Family Limited Partnerships: More or Less Than Meets the Eye?
By Attorney Paul T. Czepiga, JD, CPA
"Everybody's doing it, doing it, doing it, everybody's doing it, doing it, yeah!"
So goes the jingle from an old television commercial, but the jingle could apply as well to Family Limited Partnerships ("FLPs"). The question to explore in this article is whether everybody ought to be using FLPs for estate planning and other purposes or whether they are being oversold or misunderstood. This article, although not a complete treatise on FLPs, will hopefully acquaint the reader with FLPs sufficiently so that you can identify those instances when they should be considered for your client.
What is A Family Limited Partnership?
An FLP is nothing more than a limited partnership whose partners consist of related individuals, trusts, or corporations. Typically mom/dad will be the general partners of the FLP. As an alternative, a corporation or trust controlled by mom/dad could serve as the sole or one of the general partners. Children are usually not general partners, although they can be. If they are, it is under an arrangement where they do not have sole control over the partnership's daily activities. A corporate general partner is used to ensure that the partnership does not accidentally dissolve for lack of a general partner. This would occur upon the death of the sole general partner if the general partner was an individual. If parent were widowed and none of the children were suitable general partners to serve with parent, then a corporation controlled by parent should be used as the general partner.
The ownership of the general partnership interests is structured so that parent will always control major partnership decisions. Such decisions would include, at a minimum, investment of and distribution authority over partnership assets. Leaving parent in control (control means that parent has a majority of the voting rights of the general partnership interests) gives parent the psychological feeling that 'nothing has really changed' and insulates the partnership assets from potentially imprudent decisions that younger family members might make.
Ownership of the limited partnership interests is not as important as the general partnership interests. Under Connecticut law, CGS section 34-15, a limited partner, to maintain their limited liability, may not participate in the control of the partnership and their ability to impact major decisions is also limited. For these reasons, parents are not 'threatened' by having their children as limited partners.
Initially, the children need not be limited partners at all. Parents can own all partnership interests, limited and general, but remember that under Connecticut law a partnership consists of two or more people. If you have a single parent situation, that sole parent cannot be the sole general and the sole limited partner. If children are brought in initially as limited partners, they should use their own funds to 'buy in' or, if their buy in funds are to be gifted by parent, there should be a time lag between the gift and the purchase of the limited partner interests.
Why Use a Family Limited Partnership?
There are three reasons for using a family limited partnership: to protect assets from creditors, to educate younger family members about the world of finance, and for estate planning. These are explored in detail below.
Asset protection is achieved because it is believed that if a creditor obtains a judgment against a partner, than all the creditor can obtain from a court is a charging order against the debtor's share of any partnership distribution. In other words, if the partnership declares a distribution, the debtor partner's share will be paid to the creditor to the extent of the debt. In addition, under a charging order, the creditor is obligated to report as income the debtor's share of any partnership K-1 income. (Rev. Rul. 77-137). What typically results is that a creditor ends up with income recognition, but the partnership either ceases or greatly reduces distributions.The creditor has no cash from the partnership with which to pay tax on income allocated to it. Such a scenario is abhorrent to a creditor so the creditor usually does not seek satisfaction of its debt from the debtor's partnership interest and the partnership is, therefore, left free to continue distributions to all partners, including the debtor partner.
Education of Younger Partners
Educating younger family members about financial matters is also cited as a benefit of an FLP. The theory is that the family has accumulated great wealth with a diversified collection of investment assets, and would like to expose the next generation to money management matters as a step in a larger succession plan. This reason is more incidental to the other two reasons (estate planning and creditor protection) and is not a primary motivating factor. As a limited partner, the younger members can sit in on meetings of the general partners (provided that they do not participate), will receive Schedule K-1's and learn about income taxes, will learn about partnerships and how they work, and gradually, it is assumed, be drawn in at a measured rate, to the family wealth.
Why the increased attention to and use of FLPs? The answer can be found in the "anti-abuse regulations under IRC section 701 finalized by the Treasury Department on December 29, 1994. The underlying theme of section 701 is that there must be a nontax business motive for the partnership. The determination will be a facts and circumstances test. (Trea. Reg. Section 1.701-2(c)). In addition, the regulations implied (in background discussion) that when analyzing the 'tax motive', estate and gift taxes would be considered. The Regulation contained two examples that involved FLPs. In the two examples, one FLP passed muster (example 5) and the other did not (example 6). Practitioners were understandably concerned with the extension of an income tax regulation to the gift and estate area.
A saving grace came in IRS Announcement 95-8 in which the IRS withdrew examples 5 and 6 from the Regulation and stated that the anti-abuse rules would apply only to income taxes and not to gift and estate taxes. The regulations also sanctioned limited partnerships that hold marketable securities, although IRC section 721(b) must still be considered. For now, then, the use of FLPs has a green light so long as other code sections are adhered to, including chapter 14.
Let's take a look at an example. Assume parents have $1,000,000 of investments which they wish to place in an FLP. They create the FLP in which they each own a 0.5% general partner interest and they each own a 49.5 % limited partner interest. One of their goals is to transfer the limited partner interests to their 4 children. Each year, using annual exclusion gifts, they can convey $80,000 to their four children. Because discounts are allowed, even with simultaneous gifts to children (Rev. Rul. 93-12) , the parents can safely take an average combined discount of around 30% for lack of control and lack of marketability based on IRS case law. Assuming that the retained general partnership interest of 1% is worth $100,000 ( a control premium), the result is that in about 8 years they can fully gift away their limited partnership interests without transfer taxes ($1,000,000 - $100,000 general partner interest = $900,000 x .70 (net of discount) = $630,000 value of limited partner interests). If they wish to utilize their unified credit, they can complete the gift immediately, each parent using around one half of their unified credit. Valuation of the general and minority partnership interests is, of course, crucial and should be prepared by a valuation specialist and the discount assumptions made in this example should not be taken as gospel. Query as well whether you can obtain a "double discount" by putting a closely held business interest (which qualifies for discounts in and of itself) into an FLP?
What have parents accomplished that they could not accomplish with another estate planning technique? For starters, they have retained control up until death. Unlike a Grantor Retained Annuity Trust (GRAT) that requires a fixed number of years and that is geared to end prior to death, at which time the assets pass out of parents' control, parents in an FLP can retain control through their ownership of the general partner interests, up until the time of their death. The attendant draw back to this is that the value of the general partner interest will be included in their estate and that there may be a control premium attached to this interest. For many people, this will be an acceptable tradeoff for lifetime control.
Parents have also retained an income interest to the moment of death. Again, with a GRAT, the parents' income interest must be a fixed percentage or amount and also must end at the termination of the GRAT. With the FLP, however, the parents are able to retain something akin to an income interest to death by taking a management fee or guaranteed payment as the general partners. This fee must be supported by the level of management activity or performance of the partnership's assets. For this reason it probably cannot (and for tax reasons should not) be equal to all the income generated by the partnership assets, but it can often times come close.
A Shot Over the Bow?
As always in the tax arena, over aggressiveness can be fatal. For example, in Technical Advice Memorandum 9719006 (originally unpublished by the IRS), a decedent's assets consisted of rental property and marketable securities held in a revocable trust and a marital trust of which his two children were remainderman. Two days before decedent's death, the decedent, acting through his two children in representation capacity, formed an FLP and the trusts contributed property valued at $2,259,143 to the partnership. The decedent was terminally ill at the time and life support had been removed. When the decedent died two days later, the estate claimed that decedent's partnership interests were worth $1,177,013, taking an overall 48% discount. The IRS collapsed the entire scheme on two grounds. First, the IRS held that the arrangement was to be treated as a single testamentary transaction and the partnership interests disregarded. Given the facts, it is hard to dispute this. Second, the IRS held that the arrangement failed Section 2703(a)(2). In particular, the IRS concluded that there was no business purpose for the arrangement. The TAM is a reminder that substance prevails over form and that family transactions are subject to special scrutiny, the presumption being, as stated in the TAM, that such transactions are not arm's length. The sole purpose of the arrangement was, the IRS held, to depress the value of the partnership assets that passed through the decedent's estate to the children who would have received them anyway.
As the TAM demonstrates, when working to reduce our clients' estate tax exposure with anything other than IRS sanctioned techniques that involve objective valuations (like a GRAT), one can never be certain how solid the ice is under one's feet. This does not mean that FLPs should be avoided--they are a very useful tool with advantages that cannot be found elsewhere--but there should always be a primary reason, other than estate tax reduction, to use them. They are not mere glitz without substance, but they should be compared with other items on the estate planning menu and selected when they fit your client's risk tolerance and facts.