduce his taxable es-tate substantially in two ways. First, the gifts' values are net of discounts, whereas if Mr. Z had retained the property until his death no discount would be allowable. Second, under federal law, the gift tax is based on the net (after-tax) value of the gift, whereas the estate tax is based on the gross estate before taxes. For exam-ple, assume Mr. Z. takes a 25% dis-count on his $1,010,100 gift, for a net gift of $750,000. After subtracting out his previously unused unified credit, he pays a gift tax of $55,500. Assuming he dies four years later, $1,055,500, (.99 (1,010,100) + 55,500) and the appreciation on that amount, has been removed from his estate, leaving his estate owing a federal tax of approximately $395,000. On the other hand, if he does not make the gift and dies four years later, the orig-inal amount (plus any appreciation) is subject to estate tax (on $2,000,000) of $588,000. Although Mr. Z would have to survive three years after the gift is made to avoid the gift taxes being added back into his estate, even if he fails to do so he will still have reduced his estate by the amount of the discount.

FLPs can also be used by younger individuals who wish to make annual exclusion gifts. Mr. and Mrs. L, who have two sons in elementary school, own some out-of-state real property. Both earn six-figure salaries and they want to start making family gifts. They would prefer not to set up cus-todial accounts, which would go to the children outright, and unsuper-vised, when each reached 18 (21 in some states). On the other hand, the tax rates on accumulated income make trusts unappealing. Also, if the couple wants the full amount gifted to a trust for a minor son to qualify for the annual exclusion, all principal and undistributed income must be distributed (or be accessible) to the child upon turning 21.⁵

By creating an FLP with them-selves as the general partners and the initial limited partners, they circum-vent these problems. They can each give out percentages of their limited partnership interests every year to use up their respective annual exclusions. Most state laws permit custodians to hold partnership interests under the Uniform Gift to Minors Act (UGMA).⁶ By taking lack of mar-ketability and minority discounts, the actual amounts gifted can exceed $20,000 per year to each child. After the children turn 21, the distributions of income remain subject to the gen-eral partners' (i.e., the parents') dis-cretion, and the boys do not have ac-cess to the assets outright as long as the partnership exists.

The L's case points out another ad-vantage in creating an FLP where there are multiple donees-ease of management. Instead of administer-ing separate trusts or receiving indi-vidual statements on various UGMA accounts, the paperwork is central-ized and thereby minimized.

Moreover, by transferring title to the real property to the partnership, Mr. and Mrs. L can make fractional interest gifts through assignments of partnership interests, instead of hav-ing to prepare and record new deeds each year. As long as the parents act as general partners, they alone may sell the property. To younger cou-ples, an FLP may be more appealing for a vacation residence than a per-sonal residence trust in which title and control vest in the beneficiaries after a stated term of years. Lastly, ownership of out-of-state property by the partnership can avoid the ex-pense and delays of ancillary probate.

Income Tax
Ramifications

FLPs can generally be formed and funded without income tax conse-quences to the donor. Although the IRS will consider the partnership ter-minated when there is a sale or ex-change of 50% or more of the part-nership capital and profits, this rule does not apply to assignments of lim-ited partnership interests in an FLP to family members.⁷ Since the limited partners must pay income tax on their pro rata share of income earned by the partnership, income splitting among lower bracket family members provides added benefits. This factor would also deter creditors from ob-taining a charging order against a lim-ited partner's interest since the limit-ed partner would have to report any "phantom income" even though no distributions may be made.⁸

1. For a discussion of the use of limited partner-ships in the asset-protection context, see Rothschild, "How Far Can You Go to Safeguard Your Clients' Assets, The Practical Accountant, May 1994, p. 22
2. Ltr. Rul. 9131006.
3. Ltr. Rul. 9415007.
4. Rev. Rul. 93.12.
5. Section 2503(c).
6. Caution: The custodian should not be a parent so that those assets will not have to be included in the parent's gross estate if the parent dies when the child is still a minor.
7. Section 721; Rig. 1.708.1(b)(1)(ii).
8. Rev. Rul. 77-137.

GIDEON ROTHSCHILD, CPA, J.D., practices law in New York City. He specializes in estate planning and tax matters.