How family limited partnerships can be used to reduce gift/estate taxes.

• Author: Risius, Jeffrey M.

In Rev. Rul. 93-12, the IRS reversed its previous position of "family attribution"; that is, the Service will no longer disallow minority and marketability discounts solely because of the family relationship of the shareholders. Thus, if a donor who owns all of a corporation's common stock gives 20% of the stock to each of his five children, each of the five gifts will be valued separately as a minority interest rather than aggregated as a single controlling interest.

Since this ruling, family limited partnerships (FLPs) have been an increasingly popular estate planning tool. Recently released Regs. Sec. 1.701-2, which details partnership anti-abuse rules, has caused practitioners uncertainty as to whether certain FLPs would be able to pass the "business purpose" doctrine. However, the IRS has now amended these rules through Ann. 95-8, which states that Regs. Sec. 1.701-2 applies solely to taxes under Subtitle A (income taxes) of the Code; in other words, the regulation will not apply to transfer taxes. This new announcement is obviously a positive development for those contemplating the use of an FLP for estate planning purposes.

Structuring the FLP

The first step in structuring an FLP is for the individuals to transfer certain assets into an FLP in exchange for partnership interest. Typically, the partnership consists of a 99% limited partner interest and a 1% general partner interest, and the agreement usually sets forth a specific time period over which the partnership will operate. Further, the partnership agreement typically assigns managing control of the partnership to the general partner, but provides that all partnership interests have the same rights with respect to ongoing distributions of income and capital. (By not creating two ownership classes, the FLP should not fall within the scope of Sec. 2701, which prescribes special valuation rules.)

The individuals then make gifts of the limited partner interests to their heirs, while retaining the general partner interest. With a properly designed FLP, the limited partner interests are valued at less than the proportionate value of the underlying property itself. This discount reflects partnership attributes that inhibit the limited partners from directly enjoying the ownership of the underlying assets. Some typical partnership attributes include:

* General partners are given all the decision-making power. Even though the limited partners may own a significant interest in the...