From the March 2006 issue of Wealth Manager Web • Subscribe!

March 1, 2006

OUT OF REACH

Family limited partnerships (FLPs) are an effective planning technique for reducing gift and estate taxes. Experts insist that while FLPs may have taken some hits from a string of recent Internal Revenue Service victories in the United States Tax Court, they are not down for the count. Properly set up and operated, they say, FLPs remain a viable gift and estate planning technique. "They're not dead, but you do have to be careful and do the right thing and don't do the wrong things," says Calvin Brown, vice president of planning for the Monitor Group, a comprehensive wealth management firm in McLean, Va. Brown has used FLPs in the past and says he will not hesitate to recommend them in the future, when appropriate.

In fact, Brown is not too worried about the FLPs he set up in the past, and has not made any changes to any of the firm's existing FLPs. "We weren't that aggressive before. We had legitimate reasons for setting up family limited partnerships, drew up the appropriate documents and hired independent valuation experts to value the interests," he says. And operational requirements are also strictly adhered to. For example, Brown personally makes sure that all FLP clients actually hold annual meetings with a member of his firm in attendance to take minutes.

But some advisors are less enthusiastic. In 2005 Curt F. Fey, a financial planner in Pittsford, N.Y., dissolved a FLP he helped to set up five years previously. The FLP had been set up to hold a vacation rental that the senior family member used on occasion. The senior family member, explains Fey, believed that too much work was needed to maintain the FLP, and it was not worth it.

FLPs were called into question in the now famous 2003 tax court case, Estate of Strangi v Commissioner, the first case to get the attention of the planning community. Strangi was terminally ill when he transferred assets--including his personal residence--into a FLP. He died four months after the transfer. In successfully challenging the FLP's legitimacy, the IRS relied on Internal Revenue Code section 2036 which essentially says that if you give away assets in your lifetime, but retain "strings" to the asset, the asset will be "pulled" back into the estate.

How they work

FLPs reduce gift and estate taxes through the creation of minority partnership interests. A senior family member, usually a parent, sets up a limited partnership to hold assets. A general partnership entity is created at the same time. Partnership interests are then transferred to other family members--usually the children of the senior family member setting up the partnership. At the same time, a second entity is created to be the general partner of the limited partnership. The senior family member retains a controlling interest in the general partnership entity and begins to transfer interests in both the general partnership and the limited partnership to his or her children.

Because creating a partnership and transferring assets into it results in a reduction in overall values, any taxes--both estate and gift taxes are "transfer taxes"--resulting from the transfer of partnership interests are also reduced. The reduction in value results from the creation of the partnership; transferring assets into a partnership makes them illiquid, minority interests.

No arms-length purchaser would pay the full value of the underlying assets for a minority partnership interest, explains Alfred Peguero, a partner at PricewaterhouseCoopers in San Francisco. In other words, if the underlying assets attributable to a partnership interest are valued at $500,000, no one would actually pay $500,000 for that partnership interest. The purchase price would be discounted to take into account the limited marketability and lack of control.

The marketability of a minority interest is limited because the minority interest gives the owner no control over the partnership, says Peguero. The owner of the interest also cannot force a sale to get money out of the partnership, he adds. So if $20 million in assets are transferred to a limited partnership, the overall value of all partnership interests is generally 20 percent to 40 percent less than $20 million. In this example, using a 30 percent discount rate, the $20 million in assets becomes $14 million in limited partnership interests.

When interest in a FLP is transferred from a senior family member to a child, the gift tax is not assessed on the value of the underlying assets in the partnership, explains James R. Robinson, an associate at the Atlanta law firm of Arnall Golden Gregory LLP. Instead, the gift tax is assessed on the value of the minority partnership interest being transferred.

In another example, by transferring assets to a FLP and gifting partnership interests instead of the actual assets, parents can reduce overall gift taxes paid, explains Daniel Hall a manager at PricewaterhouseCoopers in San Francisco. Using IRS valuation principles, Robinson explains that if the underlying assets transferred to a child are $500,000, the valuation of that partnership interest is generally 25 percent to 45 percent less than $500,000. Therefore, if the underlying assets of a partnership interest are worth $500,000 at a 30 percent discount rate, the value of the partnership interest is $350,000. Gift taxes would be assessed, then, on the value of the $350,000 partnership interest transferred and not the $500,000 in underlying assets associated with that interest, says Robinson.

Gifting away assets through a FLP also removes assets from the senior family member's estate, says Jeff Pennell, a professor of law at Emory University. If the senior family member consistently gifts away interests in the limited partnership to the second generation, he explains, then the underlying assets are removed from his or her estate, so that no estate taxes are paid on interests.

While partnership interests gifted away are removed from the senior family member's estate, retained interests in both the general and limited partnerships do remain in the estate. Even then, however, there are tax savings because values are discounted by creation of the FLP. For example, suppose a patriarch transfers $20 million in assets to a FLP which is discounted by 30 percent to $14 million, then dies owning 85 percent of the partnership. Under this scenario the father's estate will include 85 percent of $14 million or just under $12 million. In other words, the estate does not owe estate taxes on 85 percent of the partnership's $20 million in underlying assets. Instead the estate owes taxes on 85 percent of the discounted value of the overall partnership or approximately $12 million, provided that the FLP was properly structured and operated.

Pushing the Limits

However, the Internal Revenue Service has successfully challenged a number of FLPs, and when the IRS succeeds in its challenge, the FLP entity is disregarded and the underlying assets of the partnership are pulled back into the estate to be taxed. In other words, the IRS "looks through" the partnership to include the full value of the partnership's assets in a decedent's estate and subjects it to tax.

FLPs can still survive IRS and tax court scrutiny, but abusive FLPs definitely will not. "Any time you have a technique like this, you'll have practitioners who push the limits," says Hall. Generally, FLPs with no legitimate business purpose, other than the avoidance of gift and estate taxes, push the limits and will not survive scrutiny, he says.

"What you've been seeing in the case law are similar patterns of 'bad facts,'" Hall says. Bad facts, he adds, include transfers of upwards of 98 percent of the senior family member's assets--including personal assets--into the FLP, or the senior family member treating the partnership assets as personal assets and writing checks on the FLP for personal expenses. "The IRS has always viewed family limited partnerships as a tax-limiting vehicle and nothing more," says Robinson, "although, until recently, they had a hard time convincing the tax court of that."

After Strangi, another case that garnered a lot of attention was the 2005 Bongarde case. In Bongarde, the patriarch who set up the FLP died unexpectedly within a short period after transferring the assets. The court held that no non-tax reason existed to put the assets in a FLP, so it pulled the assets back into the estate for taxation. In invalidating the FLP the court noted that although assets were supposedly transferred to diversify them, they were never actually diversified. Furthermore, the court noted that the assets transferred were already in a trust so they already had bankruptcy protection.

Surviving Scrutiny

Estate filings indicating that there are FLP holdings now receive a great deal of scrutiny from the IRS. When a FLP is flagged, the IRS generally sends out a one-page letter asking questions about the FLP. To defend the FLP, the estate must answer those questions with sensible arguments targeted specifically to the facts of that FLP. "You have to be well prepared to defend the bona fides of the partnership to the IRS," says Robinson.

If after setting up a FLP, nothing changed but the title of the interest, it is likely that the entity will not be respected, says Robinson. Particularly if the matriarch or patriarch uses the partnership's assets as a personal account or uses them for personal expenses, he adds. When setting up the FLP it is important that no personal assets of the senior family member, such as cars or personal residences, are transferred into the partnership. The transferor should retain enough assets outside of the partnership to sustain his or her lifestyle, says Brown, so that they do not need to utilize the partnership assets for personal expenses. "It really has to be set up with excess assets," he says.

Properly formed and properly operated FLPS, however, should continue to receive material discounts for lack of control and marketability, the experts say. To meet IRS scrutiny, a FLP should have a legitimate and significant business purpose to exist beyond just reducing taxes. For example, managing a family business or investment management could be legitimate business purposes.

After Strangi, says Robinson, the courts developed a test to see if FLPs pass muster. The "business purpose" test for FLPs asks if there is a valid non-tax reason for the partnership. If a legitimate business purpose exists for setting up the FLP, then the partnership is deemed okay by the courts. For example, in one case the assets transferred to the partnership were working oil and gas interests. The court, says Robinson, noted that these types of interests are almost always held in a partnership. Rental real estate is also a legitimate asset to transfer to limit liability, he says, since commercial real estate is also generally held in some form of limited liability entity. In another case, says Hall, the FLP was set up as a pre-IPO strategy, and that was held to be legitimate. Creditor protection is another valid reason for setting up the partnership, as is bringing the second generation into the business or providing them with investment management experience.

"The key thing is to document all the non-tax reasons for establishing the partnership," says Brown, "to try to get as many facts and circumstances as you can on your side." The partnership entity should be validly formed before it is funded, he says. All the business and non-tax purposes behind the formation should be documented in writing and the senior family members setting up the entity should not have unilateral access to the assets. And, if any distributions are made, all distributions from the FLP should be pro-rata to all partners, Brown says.

If the "business purpose" test is not met, the FLP can still pass muster, says Robinson, if there was no express or implied agreement that the person setting up the partnership would retain the right to the income from, or the beneficial enjoyment of, the property transferred to the partnership. This is a much harder test to prove, however, he adds.

Furthermore, the actual running of the FLP must be done in a way to support the idea that the FLP was formed for a legitimate and significant non-tax purpose. It is very important, say the experts, to pay vigilant attention to the operational details of the FLP. Make sure the FLP is being managed the way it needs to be managed. And, if advisors currently have clients who set up FLPs in the past which appear to run afoul of the rules, the problems should be addressed as quickly as possible, adds Peguero. If clients are using partnership accounts for personal expenses, that has to stop, he says. And, he warns, if qualified appraisals of partnership interest have not been done, then they should be. The IRS takes the position that if there is no substantiation for the discount, they will not allow any discount to be taken, he says.

The FLP is still a valid planning vehicle. But advisors need to be aware of factors such as whether the senior family member who set up the partnership has retained too much control. Of course, how much control is too much control is still unclear, says Robinson. Furthermore, parents who set up these partnerships have to retain enough assets outside of the partnership so that they have no need of the assets within the partnership, he says.

"As an estate planning tool, it's still viable, but the facts have to be right," says Hall, who offers the following checklist:

Do not transfer personal assets into the partnership

Respect the partnership as a separate business entity and establish a clear business purpose for the FLP.

If the senior family member who set up the FLP takes a distribution from the partnership, make sure that each child gets a pro-rata distribution as well.

Most importantly, make sure there is a significant non-tax reason--such as investment management or to provide a vehicle for a gift giving program--for the existence of the partnership.

And, make sure that reason can be justified: for example, if the reason is asset diversification, make sure the assets are indeed diversified.

Elayne Rober tson Demby, JD, has covered executive compensation, employee benefits and financial issues for more than 10 years.

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