The Family Limited Partnership

Clients whose estates are in excess of the $2,000,000 unified credit equivalent may often ask their professional advisors for ways to minimize estate taxes upon death while retaining control during their lifetime. The Family Limited Partnership (FLIP) is such a vehicle. It allows the older generation to make lifetime gifts to the partnership, retain control as the general partner, and receive significant discounts on the value transferred. By using a FLIP to transfer interests in property, the donor may be able to take substantial valuation discounts when determining the value of gifted property. In fact, the combination of minority interest and lack of marketability discounts can result in the reduction of gift tax value by as much as 25% to 60% from underlying liquidation values. The future appreciation of those assets is removed from the estate at death and assuming the senior members have retained a less than 50% interest, a minority discount is available for the remaining interests for estate tax purposes. From an estate and gift tax planning perspective, the FLIP presents the client with valuable opportunities to utilize substantial discounting valuation techniques through transfer of limited partnership interests within the family including the ability to leverage the use of the $12,000 annual gift tax exclusion as well as the unified credit and the $2,000,000 generation-skipping transfer tax exemption. The value of limited partnership interests in family limited partnership conveyed to children prior to the death of the donor are not subject to estate taxation in the estate of the decedent. More importantly, for most clients, the FLIP facilitates gift giving and wealth transfer while allowing the donor to retain control during his or her lifetime.

This brief discussion will present in general terms the various planning opportunities available with FLIPs. It is important to note that this information is not meant to serve as an absolute solution to all clients. All those who have interest in this technique need to further discuss this vehicle with their tax and legal advisors.

Definition and Structure of the FLIP

Definition - A limited partnership is formed under state law and is an entity separate and apart from its owners, who are the general and limited partners. A family limited partnership is simply defined as a limited partnership between family members. The general partners have total responsibility for the management of the partnership. The limited partners must remain passive and play absolutely no role in the management of the partnership. As long as the limited partners refrain from management participation, they will be free from liability on partnership obligations.

Structure - Typically a senior family member (and often the spouse of the senior family member) will transfer assets into a FLIP in exchange for a general partnership interest (if the senior family member wishes to maintain control and management of the assets) and a limited partnership interest. Other family members may be brought in as general partners or limited partners so long as those members make a contribution to the partnership.

The FLIP is created under state law and governed by the statutes of the governing jurisdiction. Once the partnership agreement is finalized and executed, the partners will then transfer the selected assets into the name of the partnership by deed, assignment, etc.

Thereafter, the donor will begin gifting off limited partnership interests to the donor’s family members thereby transferring all future appreciation and earnings attributable to partnership property out of the donor’s potential taxable estate.

Asset Protection Benefits

The FLIP is a unique entity that provides ultimate control and management of partnership assets while at the same time providing asset protection benefits. In the FLIP, there are one or more general partners who are vested with the management control of partnership affairs and assets. Limited partners, of which there can be one or more, do not have any control or management in partnership affairs or the management of assets. The limited partner’s role is passive and therefore, has limited liability for the obligations of the partnership. Because a general partner, unlike a limited partner, is liable for partnership obligations, it is safest, from an asset protection perspective, for a corporation to serve as the general partner. This insulates the involved individuals from personal liability and the possibility of lost personal assets. Partners have no interest in specific partnership assets, meaning a partner’s creditors cannot reach specific FLIP assets. Creditors appearing after the formation of a FLIP may have little success collecting against a family member’s FLIP interest.

When deciding which assets to place into a FLIP, the family must be careful not to commingle high liability assets with low liability assets. If a FLIP itself becomes subject to a lawsuit, all the asset within that partnership will become subject to the claims of the partnership creditor. Negative circumstances can potentially occur if an asset within the partnership can cause liability. For example, one should never place a potentially liable assets such as commercial rental property into a FLIP with a safe assets such as one’s personal investment portfolio. The reasons for that advice should be obvious.

Estate and Gift Tax Advantages

For transfer tax purposes, if you make a gift of a limited partnership interest in a FLIP, the amount of the gift for gift tax purposes is the value of the limited partnership interest given. Under the Internal Revenue Code, the value of the gift interest is the amount that a willing buyer would pay a willing seller. In other words, the limited partnership interest gifted is valued at the amount that an unrelated third party would pay for the limited partnership interests. Likewise, for estate tax purposes, the value of property in the decedent’s estate is determined based upon the value of property as it passes to the estate beneficiaries. In either case, the value of the property in the hands of the donor should not be controlling for transfer tax purposes. In other words, based upon the "willing buyer and willing seller" test, the value of transferred property should be determined based upon the value of the property that the transferee receives, and not based upon the value of the property that the transferor possessed.

In the context of the FLIP, the fundamental underlying principal with discount valuations for gifts of FLIP interests is that the sum of the parts does not equal the whole. In other words, because limited partners are restricted under state law and the terms of the partnership agreement from forcing liquidation of the partnership, and even from participating in management decisions, the value of the limited partnership interests transferred should be discounted to reflect their lack of control over the partnership and its activities. Similarly, because the FLIP agreement will contain restrictions on the transfer of limited partnership interests, lack of marketability discounts will also be available in valuing gifts of limited partnership interests.

Final Thoughts

FLIPs can provide the following benefits:

  • They can be formed without adverse income tax effects
  • They allow for centralized management of family investments
  • One or more parents as general partners may control the FLIP
  • Limited partnership interests may be valued for gift tax purposes at a substantial discount from underlying asset liquidation values
  • Limited partnership interests may be used as a convenient intra-family currency for gift purposes
  • The creditors of the partners have no access or very restricted access to assets of the FLIP
  • The FLIP interests of the parents, may in certain cases, be valued at a discount for estate tax purposes at death.

Conclusion

The benefits of the FLIP are only limited by one’s objectives and imagination. The use of the FLIP will continue to increase and possibly become the vehicle of choice for income tax reduction, out-of-state property management, senior family control, managed transfer of family wealth, asset protection and discount valuations for gift and estate tax purposes.

Recent Revelations

The Internal Revenue Service is aggressively pursing those who attempt to abuse the use of this beneficial planning vehicle. While this may appear to be troublesome to those considering the appropriate use in their planning, this notice is meant solely to warn users to honor the entity and follow the advise of professionals to assure the proper structure and continuation of such a plan. It is not advisable to get involved in this type of plan under a time constraint. This plan requires sufficient time to be effective and also requires prudent guidance from tax and legal advisors. A properly designed FLIP continues to provide families with an effective tool for the purposes and goals outlined above.

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