FAMILY LIMITED PARTNERSHIPS
Not an Estate Planning Panacea
Executive Director, Tax Freedom Institute
Copyright 2006, Daniel J. Pilla
Published by Winning Publications, Inc.
The strategy de jure in estate planning is the use of the Family Limited Partnership (FLP). But like any estate planning or income tax planning strategy in general, there are potential potholes into which one can easily fall if you’re unaware of them when you start down the planning road. This report will alert you to some of the problems and benefits attributable to the Family Limited Partnership insofar as estate planning is concerned. First, I address some of the key advantages of the FLP. Then, I show you the hidden traps and how to avoid them.
How a Limited Partnership Works
A limited partnership is created when one entity, generally a corporation, combines with others, usually a group of individuals, to form a partnership to conduct business. Under a limited partnership arrangement, the corporation becomes the general partner and the individuals are the limited partners. The corporation retains, say 10 percent of the ownership interest and the general partners hold 90 percent. At the same time, the corporation is considered the general partner and the individuals are the limited partners.
The real advantage of the limited partnership goes to the limited partners. This is one of the key elements that entice their investment. From a tax standpoint, partnerships are not subject to double taxation. That means the profits of the partnership flow through directly to the partners. They in turn report the income (or loss) on their own tax returns and pay the tax accordingly.
Another distinct advantage of the limited partnership is that state law generally provides that the limited partners cannot be held liable to any of the partnership’s creditors for debts owed by the partnership. Hence, the name limited partnership. Thus, a limited partner is liable only to the extent of his initial investment in the partnership. This is a marked distinction from a typical partnership in which all partners are generally held fully liable for partnership debts.
Yet another advantage is that assets owned by the partnership are not subject to attachment by creditors of a limited partner. Because the FLP is a separate legal entity, it has the right to hold property and enter into contracts to the same extent as any individual, subject to applicable state laws. Therefore, partnership assets are property that is considered separate and distinct from that of the various limited partners. In this regard, the limited partnership is more like a corporation. But rather than holding stock, limited partners hold a limited partnership interest.
The Estate Planning Advantage
The reason people choose the FLP as an estate planning tool is simple. By contributing assets to a FLP, one takes those assets out of his name with the idea that they will be excluded from his estate for purposes of computing the estate tax liability when he dies. And while it’s true that the individual holds interest in the FLP rather than the asset itself, it is generally accepted that the FLP interest is worth much less than the asset itself. Because the FLP interest is worth much less than the underlying asset, the potential for estate tax liability is cut substantially.
Here are some key reasons the FLP interest is worth less than the underlying assets.
1. A limited partner lacks control over the asset. Even if a single limited partner held 90 percent of the limited partnership interest, he would still lack control over the partnership. This is because the general partner, the corporation, is the controlling partner. Thus, no single limited partner or consortium of limited partners has the power to control the disposition of partnership assets.
2. The limited partnership interest generally lacks marketability. Unlike stock in a publicly traded corporation, the partnership interests in an FLP are highly illiquid. For example, how would you find a buyer to invest in, say, a 20 percent interest in an FLP where the general partner is a corporation, the shareholders of which are members of your family, and where the other limited partners are also members of your family? It is highly unlikely that anybody outside the family would make such an investment.
3. Potential investors are not buying the assets of the partnership. As stated above, the limited partners do not own the assets. What you purchase when you invest in a limited partnership is the potential of profit on the business activities of the partnership but without the risk, in excess of your initial investment. Therefore, potential buyers of an FLP interest must be sold on the potential for profit. That is generally going to be a very hard sell in the case of any FLP.
For estate tax purposes, all this adds up to a substantial reduction in the value of assets placed in a limited partnership. In some cases, the property owned by an FLP is removed from the estate tax equation entirely. This means that your estate tax liability is cut, and in some cases, eliminated if the reduction in value is sufficient to push the value of your estate under the estate tax threshold. For these reasons, the FLP is worthy of consideration as an estate planning tool.
However, there are important factors that come into play in determining whether the IRS will accept your FLP for estate tax purposes. Let’s now examine these factors and identify the booby traps associated with Family Limited Partnerships. There are several of them. If you don’t know what they are, it’s quite likely that any FLP structure you set up will be entirely worthless for estate tax purposes.
The Pitfalls of a Family Limited Partnership
For all the benefits of an FLP, there are planning issues that must be considered before the FLP will accomplish the goal of removing property from the estate tax calculation. In any transaction that is entered into for estate tax planning purposes, be mindful of section 2036(a). This section allows the IRS to pull assets back into the estate for estate tax purposes in a number of different situations.
Here are some of the key reasons why the Tax Court might allow the IRS to pull assets back into one’s estate, despite an otherwise perfectly legal FLP.
1. Retaining control, lifetime enjoyment and economic benefit of the asset. There are two key elements to determining ownership of property. The first is title. The second is control. One may give up title to property by transferring it to an FLP, but if he retains full control of, and the unencumbered use and enjoyment of the property, the IRS will consider him as the owner of the property under code section 2036.
The right to control the property, or the right to lifetime enjoyment and economic benefit is determined from all the facts and circumstances of the case. Take note that many estate planners specifically declare that one of the benefits of their FLP strategies is that one may continue to control, use and enjoy the property after the creation of the FLP as fully as they did before it was created.
Even if there is no express agreement to this effect, the courts can “infer” such an agreement based on the facts of the case. For example, if one continues to use the property contributed to the FLP in the same manner as he did prior to the creation of the FLP, such use might infer an agreement.
In cases where “nothing but legal titled changed,” expect the Tax Court to pull the asset back into the estate. See Turner, Executrix of the Estate of Thompson v. Commissioner, 2004 TNT 171-8 (3rd Circuit, 2004).
2. Lack of a business purpose for the FLP. Generally, code section 2036 cannot apply in cases where there is a “bona fide sale for adequate and full consideration.” Thus, the IRS is not free to simply pull back into one’s estate all the property that was legitimately sold prior to death. However, the sale must be legitimate. One cannot sell a $2 million home to a nephew for $200,000 and consider that the home will not be counted as part of the estate.
FLP promoters often state that the FLP interest one receives in exchange for his contribution of property to an FLP is adequate consideration for the transfer and therefore, section 2036 does not apply. This may be true if the FLP is itself engaged in business and there is a clear business reason for the transfer. But remember, the stated purpose of an FLP is to create a situation where the donor of the property no longer owns or controls it. Therefore, by definition, the value of the FLP interest cannot be equal to the value of property contributed since the limited partner cannot personally use or dispose of the property. The FLP interest must therefore be less than the value of the property contributed.
But where the FLP is pursuing legitimate business concerns, the donor of the property realizes adequate consideration for the contribution despite the disparity in values. This happens for two reasons. The first is the potential for annual income from the venture. A person with the hope and expectation of receiving substantial future income is compensated for his property through the receipt of that income. Secondly, the long-term growth in the value of a partnership interest is also a form of consideration. What is worth $X today might be worth $X x 3 over time. That growth is a form of consideration. In such cases, section 2036 will not apply to vitiate the transfer.
However, where there is no legitimate business venture, the Tax Court will likely find that the FLP simply acted as a vehicle for changing the form in which a person holds his property – that is to say, “a mere recycling of value.” See Estate of Harper v. Commissioner, T.C. Memo 2002-121 (U.S. Tax Court 2002).
3. The nature of the assets transferred bears upon the determination of a business purpose. In many cases, the FLP plan calls for transferring personal assets such as a home and investment securities or retirement savings into the partnership. In such a case, it will be difficult to persuade a court that these assets will be used in the pursuit of a legitimate business venture. For example, to what business use can one’s personal residence be put? Unless that residence is used to collateralize a mortgage for operating revenue, it’s not likely that a residence serves any business purpose.
On the other hand, where the transfer is that of an operating business and there exists a legitimate, non-tax business purpose for the transfer, code section 2036 will not apply. See Estate of Stone v. Commissioner, T.C. Memo 2003-309 (U.S. Tax Court 2003).
4. Transfers that are not at “arm’s length.” Generally, an arm’s length transaction is one that is “bargained for.” That is, when two sides to the exchange have sufficient divergent interests in the exchange, those interests tend to offset the potential for any one-sidedness in the outcome.
Code section 2036 and its regulations do not state that transactions must be at “arm’s length” to be legitimate, but they certainly must be “bona fide.” As a practical matter, if a transaction is bona fide, it is also one that is at arm’s length. But as long as the seller parts with his interest in the asset sold and the buyer parts with his interest in the consideration paid, you have a bona fide sale. See Kimball v. United States, 371 F.2d 257 (5th Cir. 2004).
However, the courts will not determine that an arm’s length or bona fide sale occurred where the individual who transfers property to the FLP stands “on both sides of the transaction.” Estate of Strangi v. Commissioner, 115 T.C. 478 (U.S. Tax Court 2000); affm’d in part and rev’d in part, 293 F.3d 279 (5th Cir. 2002).
A person stands on both sides of a transaction when all the benefits of the transaction are one-sided. This might occur when there is no independent person involved in the creation of the FLP. That is, one person—the person who contributes all the property—determines how the FLP will be set up and operated. It might also occur where the only benefits of the FLP are tax benefits, and they accrue only to the person who created and transferred all the assets to the FLP.
5. Lack of good faith. Tax regulations require that transfers of assets be done “in good faith.” To constitute a good faith transfer to an FLP, the partnership must provide the transferor with some potential for benefit other than potential tax savings. Even when all the “i’s are dotted and t’s are crossed,” a transaction that’s motivated solely by tax planning and with no “business or corporate purpose is nothing more than a contrivance.” See Gregory v. Helvering, 293 U.S. 465 (Supreme Court 1935).
An Important Word of Caution
Family Limited Partnerships are heavily marketed as effective estate planning tools. But since the FLP cases started finding their way to the Tax Court several years ago, the government has won all but one challenge. In each of the other cases, the IRS was successful under code section 2036 in pulling the assets contributed to the FLP back into the transferor’s estate. The FLP thus became entirely worthless for estate planning purposes in those cases.
Parenthetically, the case the government lost is Church v. United States, 2000 TNT 30-56 (W.D. Tex. 2000), aff’d without a published opinion by the Fifth Circuit Court of Appeals, 268 F.3d 1063, (5th Cir. 2001).
Have Your Plan Reviewed
In light of the above, it is important to have your estate plan reviewed if it involves FLPs. If not, you run the risk that your estate will face untold thousands of dollars in tax, penalty and interest assessments, not to mention the hassle and cost of audit and potential litigation. Even worse is the situation that your heirs might have to liquidate assets to pay taxes. To top it all off, the money you paid for the foolproof estate plan will have been entirely wasted.
To have your estate plan reviewed, contact the Tax Freedom Institute member nearest you. The Tax Freedom Institute is a national association of attorneys, accountants and enrolled agent who practice in the area of taxpayers’ rights issues and IRS problems resolution.
If you already have a problem with the IRS and need professional assistance in resolving it, consider becoming a member of the Tax Solutions Network. You’ll receive valuable benefits as a member, including a thorough evaluation of your situation and written plan of action to resolve your problem. For more information, you can call my office at 800-346-6829.
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