The Law Firm of Satterlee Stephens Burke & Burke LLP

Family Limited Partnerships - The Planning Rage of the 90's

From Ideas for Individuals August 1996 issue

In the 90's, family limited partnerships have become the centerpiece for family wealth planning for high net worth individuals. For people who have significant wealth, this may well be the best answer to reducing estate taxes and achieving many other non-tax benefits.

The tax laws have conspired over the past 25 years to eliminate most high-leverage planning strategies. However, recent developments have caused a resurgence of the popularity of Family Limited Partnerships.

How Does It Work?

A Family Limited Partnership ("FLP") is simply a limited partnership among members of a family. A limited partnership has both general partners (who run the partnership) and limited partners (who are passive investors). General partners have unlimited personal liability for partnership obligations, while limited partners have no liability beyond their capital contributions. Typically, the partnership is formed by the older generation family members (for the purpose of our discussion, the parents), who contribute assets to the partnership in return for general partnership units and limited partnership units. The parents can then embark on a plan of giving limited partnership units to their children and grandchildren, while retaining the general partnership units that control the partnership.

Any type of property can be contributed to an FLP. For example, FLPs have been formed to hold family compounds, businesses, rental real property, and in some cases marketable securities.

The partnership agreement will govern how partnership income is divided among the partners. Generally, both general and limited partners share income and cash flow based on their percentage interest in the partnership. It is important to realize that although income tax liability passes through to partners automatically, cash is not distributed to partners until the general partners determine to make a distribution. In this way, the general partners retain control over the assets in the FLP, whereas limited partners are granted very limited rights. Limited partners also have restrictions on their ability to transfer their partnership units to others, so that the general partners can prevent the units from being transferred outside of the family.

The Benefits Are Significant

There are many tax and non-tax benefits to FLPs. However, we do not recommend this concept for a contribution of assets worth less than $1,000,000. Important benefits include:

h Reduced asset values for estate and gift tax purposes through significant valuation discounts.

h Ability of the general partners to make substantial gifts yet maintain control of the partnership assets.

h Continuing control of income from transferred assets since distributions from an FLP must be authorized by general partners.

h Identification of partnership assets as separate assets and not marital assets. This would be important in the event of a divorce.

h Control the future investment of family assets and retain a critical mass to enhance future investment opportunities.

h Reduced probate costs with respect to real estate located in other states. No ancillary administration is required.

h Institutionalization and enhancement of family communication on family business and investment matters.

Transfer Tax Benefits

The principal benefit of an FLP is its significant impact in reducing a transferor's gift and estate tax. By using an FLP, the owner can take advantage of gift and estate tax valuation rules relating to "minority interests" and "marketability" that can reduce transfer taxes. Due to the significant restrictions imposed on the limited partnership units, the partnership units typically will have a value that is approximately 30 percent less than the value of the assets that originally were transferred to the partnership. (actual discounts can range from 25% to 60%).

For example, if the parents in a family transferred $1,000,000 in assets to a family limited partnership, and transferred limited partnership units representing 90% of the partnership interests, those units would be valued at approximately $630,000, compared with the $900,000 value of the underlying partnership assets associated with those limited partnership units. Thus, when the parents transfer the limited partnership units to the younger generations, their transfer taxes will be significantly lower than if they had transferred the partnership assets directly to the younger family members.

Once the FLP has been established and funded, limited partnership units may be given to younger family members by means of an annual program taking advantage of the $10,000 gift tax exclusion. Parents may make tax-free gifts of limited partnership units with a value of $10,000 ($20,000 if married) to each child or grandchild each year. The discounts described above will be used in determining the value of these gifts, removing the property from the parents' estates at a lower value. In addition, the future appreciation in the value of the limited partnership units will be excluded from the donor's gross estate for estate tax purposes. Over time, a series of gifts of partnership units made in this manner can result in large transfer-tax savings.

Illustration: Mother and Father transferred assets worth $1 million to an FLP. By making annual gifts of partnership units with a discounted value of $20,000 to each of their four children and three grandchildren over a five-year period, the parents will transfer partnership units with a total discounted value of $700,000 out of their estates tax-free. These units would represent the ownership of $931,000 of partnership assets.

The parents may also choose to transfer a larger block of limited partnership units, taking advantage of the transfer tax unified lifetime credit. This credit permits each parent to give or bequeath (during life or upon death) a cumulative amount of $600,000 to anyone without incurring federal gift or federal estate tax. A large gift of limited partnership units discounted in value may be made in addition to annual exclusion gifts. Such a gift may be recommended when significant future appreciation is anticipated, because it will remove a greater portion of the assets from the parents' estates before the assets increase in value.

Illustration: Mother and Father transferred assets worth $2 million to an FLP in return for 20 general partnership units and 980 limited partnership units. They then gave 425 limited partnership units to their children, with a discounted value of $595,000, and used Father's unified credit to offset the gift tax. This gift immediately removes a total of $850,000 from their estate, as well as the future appreciation in value of the partnership units without paying any Federal gift tax.

If the parents die while still holding partnership units (either general or limited), the estate tax value of their partnership units may also be reduced by discounts (1) for lack of marketability, (2) as a general partner, for potential liability of the general partner to the limited partner, and (3) if appropriate, because it represents a minority interest. This could also result in reduced estate taxes.

Income-Tax Benefits

The primary income tax benefit produced by an FLP results from shifting income between different taxpayers by means of gifts of limited partnership units. If all tax law requirements are met, each partner is liable for tax on his or her distributive share of partnership income, whether or not that income is distributed. Over several years, the allocation of taxable income to family members in lower tax brackets can substantially reduce overall family income taxes.

Careful Planning Is Essential

Using an FLP in one's estate planning requires careful analysis and strict compliance with IRS requirements, as well as professional assistance.

If the transferred property includes real property, art work or a business, the transferor must obtain an appraisal to establish the value of the property. It is also essential to have a qualified appraisal to establish the discounted value of the partnership interests.

For individuals with a high net worth, the family limited partnership provides a means by which to pass assets along to other family members with significant estate, gift, transfer, and income tax benefits. To find out if a family limited partnership is a sound asset management tool for your family, please contact Robert H. Goldie, Paul J. Powers, Jr. or Kirk H. O’Ferrall at Satterlee Stephens Burke & Burke LLP via e-mail or phone at: (212)818-9200.