Family limited partnerships (FLPs) have become an increasingly popular way to transfer assets at a substantially reduced gift and estate tax cost. Here's a primer on this useful but complex topic.
How FLPs work: Typically, the parents contribute assets to a limited partnership taking back a small general partnership interest and a large limited partnership interest. The parents then gift limited partnership interests to their children (or to trusts for their benefit) under the protection of their annual exclusions and/or unified credits, while retaining the general partnership interests, which allows them to manage the partnership assets and control the making and withholding of distributions. When the FLP is dissolved, typically after the second parent dies, the assets are proportionally divided among the children as partners.
How FLPs reduce value of assets for gift and estate tax: Because limited partners do not participate in management, cannot compel partnership distributions, and cannot compel liquidation to obtain partnership assets, and because their right to sell their interests is usually subject to restrictions, the parents may significantly discount the value of gifts of limited partnership interests made to the children.
These include discounts for lack of marketability and for minority interest. Such discounts can be quite substantial and might range from 30 percent to 60 percent, depending upon how the FLP is structured and drafted. These discounts permit the parents to leverage their annual gift tax exclusions, unified credits and generation-skipping tax exemptions.
For example, if the limited partnership interests are discounted by 40 percent, a married couple could give away to each child every year limited partnership interests worth $33,333, which would be discounted to $20,000 and protected by the annual gift tax exclusion.
If the donor was willing to give away a majority of his general partnership interest during his lifetime, the interests (general and limited) owned at death likewise would qualify for valuation discounts for estate tax purposes.
In 1993, the IRS reversed its long-standing position and ruled that a minority discount is available with respect to transfers between family members despite the fact that after the transfer control exists as a family unit. This ruling has led to a large increase in the use of FLPs as an estate planning tool.
If the FLP produces a significant cash flow (for example, because it owns an active business), a gift of limited partnership interests to a Grantor Retained Annuity Trust (GRAT) is a particularly effective way to leverage the donor's unified credit. The discounts available with respect to the limited partnership interests mean that the annuity payout (rate of return), expressed as a percentage of the discounted value of the interests transferred to the GRAT, will be significantly higher, resulting in a significant reduction in the amount of the gift. In many cases, this results in the value of a gift at or near zero.
How FLPs facilitate annual exclusion giving: Annual exclusion gifts of direct interests in property sometimes are inappropriate. For example, gifts of a direct interest in real estate may be cumbersome, and gifts of a direct interest in an investment portfolio will not permit the donor to continue to receive income from, or direct investment of, the portfolio. Gifts of limited partnership interests, on the other hand, are simple and permit the donor to continue to receive income and make investment decisions.
How FLPs permit control over transferred assets: Many parents would like to make substantial gifts to their children, but are concerned about losing control over the gifted property, including control over the flow of income from that property. If the property were transferred to a trust, and the donor retained control over the making and withholding of distributions, the property would be includible in the donor's gross estate. By contrast, if the parents give limited partnership interests to their children, the transferred limited partnership interests will not be included in the donor/general partner's gross estate even though the donor, as general partner, continues to manage the partnership and in effect controls the timing and amount of distributions.
In drafting the family limited partnership agreement, however, great care must be taken not to grant too much control to the general partners. Too much control could result in (1) gifts of the limited partnership interests being considered future interest gifts, making them ineligible for the annual exclusion; (2) gifted limited partnership interests being included in the donor's estate; or (3) children being disregarded as limited partners. The partnership agreement should not give the parents complete management authority, including the right to regulate cash flow, while restricting the limited partners' ability to dispose of their interests without the consent of the parents. Generally, the more control the parents want over partnership operations, including cash flow, the fewer restrictions there should be on transferring partnership interests.
How FLPs protect family assets from creditors: Another advantage of the FLP is that it is difficult for creditors of the partners to reach the underlying partnership assets. This is significant for parents who are in a high-risk profession, or who want to transfer assets to their children, but are concerned a child might be sued or that a child's former spouse might obtain such assets in the event of a divorce.
Property owned in other states: If a decedent owns real estate or tangible personal property in a state other than his domicile, it will be subject to a separate probate proceeding in the foreign jurisdiction. Putting such property into a FLP will convert it into intangible personal property subject to probate in the state of the decedent's domicile, regardless of the physical location of the underlying assets, thus avoiding ancillary probate.
Income tax considerations: Since a proportional share of the partnership's income will pass through and be taxed at the limited partners' rates, the FLP can shift income from the parents, whose income tax rate may be as high as 35 percent, to the children, whose income tax rates may be as low as 15 percent or 25 percent. This is so even if partnership income is not distributed to the children. However, if the child is under age 19, the income with respect to the gifted limited partnership interest will be taxed at the parents' income tax rates.
Generally, no gain will be recognized when forming an FLP. If, however, the property contributed to the FLP is mortgaged and the mortgage exceeds the property's basis, gain equal to the difference will be recognized. This result could be avoided if the FLP does not assume the mortgage.
[Lawrence Peck is an attorney practicing in New York City.])