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A Multifaceted Estate Planning Tool

By Herbert B. Fixler, Charles A. Barragato, and William O. Cranshaw

In Brief

Family as Partners

Federal estate taxes can climb to 55% without regard to any state death tax assessment. Even if a client wants to avoid some of the tax burden through gifts to family members, there are costs and limitations, to say nothing about most clients not necessarily being willing to give up lifetime management and control of their assets.

The authors demonstrate when and how a family limited partnership (FLP) can serve as a multifaceted estate planning tool for helping clients in their quest to transfer some of their assets to family members. There is a discussion of how gifts of assets can be made without giving up management and control. Utilizing an FLP can also result in lower gift taxes by taking advantage of valuation discounts.

Among the other items addressed are: the structure and formation of an FLP, the risks involved, and Federal, state, and local income tax considerations.

The limited partnership (LP) has been used as the entity of choice for persons wishing to pool their assets and secure the limited liability afforded by a corporation without the extra layer of corporate tax. With increasing frequency, estate planners are advising the use of LPs as investment vehicles to hold family investment assets such as real estate, business interests, and securities. LPs make it possible for taxpayers to consolidate their assets and centralize asset management and tax, legal, and accounting services in a flexible business arrangement. In addition to achieving limited liability, the LP may afford a degree of protection from creditors which can be of particular interest to those in high-risk professions or who have children that are not ready to assume control over assets intended for their use.

Other factors enhance the attraction of the LP as an estate planning vehicle. First, the LP provides taxpayers with a simple way of making indirect transfers of interests in partnership assets to family members through gifts or sales of LP interests. For example, interests in a partnership's real estate may be given to recipients through simple assignments of partnership interests instead of separate deeds of specific properties that must be recorded. Similarly, if the assets are marketable securities, children may be given interests in a diversified portfolio without having to divide up blocks of stocks and bonds into numerous smaller lots. Second, the transferees of LP interests are not given direct ownership rights in partnership assets and management control over such assets. Control of the timing and amount of cash distributions to the transferees is vested in the general partner. Finally, LP interest values may be discounted when compared to the value of the underlying property because limited partners cannot control the partnership--they are minority interests--and the interests are not readily marketable. These discounts permit more property to be given away without a substantial gift tax than would be possible if direct gifts were made of the partnership's assets.

When to Use the Family Limited Partnership

The family limited partnership (FLP) should be considered an integral part in the estate planning for taxpayers with diversified assets of significant value who want to transfer interests in such assets to children, grandchildren, and others. At the same time, they can retain control of asset management, cash, and distributions. There is no threshold amount or entry level at which consideration should be given to an FLP. An FLP may be warranted when there is likely to be estate tax payable at death, the death of the survivor, or the death of a spouse, that has not been provided for through life insurance or other sources.

The Federal estate tax top rate is 55% for taxable estates of at least $3,000,000, and gift planning is essential for those with assets likely to reach or exceed that amount. The $600,000 Federal transfer tax exemption is used frequently to shelter gifts of FLP interests from gift tax.

An FLP is also an excellent vehicle for implementing a program of gifts sheltered from gift tax by the gift tax annual exclusion. The annual exclusion makes it possible for individuals to make a gift of a present interest in property of up to $10,000 in value each year to each donee--$20,000, if an individual is married and the spouse consents to gift-splitting. Federal and possibly state gift tax returns may have to be filed in respect of gifts of FLP interests.

An FLP may be well-suited for those with concerns about claims of future creditors. Generally, assets owned by an FLP cannot be reached by a limited partner's creditors unless the transfer to the partnership was a fraudulent conveyance. A creditor's remedy is limited to a charging order against the partner's interest, which only permits the creditor to receive the partner's share of distributions from the partnership. Since the general partner in an FLP controls the timing and amount of distributions, the value of the charging order may be greatly reduced. Additionally, the creditor holding the charging order is taxed on the undistributed income allocated to the partnership
interest pursuant to Rev. Rul. 77-137, 1977-1, CB 178.

While the valuation discounts, inherent in gifts of interests in FLPs, may achieve transfer tax savings without appreciation in value of the underlying assets, as with any gift program, transfer tax reduction is best achieved by shifting future appreciation and income away from the donor to the donee. Accordingly, an FLP should be established long before the donor's anticipated death so that more appreciation can escape transfer tax.

Valuation Discounts Applied to
FLP Interests

The valuation of equity interests in FLPs is based on many of the concepts and principles used in valuing closely held companies. In fact, numerous factors considered in today's FLP valuations can be attributed to traditional techniques for valuing interests in investment holding companies. The IRS Valuation Guide for Income, Estate and Gift Taxes contains a chapter on this subject. The fair market value of minority interests is determined by applying twin tier discounts to the net asset value of the holding company. The twin tier discount structure is directly applicable to the valuation of FLP interests so long as limited partners' rights are comparable to those of minority interest shareholders in terms of not having the ability to--

* force participation in management

* force the sale or liquidation of assets

* get their pro rata share of asset value

* control cash flow distribution policy.

The twin tier structure is composed of a minority interest discount and a discount for lack of marketability. By definition, the minority discount represents the reduction from the pro rata share of the value of the entire enterprise that reflects the absence of the power of control. The marketability discount represents an amount or percentage that is deducted from an equity interest to reflect the lack of liquidity or ready market. Numerous court cases have supported the validity of these discounts. The minority discount in the context of a family controlled business has also been recognized by the IRS in Rev. Rul. 93-12, 1993-1 CB 202, abandoning its long-maintained position that no such discount was available.

The starting point for the determination of the fair market value of an FLP interest is typically net asset value adjusted to reflect the current value of the underlying assets. The minority discount is most often based on capital market evidence which quantifies the lack of control. Depending on the asset classes involved, appraisers analyze the relationship between security prices and net asset value for publicly traded entities that hold similar assets. In the case of an FLP holding marketable securities, closed-end common stock funds are frequently utilized to determine the minority discount. For FLPs owning interests in real estate, certain REITs and the secondary market data for real estate partnership transactions are often analyzed to determine this discount. The minority discount typically ranges from 5% to 25% depending on the type of FLP underlying assets.

In determining the marketability discount, appraisers typically rely on published studies or proprietary data. Many of these studies are based on the discounts of restricted public securities from their freely-traded values. Other studies for determining this discount rely on the expected cost of public offerings. The marketability discount typically ranges from 15% to 35%.

The exhibit shows how the minority and marketability discounts should be applied to a mixed asset FLP in which a 10% limited partnership interest is being valued for estate planning purposes. The aggregate discount in the exhibit is approximately 40% of the interest's pro rata share of the FLP's underlying net asset value.

It is important to note that while the valuation methodology is based on the FLP balance sheet, a thorough appraisal will also give consideration to the income statement. Calculation of implied yields on the discounted fair market value act as a reasonableness check on the conclusions. If yields are determined to be far in excess of market rates of return, a second look at the discount structure may be required.

Structuring an FLP

An FLP is generally structured using an S corporation general partner, which is controlled by the parents or other senior family members. The bulk of the FLP interests are initially held by senior family members. If only one senior family member creates the FLP, controls the general partner, and receives the FLP interests, junior family members should also contribute assets to the FLP and become limited partners. The FLP then will be recognized for state law and tax purposes. If outright ownership of FLP interests by junior family members is not desirable, such interests may be held by trusts.

In order to restrict the ability of limited partners to withdraw from the FLP and receive a distribution of FLP assets, the FLP is frequently formed in a state such as California, Delaware, or Georgia. These and certain other states have enacted the Revised Uniform Limited Partnership Act (RULPA) with modifications that prohibit limited partners from withdrawing from an FLP and receiving a distribution unless the partnership agreement provides otherwise. It is essential that the state not impose onerous income or other taxes upon the FLP or its partners. Formation of the FLP pursuant to restrictive RULPA provisions should also serve to enhance the discount for lack of marketability by avoiding the provisions of IRC section 2704(b). This section requires that certain restrictions in partnership agreements, called "applicable restrictions" (which are more restrictive than applicable state law), be ignored for gift tax valuation purposes.

After the FLP is formed and funded, senior family members may proceed to make gifts of FLP interests to junior family members. In certain circumstances, such interests may also be sold. In order for a recipient to be admitted as a substitute limited partner, the provisions of the partnership agreement governing admission of new partners must be complied with. Alternatively, the recipient may be treated as a mere assignee of an FLP interest. An assignee has most of the economic benefits of a limited partner but none of the voting and other rights afforded to full limited partners. Treatment of a transferee as an assignee rather than a substitute limited partner may enhance valuation discounts.

The FLP is governed by the partnership agreement which specifies the manner in which the FLP will be managed and its business conducted. Control over these functions is vested in the general partner, and the limited partners are typically given no right to participate, although they are given the right to vote on certain important matters. Control of the FLP (through the corporate general partner) by the donor of limited partnership interests should not cause such interests to be included in the gross estate of the donor, provided the partnership agreement does not eliminate or significantly reduce the fiduciary standards imposed upon general partners under state law and the FLP is actually managed in a manner consistent with such standards. However, excessively restrictive provisions may make gifts of FLP interests ineligible for the gift tax annual exclusion because they are not present interests. Moreover, retention of control over the general partner on the death of the donor may cause the estate tax value of the donor's remaining FLP interests to be determined based upon the value of the partnership's underlying assets without regard to valuation discounts.

Income Tax Considerations

It is essential that the FLP qualify as a partnership for Federal tax purposes. Generally, this should not cause difficulty given the recent issuance of final "check-the-box" regulations, which became effective January 1, 1997. Under these regulations, newly-formed domestic pass-through entities with at least two members are automatically classified as partnerships.

When property contributed to an FLP includes appreciated securities, the investment company diversification rules of IRC section 721(b) must be considered. That section may require gain to be recognized by the transferor if appreciated securities are transferred to the FLP and more than 80% of the FLP's assets consist of marketable securities. Unlike transfers to controlled corporations, there are no timing or control restrictions on transfers to partnerships, and gains can be easily avoided.

It is important to identify the tax bases of all assets transferred to the FLP. Under IRC section 722, a contributing partner's tax basis is equal to the sum of the money and the adjusted basis of other property contributed to the FLP. If the FLP assumes certain liabilities of partners, the partners must adjust their respective partnership tax bases for increases and decreases in such liabilities. This bases adjustment is affected via a deemed cash distribution/contribution to or from the partners. Both the contributing partners and the partnership will receive a tacking on of holding periods for all contributed assets that are considered either capital assets or IRC section 1231 property.

Planners must take into consideration state and local taxes that may result from the transfer of property to an FLP. There are numerous tax elections that an FLP may be required to make. IRC section 703(b) requires that a partnership consider those accounting elections that affect the calculation of its taxable income or loss. The more significant elections include overall accounting methods [section 446(c)], amortization of organization expenses [section 709(b)], MACRS methods (section 168), installment sales (section 453), like-kind exchanges (section 1031), and tax years other than a required year (section 444). Income or loss allocation must conform to the provisions of IRC section 704(b) and applicable regulations.

If property contributed to the FLP has an inherent built-in-gain, IRC section 704(c) requires that any precontribution appreciation be specially allocated to the contributing partners. Reg. section 1.704-3(a)(7) further requires that where the contributing partner subsequently transfers all or a portion of the partnership interest, the transferee steps into the shoes of the transferor for purposes of applying the special allocations.


The FLP can be a dramatically effective vehicle by which clients can transfer wealth to junior family members at substantially reduced transfer tax costs. But, it does involve risk.

An FLP, especially one that owns only marketable securities, may not be treated as a partnership because it lacks a "business purpose." IRC sections 731(c) and 7701(a) of the IRC and PLR 9547004 indicate that a partnership may have an investment or a financial, as opposed to a business purpose. Accordingly, an FLP formed with marketable securities or other investment assets should have a valid purpose sufficient to be recognized as a partnership.

Another risk is highlighted in a
technical advice memorandum (TAM9719006). In the TAM, the national office of the IRS took the position that an FLP formed on behalf of a 92 year-old woman who was terminally ill, had been removed from life support, and died two days later was a sham. Accordingly, the IRS held that the interests in the FLP, which were purchased by the children from a marital and a living trust--the children were trustees--for a minor amount of cash and a 30-year note were to be treated as direct interests in the FLP's real estate and marketable securities. The facts in the January TAM were particularly egregious, and the creation of the FLP apparently served no purpose other than transfer tax reduction. However, in the TAM, the IRS clearly indicated its intention to utilize IRC section 2703(a) to foil the FLP. Simply put, section 2703(a) provides that options, agreements, or other rights to acquire or use property at a price which is less than the property's fair market value and restrictions on the right to use or sell such property are to be disregarded in determining the transfer tax value of such property. In essence, the IRS argument is that the partnership agreement itself is subject to section 2703 which serves to make irrelevant, for valuation purposes, restrictions in the agreement or inherent in the partnership structure including restrictions imposed by state law. According to the IRS, the
transfer of FLP interests should be
valued as if the underlying partnership assets are being transferred and the
existence of the partnership is to
be ignored.

Although it is clear that the IRS intends to press its section 2703(a) attack on FLPs, it appears the section could only apply to the property of an FLP rather than to the partnership interests themselves. Accordingly, in order to prevail, the IRS would have to show that the FLP is a sham without economic substance or that the transfer of assets to the FLP and the subsequent transfer of FLP interests were one transaction with two interdependent steps. Even if the IRS were to be successful, it is possible that taxpayers may find protection in section 2703(b) which provides that the rule of section 2703(a) will not apply if there is a bona fide business arrangement which is not a device to transfer property to family members at less than full consideration and the terms of which are comparable to those of similar arrangements in arms-length transactions. Note that section 2703(b) imposes a three-part test, all of which must be satisfied, to take an arrangement outside the scope of section 2703(a).

Team Approach Is Best

The FLP is an effective tool for estate planners. Although it is essential that future developments in the courts, Congress, and IRS be monitored, care in the structuring and conduct of FLPs should be helpful in securing their benefits for clients. Whenever possible, FLPs should be formed with diversified assets contributed by multiple family members. Management of the FLP should scrupulously follow business practices found in entities which are not owned by the members of a single family. It is essential that FLP interests transferred by gift or sale be appraised by a qualified appraiser. Finally, since the FLP cuts across several professional disciplines, the team approach should be utilized whenever an FLP is to be established. *

Herbert B. Fixler, Esq., is a partner of the firm Hall, Dickler, Kent, Friedman & Wood, LLP and co-chair of the firm's estate planning and administration department; Charles A. Barragato, CFE, CPA, is a professor of accounting and taxation at the C.W. Post School of Professional Accountancy ­ Long Island University; and William O. Cranshaw, is a vice president and director of Management Planning, Inc., a Princeton, NJ based valuation advisory firm.

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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