Harvey & Parmelee LLP
Certified Public Accountants

Tax Tips

Family Limited Partnership - February 2000
Richard Scrivanich - Partner

A family limited partnership (FLP) is one way to reduce gift and estate taxes on assets transferred to children or grandchildren. Despite recent aggressive attacks by the IRS on FLPs, they continue to be a popular business entity choice for many. The tax benefits of an FLP come from the valuation discount that is available on transfers of minority interests in an FLP. The discount can be as much as 25% to 60%, and is used to arrive at a transfer value that is equal to what a willing buyer would pay a willing seller for a minority interest.

How an FLP is structured.
In a typical FLP, parents contribute assets such as real estate or stocks to the FLP, and each receives in exchange a general partnership interest of 1% and a limited partnership interest of 49%. The parents then gift their limited partnership interests to the children , grandchildren, or to a trust for the benefit of the children or grandchildren. These interests are eligible for discounts-called lack of marketability and minority discounts-for gift tax purposes. If the assets transferred are not publicly traded securities, they must be formally appraised to determine their value.

An FLP can be dissolved upon the occurrence of specific events outlined in the partnership agreement, such as the withdrawal of all general partners, the consent of all partners to dissolve, or expiration of the partnership term.

The partnership agreement and state law define the powers and rights of the general and limited partners. Generally, the general partners control all aspects of the FLP's management and operations. The limited partners do not participate in the management of the FLP and are not personally liable for the FLP's debts.

Advantages of an FLP.
There are several advantages to using an FLP:

• There is limited liability for most partners.
• The equity structure can be very flexible.
• Both formation and liquidation are mainly tax tree.
• Individual owners can be redeemed mostly tax-free.
• Partnership terms and provisions are flexible and can be changed by the partners as the circumstances warrant.
• The partnership can serve as a trust substitute.
• It can provide significant creditor protection. Limited partnership interests are seldom attached; they provide creditors only the limited rights of an assignee.
• Limited partnership interests are attractive assets to give as gifts, because they are generally excluded from consideration in marital settlements and can easily be transferred.
• Their use avoids multistate probate if real estate is owned in more than one jurisdiction.
• They avoid division of assets on the death of the partnership interest holder.
• They maintain family control of assets held by the partnership.
• Generally, they are not subject to state franchise taxes.

In addition, an FLP can be used as an effective estate-planning tool since it allows you to transfer assets to your children or other family members at a discounted value, and allows you to retain control of your assets.

Valid business purpose.
An FLP cannot be used just to avoid taxes. It must have a valid business purpose, which must be stated in the partnership agreement; and the FLP should conduct business, maintain proper records, hold periodic meetings, and vote on business matters. A valid business purpose can include managing family assets in an efficient manner, providing asset protection to family members, and improving borrowing capacity through consolidation of real estate holdings.

But if your only purpose in creating an FLP is to reduce taxes, you may be challenged by the IRS. As the use of FLPs has increased, so has the IRS's opposition to them. At first, the IRS opposed the discounting feature of the minority interest, but was unsuccessful in court with this argument. It now often litigates the size of the discount. Still, a taxpayer can avoid IRS scrutiny or rebut an IRS challenge by demonstrating the following:

1. The taxpayer must show that the partnership agreement is a bona fide business arrangement.
2. The taxpayer must also show that the partnership agreement was not a device to transfer the property contributed to the FLP to a family member for less than full and adequate consideration. The taxpayer must prove that either the drafting of the partnership agreement was not a device for transferring wealth or that the taxpayer's family did not receive the full value of the underlying assets.
3. The taxpayer must show that the partnership agreement's restrictions and terms are comparable to similar arrangements entered into by persons in an arm's-length transaction.

Tax Consequences.
Because an FLP is a flow-through entity, the income generated by the FLP is not taxed at the FLP level but at the partner level, by including it in the partner's tax returns. The donor's basis in the assets that were contributed to the FLP becomes the FLP's basis in those assets. Most contributions to and distributions from an FLP are tax-free. The distributions cannot exceed the partner's basis in the FLP. If the distributions do exceed the basis, the excess will be treated as capital gains. The partner's share of FLP income increases his or her tax basis in the FLP, and his or her share of the FLP expenses, losses, and distributions decrease tax basis.

Despite the IRS's attempt to dissuade taxpayers and planners from using FLPs, they continue to be a popular and effective vehicle for business and tax planning. FLPs offer many advantages to family members who want not only some protection against transfer taxes, but who also need a business structure with creditor protection and a flexible equity structure.

If you have any questions as to whether or not a family limited partnership can help reduce potential estate taxes specific to your situation, please give me a call at (562) 698-9891.

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