Family limited partnerships.

Taxpayers are always looking for new ways to reduce taxes. In no area is this more obvious than in estate planning. The combination of relatively high estate and gift tax rates, increased wealth for many more individuals and the elimination of some traditional techniques used by taxpayers to transfer assets to children and other descendants has caused estate planners to examine different ways to structure taxpayers' business and personal affairs. One currently popular vehicle is the family limited partnership (FLP).

FLPs can provide taxpayers with estate, gift and income tax benefits. In addition, they can help facilitate the administration of a taxpayer's estate, provide personal benefits to family members and serve as an extra layer of protection for a family's assets. They are best used when a taxpayer is worried that his or her assets may be exposed to creditors, when probate would place assets on the public record and be expensive, when the estate would be subject to high rates of estate or gift taxes and when the estate might be required to sell (or at least give up control of) some of its assets to pay the taxes or meet some other estate planning objective.

MECHANICS

An FLP is set up like other limited partnerships. The general partners manage the partnership and have unlimited liability, while the limited partners have no say in the running of the partnership but have limited liability for partnership debts.

In its simplest form, a taxpayer establishes an FLP, transfers property to the partnership and then gives limited partnership interests to children or grandchildren (or to trusts for their benefit).

Funding for an FLP should be done with investment or business property, such as real estate, partnership interests, stock in regular corporations or cash. Personal residences, life insurance, pensions (or individual retirement accounts) or S corporation stock would not be appropriate.

ADVANTAGES

* Gifts of limited partnership interests are gifts of present interests, even if the donor is the general partner otherwise controlling the FLP. As such, they are eligible for gift tax annual exclusions, the estate and gift tax lifetime exclusion and, if appropriate, the unlimited marital deduction.

* Because a minority interest in a partnership is being transferred, minority or lack of marketability discounts, or both, can be used in establishing the gift's value. Ultimately, more assets can be passed on with fewer taxes paid.

* An FLP allows the donor to give up ownership of an asset for estate and gift tax purposes but at the same time retain control.

* An FLP provides flexibility in management. In his or her decisions, the general partner is held to the standard of a "business judgment rule" rather than a stricter "prudent person" standard that would be applicable for fiduciaries.

* Ownership of limited partnership interests provides greater protection both against future creditors and in marital dissolution situations. Creditors are limited in their actions against owners of limited partnership interests since owners have interests in partnerships and do not own the underlying assets.

DISADVANTAGES

* If the FLP is poorly structured (in terms of the types of assets transferred) or dissolves within five years of the transfer of appreciated property, gain may need to be recognized and transferred property treated as newly acquired (requiring a new, extended depreciation schedule).

* While the Internal Revenue Service has conceded that minority discounts may apply to gifts of interests in family businesses, the IRS still may question the appropriateness and amount of discounts in FLP situations.

* While ownership of an FLP interest provides some protection against creditors, the protection is not absolute. Depending on the assets transferred to fund the FLP, the purpose and nature of the transfer of these assets, the applicable state law governing limited partnerships and the court in which a creditor's claim is brought, the level of protection may be reduced or eliminated.

For a discussion of some of the aspects of family limited partnerships, see the Tax Clinic, edited by Alan Witt, in the October 1994 issue of The Tax Adviser.