All in the family: is a family limited partnership the right structure for you?

Billed as one of the most effective asset protection tools in a financial planner's arsenal, family limited partnerships (FLPs) have been touted as a way to safeguard assets while cutting income and estate taxes. But recent IRS challenges suggest they can also be very risky.

So which is it? Ultimately, whether an FLP proves an effective wealth transfer method or a dangerous IRS magnet depends on its structure and operation. As a limited partnership established among family members, an FLP lets a donor place assets into a partnership and gift noncontrolling interests to family members. Because an FLP typically places substantial restrictions on the sale or transfer of these interests--known as partnership units or shares--their value is discounted by between 20 and 50 percent for tax purposes.

"In the case of a family ranch, for example, the senior generation could place that real estate in an FLP in which partners waive the right to transfer interest outside the family, cede day-to-day control to the general partners, and are bound to arbitration in the case of conflict," explains Lee Garsson, a senior vice president at Bank of America. "Those burdens imposed by the FLP--the fact that the partnership interest is not as marketable as its underlying asset--account for the valuation discount. The standard of valuation is then not what a hypothetical buyer would pay for the underlying assets on the open market, but what he would pay for the partnership units knowing all the restrictions and limitations set forth in the agreement."

Reasonable in theory, valuation discounts sparked IRS scrutiny--and for good reason. Many FLPs of the last decade were thinly veiled estate tax evasion efforts, claiming unwarranted discount valuations of as much as 90 percent. "The IRS has attacked FLPs both for a lack of business purpose and for the amount of discount taken," reports Julie Krieger, a financial principal at private wealth management firm Lowry Hill. "It also successfully attacked FLPs where the family didn't administer the FLP in accordance with the agreement or when there were deathbed transfers into an FLP."

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In short, the IRS takes a dim view of partnerships solely as a means to minimize estate taxes. In fact, in a case (Strangi III) now under appeal, the U.S. Tax Court ruled that because a parent retained too much control over the property in an FLP the valuation discount did not apply, a finding that subjected 100 percent of the assets to estate tax.

Yet, when carefully structured and managed, FLPs remain a viable strategy, says Garsson, who cites arbitrary valuations, partnerships in name only, and poor management as huge red flags. "First, a good independent appraiser who can support his valuation estimate is key," he advises. "Second, the taxpayer should not treat the FLP as his own personal piggy bank by comingling personal and partnership funds."

Instead, the FLP's donors should retain enough assets to live on and should cede control of the assets by naming a spouse, heir or independent trustee as general partner. Distributions from the partnership should be proportionate to ownership. For example, parents who transfer 90 percent of partnership interest to their children but retain 90 percent of the partnership income weaken the partnership's credibility.

Ideally, FLPs should also demonstrate some kind of nontax purpose, such as management of family business assets, business succession planning, or protecting family assets in the event of divorce or death, explains Garsson, who adds that the purpose should be carefully documented.

Due to setup costs and personal exemption amounts, taxpayers should consult a pro on whether an FLP is appropriate, says Krieger, who recently completed one for a couple with real estate properties and investments. "The FLP allowed them to utilize their gift exemption of $2 million to gift more assets to their children due to the valuation discount," she says.

Those interested in FLPs should move quickly. A recent Congressional Joint Committee on Taxation proposes curbing the use of the FLP "strategy" being "employed to manufacture discounts that do not reflect the economics of the transfers during life and after death."

But that doesn't mean the FLP's days are necessarily numbered, says Garsson, who notes that similar proposals have languished in Congress for years. "And, if it does happen, it's likely to apply only to future asset transfers. Discounts on previously transferred assets would be unaffected."