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Family limited partnership may be preferable to a family gift trust.

Imposition by the Revenue Reconciliation Act of 1993 of the virtual "flat rate" tax on fiduciary income tax returns has removed most of the advantage of accumulating taxable income in a family gift trust. Thus, the marginal 39.6% rate, including the 10% surtax applicable to married taxpayers with joint return taxable income exceeding $250,000, applies to trust income exceeding $7,500. Even so, complications from the accumulation distribution rules remain in the Code.

In addition, donors may be concerned about the inflexibility of an irrevocable trust or the difficulties in managing family investment and business activities when an "independent trustee" is mandated (i.e., when the trustee has discretionary power to distribute income and principal). There may also be concerns as to the selection of the trustee and general loss of management direction within the family.

Recent letter and revenue rulings announce principles that enhance a family limited partnership as a gift vehicle. In Letter Ruling (TAM) 9131006, the IRS held that gifts of limited partnership interests were present interest gifts eligible for the Federal gift tax annual exclusions, even though the donor was the general partner otherwise controlling the family limited partnership. Similarly, in Letter Ruling 9310039, the Service concluded that a gift by a general partner of his limited partner interests (98% of the entire partnership) to his spouse did not involve terminable interest property and therefore qualified for the unlimited Federal gift tax marital deduction.

The IRS has accepted court decisions that hold that a minority discount can be used to value the gift of stock in a family corporation when the gift itself involved a minority stockholding, even though the donor and donee or donees as a group control the corporation (Rev. Rul. 93-12). The courts had reasoned that the donee holding a minority stockholding could not force liquidation of the corporation to reach its underlying assets. The same principle should apply to gifts of limited partner interests if there are at least two general partners. Death or insolvency of a general partner need not dissolve the partnership when the other general partner continues to manage the partnership property. In the absence of dissolution, the donee limited partners would not have the power to vote on whether the limited partnership should be reconstituted.

In Rev. Proc. 93-27, the IRS clarified the treatment of a transfer of a partnership profits interest in consideration of future services of the transferee. Receipt of the interest in partnership profits will not constitute taxable compensation income unless there is a substantially certain and predictable stream of income from partnership assets (such as high-quality debt securities or a high-quality net lease), or the partner disposes of the interest in partnership profits within two years after the date of receipt. (A transferee of corporate stock necessarily will report taxable income based on its fair market value, since the capital and profits interests are not divided.) in addition, in the case of Moore, TC Memo 1991-546, the Tax Court held that marketability and minority discounts justified a 35% reduction in the intrinsic value of partnership interests in computing the value of gifts of general partner interests.

The gift vehicle can be established with transfer of investment and business property to the partnership by the "founder" followed by gifts of (usually limited) partnership interests to the donees. The gifts qualify for the annual exclusion, the marital deduction when applicable, and should be discounted 35% from their intrinsic underlying value in computing the taxable gifts.

Beyond these tax advantages, the family limited partnership permits the founder (donor) to control cash distributions, consolidate business and investment management, and establish investment policies by business judgment (rather than the stricter prudent fiduciary rule). Protection against future preditors and marital dissolutions is obtained to a certain extent, since claimants against the limited partner usually can obtain only a "charging order," which reaches only actual distributions on the related limited partnership interest.

Importantly, the partnership agreement can be amended to provide for resolution of disputes by arbitration rather than litigation. An improved "attitude" often is achieved because the donees participate in partnership meetings and collaborate in the family investment and business endeavors, rather than serving only in a "remittance man" role.
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Author:Hjelmstad, Robert P.
Publication:The Tax Adviser
Date:Jan 1, 1994
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