How family limited partnerships can be used to reduce gift/estate taxes.

In Rev. Rul. 93-12, the IRS reversed its previous position of "family attribution"; that is, the Service will no longer disallow minority and marketability discounts solely because of the family relationship of the shareholders. Thus, if a donor who owns all of a corporation's common stock gives 20% of the stock to each of his five children, each of the five gifts will be valued separately as a minority interest rather than aggregated as a single controlling interest.

Since this ruling, family limited partnerships (FLPs) have been an increasingly popular estate planning tool. Recently released Regs. Sec. 1.701-2, which details partnership anti-abuse rules, has caused practitioners uncertainty as to whether certain FLPs would be able to pass the "business purpose" doctrine. However, the IRS has now amended these rules through Ann. 95-8, which states that Regs. Sec. 1.701-2 applies solely to taxes under Subtitle A (income taxes) of the Code; in other words, the regulation will not apply to transfer taxes. This new announcement is obviously a positive development for those contemplating the use of an FLP for estate planning purposes.

Structuring the FLP

The first step in structuring an FLP is for the individuals to transfer certain assets into an FLP in exchange for partnership interest. Typically, the partnership consists of a 99% limited partner interest and a 1% general partner interest, and the agreement usually sets forth a specific time period over which the partnership will operate. Further, the partnership agreement typically assigns managing control of the partnership to the general partner, but provides that all partnership interests have the same rights with respect to ongoing distributions of income and capital. (By not creating two ownership classes, the FLP should not fall within the scope of Sec. 2701, which prescribes special valuation rules.)

The individuals then make gifts of the limited partner interests to their heirs, while retaining the general partner interest. With a properly designed FLP, the limited partner interests are valued at less than the proportionate value of the underlying property itself. This discount reflects partnership attributes that inhibit the limited partners from directly enjoying the ownership of the underlying assets. Some typical partnership attributes include:

* General partners are given all the decision-making power. Even though the limited partners may own a significant interest in the partnership, they usually do not have the power to affect decisions.

* Limited partners cannot withdraw from the partnership before the end of the partnership's term or unless all the partners agree to dissolution.

* Limited partners do not control the timing or amounts of distributions. In fact, the limited partners are dependent on the general partner to make distributions that will cover the income tax obligations of the limited partners resulting from the partnership.

* A limited partner is typically restricted from transferring his interest without first offering it to the other partners (i.e., a right of first refusal).

* Assignees of limited partner interests become partners only on the consent of all the other partners (or at least a majority), and until admission, assignees possess no rights of a partner other than to receive distributions.

These attributes clearly make owning assets through an FLP less desirable than owning the underlying assets directly. This is why discounts are warranted when valuing gifts of limited partnership interests.

Methodology in determining valuation discount

The discount associated with limited partner units can be broken down into two parts: a discount for lack of control (minority discount) and a discount for lack of marketability. Control is advantageous to an investor in a partnership because of the ability to make distributions, buy and sell assets, approve mergers, pay oneself a management fee, and to cause other actions that would affect the partnership's value. Thus, a controlling interest is more valuable than a minority or limited partnership (i.e., noncontrolling) interest. Marketability discounts reflect the lack of liquidity of a limited partnership interest. Market research on restricted stock issues has demonstrated that investors require a discount to invest in assets that lack marketability. Similarly, a buyer of a limited partnership interest would consider the transfer restrictions and the inability to affect partnership distributions in formulating a purchase price.

In general, the methodology for determining the valuation discount includes:

* Identification of the features of the subject limited partnership units that affect marketability and control.

* Comparison of the limited partnership units' features to the features of securities included in published studies on marketability and minority discounts.

* Observations of discounts occurring in market transactions.

* Consideration of qualitative information about the general and limited partners (such as age, health, other financial resources, etc.) that could affect future distribution policy or the partnership's term.

Overall, the less control and liquidity the limited partners can expect, the higher the valuation discount.

Example: A married couple, H and W, contribute assets with a value of $2,000,000 to an FLP structured with 1% general partner interests and 99% limited partner interests. They give the limited partnership units to their daughter. Based on the features of the partnership agreement and other factors, a valuation consultant determines the appropriate valuation discount to be 40%. Based on this conclusion, the value of the gift equals $1,188,000 (($2,000,000 X 0.99) X (1 - 0.40)). Assuming a transfer tax exclusion of $1,200,000 available to H and W, they are not subject to a tax on their gift. Without the FLP arrangement, they would be taxed on $780,000 (($2,000,000 X 0.99) - $1,200,000). Assuming a 50% transfer tax rate for simplicity, H and W could save $390,000 by using an FLP.

Not only does the FLP arrangement allow more assets to be given with lower gift tax consequences, it also removes the assets from the donor's estate, consolidates the assets for efficient management, facilitates keeping family assets in the family and allows the donor to retain control of the assets (through his role as managing general partner).

FLPs provide significant tax and nontax advantages and should be considered in the estate planning process. In order to avoid potential pitfalls, it is important to work with an experienced estate planner who can carefully draft the partnership agreement. Another key component of this estate planning technique is to document the discount used. To better withstand IRS scrutiny, most estate planners suggest that taxpayers obtain the opinion of a professional familiar with marketability and minority discounts. Overall, given the limited applicability of the recently released partnership antiabuse rules as they relate to transfer taxes, FLPs can still be used effectively in the estate planning process.