When is a family limited partnership an appropriate tax savings vehicle?

Family limited partnerships (FLPs) have become extremely popular estate planning tools, offering creditor protection, flexibility of structure and the possibility of limiting the rights of a younger generation. In addition, a properly structured FLP should also provide the taxpayer with transfer tax savings, through discounts on the value of lifetime gifts of limited partnership interests and potential discounts on the value of limited partnership interests held at death.

Discounts on Limited Partnership Interests Held at Death

If a taxpayer dies holding a limited partnership interest, discounts for lack of control and lack of marketability may be available; these discounts reflect restrictions on the limited partner's withdrawal and other rights. In order to claim the discounts, the taxpayer cannot have the ability to override these restrictions in his capacity as a general partner or manager of the partnership.

In Letter Ruling (TAM) 9719006, the Service recently attacked a taxpayer's right to these discounts on two fronts. First, the IRS argued that the formation of the FLP and transfer of the partnership units had no economic substance and should be ignored for estate tax purposes. The second argument relied on Sec. 2703(a)(2), which provides that, for transfer tax purposes, the value of property shall be determined without regard to any "restriction on the right to sell or use such property." The Service argued that the terms of the FLP restricted the rights to use and sell the underlying property; therefore, the FLP should be ignored for transfer tax purposes. The facts in the TAM were so objectionable that the IRS's conclusions seemed fair. However, most situations will not be so clearly objectionable; the Service may likely find courts reluctant to follow this same rationale.

Given the IRS's objections, it is clear that discounts on limited partnership interests and similar transactions will come under heavy scrutiny. Therefore, it is increasingly important, whenever possible, to document an FLP's business purpose and avoid the deathbed planning that resulted in the issuance of the TAM.

Discounts on Limited Partnership Interests Transferred During Life

The ability to transfer limited partnership interests in an FLP during a parent's lifetime, while claiming a discount on the value for lack of control and lack of marketability, can result in significant transfer tax savings.

Example: Parents M and F establish a valid FLP, which has $1,000,000 of underlying assets. M is the FLP's sole general partner; F owns an 80% limited partnership interest that is supported by $800,000 in underlying assets. However, due to discounts for lack of control and lack of marketability, the limited partnership interest is valued at $600,000 for transfer tax purposes. F makes a gift of the 80% limited partnership interest to his child. The transaction has removed $800,000 from F's estate at a transfer tax value of $600,000. Assuming F is subject to the highest estate tax bracket, the transfer tax savings is $110,000, plus 55% of any appreciation after the date of the gift.

The major pitfall in this type of transaction is that the basis of the FLP's underlying assets remains at F's original cost basis. If F funded the FLP with low-basis assets, a significant income tax will be generated on a sale. This income tax would have been avoided if F had died holding the assets, because there would have been a step-up in basis to date of death value. For example, if the underlying assets in the example had a basis of $100,000 at the time of the gift, the deferred income tax (assuming a 28% capital gains rate) on the underlying assets supporting the 80% limited partnership interest would be $201,600 [($800,000 - $80,000) X 0.28], with a potential additional 28% tax on any appreciation after the date of the gift. This calculation does not consider state taxes, decreases in the capital gains tax rate in the recently enacted Taxpayer Relief Act of 1997, the timing of the gain realization, or the potential to hold the interest until the heir's death and receive a step-up in basis at that time. However, it is clear that the income tax implications of the gift offset the transfer tax savings, unless the property appreciates considerably after the date of the gift.

The following mathematical equation will determine the amount of overall tax savings (or cost) that may be realized through current gifts of property to an FLP.

Estate tax marginal rate = ET Income tax marginal rate = IT Value of underlying assets = VU Basis of underlying assets = BU Value of limited partnership interest = LP Appreciation on underlying assets = A

Net savings / (Cost) = (ET X (VU - LP)) + (ET X A) - (IT X VU - BU)) - (IT X A)

Using the example, the formula can be solved as follows:

Net savings/(cost) = (0.55 x $800,000 x $600,000)) + 0.55A - (0.28 x $800,000 - $800,000)) - 0.28A = $110,000 + 0.55A - $201,600 - 0.28A = 0.27A - $91,600

Therefore, for the transfer tax savings to equal the income tax detriment of the gift, the gifted property would need to appreciate $339,259 from the date of the gift to the date of death. Any appreciation over this amount would result in a net tax savings, while any lesser appreciation would result in a net tax cost. For instance, if appreciation were $400,000, a net tax savings of $16,400 would result. Under these facts, it is unlikely that putting such property in an FLP and gifting it to the next generation would be appropriate. (Note, however, that if a capital gains rate of 20% is used, the amount of appreciation required to break even is $97,142.)

This formula does not consider the possibility that the income tax cost can occur before or after the estate taxes must be paid, or be completely eliminated if the donee holds the property until death. Another consideration ignored is the opportunity cost that may be lost if other alternatives would have been implemented. However, the equation quantifies the net tax effect of lifetime gifts of FLP interests after considering both income and transfer tax ramifications. This should help a taxpayer and his adviser consider the timing issues and properly analyze the alternatives.