The Kaleidoscopic World of Family Limited Partnerships: Issues to Note en Route to the Successfully Planned California Real Estate Family Limited Partnership

• Publication year: 2003
• Author: By Steven D. Anderson, Esq. and Quynh T. Tran, Esq.

THE KALEIDOSCOPIC WORLD OF FAMILY LIMITED PARTNERSHIPS: ISSUES TO NOTE EN ROUTE TO THE SUCCESSFULLY PLANNED CALIFORNIA REAL ESTATE FAMILY LIMITED PARTNERSHIP1

By Steven D. Anderson, Esq. and Quynh T. Tran, Esq.^*

I. INTRODUCTION

Many owners of California investment real property have enjoyed tremendous increases in value in recent years. In enacting the Economic Growth and Tax Relief Reconciliation Act of 2001,² Congress gave some limited relief to high net worth owners of investment real estate, but lasting protection from the Federal transfer tax burden ultimately proved illusive. Consequently, planning for the management and intergenerational transfer of real property continues to be a vital goal for many California families.

For the transfer of primary residences or vacation homes, qualified personal residence trusts are the recommended estate planning tool.³ In the investment real property arena, recent case law developments aside, family limited partnerships ("FLPs") continue to be effective, providing senior generation members with retained control of family investment real property while transferring significantly discounted interests to younger generation members, and imposing restrictions on transfer, certain creditor protections and formal governance and operational structures.⁴

Too often FLP planning has been treated as something akin to the transfer tax equivalent of Disney's Magic Kingdom. Approaching the subject from that perspective is dangerous. The effectiveness of the FLP vehicle is in most instances accompanied by myriad complexities. Many issues should be considered before employing the FLP technique,⁵ particularly in the context of real property. Although most planners concentrate their energies on transfer tax issues, successful planners master a truly multidisciplinary approach.

A. Basics of FLP Planning

An FLP is a limited partnership formed under the California Revised Uniform Limited Partnership Act ("RULPA").⁶ Partners typically include members of more than one generation. California law also allows for the statutory conversion of other entities into a limited partnership under RULPA.⁷ Although limited liability companies ("LLCs") are sometimes utilized in lieu of FLPs, because of the rich legal history of FLPs this article focuses on partnerships to the exclusion of LLCs.

The creation of the partnership must comply with RULPA and is accompanied by contributions of real property by co-tenants (who are also partners), or contributions of cash and the FLP's subsequent acquisition of real property interests, followed eventually by transfers (either by gift or sale) of limited partnership interests. The timing and sequence of these steps can engender special tax and non-tax considerations.

A chief benefit is the ability of the transferor senior generation member to retain control. Typically, control is vested in the general partner, and limited partners possess limited voting and control rights (confined to a few instances specified by California statutes and in most cases also by agreement).⁸ The value of the partnership interests transferred to younger generations via inter vivos gift or sale may be adjusted to take into account both lack of marketability and lack of control factors. The value of any retained FLP interest may be similarly adjusted for estate tax purposes.

B. Issues To Consider

1. FLP Structural Issues

Of vital importance is structuring the partnership interests by determining the persons, entities and/or trusts to be the general and/or limited partners. A brief discussion of potential liability, creditors' rights and managerial issues sets the stage for the client. Many owners of "passive" investment real property simply insure their risks of ownership; owners of operating businesses or persons intending to act as property developers may desire greater protection.

For liability limitation purposes, one must consider whether to create a separate LLC or S corporation general partner. This would limit liability to the assets of the entity at all levels.⁹ Another consideration is the avoidance of court proceedings upon a partner's incapacity or death, an objective achieved by insuring the partnership interests (or interests in entities owning partnership interests) are held in revocable living trust form.

Family composition, as well as the configuration of family property interests as separate or community, are important factors. Because of the changing complexion of California families, potential partners commonly include spouses owning mixed property as well as members of several generations and in some cases nonprofit organizations.

Meeting the practicalities of each particular family situation is important. Although the IRS is permitted under Chapter 14 of the Internal Revenue Code of 1986, as amended ("IRC") to disregard for valuation purposes supermajority voting requirements and other contractual restrictions more strict that those imposed under "default" state law provisions, such restrictions affecting FLP governance and ownership often are still desirable for non-tax reasons.¹⁰

The disposition of FLP interests on death must not be overlooked. Relevant California property tax issues include the rules regarding reassessment upon the "change in ownership" of the real property. With respect to federal transfer tax law, structuring ownership of FLP fractional interests by irrevocable

[Page 5]

trusts established upon the death of the first spouse to die entails evaluation of the risk of "aggregation" for transfer tax valuation purposes; ownership divided among individuals and lifetime irrevocable grantor trusts may also result in an FLP being "disregarded" for income tax purposes. Fractionalizing real property interests and structuring FLPs owned by multiple irrevocable trusts remain extremely desirable goals.

2. The FLP Planning Checklist

Before embarking on FLP creation, the following items demand consideration:

• Will transfer of the property to the partnership trigger a property tax reassessment?
• Will transfer of the property to the partnership make the property ineligible for the $1,000,000 parent-to-child reassessment exclusion? Can the pre-formation creation of co-tenancy interests minimize the impact of loss of the exclusion?
• What changes in ownership resulting in reassessment are likely to occur upon subsequent transfers of interests in the FLP entity itself?
• Will transfer of the property to the partnership trigger any adverse income tax consequences, and if so, can issues be eliminated through customized drafting?
• Are lifetime or testamentary irrevocable trusts contemplated as partners, and if so, does the existence of trustee-partners complicate the income and/or property tax analysis?
• What is the effect of the "grantor trust" status of irrevocable trust partners on the income tax consequences of FLP creation or post-creation transfers of partnership interests?
• Was any property proposed to be contributed to the FLP acquired in a tax-deferred exchange under I.R.C. § 1031?
• Is a nonprofit organization-partner contemplated, and if so, have the income tax issues unique to that type of partner been considered?
• Will transfer of the property to the partnership trigger any county and/or city transfer taxes (e.g., documentary transfer taxes)?
• Will transfer of the property to the partnership trigger a "due on transfer" clause under the terms of any loan agreement or security instrument encumbering the property? Is lender's consent needed?
• What is the effect of transfer to a new entity on existing title insurance coverage?
• What will be the initial legal, accounting and appraisal costs and will the family enlist the appropriate professional support network and maintain the organizational discipline necessary to protect the planning from potential Internal Revenue Service challenge?
• Will subsequent transfers complicate family business succession planning or result in difficult impasses among family members? Do supermajority voting or other restrictions provide a solution notwithstanding their lack of effect on available valuation discounts?
• If irrevocable trusts are intended to be partners, have "ancillary issues" including the application of California's Prudent Investor Act¹¹ and the Uniform Principal and Income Act¹² been addressed in the drafting process?

II. FORMATION AND INITIAL TRANSFER

A. Importance Of Compliance With Formalities

In recent years the Internal Revenue Service ("IRS" or the "Service") has mounted challenges to the use of FLPs as estate planning vehicles by focusing on FLP formational, structural and managerial issues, making these issues more important than ever.¹³

B. Documentation

Relatively simple formational prerequisites (a Certificate of Limited Partnership (Form LP-1), a partnership agreement, and an Application for Employer Identification Number (IRS Form SS-4)) are only the beginning of the analysis. Other steps include deeds effecting pre-capitalization co-tenancy structure and/or initial capitalization, with appropriate Preliminary Change of Ownership Reports ("PCORs") and Claims for Reassessment Exclusion for Transfer Between Parent and Child (§ 63.1 of the California Revenue and Taxation Code ("Rev. & Tax Code")).

Capitalization and creation of deposit accounts should occur in a timely manner - paralleling the manner in which such steps would be taken among unrelated third-party investors. As explained in Section III, below, for California property tax reassessment reasons, post-capitalization transfers of FLP interests should occur at a later time, separate and removed from the date of FLP capitalization.

C. Valuation - Substantiating Appraisals And Valuation Opinions

Under current federal transfer tax law,¹⁴ significant valuation discounts apply when valuing gifts of minority interests in FLP entities as well as fractional interests in real estate. Fee interest appraisals and partnership interest valuation reports are required by Treasury Regulations to substantiate the...