Using Family Limited Partnerships

A family limited partnership (FLP) is a partnership in which the general partnership interest is usually held by a senior family member, with limited partnership interests owned by younger or junior family members. It is an estate planning technique that is used to accomplish several valid objectives:

• Unifying control over various assets under one manager.
• Creating interests that can be transferred to family members at discounted valuations.
• Ensuring transfers to intended heirs.

Overview of FLPs

These arrangements are best understood by example. Say a wealthy grandparent owns securities, realty, and other assets and wants to pass interests to children and grandchildren gradually in order to do so on a tax-free basis, while retaining control over these assets for the rest of his life. The grandparent knows that each person has an annual federal gift tax exclusion-$12,000 in 2008-that can be used to make tax-free gifts to as many recipients as desired. If he has three children and seven grandchildren, the grandparent can transfer $120,000 in one year ($12,000 to each of these 10 recipients) with no gift tax cost. (Married couples can opt to make joint gifts, thereby doubling the exclusion amount even though only one spouse owns the property.)

The grandparent sets up an FLP, transfers these assets to the partnership, and keeps the general partnership interest for himself. This lets him retain control over management of the assets, deciding when and to what extent distributions will be made by the partnership to its owners.

The grandparent then gives away limited partnership interests to his children and grandchildren. Because these limited partnership interests lack control (they represent minority interests) and cannot be easily transferred (they are not publicly traded and lack marketability), the interests qualify for valuation discounts. For example, say the FLP holds $1 million in assets. A 2% interest is not necessarily $20,000; due to valuation discounts of, say, 40%, it may be valued at only $12,000 (the amount of the annual gift tax exclusion). Thus, in one year, the grandparent can effectively transfer about $200,000 of interests in the FLP at no tax cost. Transfers can be made year after year until as much has been transferred as desired.

Important: Valuation usually requires the assistance of an expert appraiser who can help determine what the interests in an FLP are worth.

Tax traps

The IRS looks closely at FLPs-there is even a new box to be checked off on the federal estate tax return indicating that the estate includes an interest in an FLP. Why is the IRS so concerned about FLPs? It believes that in some situations the arrangement is used as a tax dodge-to pass on interests at less than the full value of the underlying assets with no real purpose to the arrangement other than these tax savings. The IRS looks to see that:

• There is a valid business reason for using an FLP to hold assets. This can be for the purpose of obtaining expert management of assets by a family member or obtaining economies of scale for administrative costs.
• The arrangement is respected by all the parties involved. If the assets are treated as still being wholly owned by the original owner, the IRS may call the FLP a sham.

Important: Work with a knowledgeable estate tax attorney who can help craft an FLP that meets IRS criteria.