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The Family Limited Partnership

The Family Limited Partnership > Overview
Overview
Over the past five years, the Family Limited Partnership (FLP) has risen from obscurity, as a little known tax loophole, into the preeminent vehicle for asset protection and estate planning. A recent article in Forbes extolling the benefits of the FLP—headlined “Cut Your Estate Taxes in Half”—claimed that individuals were successfully using this technique to discount the value of their estate by up to 90 percent.

In this section, we will discuss the features of the Family Limited Partnership which provide remarkable advantages and planning opportunities. By itself, or in combination with other techniques, the FLP can be used to create a powerful strategy for asset protection and for realizing estate tax and income tax benefits.

In the March 2004 issue of MD Net
Guide, I broadly and briefly described
some of the popular legal strategies
for asset protection. This article will
focus more closely on one specific
strategy, known as the Family Limited
Partnership (FLP). This strategy has
been popular for asset protection and
tax planning for many years, but the full
scope of what could be accomplished
through its utilization has been a source
of considerable debate among legal professionals
because some of the relevant
case law has lacked a desirable level of
clarity and direction. On the tax side,
the IRS has consistently challenged the
available tax benefits—losing most of
the time, but with just enough success
to add a dose of uncertainty into the
planning process.
This somewhat murky picture has, however,
gotten decidedly clearer in recent
months. In its May 20, 2004 decision
regarding the case of Kimbell vs. United
States (www.ca5.uscourts.gov/opinions
/pub/03/03-10529-CV0.wpd.pdf), the
Fifth Circuit Court of Appeals soundly
rejected the IRS arguments against
FLPs and, in the process, created definitive
law and delivered clear instructions
for achieving remarkable tax savings
and asset protection.
Family Limited Partnerships
A complete discussion about FLPs
can be found online at www.rjmintz.
com/appch5.html. Stated briefly,
a FLP is a type of limited partnership
that is formed by an official
filing with the Secretary of State of
the state in which the Partnership is
to be created. The FLP is a separate,
legal entity, with its own tax identification
number. Any income or loss flows
through to the partners and is reported
on their tax returns. The key provisions
for accomplishing tax savings and
asset protection are set forth in an
FLP agreement prepared by your legal
advisor based upon your particular
circumstances and objectives.
In the typical scenario, family savings,
investments, and titles to business
and real estate interests are transferred
into the FLP, which, if properly
structured, protects these assets
from potential claims and lawsuits.
Even if a plaintiff were to win a
judgment against you, they would be
unable to reach into the FLP to seize
this property. The ownership of the
interests in the FLP is usually protected
in a trust designed for this purpose
(see www.rjmintz.com/ownershiptrust.
html).

Tax Savings
To get a better idea of how this all works,
consider the following example of how one
family might set up a FLP. Suppose our
hypothetical parents transfer assets worth
$1 million to an FLP and then give 40% of
the limited partnership interests to their
children. This allows the parents to maintain
full control over the property. In this
situation, these gifted FLP interests are
not valued at $400,000 for tax purposes.
Instead, since these limited partnership
interests cannot control or affect management
decisions made regarding the dispensation
of the assets, and cannot be sold or
otherwise converted into cash, tax law
says that they are not worth $400,000.
They are instead worth something less,
maybe $250,000. By using this technique,
the parents have transferred $400,000 in
value out of their estate to their children
and reduced future estate taxes by as
much as $75,000 or more. The actual savings
realized through this strategy
depends upon the actual value of the
assets transferred into the FLP, the size of
the gifting program adopted, and the
amount of the discount applied.
As might be expected, the IRS has
consistently opposed this strategy,
although the results of court cases have
been mixed until recently. Generally,
when an FLP was established near the
time of death for the sole purpose of
reducing estate taxes, or when the FLP
was treated like the owner’s personal
pocketbook, without regard for legal formalities,
the challenge by the IRS has
been successful. For more information,
see Estate of Albert Strangi vs.
Commissioner (TC Memo 2003-145) at
www.ustaxcourt.gov/ InOpHistoric/
Strangi.TCM.WPD.pdf. A summary of this
decision may be found at www.mpbcpa.
com/library/ newsletters/valuation/
Fall%202003%20FLP.pdf. In Strangi, the
Tax Court ruling significantly restricted
the circumstances under which the FLP
could achieve meaningful tax reduction.
Many advisors felt that the new burdens
imposed by the Tax Court would dampen
the use of the FLP for these purposes.

Kimbell vs. United States
Then came the Kimbell case, wherein
the Fifth Circuit Court of Appeals
handed the IRS a massive defeat. The
case illustrates the savings that can
be produced by FLP planning in even
the most basic form. Mrs. Kimbell,
a 96-year-old woman, transferred
property worth $2.5 million to an
FLP in exchange for a 99.5% limited
partnership interest. Her son Bruce
(through a limited liability company)
was the general partner with the right
to manage partnership assets. He had
managed his mother’s financial matters
prior to the time the FLP was established.
Mrs. Kimbell retained the right
to remove the general partner and
replace him with anyone else (including
herself), since she owned almost all of
the limited partnership interests. As
recited in the Kimbell FLP Agreement,
the stated purpose of the FLP was to:
“…increase Family Wealth; establish a
method by which annual gifts can be
made…continue the…operation of the
Family Assets and provide protection to
Family Assets from claims of future
creditors against a Family
member…”(emphasis added.)
When Mrs. Kimbell died, soon after creating
the FLP, her estate valued the 99.5%
limited partnership interests at $1.25 million—
a 50% discount from the value of the
property she transferred—claiming that
the lack of control and marketability associated
with limited partnership interests
reduced their value significantly. The Court
did not discuss the specific amount of
claimed tax savings, but in general, a
reduction in value of this amount saved the
estate approximately $500,000 in taxes.
The IRS took the position in the case that
Mrs. Kimbell had not engaged in a significant
business transaction and that she had
merely changed her form of ownership over
the property. According to the IRS, Mrs.
Kimbell did not relinquish any substantive
management or control over her property
and therefore the transfer to the FLP
should be disregarded for tax purposes.

Kimbell Guidelines
The Court disagreed with the IRS and
held that Mrs. Kimbell’s estate was
entitled to the full benefit claimed. The
Court detailed the analysis to be
applied in these cases and the rules
which must be followed:
1. The limited partnership interests in
the FLP that Mrs. Kimbell received
were proportionate to the amount of
her contribution. If you form an FLP
and contribute $90 and your children
contribute $10, you must receive a
90% interest in the FLP. The records of
the partnership must properly account
for the contributions of each partner.
2. Partnership formalities must be satisfied.
The FLP must be properly organized, the
FLP Agreement must specify the rights
and responsibilities of the partners, and
assets contributed to the FLP must be
properly and legally transferred.
3. The FLP must serve a valid business
purpose, such as asset protection.
The Court noted that the FLP was
established because Mrs. Kimbell’s
“…living trust did not provide legal protection
from creditors as a limited partnership
would. That protection was
viewed as essential by [Mrs. Kimbell’s
business advisor]…because she was
investing as a working interest owner in
oil and gas properties and could be possibly
liable for any environmental issues
that arose in the operation of those properties.”
Other business purposes besides
asset protection could be the desire to
consolidate management of family
assets and to provide for a continuity of
ownership for younger generations.
4. To avoid weakening the FLP for tax,
business, and asset protection purposes,
assets and income from the FLP should
not be used for personal or household living
expenses. Use the income from your
practice or set aside sufficient other
assets to meet recurring expenses.
An additional point is that Mrs. Kimbell
did not give away her ownership of the
limited partnership interests. No transfer
to her children took place (as reported
in the case). She transferred substantially
all her assets into a newly formed FLP
and then claimed that the limited partnership
interests that she received in
exchange were 50% less than the property
itself. We will need to see how this
issue is handled by other courts in the
future, but for the present it represents
a loophole of such significant proportions
that the estate tax can almost be
said to be voluntary in its application.
When the guidelines offered by the Court
are followed and a solid business purpose
such as asset protection is the
foundation of the plan, the Family Limited
Partnership may serve as the cornerstone
for most advanced financial plans.

Estate Planning Issues

Estate Tax Planning with FLP’s
We can expect to achieve excellent estate tax benefits as well as asset protection advantages with a properly designed FLP or LLC structure.

It has been established that many FLP (or LLC) planning techniques, together with a knowledgeable estate planning attorney, can substantially reduce or eliminate estate taxes in a variety of circumstances . The legal discounting of the value of a gift of the limited partnership interests, by as much as 40%, when combined with other available techniques, has clearly taken the bite out of the estate tax. With few exceptions, the IRS has been unsuccessful in its legal attacks against these benefits.

However, since these techniques produce such favorable tax results, the IRS and the courts are creating fairly specific rules to follow in order to achieve the available benefits. Recent cases demonstrate the anticipated lines of attack from the IRS as well as the suggested structure necessary to preserve a favorable result. The problems usually arise over the issue of whether the creator of the FLP has retained an impermissible level of control over supposedly “gifted” assets.

Annual Exclusion
In Hacki v. Commissioner (18 T.C. No. 14 (March 2002) the Tax Court held that based on the language in the limited partnership agreement, the gift of a limited partnership interest did not qualify for the annual gift tax exclusion. To understand the background, you probably know that you are allowed to make a gift each year of up to $11,000, without creating a gift tax. You can make these gifts to any number of people you wish. It is a good way to reduce the size of your estate and minimize future estate taxes. FLP’s are a good technique for this because of the discounting applied to the value of the gift.

The caveat to the rule is that in order to qualify for the annual exclusion, the gift has to be a “present interest.” You have to give something that has some value immediately to the donee. A cash gift of $11,000 certainly qualifies since the donee can take that money and spend it. However, if you give your child an interest in an FLP what is he going to do with it? It can’t be sold and the child has no right to management. Although it may have value in the future, it is not worth much today. Let’s face it. That’s probably why you gave it to him in the first place.

In response to this case, for clients intending to use their FLP for maximum estate tax benefits, we make sure that the language in the Family Limited Partnership Agreement provides the donee child with enough current value to insure that the gift qualifies for the annual exclusion. This is not difficult and doesn’t compromise the control exercised by the client, but the terms of the agreement must satisfy the holding of the case in order to accomplish the intended result.

Disallowed Discount
In the case of Albert Strangi (TC Memo 2003-45 rem’d by 293 F3d 279 (5th Cir. 2002)) the Tax Court disallowed the claimed discount on the grounds that the founder retained too many powers over supposedly ‘gifted’ partnership assets. The FLP made disproportionately large distributions to the founder and ultimately paid his estate taxes and other expenses, ignoring the legal interests of the limited partners. In spite of the legal format of the structure, the founder continued to treat all assets as his own and to maintain complete power and enjoyment over the “gifted” assets. The limited partners enjoyed no benefits or protection of their rights under the plan as operated.

When a Family Limited Partnership is intended to serve as a vehicle to avoid substantial estate taxes, several hundred thousand dollars or more, the conservative approach suggests that we include a third party, to protect the rights and interests of the limited partners. Sometimes we use the third party as a trustee of a trust that holds limited partnership interests for other family members. Some financial institutions, trust companies and accounting firms have established specialized “Family Limited Partnership Groups” to handle valuation questions and “control” issues. The additional fees for these services (ranging from modest to expensive) can be weighed against the amount of available tax savings (and additional asset protection) to determine whether this is a sound economic approach.

The Partnership Agreement
Concurrently with the filing of the Certificate of Limited Partnership, a written partnership agreement must be prepared. This is the document that governs the affairs of the partnership. It sets out the purpose of the partnership, the duties of the general partners, matters on which the vote of the limited partners is required, the share of partnership capital and profits to which each partner is entitled, and all other matters affecting the relations between the partners. When creating a Family Limited Partnership for estate planning and asset protection purposes, the partnership agreement must also contain certain key provisions designed to accomplish your objectives. Taken together, these provisions must ensure that a creditor can never achieve any influence over partnership affairs and that Husband and Wife, as general partners, always maintain absolute control over the assets of the partnership. These provisions are unique and essential to a properly structured Family Limited Partnership.

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