Advantages

• Control. Control can be an advantage of the FLP and a disadvantage, as described in more detail below. One of the primary reasons that clients refuse to make lifetime transfers of wealth to children or other family members is loss of control. For instance, say you own 100 percent of the stock in your closely held business that you estimate is worth $16 million. You know that you should be transferring stock to your children and grandchildren to reduce the impact of future estate taxes. But you're frozen into inaction because you do not want to risk losing control—even to your family. As a result you do nothing. The FLP may allow you to retain some control of the decisions concerning your business, while also letting you address your estate tax concerns. If you are the only general partner, no one else has voting rights or decision-making authority. However, if you are the only general partner, the IRS may argue that you have too much control and any valuation discounts will be ignored. Therefore, it is advisable to share control of the company. In order to further reduce the risk of an IRS attack, some individuals choose to give up all control. An individual who is not ready or willing to give up half or all of the control of the FLP should be advised that the IRS may attack the entity structure if audited.
• Leverage. One of the primary advantages of the FLP is the leverage that is created when you gift partnership interest to your family members. Through various discounts, you are able to transfer $1 worth of property for substantially less than $1, which allows you to reduce the size of your estate much more quickly than would otherwise be possible. We will discuss valuation discounts in more detail later in this chapter.
• Ease of transfer. The FLP allows you to take a large asset and divide it into small pieces that can be easily transferred. You can imagine how difficult (and expensive) it would be to divide a large tract of land into pieces small enough to use as annual gifts to children. Surveys, deed and title transfers, and court filings would make transfers impractical, particularly if you planned to make transfers each year as a part of a lifetime wealth transfer program. With your FLP, you simply transfer partnership units, which involves simple mathematics once the partnership property has been valued, including the appropriate discounts.
• Asset protection. The FLP provides excellent protection against creditors for the limited partners. It is possible for a creditor of a limited partner to force the partner to assign his or her interest to the creditor in satisfaction of a legal claim. As an assignee, the creditor's rights are generally limited to any distributions declared by the general partner. The creditor is also treated as a partner for income tax purposes. If the partnership has income but not distributions, the creditor is placed in the unenviable position of having so-called phantom income; that is, they owe taxes but received no cash with which to pay them. This will serve as a deterrent to even the most persistent creditor.
• Ease of establishment and simplicity of maintenance. An FLP is relatively easy to create: all you do is prepare the partnership agreement, transfer the deed or title to the partnership name, and issue partnership certificates. Even the subsequent transfers of undivided interests in the FLP are easy. You simply amend the partnership agreement.
• Probate avoidance. Property held in an FLP avoids probate. This is particularly useful if you have property located in more than one state. Avoiding the probate process may save your heirs time, money, and aggravation (the FLP interest itself does not avoid probate).
• Privacy. Closely related to avoiding probate, an FLP provides a structure that keeps the family's business private. This is the case both during life and after your death. If you do not want the world to know what you own, how much it is worth, and who inherited it upon your death, then an FLP is an excellent choice.
• Income benefits to the general partner. Our clients often express the dual concerns of a continuing need for income and a need to reduce their estates to minimize taxes. They fear that if they give their income-producing property away, they will be left without the financial support they desire. The FLP can address this issue effectively because the general partner can pay him- or herself an income as the manager of the partnership. Of course, the general partner must actually be working for the FLP. This is in addition to and apart from the share of declared distributions.
• Centralized management. The FLP provides the benefit of centralizing the management of all assets held in the partnership. There is one partnership tax return, and if desired, there can be only one partnership bank account.
• Continuity of management. A significant feature of the FLP is that it can provide for continuity of management upon your death. Your partnership agreement will list your successor manager. It is particularly important that your document include a succession plan should you become incompetent due to sickness or accident.
• Annual gifting. Your gift of a partnership interest should qualify for the annual gift tax exclusion, although some practitioners argue that you should include a put right (similar to a current access to property right in an insurance trust). This helps reinforce the fact that the gift is a “present interest” and qualifies for the annual gift tax exclusion.

Now that we have made a persuasive case for using an FLP as part of your estate plan, let's look at some of the disadvantages.

Disadvantages

• Control. As mentioned above, maintaining some control can be viewed as an advantage of the FLP planning technique. However, the degree of retained control should be carefully evaluated. Often, the IRS will focus on the level of control retained by the donor (if the donor is the sole general partner or a co–general partner). If too much control is retained, the IRS may attack the valuation discounts applied to the entity. The IRS may also argue that the donor attempted to transfer property out of his or her estate (via gifts of FLP interests), but maintained too much control over the transferred property. Therefore, the IRS may argue that the donor never gave up the property and it should be included in his or her estate for estate tax purposes. This is something that should be carefully considered when evaluating how much control the original property owner should retain in the FLP.
• Valuations. In order for you to transfer portions of your partnership interest, the fair market value of these interests must be determined. For certain assets such as publicly traded securities, this is no problem. However, it is far more difficult to value assets such as real estate, so you will need to get qualified appraisals. A qualified appraisal does not mean that you get your friendly local real estate agent to give you an estimate of value; rather, it means hiring an appraiser who will complete detailed research as to the partnership's value and issue a written report. The appraisal will need to be completed as of the date you are making a transfer of partnership interests on the date of the partner's death. If you are making annual gifts of your partnership interests, you will need annual updates of your appraisal(s). Appraisals can be expensive, costing several thousands of dollars. Before you decide to use the FLP, you should get a sense of what the appraisal costs will be. Often, you can find an appraiser who will update the appraisal annually for a reduced fee. One way to cut appraisal costs is to have them done every other year. For example, say you have the partnership real estate appraised in December of one year and use that value to make gifts for that year and January of the following year. Then you wait two years and repeat the process.
• Determining discounts. One of the primary advantages of the FLP is that you create leverage in your gifting program. Say you want to give your son a parcel of land worth $10,000. By using the FLP, the value of the transfer is $7,000 or less because you are transferring a partnership interest in the property rather than the property itself. As a partnership interest, it carries certain restrictions as to marketability and control, which makes it less valuable. How much of a discount will an appraiser apply to the property? This is an important question that is best answered by an expert in discount valuations. There are actually companies that specialize in this type of work. This is not an exact science and is subject to challenge by the IRS. If the IRS does challenge your discounts, the expert's report will serve as his or her testimony in most cases. You will want to choose someone who is qualified to do this type of work and who can issue a report that adequately defends his or her positions. As mentioned earlier, the costs of appraisals, discount valuations, and a possible legal battle with the IRS can be significant.
• Retaining appreciated property. With an FLP, the value of the gift of a partnership interest is based on the date of the gift. If, as the general partner, you retain a large partnership interest in appreciating property, the growth of that property is increasing the value of your estate. This can make it difficult to manage the growth of your estate, which is typically one of the primary objectives. Contrast this with other strategies such as the installment sale or grantor-retained annuity trust (GRAT), which effectively transfer all future growth to your donee.
• IRS challenge. The IRS is unhappy with the effectiveness of the FLP in reducing and avoiding taxes. FLPs are thus more likely to be subject to an IRS audit than some of the other techniques discussed. This is partly due to the fact that many of your assumptions are based on somewhat subjective estimates rather than exact mathematics. The IRS will particularly focus on your assumptions as to fair market value and discount valuations, which can be easily argued because there are no exact answers. To adequately defend yourself, you will want to make sure that you employ experts in the field, including attorneys, accountants, appraisers, and valuation experts.

Discount Planning

With the help of a qualified appraiser, two types of discounts are potentially available under the FLP.

Calculating Discounts

Calculating the various discounts is a job that should be performed by knowledgeable and qualified appraisers. Discounts for lack of control or marketability are not mutually exclusive. They can be aggregated. These discounts can apply to the general partners as well as the limited partners, but typically in lesser amounts. The fact that you transfer property from your name outright to an FLP possibly creates a discount for you even if you retain the bulk of both the general and limited partnership interests. However, most valuation experts have become more conservative in this area. Typically, if a person creates an FLP and retains the bulk of both the general and limited partner interests, the appraiser is less likely to apply a significant discount. The theory being that the original property owner has maintained too much control over the property. If the original property owner retains only some control over the property (by retaining some general partnership interests), then an appraiser may apply a modest discount to the general partnership interests. This discount is typically less than the discount applied to the limited partnership interests. Some appraisers will take an even more conservative view and reduce the discount applied to the limited partnership interests if the appraiser determines that the limited partnership interest owner retains control over the entity by virtue of the fact he or she also owns some or all of the general partnership interests. We have seen examples of discounts of as much as 40 percent to 50 percent being applied. However, discounts that high can be a red flag. In most cases, discounts can range from 20 percent to 35 percent. The amount of the discount will depend on the underlying assets owned by the entity and the degree of control given to the general partnership interest or limited partnership interest (depending on which interest is being valued). One of the most important elements in setting up your FLP is getting an appropriate discount valuation. You will want to choose someone who specializes in this field and has experience in defending his or her work. The stakes are very high if an inappropriate discount is applied and the IRS attacks the entity or the discount. A successful attack by the IRS can result in additional estate or gift taxes due (as a result of undervaluing property) or in the inclusion of previously transferred property back in the donor's estate (because he or she retained too much control). Therefore, your goal should be an appropriate discount based on defendable evidence and facts which apply to your particular FLP.

Maximizing Your Discounts

The larger your estate, the more important it will be to properly execute discount planning in the form of FLP planning. This can be accomplished through several well-thought-out strategies:

• Use an FLP only if the circumstances are appropriate. An FLP should have a non-tax-avoidance purpose. Examine whether liability protection will be gained or other nontax goals will be attained by the FLP planning. All of the non-tax-avoidance reasons for the FLP will help the appraiser in preparing his or her report and quantifying the discount.
• Focus on the amount of control being retained. The greater the degree of control retained, the more likely the discount will be reduced. In addition, the greater the amount of control retained, the more likely the IRS will attempt to attack the entity and possibly include the entire entity in an individual's estate (despite the fact previous gifts have been made).
• Certain states have laws that make it more difficult for partners to withdraw from the partnership or otherwise liquidate their interest. This is accomplished through a requirement that the partnership have a fixed termination date. By forming your partnership in one of these states, you will receive a larger discount.
• It is important to form and fund your FLP before you make any gifts of partnership interest. People sometimes make the mistake of forming the partnership and funding it with only nominal amounts of property. They then make substantial gifts of partnership interests to family members and later transfer substantial amounts of assets to the partnership. This results in contemporaneous gifts to the family members and could be attacked by the IRS, resulting in adverse tax consequences.
• Consider adding language to your partnership agreement restricting liquidation. This provision can be substantially fortified by having a non-family-member limited partner, such as a charity, which must also agree to any liquidation. The inclusion of this restriction may result in a greater discount.

Recognition of General and Limited Partners' Rights

Care must be taken in structuring your FLP so that an appropriate balance is struck between giving the general partner the desired control over decisions and restricting those powers sufficiently so as to not disqualify the partnership for tax purposes. This is of particular importance where the general partner is the donee rather than the donor. Say you form an FLP, fund it with your assets, and make your son and daughter co–general partners at a 2 percent interest each. You retain a 96 percent limited partnership interest. However, you continue to make all the decisions regarding partnership business while your children act as rubber stamps for those decisions. As far as the public is concerned, you are still the one in control—the partnership contact person. This is exactly how the IRS will view the arrangement, and your partnership will likely be attacked by the IRS if audited.

Recognition of partnership income must be allocated in an appropriate manner. Each partner must receive their pro-rata share, net of partnership expenses. For income tax reasons, you may want to shift a larger portion to your children who are in a lower tax bracket than are you. Some advisers will draft the partnership agreement to allow this. However, doing so means you're subject to scrutiny and possible disqualification by the IRS. At the same time, the general partners must be compensated fairly for their management services. Often, the general partner will work for free to make additional income available to the limited partners. At the opposite end of the spectrum is the general partner who desires a disproportionately higher income from the partnership and therefore pays him- or herself more compensation than the services are worth. Either extreme is subject to challenge by the IRS. It should be noted that what is considered fair compensation to the general partner can be a wide-ranging dollar amount. You should consider not only what the actual services are worth but other compelling issues as well. For instance, as a general partner, you are exposed to unlimited liability. As a result, a corporation or LLC is often used as the general partner.

Limited partners should receive copies of partnership tax returns, and if the partnership agreement gives them any voice in management decisions, those rights should be respected. The donor should also not retain powers to unreasonably restrict a donee's right to dispose of his or her partnership interest. This is typically handled through a first right of refusal by the general partner and/or limited partners. Your agreement should not contain a set price for which the donor can buy back a donee's partnership interest. To do so might constitute a detrimental interest on the part of the donee, which is restricted in the regulations.

Minors' Interests in Family Limited Partnerships

Minors (as well as legally incompetent persons) are allowed to own interests in an FLP. A minor's interests can be held by a custodian under a Uniform Gifts to Minors Act (UGMA) or a Uniform Transfers to Minors Act (UTMA) or by a trustee under a trust account. Note that not all states have adopted the UTMA regulations, and some states may not allow a minor's account to hold a partnership interest. Extra care should be taken where the donor will also act as the custodian or sole trustee. To do so could cause the minor's interest to be includable in the donor's estate. Also, the IRS will closely scrutinize these situations to be certain that the donor is acting solely in the interest of the minor. One excellent attribute of using FLP interests for gifts to custodial accounts is that it solves the problem of transfer of control when the minor reaches legal adulthood. If you transferred securities to a custodial account, your child would legally take control of the securities based on state law (usually age 18 to 21). At that point, the child could do whatever he or she pleased with the funds. However, if the asset is a limited partnership interest, their rights and control are significantly limited.

Using Multiple Family Limited Partnerships to Maximize Benefits

Some individuals may benefit from establishing more than one FLP. One primary advantage of doing so is to enhance asset protection by separating safe assets from risky assets. Safe assets would include assets such as marketable securities, notes receivable, or idle cash; risky assets include real estate, closely held business interests, or general partnership interests. By separating these asset groups, you insulate your safe assets from liability attributable to the risky assets. If you own real estate that later becomes subject to a legal award for environmental damages, your personal securities and cash would not be exposed to this suit or claim. Separating assets also allows you to fine-tune your gifting program by allowing you to maintain 100 percent ownership of the safe asset FLP while gifting limited partner units of the risky FLP. It may also be appropriate to separate risky assets into multiple FLPs for the reasons just stated. The downside to having multiple FLPs are costs in setup and ongoing administration. In addition, although we're suggesting that you consider placing your marketable securities and cash in a separate FLP, we caution you that special rules are applicable in this situation. You must avoid having your asset treated as an investment company, so you should consult with a professional adviser experienced in this important area.

Limited Liability Companies

A limited liability company (LLC) provides many of the same features as the FLP, with a few notable distinctions. One of the primary advantages is that all members of an LLC have limited liability for the debts and obligations of the company. As you remember, with the FLP, only the limited partners enjoy this protection. The general partner has unlimited liability. In most other respects, the LLC enjoys many of the same benefits as the FLP, including asset protection, valuation discounts, continuity and consolidation of management, income tax shifting, and probate avoidance (for the underlying asset not the LLC interest).

There are some disadvantages to the LLC compared with the FLP. First, the laws governing LLCs vary from state to state. You and your professional adviser will need to review your own state laws carefully. Second, in most states, a member has the right to withdraw from the company and receive the fair market value of his or her interest. This freedom of transferability can affect the size of discounts available in the LLC. Also, the complete withdrawal or death of a member can result in the dissolution of the company. In some states, it is possible to include language in the company's operating agreement that satisfactorily deals with each of these problems.

The FLP can be an ideal tool for owners of closely held business interests or family farms. Often, these individuals want to have family members succeed them in the family business. Therefore, succession planning is essential in these situations. If you own your own business, Chapter 14 will provide you a thorough review of succession strategies for you to consider.