Family Limited Partnerships ("FLP")

An FLP is an arrangement whereby family members contribute assets such as cash, real estate and perhaps marketable securities to a partnership in exchange for a partnership interest. An FLP is an attractive way to hold property because it has both tax and non-tax advantages.

The FLP has three tax advantages:

1. Creating discounts to decrease the federal estate tax.
2. Creating similar discounts to decrease the gift tax cost of making gifts to any one or more of your children.
3. Protecting assets from creditors.

An FLP is created by preparing a partnership agreement and securing a federal tax ID number. For purposes of this example, assume that $500,000 worth of commercial real estate is transferred to the FLP in return for a 98% limited partnership (LP) interest and a 1% general partnership (GP) interest. The creator (you) of the FLP holds the 98% LP interest and a 1% GP interest. Another individual, typically a child, transfers assets to the FLP in exchange for a 1% LP interest. Over time, the 98% LP interests can be transferred to your children. You, the owner of the GP interest, has the sole power to sell the property, exchange the property or acquire additional property as you direct. The limited partners may not participate in management of the partnership or decide on distributions of income.

VALUATION DISCOUNTS

There are two potential discounts on the value of the limited partnership interests which make the FLP attractive.

1. First, a market discount may be available, since limited partnership interest are not readily tradable (e.g., in comparison to stock on the New York Stock Exchange).
2. Second, a minority discount may be available because a limited partner may not participate in the decision making process of the partnership.

Because of lack of marketability and control associated with the LP interest, the value of the LP interest may be discounted for estate and gift tax purposes at anywhere from 20% to 50%. Although market and minority discounts have repeatedly been approved by both the courts and the IRS, an appraisal is generally necessary to establish the amount of the discount.

Therefore, assuming $500,000 is contributed to the FLP and a 40% discount is obtained on the value of the LP interests, you can transfer $490,000 (98% of LP interest x $500,000) worth of LP interests at a value of $294,000 for gift tax purposes. Alternatively, if instead of gifting the LP interests, the value of the limited partnership interest for estate tax purposes is reduced by the 40% discount, the value for estate tax purposes would also be $294,000. As a second alternative, $33,000 worth of partnership property in LP interests can be gifted each year to each beneficiary free of gift taxes by using both spouses' $20,000 annual exclusions.

LP RIGHTS

The general partner manages the partnership and decides when to make cash distributions from the partnership. If distributions of profits are made, they must be given to all partners in proportion to their ownership interest in the partnership. Therefore, until you (as the general partner) begin making specific gifts, you maintain a significant share of partnership profits.

The LP interests do not carry the right to participate in the management of the partnership or to decide on distributions of income. These rights remain with the general partner. A limited partner usually cannot require liquidation of his or her interest. Under the limited partnership acts of most states, a limited partner cannot transfer the right to be a limited partner; he or she can only assign the right to share in profits and losses. Normally, the general partner must consent to the assignee becoming a substitute limited partner.

PROTECTING ASSETS FROM CREDITORS

Since each partner owns a partnership interest, as opposed to a portion of the underlying partnership property, creditors of a partner are only entitled to a "charging order". Consequently, a creditor should not be able to attach partnership assets, force a dissolution of the FLP, force a distribution of partnership property, replace the partner or vote on behalf of any general partner. Rather, a charging order generally entitles a creditor to income distributions only after the general partner decides to make such distributions. Even if no such distributions are made, the creditor is likely required to report the "phantom income" on his or her tax return. Reporting income without receiving any actual cash to satisfy such tax liability may influence creditors to initially resolve any differences through negotiation.

An FLP may also provide protection for a divorcing child. Even if a gift of the LP interest is considered "marital property" (which generally is not the result), in addition to the asset protection advantages discussed above, the partnership agreement can give the remaining partners the right to purchase the partnership interest at the discounted value. Consequently, only the discounted value should be included in the marital estate.

AVOIDANCE OF PROBATE

The creation of a Family Limited Partnership will not affect the avoidance of probate advantages associated with the creation and administration of a Revocable Living Trust. FLP interests are personal property, and therefore can be contributed to a Revocable Living Trust. Additionally, real estate in a foreign state may be contributed to the partnership so that ancillary probate may also be avoided.

Non-tax Advantages

The FLP certainly has a variety of tax advantages and asset protection advantages. However, and perhaps more importantly, there are several non-tax advantages, such as:

• A vehicle to educate children about investments and/or the family business while the parent retains control.
• A vehicle to provide a pooling of investment assets.
• A vehicle to ensure that certain assets remain in the family.
• Flexibility, in that the partnership agreement can always be amended.

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