Preferential aspects of FLPs.

Chapter 14 of the Code was enacted in the Revenue Reconciliation Act of 1990 to curb perceived estate freeze abuses. However, the recent decline in interest rates and a number of developments have reinforced an effective method to retain a right to a fixed amount of income and control of assets while freezing their value for estate tax purposes--namely, a family limited partnership (FLP) with a retained preferential interest. The concept is simple: The parents transfer real estate, securities and other appreciating assets to a limited partnership in exchange for a general partner interest, a preferential limited partner interest and a nonpreferential limited partner interest.

The preferential limited partners might be entitled to a preference, such as a guaranteed payment for the use of capital as described in Sec. 707(c). However, care must be taken not to retain a preferential limited partnership interest that would be considered an applicable retained interest (such as a distribution right under Sec. 2701(b)(1)). In that event, a gift of a nonpreferential limited partnership interest would be subject to the special valuation rules of Sec. 2701 and would defeat the client's estate planning goals. Under Sec. 2701(c)(1)(B), however, a distribution right expressly does not include a right to receive a guaranteed payment (described in Sec. 707(c)) of a fixed amount.

By structuring the partnership with preferential and nonpreferential limited interests, the parents, as general partners, remain in full control of the assets. In addition, as the preferential limited partners, they receive a fixed cashflow that will not be subject to self-employment taxes. Independent of the preferential distribution and subject to the business's reasonable needs, as general partners the parents can decide whether they want to make distributions on the general partner and nonpreferential limited partnership interests (keeping in mind that a general partner has a fiduciary duty to act in the best interests of all partners).

Once the partnership is up and running, the parents could then consider selling limited partnership interests to a defective trust and/or setting up a gifting program under which they give the nonpreferential limited partnership interests to their children and grandchildren. Because the parents would be making gifts of limited partnership interests, discounts may be available for the lack of marketability, lack of control and for any built-in gains tax, see Estate of Davis, 110 TC 530 (1998) and Eisenberg, 150 F3d 50 (2d Cir. 1998).

FROM DON WALLGREN, CPA, DULUTH, MN