What has generally been accepted as the tax, creditor protection, and estate planning benefits of the family limited partnership (“FLP”) include its flexibility, decreased estate and gift tax liability, family business planning (beyond tax considerations), preservation of family assets vis-a-vis outsiders (a client is often being pursued by creditors or hopefully begins this planning well before that time when the threat is still on the horizon), possibilities for favorable income tax treatment, and similar benefits.
Set forth below is a very simple checklist of some of these benefits. There are many nuances and crucial variants which would take a far lengthier article to address and, additionally, the issues must be worked out in the context of a client’s asset mix, its current financial situation, any threats of litigation and indebtedness, and working out an appropriate mix of protections and organizational structures.
As usual the maxim that bulls and bears both have their day but pigs are put on a spit for the luau holds.
Reduced Valuation
The use of an FLP can depress the value of family assets for transfer tax and creditor protection purposes. This depressed value can be used to minimize estate and gift tax liability. Should the FLP be terminated, the liquidation value of the assets would of course reappear.
This key discounting benefit is attributable to what are in fact two separate bases for a discount in valuation. The first is denominated the minority interest discount, which has gift tax as well as other ramifications. For example, the value of a whole company is greater than the value of the sum of its parts, so that a father giving 20% of his company to each of five children actually gives away less than 20% to each of the whole value of the company. If, by analogy, a donor can make a transfer of a partnership interest (where the FLP owns the business and investment assets), the donor will be much better off than if he or she simply transfers particular property (such as by giving a 1/5th interest in the property as tenants-in-common) which can easily be compared to other pieces of property. But the values of the five separate partnership interests in the partnership holding that very same asset will not add up to anything like 100%.
Additionally, often the only valid method for determining the fair market value of the partnership interest is the capitalization method. If the FLP itself cannot be liquidated prior to its term because the FLP does not allow it, or because the General Partner will not consent to it, the interest must be valued as a going concern on a going basis rather than on a liquidation basis, with the result that the actual cash generated by the particular minority interest (a matter within the sole discretion of the general partner) becomes critical to the valuation. In other words, the value of the partnership interest will be valued in the hands of the donee rather than in the hands of the donor, a big difference.
The second discount factor is that which arises by virtue of the lack of marketability of the interest. In practice, both of these discounts are often denominated as the minority interest discount but are differentiated insofar as concerns the marketability discount by the fact that, for example, an Apple shareholder suffers no discount relative to the shares held by a leading mutual fund since the shares of both are equally marketable.
The interests in the FLP, however, are not readily marketable because no one in his right mind would take a minority interest in a closely held enterprise where the number of ways to legitimately diminish the value of the minority interest is limited only be the bounds of the imagination. The net effect of both these discounts, and the rule of thumb among tax practitioners based on a number of tax court decisions, is that a 25% – 40% reduction in valuation is a realistic benefit to be anticipated.
Some limited partnership principles may serve to underline and further explain the nature of these discounts. A limited partnership interest does not carry with it any rights to manage or control the partnership or to compel distributions. Therefore, because a limited partnership interest lacks management and control rights and is unmarketable, it will be subject to both minority interest and lack of marketability discounts. The general partner manages the partnership and has control over the investment and business decisions of the partnership and determines when and in what amount any distributions will be made, a critical factor to the determination of value within the context of the minority interest discount. A general partnership interest, because of its management and control of the partnership, will not receive a minority interest discount. However, a general partnership interest, because it is not marketable, will still have a lack of marketability discount. There may also be a “keyman discount” which may be applicable to a general partnership interest.
As you go forward, and perhaps use this short memo as a reference, it is worthwhile to remember the components of the discount principal. Ultimately, the issue is determined by appraisal and the appraisers can legitimize the percentage discount only by doing the following:
- making an analogy between a limited partnership interest and a minority interest in a corporation
- verifying that the limited partners do not have a management role of control over operations of the FLP
- verifying that the partnership agreement has a provision distancing the limited partners from the underlying assets
- verifying that the partnership agreement provides that a limited partner is unable to withdraw from the FLP prior to its dissolution or liquidation;
- verifying that there is an inability to dissolve the FLP and reach the value of the underlying assets
- verifying that there are restrictions on transferability, that there is a right of first refusal, and that an assignee is not admitted as a member until approved by the general partner or the other limited partners
- examining illiquidity factors, including whether or not the FLP requires additional capital contributions to meet operating expenses
- verifying that the partners cannot require a return of their capital contributions or require other distributions
The minority discount is generally viewed as being applicable even to the interest of a partner who is both a limited partner and a general partner. In this regard, you will need to determine whether there will be two general partners having equal rights, one general partner with 50/50 ownership or a single general partner. In any event, when an appraiser prepares a valuation report on the value of the limited partnership interest, the appraiser will not ordinarily take into consideration whether or not that limited partnership interest is owned by a partner who is also a general partner. The value of the transferred limited partnership interest will therefor be determined in the hands of the transferee and not in the hands of the transferor.
Accordingly, it does not matter what the transferor could have done, but rather what the transferee can do. Thus, the value of a limited partnership interest which is transferred will be valued the same whether or not the transferor was both a general and limited partner or just a limited partner. The transferred interest will be subject to both the minority interest and lack of marketability discount.
Family Relation Benefits
An FLP can be used to accomplish a number of parental goals for the family. These include protection of a child from an unwanted or irresponsible spouse or from a subsequent divorce. Additionally, family limited partnerships are the ideal vehicle to transfer control of a business in a gradual manner or to allocate functions with respect to that family business among various children, all the while maintaining such control as the parents desire via their control of the general partner. The FLP provides the mechanism by which parental control over family assets is continued and gives the flexibility as to how and when distributions of family wealth are made to family members.
Creditor Protection
An FLP can be used to limit the liability of limited partners from risks arising from the activities of the FLP, or from activities which arose prior to the formation of the FLP. This is so because the collection remedies available to the creditor may be limited. The creditor can attach only the interest of the debtor, and numerous provisions of the FLP are drawn to limit the effectiveness of such collection enforcement. In my experience, the largest number of FLP’s are formed and assets transferred into them by clients who see dark clouds forming in terms of properties they own having difficulties in cases where they have large personal liabilities and loan guarantees outstanding. The “pig theory” noted earlier requires much attention here.
A client looking for a magic bullet or using inexperienced counsel may be in for a surprise. It is necessary to place oneself in the position of the creditor. Would you, as creditor, after knocking on the door to collect on a guarantee, simply walk away into the sunset when the door failed to open? Of course not. But there are ways to reach some settlement which, while paying some price, utilizes the mixture of the FLP asset-protection features with other debtor protections to preserve the greatest possible bulk of the client’s assets. This obviously requires a plan.
Miscellaneous Benefits
Under Texas law, an FLP is more flexible than a corporation simply because partnerships are more flexible for tax planning purposes than corporations. Likewise, unlike trusts which are irrevocable and nonamendable, FLP’s can be amended or revoked. The dissolution of an FLP will not trigger adverse the type of tax consequences which can occur with the dissolution of a corporation. An FLP can have more favorable income tax treatment than either a corporation or a trust. An FLP provides more flexibility in making investments than a trust because the FLP is subject to the business judgement rule whereas a trust is subject to the prudent man rule.
In addition, the manager of the FLP can make investments pursuant to modern portfolio theory while trustees of a trust typically do not do so.
Challenge
Because the use of an FLP can produce significant valuation discounts or substantially reduce valuation or collectibility in the case of creditor enforcement of remedies, either the IRS or such a creditor might attack the FLP on a number of bases. As to the IRS, they have already had difficulty disputing the valuation discounts achieved by the use of FLP’s, so long as they have been supported by legitimate appraisals.
The IRS in its internal manuals has acknowledged having been defeated in this area. Accordingly, the basis for either an IRS or a creditor attack will be that the FLP is a sham and a fraud. By this theory, the sole purpose for organizing the FLP was to artificially depress the value of assets or to hide assets from legitimate creditors, and therefor should be totally disregarded. It is critical therefor that a client should understand, review, and determine the non-tax and non-creditor protection purposes for which it is organizing an FLP. In other words, there should be legitimate business purposes as well as legitimate tax avoidance purposes for organizing the FLP. Proper planning can usually establish such legitimate purposes and therefore provide the protection the debtor client needs.
The tax avoidance purposes are certainly legitimate as a shield and defense against the creditor claims. In an attack by the IRS, however, it will not do for the taxpayer to respond in court that the reason for establishment of the partnership was the avoidance of significant estate and gift taxes nor in a
Additional Estate and Gift Planning Tool: The Grantor Trust
While the FLP is an alternative to complex trust arrangements, it is possible to enhance the benefits of the FLP by using a grantor trust. From a logistical standpoint, what would be done in establishing the FLP would be to contribute all or so much of the assets as the grantors wished to the entity and have the family members buy in or receive interests via a gifting program subject to the planning considerations relevant to the gift tax.
What is additionally available, however, is a sale of specific properties forming a part of the FLP’s assets to a grantor trust (whose beneficiary might, for example, be the client’s children) at the discounted value that has been discussed above, for the very reasons such minority interest and marketability discounts are available. The purchase price could be payable by a promissory note.
The additional purpose served would be that, under applicable Internal Revenue Code and Treasury Regulations provisions, all the income attributable to that property would still be attributable to the parents who previously owned the property, but the trust can pay for its interest out of the proceeds it receives from that property.
