When a Family Limited Partnership is a Bad Idea
Why Family Limited Partnerships Are Good.Family limited partnerships ("FLPs") have been an important tool for estate tax planning for at least 40 years.
For asset protection purposes they help Mom and Dad protect their interests in investment assets. Mom and Dad only retain a limited partnership interest. If Mom and Dad get sued, the successful plaintiff (now a judgment creditor) can only get Mom and Dad's limited partnership interest. The judgment creditor might receive "phantom" income: if the FLP has taxable income but does not distribute cash to allow the partners to pay their taxable income, the judgment creditor will be very unhappy.
For estate tax purposes, the FLP allows Mom and Dad to take advantage of valuation discounts. (1) Discount for lack of marketability - limited partnership interests don't trade on the New York Stock Exchange; and (ii) Discount for lack of control - limited partnership interests don't control the FLP (the GP interests control the FLP). These discounts might be as much as 45%.
Example: Formation Of An FLP.Mom and Dad, ages 60 and 65, have $10,000,000 of investment real estate. They form Children's Trust #1 ("CT#1) and Children's Trust #2 ("CT#2"). CT#1 forms a Corporate General Partner ("GP"). Mom and Dad give an undivided 2% interest in the real estate to CT#1, which contributes it to the Corporate GP. Mom and Dad give an undivided 1% interest in the real estate to CT#2. Now Mom and Dad contribute their 97% interest to the FLP. The Corporate GP contributes its 2% interest to the FLP. CT#2 contributes its 1% interest to the FLP. As a result, the FLP's partners are: 2% Corporate GP; 97% Mom and Dad as LPs; and 1% CT#2 as an LP.
Example: Gift Of A 20% Limited Partnership Interest.Mom and Dad now give 20% of the LP interests to CT#2. What is the value of the gift? You would think that 20% of $10,000,000 = $2,000,000. Were that the case, Mom and Dad would use up their entire $1,000,000 per person lifetime transfer tax exclusion. However, they hire a business appraiser who opines that the combined discounts for (i) lack of marketability and (ii) lack of control for limited partnership interests is 40%.
As a result, the value of the gift of a 20% limited partnership interest is $10,000,000 X 20% X 60% (to allow for a 40% discount) = $1,200,000. In other words, the use of the FLP allows Mom and Dad to use $800,000 less of their combined lifetime gift exclusion. That is quite a bit of leverage.
Example: Benefit Of An FLP On Surviving Parent's Death.Assume that Mom and Dad give no more LP interests. On the first spouse's (Dad's) death the parents have 77% of the LP interests. Assume further that through a variety of gifts they have no more lifetime exclusion left. Assume that the remaining exclusion is $2,500,000 per parent. So the 77% of the FLP is allocated as follows: 38.5% is Dad's half. It is valued at $10,000,000 X 38,5% X 60% = $2,310,000. Therefore it is entirely allocated to his "exemption" or "bypass" trust. In other words, it is not going to be included in Mom's estate when she dies.
When Mom later dies, her 38.5% is also discounted for lack of (i) control and (ii) marketability, so it is also worth $2,310,000.
What was the saving achieved through use of the FLP? Mom and Dad gave away 23%. As a result the remaining 77% was valued at (2 X $2,310,000 = ) $4,620,000 instead of at $7,700,000. That is a 40% savings! Again, the FLP achieves a great deal of leverage.
When The FLP Is A Bad Idea: Mom And Dad Are Old And/Or Unhealthy.Now assume the same facts as above except Dad is dead. Mom is either (i) a healthy age 92 or (ii) an unhealthy age 85. No estate tax planning has been done. Mom and the children ask the lawyer "what should we do to reduce the ultimate estate tax? We've heard great things about FLPs. "
An FLP set up under these circumstances will be looked at with great suspicion - even actual hostility - by the IRS. If this gets to the U.S. Tax Court, the IRS will get a sympathetic hearing. A recent case involved a lady who was 92 years old when the FLP was formed. Estate of Concetta H. Rector, T.C. Memo. 2007-367 (December 13, 2007).
The IRS will look for evidence that Mom transferred the assets to the FLP but maintained the right to the income. Perhaps Mom did not maintain enough assets outside of the FLP to maintain her standard of living. If that is the case, the IRS will attempt to ignore the FLP completely, a tax planning disaster. In this case the FLP was a bad idea.
When The FLP Is A Bad Idea: Debt On The Property.When the parents' property is subject to significant debt the parents may achieve a better overall tax result by giving undivided interests in the real estate to their heirs. The advantage of gifts of TIC interests over interests in FLPs increases with the percentage of debt. There are differences in the type of debt, e.g., recourse debt makes a gift of a TIC interest even more attractive.
Conclusion: FLPs Are Not The Best Structure For Every Family's Estate Tax Plan.Family limited partnerships - and Family Limited Liability Companies - are excellent tools to achieve gift and estate tax savings. However, there are situations when a gift of undivided interests in the properties (gift of TIC interests) is likely to be a better idea than the formation of an FLP and gift of LP interests. Those situations include when the (i) parent or parents are much older or in poor health and (ii) property is subject to a lot of debt.
As always, there is no substitute for meeting with competent estate tax planning counsel, giving that lawyer all of your facts, both business and personal, and all of your goals and objectives (only one of which is tax savings).