Flps for Family Asset Management and Transfer Tax Planning
| Jurisdiction | Colorado,United States |
| Citation | Vol. 24 No. 6 Pg. 1245 |
| Pages | 1245 |
| Publication year | 1995 |
1995, June, Pg. 1245. FLPs for Family Asset Management and Transfer Tax Planning
The family limited partnership ("FLP") remains a useful device to assist in the management of family businesses and other forms of family wealth. If drafted correctly, the FLP can provide pass-through taxation, some liability protection, a fundamental and flexible management structure and tax saving valuation discounts. However, the practitioner should bear in mind constantly changing rules, including several "tax traps" for the unwary.
This article summarizes various benefits and concerns associated with the formation and operation of FLPs, including recent developments in the partnership anti-abuse regulations and new partnership distribution provisions adopted by Congress in late 1994. This article by no means is intended to be a comprehensive list of FLP issues or a substitute for individualized research.
An FLP is a limited partnership formed under state law in which family members are the partners. In Colorado, all limited partnerships formed on or after November 1, 1981, are formed under the Colorado Uniform Limited Partnership Act of 1981.(fn1) A limited partnership must have one or more general partners and one or more limited partners.(fn2) General partners typically have the right to manage the partnership and are exposed to personal liability for the actions of the partnership. Limited partners may not participate in the management and, accordingly, are not subject to personal liability unless they are also general partners or they participate in the control of the business.(fn3) This limited liability feature, combined with the flow-through taxation that most limited partnerships possess, resulted in the popularity of limited partnerships.
Limited partnerships offer several possible advantages over limited liability companies ("LLCs"). The limited partnership may present the greatest possible chance of avoiding the valuation rules contained in § 2704(b) of the Internal Revenue Code of 1986, as amended ("Code"). Further, the use of valuation discounts is well established in the valuation of FLP interests, but as yet it is unclear how such discounts will be applied to LLC membership interests. In contrast, an LLC offers limited liability protection for all members, not merely limited partners as in limited partnerships.
Practitioners should pay equal attention to non-tax-related factors, as well as tax-related factors, when creating an FLP. As discussed below, the Treasury Department has recently issued regulations which provide guidelines for the recharacterization for tax purposes of entities which are established for tax benefits and which do not otherwise have a substantial business purpose. These regulations do not apply to the transfer taxes associated with FLPs; however, practitioners should carefully document the substantial business purposes for the formation of a limited partnership.
Older clients often seek a gift program that will minimize transfer taxes by shifting assets and associated appreciation out of their estates while maintaining some control of the assets transferred. The FLP is one of the few entities that allows such flexibility. The older generation may contribute assets to the FLP in exchange for both general and limited partnership
A general partner may retain operational control despite holding only a small ownership percentage of the entire partnership. Maintenance of control by a general partner will not cause the transferred limited partnership interests to be pulled back into the transferor's estate under § 2036 of the Code since the general partner has fiduciary duties to the other partners.(fn4) A decedent's gross estate includes the value of all property of which the decedent made a transfer and retained the possession, enjoyment, right to income or the right to designate the persons who have the right to income.(fn5)
Not infrequently, members of the older generation may desire assistance in the management of assets. For example, an older generation husband and wife may own several parcels of rental real property which they desire to keep in the family but they may no longer wish to be involved in the day-to-day operations and management of the property. They may contribute the rental property to the limited partnership in exchange for limited partnership interests and either give the general partnership interests to the managing children or have the managing children contribute additional working capital in exchange for the general partnership interests. Thereafter, the parents may make gifts of their limited partnership interests to family members or trusts for such members.
Gifts of limited partnership interests can be made incrementally in amounts equivalent to the grantor's exclusion of $10,000 per year, per donee ($20,000 per year per donee, if gift-splitting is elected) to avoid transfer taxation.(fn6) The Internal Revenue Service ("Service") has indicated that gifts of limited partnership interests may satisfy the present interest requirement of Code § 2503(b) despite retained managerial control by the grantor. In several private letter rulings, the Service reasoned that, while a general partner may control the timing of partnership distributions, governing state law requires a general partner to exercise powers in a fiduciary capacity subject to a high standard of conduct toward the limited partners.(fn7) Therefore, the gifts of limited partnership interests were deemed outright gifts of ownership interests which qualified as completed gifts.
Gifts of partnership interests where the underlying partnership assets consist of non-income-producing property also are of potential concern in qualifying for the annual exclusion. For example, in Stark v. Commissioner,(fn8) the Eighth Circuit affirmed a decision disallowing the use of the annual exclusion for gifts in trust of non-dividend-producing, closely held stock. The court found that the value of the gifts had no "ascertainable value" and thus did not qualify for the annual exclusion. It is uncertain whether Stark will consistently be applied to gifts of FLP interests; however, practitioners may want to consider the inclusion of Crummey-type powers of withdrawal in the partnership agreement where the underlying partnership assets are not clearly income-producing assets. The withdrawal provision could grant the right to each partner to withdraw certain capital contributions within a window period, such as thirty days.(fn9)
In those instances where the limited partnership contains property with potential future appreciation, it may be prudent to give greater interests to the children earlier in the life of the partnership to minimize transfer taxes liability. When gifts larger than the grantor's annual exclusion are transferred, the grantor can use part of his or her unified credit against the payment of transfer taxes due.(fn10)
Practitioners should be alert to the timing of gifts in view of the recent Anti-Abuse Regulations under Subchapter K (discussed at greater length below). In Example Five of the proposed regulations, the Service approved a family partnership created to hold actively managed, income-producing real property. However, parenthetical language in the explanation suggested approval might be withheld when gifts of partnership interests occur immediately after the creation of the partnership.
Although Example Five has been deleted from the final regulations, practitioners should be alert to the possible reappearance of timing concerns in Service rulings and should consider forming the FLP early enough to provide a meaningful window between formation and initiation of a substantial gift program. The Service still may seek, even absent regulatory authority, to disallow the validity of the formation of a partnership.
Generally, if a family member has failed to satisfy his or her obligations with respect to an individual creditor's claim which arose after the formation of the partnership, the creditor's only remedy against the partner's interests is to obtain a "charging order" against the family member's partnership interest.(fn11) The creditor may be treated as an "assignee" of the partnership interest able to receive partnership distributions, if any, but unable to participate in management unless the partnership agreement provides otherwise.(fn12) As a further protection, the partnership agreement may be drafted to provide that a potential involuntary transfer of a partnership interest to a creditor is not a permissible transfer and, as such, gives the partnership the option of buying the troubled partner's former interest at fair market value.(fn13) As a result of valuation discounts for lack of marketability and minority interest, which are discussed below, the fair market value of a partner's interest may be less than the value of the underlying assets, thereby providing protection to some of the family assets.(fn14)
Similarly, a partnership...
To continue reading
Request your trial