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Family limited partnerships: Alive and kicking

Don't let new scrutiny scare you off this great estate-planning tool

by on
in Leaders & Managers,Management Training

Reports about the demise of family limited partnerships (FLPs) are greatly exaggerated.

As long as you structure an FLP correctly, it still remains the perfect vehicle to avoid income taxes and estate taxes on your business interests while offering protection from creditors. Also, an FLP can help you shift family-business ownership to the next generation at a discounted value.

But a recent Wall Street Journal story said some estate planners are shying away from FLPs. A recent Tax Court decision mandates that FLP deals should now include more bells and whistles. But that doesn't make FLPs unattractive or unworkable. In fact, the required bells and whistles can actually make the FLP even more effective.

The key point: For your FLP to withstand the new scrutiny, you can't maintain too much control over the assets transferred to the partnership. Create it, and run it like a real partnership, not as your private piggy bank. Here are the details:

Shift wealth at discounted value

For the most part, FLPs are structured like other limited partnerships. The difference: All the partners are family members. At least one family member—usually the patriarch or matriarch—acts as "general partner" and manages the business. The other family members become limited partners.

After you transfer assets to an FLP, you can gradually give away limited partnership interests to younger relatives—say 2 percent per year per child. That effectively removes a substantial amount of assets from your taxable estate over the years.

Best of all, those limited partnership interests can be given away at discounted values because no public market exists for them. For example, you might give away assets worth $1 million that may be valued at only $600,000 if held within an FLP.

FLP arrangements that aren't properly formed have come under IRS attack. In such cases, the IRS took the taxpayer to court, charging no substance to the transfer of assets to the FLP. So assets were returned to the taxable estates of the creator (after their deaths) and taxed at their full value, with no discounts.

In one well-publicized case, the Tax Court tossed out a deceased Texas businessman's FLP, forcing his heirs to pay nearly $2 million in federal estate taxes. (Estate of Strangi, TC Memo 2003-145)

His mistake: maintaining too much control over the assets in the partnership. That included making decisions on income distribution to limited partners and continuing to make personal use of assets that were owned by the partnership (including his house).

4 steps to a legal FLP

Our advice: Don't run away from an FLP, just set it up correctly. Here are four steps:

1. Observe the formalities. Properly draft the partnership documents to withstand scrutiny. Obtain professional assistance.

2. Follow through with proper administration. Set up a separate bank account for the FLP. Make distributions from that bank account in proportion to partnership interests and in accordance with
the partnership agreement. So if you retain a 10 percent general partnership interest, you shouldn't receive all the FLP's distributions.

3. Leave some assets for yourself. If you give away virtually all your wealth to the FLP, and then draw down FLP assets to live on, the FLP isn't really functioning as an independent entity, as it must. Result: The IRS could shoot it down. If so, your hoped-for tax benefits circle the drain.

4. Treat the FLP like a true partnership. All the partners should meet regularly to discuss and manage FLP assets. Even though you retain control as general partner, those meetings will help you prepare the other partners for eventual management of the assets. The more an FLP looks and works like a full-fledged partnership, the greater the chances of sustaining the tax benefits.

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