Family Limited Partnerships are Still Viable
Kegler Brown Estate Planning + Probate Newsletter January 1, 2009
The family limited partnership (FLP) or family limited liability company is a popular method for shifting wealth from one generation to another. However, because of its misuse, the IRS has attacked the planning, sometimes with successful results.
The family limited partnership is quite simply an association of two or more persons to carry on as co-owners, a business for profit. Typically, with an FLP, parents or grandparents create the partnership and transfer personally owned assets into the same. Typically the FLP is funded with real estate, stock in a family owned corporation, publicly traded securities, or a combination of these assets.
When limited partnership interests are gifted to the founder's children or other individuals, there is legal support to justify discounting the value of the partnership interests. With appropriate discounts taken for lack of control and lack of marketability, the value of the limited partnership interest that is gifted is not equal to the value of the underlying assets. Taxpayers have been very successful in justifying and supporting these discounts in the context of gifting. For the most part, the IRS attacks relating to the gifting discounts have boiled down to an argument over the amount of the discounts. Put differently, if these cases end up in tax court, it often boils down to a battle between the IRS's valuator and the taxpayer's valuator.
When grandparents or parents die owning partnership interests, it is not inappropriate to discount the value of these interests in the same manner discussed above if they die owning a non-controlling interest in the partnership. More accurately, if the decedent dies without the right to cause the liquidation of the partnership, discounts may be appropriate.
Utilizing principles found in the Internal Revenue Code, the IRS has been successful numerous times in attacking the appropriateness of discounts taken on the partnership interests owned by a decedent by establishing that the decedent either (1) died with possession or enjoyment of, or the right to the income from the assets transferred into the partnership or (2) died with possession of the right, either alone or in conjunction with another person, to designate the persons who shall possess or enjoy the property or the income therefrom. This approach by the Internal Revenue Service has caused some practitioners to declare the demise of this planning. However, upon closer analysis, a good argument can be made that the IRS has been successful in these cases because of the bad facts associated with the same. In the proper circumstances, a properly formed and properly operated partnership can still prove to justify valuation discounts on the interests owned by the founder at the founder's death. Some of the more important elements of this planning are the following:
- Decedent's control over distributions out of the partnership or liquidation of the partnership.
- Contributions to the partnership by other family members.
- Valid non-tax purposes for the formation of the partnership.
- Pro-rata distributions, if any, from the partnership.
- Avoidance of death bed situations.
- Avoid the transfer of personal assets into the partnership.
- Retaining enough assets for the decedent to support the decedent for the remainder of the decedent's life after formation of the partnership.
- Active management by family.
With these considerations and other considerations in mind, the IRS may very well accept the principles associated with discounts for lack of control and lack of marketability, notwithstanding its distaste for this planning.
Very recently, a family limited partnership was formed for one of our clients. Our client was in her 90s. Approximately 60% of the decedent's estate was transferred into a family limited partnership. The assets transferred were marketable securities. A corporation was named as a general partner of the partnership and owned a 1% interest in the partnership. Our client owned a one-third interest in the corporation with her daughter and son-in-law each owning a one-third interest in the same. Our client's daughter and son-in-law each contributed a small amount of money to the partnership as well.
Unfortunately, approximately six months after the partnership was formed, our dear client passed away. This was an unexpected death, notwithstanding our client's age. She was in great health when we formed and funded the partnership. She was able to execute all of the documents and discuss all of the issues surrounding this planning. She died owning in the aggregate approximately 98.75% of the partnership. However, she could not unilaterally cause the liquidation of the partnership.
Prior to our client's death, our client's daughter and son-in-law caused the partnership to purchase rental real estate. Thus, the partnership, which was once the owner of only marketable securities, now had other assets. The partnership entered into a contract for the aforesaid real estate prior to our client's death. However, the closing occurred subsequent to our client's death.
In preparation of the estate tax return, we hired an accounting firm to value the partnership interests owned by our client at her death. The valuation firm applied discounts for lack of control and lack of marketability of 10% and 25%, respectively. This resulted in a substantial reduction in the value of the partnership interests as compared to the underlying assets owned by the partnership.
As expected, the Internal Revenue Service audited our client's estate and focused heavily on the partnership. In light of our client's premature death, it was only reasonable to assume that the Internal Revenue Service would fight hard to negate the discounts and cause the full value of the property to be includable in our client's estate for estate tax purposes. However, the IRS accepted the 10% minority interest discount and accepted a 21% lack of marketability discount.
The success of this audit can be attributable to the fact that the partnership was properly formed and operated. Personal assets were not transferred into the partnership. Our client owned assets outside of the partnership adequate to support her for the rest of her life. This support included any estate taxes associated with our client's death. Further, actions were being taken prior to our client's death to restructure the investments of the partnership. The Internal Revenue Service put no weight on the fact that death occurred shortly after the formation of the partnership and effectively upheld the existence of the partnership and its effect on valuation.
If done properly, family limited partnerships and family limited liability companies can still prove to be viable plans to assist our clients with estate and gift tax savings. We must go into this planning with a complete understanding of the law that surrounds the same. In addition to serving the tax purposes discussed herein, these entities are also effective for succession planning, for promoting and implementing family investment activities, and for creditor protection.