From the November 2008 issue of Wealth Manager Web • Subscribe!

November 1, 2008

Writing the Documents

Due to its effectiveness in leveraging the gift tax and seamlessly transferring ownership interests, the family limited partnership (FLP) has long been seen as a viable wealth transfer strategy by estate planning professionals. As the FLP becomes a more mainstream planning technique, however, it appears that clients are increasingly all too willing to enter into an FLP without understanding how it works and even why it should be established in the first place.

It's not uncommon to hear of clients ready to put all of their worldly possessions into an FLP. They understand the tax benefits of such an arrangement, but miss the finer points required to make the FLP effective. If a client insists the reason he wants to create an FLP is to reduce or avoid taxes, you as the advisor need to pull in the reins--because that sentiment is likely to land your client in tax court.

Still, the FLP can be an effective estate planning tool, but you need to educate your clients about the risks, function and formalities inherent in this strategy.

Understanding the FLP

An FLP is an entity created by family members to accomplish such goals as transferring a family business to a younger generation, reducing transfer costs and centralizing asset management. The FLP structure requires both general partners and limited partners. The client who is establishing and primarily funding the FLP will take on the role of the general partner, the person who oversees the daily operation of the FLP business. Generally, the client will initially be the limited partner as well, with the intent of gifting the limited partnership interests to heirs.

Once the FLP is established, the client will transfer asset title to the FLP. Assets commonly used to fund the FLP include closely held stock, real estate, publicly traded securities or any combination thereof. With title now in the name of the FLP, the general partner will transfer a portion of his or her FLP interests to the heirs, making them limited partners of the FLP. The general partner retains the power to make all business and investment decisions for the FLP, but over time the general partner will reduce overall interest in the partnership.

Because of this gradual release of ownership interests by the general partner, the FLP makes for a valuable business succession planning mechanism. The younger generation receives the FLP interests as they become more comfortable with the management duties associated with the business venture.

This scenario is especially attractive to clients who worry about the potential for mismanagement when wealth is transferred to the younger generation. The client will always retain at least a fractional level of ownership (as little as 1% in some instances) and will retain control of the FLP as a general partner. Remember that limited partners do not hold voting rights, nor do they have the ability to affect daily business operations.

Tax Considerations

The Uniform Partnership Act ?6(1) defines a partnership as "an association of two or more persons to carry on, as co-owners, a business for profit." This definition provides the basis for what may be the greatest source of FLP litigation in the tax courts, which contend that too many FLPs are established with only one purpose: tax avoidance or reduction. It is imperative that the FLP have a bona fide business purpose other than tax reduction.

Although tax reduction cannot be the sole purpose of the FLP (see "Attitude Adjustment for FLPs and FLLCs," Oct. WM, page 36), it certainly is a significant benefit of a properly structured FLP. An FLP is, in fact, an excellent gift and estate tax planning vehicle. The tax advantages are evident in the FLP's ability to reduce the client's taxable estate, transfer future appreciation out of the estate, leverage the use of the annual gift tax exclusion and provide for considerable valuation discounts for gift tax purposes.

How can the FLP accomplish so much?

The advantages of reducing the taxable estate are obvious. The less property in an estate on the date of death, the less tax is paid. But the transfer of appreciation is worth a bit more discussion.

The FLP is considered an "estate freeze" technique. When you transfer quickly appreciating assets out of an estate, you effectively remove value that would otherwise be taxed in the owner's estate if it were held until death. So transferring assets out of the estate essentially freezes their value for transfer tax purposes. The estate freeze characteristic is a primary reason why FLPs are funded with equity interests and real estate rather than Treasury bills and other fixed-income securities. The continued potential for appreciation of these assets after they are transferred to the FLP is what makes the FLP such a powerful planning tool.

Transferring an interest in a partnership is a gift and is therefore subject to the gift tax. Because gifting an FLP interest is a present gift rather than a future gift to the recipient, the gift can qualify for the annual gift tax exclusion (currently $12,000). The general partners can make annual gifts of partnership interests valued at $12,000 without incurring any gift tax. This is an extremely beneficial situation, as many FLP interests are intentionally transferred over an extended period of time with minimal cost. If the value of the transfer is above $12,000, the client can also apply his or her $1 million exemption for lifetime gifts or pay the gift tax.

Finally, one of the most intriguing aspects of the FLP is the valuation discount available on transfers of FLP interests. The FLP interests are transferred to limited partners who have no voting rights or control over FLP business operations. Because there are such limitations and restrictions on the limited partnership interests, the IRS allows for a discount when valuing the interests at the time of transfer. The discounts available include a minority interest and a lack of marketability discount. These discounts can be as much as 40% of the fair-market value of the underlying FLP assets. The discount is another method to leverage the gift tax exclusion and/or reduce gift taxes.

For example, an FLP interest with underlying assets valued at $16,000 may receive a 25% discount due to the restrictions associated with the interests, and therefore the interest is valued at only $12,000 for gift tax purposes.

Pay Attention to Formalities

The area of FLP litigation is dynamic and ever-changing. Each FLP Tax Court case provides wealth managers with an opportunity to learn from others' mistakes. Following are a few best practices:

?Respect the formalities of the FLP arrangement.

?Advise clients to document business purposes and management duties.

?Strictly follow partnership guidelines as established under state law.

?Avoid commingling personal and business assets.

?Do not allow the general partners to use the FLP as their personal pocketbook.

?File gift and income tax returns in a timely manner.

Some additional issues to be considered in FLP planning could not be addressed here. Employ legal counsel and tax professionals experienced in establishing and administering FLPs. And be proactive with your clients and their other professional advisors in identifying potential problems before they arise.

Gavin Morrissey (gmorrissey@commonwealth.com ) is the director of advanced planning at Commonwealth Financial Network in San Diego, California.

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