You can get a discount of 30%, sometimes more, on estate and gift taxes by setting up a family limited partnership. That’s a tremendous discount. And the family limited partnership has advantages in addition to tax reduction. An Estate Planning strategy with so many benefits is bound to attract the IRS’s attention, and that has happened in the last year. I still strongly recommend that you consider family limited partnerships as part of your estate planning arsenal. But you must set them up as carefully as I’ve urged in the past. If you have an FLP, be sure to follow the guidelines in this article
First, let’s review the family limited partnership basics. Suppose you own a significant asset, such as a business. You form a limited partnership in which you are the general partner, with a 1% ownership interest, and the limited partners own 99%. You contribute the business to the limited partnership in return for all the limited partnership interests. Then you give limited partnership interests to your children. You can give the interests over time, so that you take advantage of the annual gift tax exclusion. Or you can give the interests in one or more larger installments, using up your lifetime estate and gift tax credit and paying gift taxes on gifts above the credit amount.
You get a discount from estate and gift taxes for two reasons. The first reason is that that partnership interests you give to each of your children would own only a minority of the business. A minority stake is worth less than a majority stake, because of the lack of control. This is recognized when valuing the partnership interests for tax purposes. In addition, there won’t be a ready market for the limited partnership interest. It can take a couple of years to find someone willing to buy an interest in a small business for what it is worth on paper. This allows another discount on the partnership interests, known as the marketability discount.
The discounts allow you to save a bundle in gift and estate taxes by giving away the limited partnership interests while you are alive. But there’s more. As general partner, you remain in control of the business. Limited partners have very few voting rights. The general partner runs both day-to-day and long-term aspects of the business, determines the amount of any distributions, and even can sell the business. You also can draw a salary as general partner. Despite this control, the general partnership interest receives a small portion of the partnership’s total value.
Obviously family limited partnerships aren’t as appealing to the IRS as they are to you. The IRS is trying to fight some family limited partnerships.
The first line of attack is on the valuation of the limited partnership interests. Congress helped the IRS in the 1997 tax law by stating that the statute of limitations on the gift tax doesn’t start running unless the value of all gifts is disclosed, including the amount of any discounts taken. The gift tax form even requires you to check a box if a valuation discount is taken. Under these new rules you have to tell the IRS what you are doing on the gift tax return, making it easier for the IRS to find and challenge family limited partnerships.
You should prepare for an IRS challenge to valuations. That means, as I have long recommended, getting at least one independent professional appraisal of the value of the overall business and of the limited partnership interests. The method used to determine any discounts should be fully explained. You also need to use an experienced estate planning specialist who will review the appraisal for reasonableness.
Another area of IRS attack is the limited partnership that is formed shortly before the original owner’s death or when the owner was terminally ill. The IRS argues that since the individual was dying, there was no intent to operate a partnership, so the partnership should be ignored for tax purposes. These IRS rulings have not been tested in court. But they are a good reason to start your estate planning early and get the family limited partnership operating normally for several years.
The IRS also continues to insist that a valid partnership requires a business purpose. To the IRS, that means you need a small business or real estate to comprise most of the partnership assets. Contributing an investment portfolio to the partnership won’t work, according to the IRS. Many estate planners disagree with the IRS interpretation, and it never has been tested in the courts. If you are forming a partnership with investments or other non-business assets, be sure to discuss the risks with your estate planning professional. You also might want to know whether the estate planner agrees with the IRS or is prepared to challenge the IRS on this issue.
Finally, be sure you actually operate the partnership. In one sad recent case, the taxpayer formed a limited partnership, had all the proper documents drafted by the lawyers, and gave annual gifts for a couple of years. Then everything stopped. Assets were not transferred to the limited partnership and the certificates of limited partnership were not filed for months. Even worse than these technical problems was that all the income from the partnership properties went into the parent’s personal bank account instead of the partnership’s. The Tax Court ruled that there was not a valid partnership, and all the partnership property was included in the parent’s estate at full value. (Schauerhamer Estate, T.C. Memo 1997-242)
The problem here is follow-through. Lack of follow-through is common in many estate plans, especially those involving trusts and partnerships. It is not enough to have the lawyer prepare solid documents that detail the estate plan. You actually have to implement the plan and follow the rules. In this case, that meant transferring all the property to the limited partnership promptly and operating the partnership as an independent entity.
The family limited partnership still is one of the top estate planning vehicles available. But getting its benefits requires you to work with a knowledgeable estate planner and to pay attention to all the detailed legal requirements.