PERSONAL FINANCIAL PLANNING

The Family Limited Partnership: A Planning Technique

By Roger D. Lorence, LLM

The family limited partnership (FLP) is a sophisticated financial planning technique that, when implemented properly, enables a family to hold and manage its wealth, including the family business, within several generations of family members as partners.

Families with significant wealth increasingly establish an FLP rather than a corporation, because the FLP is often better suited to achieving certain objectives. Specifically, the FLP is an ideal mechanism for--

* retaining the operating direction or control of the family business or investment assets by the senior family members,

* developing a succession plan for the future management of the enterprise, and

* transferring the assets (wealth) of the family between generations at the lowest permissible cost in estate and gift taxes.

What Is an FLP?

A little background on corporations and partnerships is helpful to understanding the FLP. The profits of a standard C corporation are taxed at a maximum rate of 35% (for Federal tax purposes); when the after-tax profits of the C corporation are distributed to the shareholders as dividends, those same profits are taxed a second time to the individual shareholders, up to the maximum Federal statutory rate of 39.6%. The combined corporate and personal tax rate can easily exceed 60%, even before state and local income taxes are taken into account.

On the other hand, the profits of a subchapter S corporation are, in general, taxed at the shareholder level only--making the S corporation a more appealing structure than the C corporation in many instances. However, there are numerous restrictions on the qualifications for functioning as an S corporation, even after the liberalizing amendments enacted in 1996.

By comparison, a partnership is a pure "flow-through" company, meaning that the income realized by the entity flows through and in all cases is taxable to its individual owners and not to the business per se. As a result, the limited partnership has become increasingly popular as a flexible and tax-efficient vehicle for conducting business--particularly as compared to a corporation, which is more formal and generally tax-inefficient means for conducting business.

Further enhancing the desirability of partnerships is the Uniform Limited Partnership Act adopted by a large majority of the states. This statute standardizes and simplifies the laws governing a limited partnership's conduct of business in more than one state.

Illustrative Example of an FLP

To illustrate the use of an FLP, consider the case of the Alpha Family:

The Alpha Family's senior members, Parents, are in the business of acquiring and operating office buildings. Parents have three children, one of whom, C, is interested in working for the business. Parents are the owners of a limited liability company (LLC), which is treated as a partnership for income tax purposes and owns one property. Parents have located a potential acquisition property and would like to consolidate the LLC with the new property. The issue: How should Parents proceed?

Parents may create an FLP by contributing their interests in the LLC to the FLP in exchange for general partnership interests (totaling 10% of partnership capital and profits) and limited partnership interests (the remaining 90% interest). Parents may transfer their general partnership interests to an LLC or an S corporation to obtain limited liability protection.

Next, Parents make a gift of half of their limited partnership interests to the children, dividing up the interests among the younger generation. Parents lend $2.5 million to the FLP, payable in 10 years and bearing interest at the applicable Federal rate for related party loans (assume five percent under current guidelines). C may or may not become an employee of the FLP. The FLP then acquires the new property, using $5 million in cash from the loan proceeds and a mortgage. Each year, the limited partners will be allocated their proportionate share of the rental activity profit. They will also benefit from the future appreciation of the buildings.

If structured correctly, the FLP achieves several goals:

* Parents retain effective control over the management of the enterprise during their lifetimes or for as much of their lifetimes as they decide. This results from the powers of a general partner, who manages the business and controls the distributions to limited partners.

* Parents maintain family control of the enterprise in the future through their selection of a general partner, such as C.

* Parents have obtained significant protection from creditors by combining the existing and future properties into a single vehicle, because attachment by a creditor of a limited partnership interest is a cumbersome procedure that does not carry the same rights as attachment of an asset that is directly owned by a debtor.

* Parents have funded the FLP at the lowest cost of capital permissible under the tax rules because they have lent funds to the family enterprise at only five percent, whereas the market rate for a bank loan to a similar company would be significantly higher. This means that the younger family members stand to earn a higher rate of return on their limited partnership interests than if higher-cost outside financing had been used.

As if all this is not enough, Parents have also made a gift of the value of certain limited partnership interests to younger family members, an action which carries significant, and beneficial, implications for estate and gift taxes. So much so, in fact, that the factual and legal issues pertinent to the valuation of the gifted FLP interests are crucial in determining the right set of circumstances to implement an FLP structure.

Valuing the Gifted Limited Partnership Interests: The Key to Proper Use of the FLP

One of the interesting quirks about holding an interest as a limited partner in an FLP is that the fair market value of the partnership's assets can be significantly larger than the value of the limited partner's proportionate share in those assets.

A discount in value can be justified on the basis of lack of marketability of the underlying assets (in our illustration, the rental real estate) and ownership of a minority interest. A limited partner effectively has little, if any, control over the company's affairs and is in effect locked into this form of ownership for an extended period (often 20 years). Although challenged by the IRS, the valuation of discounts in a bona fide case have been consistently upheld by the courts.

For example, in the case of the Alpha Family, if the underlying assets have a fair market value of $40 million, a 10% limited partnership interest would be valued at less than $4 million. A 25% reduction in value due to the lack of marketability and minority interest factors just mentioned might result in the valuation of a gift at $3 million, not $4 million. Every case is different. Consequently, family members making gifts of partnership interests should obtain a valuation study to document the value of the gift.

The U.S. Treasury has expressed concern over the practice of claiming substantial discounts in cases where readily tradable assets, such as marketable securities, are transferred to an FLP. One of President Clinton's 1999 tax proposals, if enacted into law, would prevent the taking of any discounts in such a case. The 1998 version of this proposal was criticized by congressional staff because of the broad and ambiguous manner in which the proposal was drafted. As a result, we advise that, until the issue is clarified, the use of valuation discounts for marketable assets in an FLP structure should be carefully considered.

Tax Guidelines for Structuring the FLP. Because the FLP, when appropriately implemented, represents an optimal way to accomplish business-oriented objectives while transferring wealth from one generation to another, Congress has imposed certain guidelines on the proper structuring of an FLP. These guidelines, known as the "estate freeze" rules, are intended to restrict two factors that are present in certain FLP structures. The first involves the definition of the rights and limitations of the general partnership interests retained by the older generation and those of the limited partnership interests that are gifted to the younger generation. The limited partnership agreement must be drafted so that it will not run afoul of key tax law requirements. The second factor pertains to claims of excessively large valuation discounts for nonliquidity and minority interests in the limited partnership gifted to the younger generation.

Appropriate Use of the FLP

In contemplating the creation of an FLP, it is critical that the choice of the partnership vehicle is specifically designed to accomplish valid business or investment purposes.

In looking at limited partnerships, the courts have been sympathetic in those cases where the FLP is used to--

* conduct a family business,

* pool family wealth and manage it in a coherent, structured way, and

* implement a succession plan for transferring management of the business from one generation to another.

Moreover, creating a larger pie by combining family wealth in an FLP means that there may be more opportunities for growth than from assets held in numerous smaller, separate, and distinct instruments.

The values of the interests transferred and retained must be carefully documented, and all conclusions regarding the values of the interests must be reasonable and in conformity with the basic principles of sound business valuation techniques. Also, it is vital that the drafting of the limited partnership be done with a certain objectivity--that is to say, due regard should be given to the kind of agreement that unrelated parties acting at arm's length would reach in a similar situation.

The rules that Congress enacted are complex: Hence, the drafting of the FLP partnership agreement and the preparation of any supporting valuation should only be undertaken by experienced professionals. In addition, the IRS and the Treasury have, for some time, viewed FLPs as an overly generous (to the taxpayer) means of transferring wealth between generations. In essence, it would seem that the IRS is interpreting the law far more narrowly than Congress intended. No doubt, over time these positions will be tested in court. In the meanwhile, the IRS's position has had something of a "chilling effect," so that use of an FLP must be undertaken with caution. *

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA/PFS

Contributing Editors:
Alan J. Straus, CPA

David N. Kahn, CPA
American Express Tax &
Business Services

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