Last year a number of Estate Planning professionals worried that the IRS and the Tax Court nailed shut the door on family limited partnerships. A recent federal appeals court decision recently made clear the door still is open, and it set some guidelines for the successful use of FLPs.
Family limited partnerships have been premier estate planning vehicles for years, especially for families with businesses. Families can use FLPs to reduce estate and gift taxes by 20% or more and to get other benefits.
There can be many variations to an FLP to meet the needs of individual families. But there is a prototype arrangement. In the prototype structure, the parents form a limited partnership. They take the general partnership interests, amounting to about 1% of the capital, and act as general partners. Then, they donate assets to the partnership in return for all the limited partner interests, amounting to 99% of the FLP’s capital. The assets most often are a family business or real estate, but other types of assets can be used.
The parents transfer all or most of the limited partnership interests to the children and perhaps the grandchildren. Most often the parents simply give the limited partnership interests, either at once or over a period of years. Some families have the children purchase the limited partnership interests over time or through loans from the parents.
Virtually all the value of the partnership and its assets are in the limited partnership interests. Once those interests are transferred to the children and grandchildren, their value and future appreciation are out of the parents’ estates. But there also are estate tax benefits if the parents retain some or all of the limited partnership interests for life.
The major estate and gift tax benefit of the FLP is in the valuation of the limited partnership interests. Estate and gift taxes are imposed on the value of assets. Limited partnership interests often are valued at less than their proportionate share of the partner-ship’s assets.
First, they get a lack of control or minority discount. That’s because limited partners have few rights in how the partnership is run. In addition, unless a limited partner owns 50% or more of the partnership’s value, each partner is a minority and cannot control any votes. It is well-established in the tax law that a minority ownership interest in a private company receives a valuation discount.
Second, the limited partnership interests get a lack of marketability discount. That is because it is difficult to find a buyer who will pay close to full value for interests in a private partnership. It could take a couple of years to find a buyer.
The discounts save taxes in either of two ways. When parents give the limited partnership interests to children and grandchildren, the discounts reduce the value of the gifts. That reduces gift taxes or the amount of the lifetime estate and gift tax exclusion that is used.
If the parents retain any limited partnership interests, then the interests receive reduced values in their estates. That reduces estate taxes.
A valuation expert determines the value of the interests.
Another feature that many parents like is that under limited partnership law, the general partners of the FLP control most aspects of the operation. Limited partners have few management rights. General partners decide how the assets in the partnership are managed and when distributions of cash or property are made.
A Tax Court ruling in 2003 was thought to deliver a blow to FLPs. Some estate planning advisers thought it was a death blow and recommended completely avoiding FLPs. Many others recommended that FLPs be used cautiously.
That Tax Court decision still is on appeal. But the federal appeals court to which it is on appeal issued a ruling in a different case that supports FLPs and sets clearer guidelines on the effective use of FLPs.
The 2003 case was Estate of Strangi (T.C. Memo 2003-145). The Strangi patriarch donated 98% of his assets to the FLP, including his residence. He technically had to pay rent to the FLP for continuing to live in the residence, but he never did. In addition, as general partner he retained control over the assets and distributed cash and property as he desired ? mostly to himself. The distributions bore no relationship to partners’ share of ownership. The Tax Court ruled that, in effect, Strangi never changed his control over the assets and had no intention of doing so. The full value of the partnership assets was included in his estate as though they were still personal assets.
In the recent case, Estate of Kimbell (No. 03-10529, 5th Cir., May 20, 2004), the matriarch created an FLP a few months before her death at 96. The assets in the FLP were working interests in oil and gas properties worth about $2.4 million. She retained the limited partnership interests, and the estate claimed a valuation discount on them when filing the estate tax return.
The court noted that the partnership contained business assets, indicating that there was a business reason for forming the FLP and that the FLP was not just a tax maneuver. Mrs. Kimbell also retained enough assets outside the partnership to support herself. Unlike in Strangi, Kimbell did not mix partnership and personal assets or use FLP assets to pay personal expenses. The court supported Mrs. Kimbell instead of the IRS.
The Kimbell case confirms that FLPs still are a useful and valuable estate planning strategy. The taxpayer in Strangi clearly abused the FLP concept and did not follow guidelines we’ve given in past issues of Retirement Watch.
For an FLP to work, there must be non-tax reasons for creating the FLP. An operating business is the best asset to transfer to an FLP. Real estate properties also can be good. Estate planning specialists differ over whether it is appropriate to contribute an investment portfolio to an FLP. You should not contribute a residence or other personal assets if you plan to continue using them. Do not pay personal expenses from the FLP checkbook. Do not keep all partnership income for yourself.
It also would be helpful if the children could contribute some assets of their own to the FLP, even if they got them by gifts from you and they are a small amount of the total value. If you really want to IRS-proof the FLP, have a non-family member be the general partner. No court case, however, requires that step.
Of course, as with any estate planning strategy it is a good idea to set up the FLP before death is imminent. Clearly, the IRS pursued each of these cases because the taxpayers were very old and near death when the FLPs were created. That enhanced the argument that tax reduction was the only reason for creating the partnerships.
The IRS has been fighting FLPs for years and likely will continue challenging them. You can enjoy the tax and other benefits if you don’t give the IRS a reason to believe your FLP is one worth taking to court.