Family Limited Partnerships, detailed & technical analysis – a tax planning research article written by Steven Christopherson – 12/18/2007:
(The legal caveat: The following article was written by Steven Christopherson. It is for information and educational use only. It represents copyrighted original material, and can only be reproduced with the express written authorization of Steven Christopherson. This article is not intended to provide legal or tax advice. Because the tax law is constantly changing, and because any tax plan or strategy is a highly individual matter, readers of this article should seek qualified professional assistance before undertaking any of the steps outlined below.)
Overview of the Family Limited Partnership (FLP):
The family limited partnership (FLP) is a sophisticated financial planning technique that, when implemented properly, enables a family to hold and manage its wealth, including the family business, within several generations of family members as partners.
In a typical situation, senior family members transfer assets to a family partnership in exchange for partnership interests, or units, which under the terms of the partnership agreement, carry with them certain rights. In general, the initial capitalization of the partnership is a tax-free event.1
Partnership interests are then gifted or sold to junior family members, or to trusts established for the junior family members’ benefit, during the lifetimes of the senior family members.
Families with significant wealth increasingly establish a FLP rather than a corporation, because the FLP is often better suited to achieving certain objectives. Specifically, the FLP is an ideal mechanism for:
• Retaining the operating direction or control of the family business or investment assets by the senior family members,
• Developing a succession plan for the future management of the enterprise, and
• Transferring the assets of the family between generations at the lowest permissible cost in estate and gift taxes.
Federal income tax rules applying to FLPs:
Family partnerships are specifically authorized under the Internal Revenue Code.2
The code section addressing Family Limited Partnerships was enacted to prevent the abuse of family partnerships to shift income from one family member to another, thereby circumventing the progressive rate structure of the federal income tax.3
The purpose of §704(e) is two-fold – and designed to enforce the following two basic principles:
• Income produced by capital should be taxed to the true owner of that capital.
• Income derived from services should be taxed to the person who performs the services.
If a partnership is used to circumvent these principles, the IRS may, in accordance with the Section 704(e) regulations, reallocate income between partners.4 Under broad anti-abuse regulations, the IRS has the authority to re-characterize transactions, and thus could even make a determination that one or more partners are not partners at all for federal income tax purposes.5
Substantial Economic Effect:
As is generally the case for partnerships, the FLP must possess “substantial economic effect.”6
The substantial economic effect rules require that allocations of income, gain, loss, deduction or credit among the partners must be consistent with the underlying economic arrangement of the partners. Additionally, there must be a reasonable possibility that the dollar amounts received by partners from the partnership are not based solely on the tax consequences resulting therefrom.7
Capital as a material income producing factor:
Consistent with a key principal that FLPs are not used to simply shift income from family members in high income tax brackets, to those in low tax brackets, capital is required to be a material income producing factor.8
Such capital may be acquired by purchase or gift.9 Additionally, goodwill can be considered capital.10
Other tax considerations:
Other tax principles must also be considered, such as whether the allocation involves misallocation of income among related parties,11 employee compensation,12 gift issues,13 and/or sale issues.14 In addition, some special allocations could create preferred senior interests and thus gift tax problems.15 Thus, while an allocation may satisfy the IRC §704(b) rules, other tax code sections may still affect the tax treatment of that allocation.
Because of the requirement that capital must be a material income producing factor,8 FLPs can be effective vehicles to transfer income producing assets to lower tax bracket family members, as well as to remove potential capital appreciation from older family members (where it is more likely that estate taxes will be assessed sooner) to younger family members.
Income producing real estate can be very useful as far as asset transfers and funding, and in meeting the requirements of Treas. Reg. §1.704-1(e)(1)(iv).
FLP tax filings:
As is generally the case for any partnership, the FLP is required to file an annual information return of income, deduction and credit.16
Income tax rules applicable to FLPs, as compared to the income tax rules of service-related partnerships:
There are a number of differences in the income tax rules between FLPs and service-related partnerships.
Family partnerships are only recognized for federal income tax purposes if the partner owns a capital interest in the partnership in which capital is a material income producing factor.17 It does not matter whether the partnership interest was acquired by gift or purchase, as long as capital is a material income producing factor.18 This is a key difference from the service partnership.
FLP tax year and accounting method:
Tax year:
The taxable year of a FLP is determined by reference to its partners.19 While a full discussion of allowable taxable years is beyond the scope of this overview, there are a number of factors which will affect the allowable taxable year. A FLP is likely to have the same tax year as its majority ownership interest, but this may not always be the case.20 It is possible that the FLP may have a year completely different than the partners under other allowable provisions and rulings.21
Accounting method:
As is the case with most taxpayers, a partnership elects its method of accounting.22 In general, taxable income is computed under the method of accounting on the basis of which the taxpayer computer its book income.23
Additionally, the method elected must clearly reflect income.24
Most elections affecting the computation of income derived from a partnership, must be made by the partnership and not the partners themselves.25 Thus, elections as to methods of accounting, methods of depreciation, section 179 elections, etc., are all generally made at the partnership level.
Under the Internal Revenue Code, Treasury Regulations and IRS ruling cited, it is thus possible for the partnership to report income and expense on a different method of accounting than some, or even all of, its partners.
Management of the FLP:
Generally under state law, a Limited Partnership is managed by a General Partner (to afford the Limited Partners limited liability protection). Because FLPs are subject to state and local laws, it is paramount that full consideration be given to the legal requirements of the particular state, as well as local law with regard to specific assets, such as real estate.
For federal income tax purposes control of the partnership and the partnership interests is an important matter, as it specifically relates to the basic tests of ownership of the family partnership.26
A partner’s rights with respect to the partnership determine whether the IRS will respect partnership allocations. In the case of a gifted interest, if the IRS determines the donor retained too much control, the allocation of income to the donees will not be recognized for income tax purposes.27
While management of the partnership generally lies with the General Partner, it is important, especially in the case of gifted interests, that too much control not remain with the donor (see discussion below regarding IRS challenges of FLPs).
The courts have addressed the issue of control:
In one case an ownership arrangement was held not to be a partnership where a mother retained control over the amount of income her children received each year. Income that was transferred to the children was placed under restrictions. While the children had the legal right to withdraw funds transferred to them, the court doubted the children were aware of this and, in any event, the mother's power to cut off the flow of funds to the children's accounts was a threat sufficient to preclude their withdrawing funds.28
But in another case, a restriction in a family partnership agreement giving the donor a right of first refusal on the transfer of a partnership interest by the donees of the interest didn't invalidate the partnership where the restriction applied equally to the donor partner. In that situation the donees were not any less partners than the donor.29
As discussed below, not observing formalities could cause the partnership to not be recognized for legal or tax purposes, potentially causing the loss of limited liability for the limited partners, gross estate inclusion for previously gifted interests as well as the loss of valuation discounts.
Gift formalities and issues:
Appraisals and valuation– The amount of a gift for estate tax and income tax purposes, is based upon the value of the gift at the date of the gift.30
Thus an appraisal can be important evidence of the amount/value of a gift. Valuation discounts are at the heart of many disputes between taxpayers and the IRS. Though many cases have been heard by the courts, the Propstra case, is an important 9th Circuit Court case upholding appraised valuation discounts.31
Segregation of funds and receipts:
In the case Estate of Schauerhamer, the decedent created a FLP with other family members several months prior to her death. However, as a General Partner, she deposited partnership income from various investments in her personal bank account. Rejecting the estate’s argument that the decedent never made personal use of the funds, the Tax Court held that she had retained enjoyment of the assets, and thus concluded that the assets were includible in her estate.32
Gifts of present interests:
For the annual gift tax exclusion of IRC §2503(b) to apply, only present interests are considered in applying the annual exclusion amount.33
Gifts into trust, can generally qualify as gifts of present interests as long as they conform to the requirements as delineated in the case of Crummey.34 (commonly referred to by tax practitioners as “Crummey Powers”)
Summary discussion on management of the FLP:
It is paramount that the client as well as his/her team of professionals work closely together to ensure that needed formalities are observed and respected.
The professionals should work closely with the client to carefully document the non-tax reasons for the partnership’s existence – both in the partnership agreement itself, as well as in correspondence between partners. Doing so will help ensure that the business purpose of the partnership can be defended (see IRC§ 7701(a)(2) discussed below) as well as to help document compliance with the substantial economic effect rules of IRC §704(b).
Types of assets amendable to FLP ownership:
A clients’ goals and the nature of his/her assets are paramount in determining whether a FLP is appropriate; and if so, how to structure the partnership.
Some assets are more appropriate than others for a family partnership.
Assets held by a partnership generally must be related to a trade or business, or income-producing venture.35
Therefore, a FLP should not be used to hold personal real estate, such as a family home.
Use of a FLP is appropriate to hold commercial or rental real estate. However, clients and professionals need to ascertain whether transfer of encumbered real estate will trigger mortgage acceleration clauses (transfers of assets, including encumbered real estate are discussed in more detail below).
Other assets amendable for contribution can be:
Marketable securities -as long as the business purpose for such funding can be documented, in order to comply with IRC §7701(a)(2). For example, marketable securities can provide liquidity to the partnership, thus establishing the business purpose.
C-corporation stock, but not S-corporation stock: A C-corporation is allowed to have a partnership as a shareholder, but an S-corporation is not.36
Types of assets not amendable to FLP ownership – and selected potential pitfalls:
Investment company rules:
Care must be exercised in funding the FLP with stocks and securities. In general, if the FLP is funded with more than 80% assets in investment form (such as stocks, securities, mutual fund share, among others), the FLP could be determined to be an investment company, with resulting tax consequences upon funding.37
S-corporation stock:
As referenced above, an S-corporation is not allowed to have a partnership as a shareholder. Doing so, will cause the S election to terminate.36
Stock in a professional corporation:
Stock in a professional corporation, such as a law or CPA practice, generally will not work, as state laws usually require such stock to be held by the individual professionals.
Encumbered property:
If contributed property is subject to liabilities in excess of basis, the contributing partner may be forced to recognize gain.38 The assumption of debt by the partnership also affects the tax basis of each partners’ interest.39
Passive activity issues:
Contributing an active business which generates losses to a FLP will generally mean that such losses will be treated as passive by the limited partners.40 There are some exceptions to this general rule, however.41
Hot assets:
“Hot assets42” can trigger gain recognition by the contributing partner.
Summary comments - assets for contribution to the FLP:
A full and complete discussion of issues and pitfalls is beyond the scope of this general overview. It is very important that the client and his/her team of professionals carefully consider the clients’ goals, assets held, family relationships, etc., in light of these and other rules in regard to FLP funding and the transfer of assets to the FLP.
Inbound transfer of realty to the FLP and the potential for transfer taxes:
In general, the transfer of assets will not result in a taxable gain recognition if the exchange is made for an interest in the partnership.43 This applies to initial funding of the partnership, or contributions to an existing partnership.44
The IRS has indicated, that the anti-abuse rules of Treas. Reg. §1.701-2 apply solely to income taxes, and will not be applied with respect to transfer taxes.45
California property tax issues:
The transfer between an owner and a legal entity which results in solely the method of holding title to the real property, and in which proportional ownership interests in the property remain the same after transfer, is not considered a transfer for reassessment of property tax purposes.46
However, such a reassessment will generally occur when there is a greater than 50% change in ownership of the underlying property.47
Thus careful planning will be needed if the clients’ goal is to transfer interests in the FLP to other family members over time.
Hawaii property tax issues:
Real property taxes in the State of Hawaii are generally administered at the county level.48
This brief overview will only consider property held in the City and County of Honolulu (island of O’ahu). Thorough consideration to statute differences between Honolulu and other counties would need to be fully considered by the clients’ team of professionals.
In general, the City and County of Honolulu assesses property taxes based upon the fair market value of realty.49
Thus, issues concerning California property tax reassessment under California Proposition 13, do not exist as such in the City and County of Honolulu.
Using an LLC in lieu of a FLP:
A family LLC may offer estate planning opportunities. Consideration should be given to the following when making a decision between utilizing a family LLC vs the FLP:
An LLC will generally provide liability protection to all members, under state laws. A FLP will only do so for the Limited Partners.
However, under the laws of some states, a single LLC member can force dissolution of the LLC. This may preclude widespread use of LLCs when valuation discounts for gift tax purposes are a significant objective.
An interesting point worth considering however is to use an LLC as a general partner in the FLP. Such an arrangement would offer liability protection for all partners, not just the limited partners.
The FLP as a vehicle to lessen estate and gift taxes:
From an estate tax perspective, using the FLP has the advantage of creating valuation discounts that reduce the value of an individual’s estate.31 However, using the FLP to reduce the value of the owner’s estate may be counterproductive if the estate tax is repealed and replaced with a modified carryover basis system.
From a gift tax perspective, the discounts applicable to limited partnership continue to make FLPs an attractive vehicle to reduce the value of lifetime gifts. Since these gifts also remove value and appreciation from the donor’s estate, they still provide estate planning benefits to owners who are likely to die prior to the estate tax repeal in 2010 or subsequent years if repeal does become permanent.
The transfer of FLP interests transferred from parents to children each year free from gift taxes:
The annual gift tax exclusion is currently $12,000 (tax years 2007 and 2008). This amount of gift of a present interest made by the donor, to the donee, is not included in the donor’s taxable gifts for the year.50
Joint gifts by husband and wife: Gifts by husband or wife to third party are considered one-half made by each.51 If such a gift split is elected, each spouse must consent to the gift split.52
The current unified credit against gift tax is $1.0 million – which applies to US citizens and US residents.53 The current unified credit against estate tax is $2.0 million (2007 and 2008).54
Taxpayers can utilize these provisions to make gifts of FLP interests to donees on either a gift-tax free basis (if utilizing the annual gift exclusion) or with regard to the unified credit against gift taxes of $1.0 million.
See below for further discussion of how this is done, and discounts utilized.
Overview of the positives and negatives of FLPs for federal income tax and estate tax purposes:
Gift tax considerations – FLPs provide the ability to transfer assets out of the estate – on a discounted basis. But assets transferred will not received a step-up in basis upon the death of the donor.55 This could result in a taxable capital gain, if the interest is subsequently sold.56
However if the donee was to acquire his or her interest as an inheritance, the tax basis of the assets would step up to the fair market value either at date of death55, or at the alternate valuation an election to do so is made by the executor.57
One of the key benefits from an estate and gift tax perspective is the ability to use valuation discounts to leverage the ability to transfer assets out of an estate, as well as to increase the size of gifts that will not be subject to gift or estate taxes.
An example probably is the best way to explain this:
A 25% interest in a piece of commercial property is not generally worth 25% of the total value of the piece of property. A 25% interest does not represent a controlling interest in the property. And a 25% interest in a piece of privately-held property is generally not very marketable.
Thus the starting point in determining the value of the 25% interest is to determine the total value of the property, then take 25% of that number, then apply discounts to the result for lack of control as well as lack of marketability.
This theory of valuation has been upheld in numerous court cases, and thus ‘works’ as a way to transfer value out of a taxable estate.58
This theory of valuation discounting can be used for both purposes of gifting during the donor’s lifetime, as well as for estate tax valuation purposes after the donor has passed away.
Death of the first parent (or elder family member, as the case may be) :
Upon a partner’s death, the successor partner’s basis in the partnership interest (outside basis) is the fair market value (FMV) of the partnership interest on either the date-of-death or the alternate valuation date, depending on which date was used in preparing the decedent’s estate tax return.59
If a partnership interest is community property (i.e., held as community property in a community property state - such as California or Washington), the basis of the entire interest is adjusted to equal its FMV on this date – even though only a one-half community interest was actually owned by the decedent at the time of his/her death.60 As a result the community property interest held by the surviving spouse is also stepped up (or down) to FMV, even though this portion was not owned by the decedent at the time of death.
This step-up or step-down applies to community property interests, regardless of which spouse was actually the partner.61
Additionally, a partnership can make an election to adjust the inside bases of the partnership assets upon the transfer of a partnership interest resulting from the death of a partner.62
Death of the second parent (or elder family member):
The death of the second parent, is the point at which the initial planning in formation comes full circle.
Provision for this event should have been made from the start, in the planning stage. If the last-surviving parent was the only general partner, the partnership agreement should have been structured to address this event. See section below for reference to the impact of death or incompetency of the general partner.
Beyond continuity of the partnership, many of the same issues which were relevant to the death of the first partner, will also apply in this scenario (IRC §754 election potential, basis step-up of IRC §1014, etc).
Special issues associated with FLPs – the one child scenario:
The partnership agreement should address the impact of a partner’s death or incompetency on the partnership. The Revised Limited Partnership Act of 1976, as well as the Uniform Limited Partnership Act of 2001, provide that the death of a general partner will cause the dissolution of the partnership unless (1) there is at least one other general partner and the agreement allows the business of the partnership to be carried on by the remaining general partners, or (2) within 90 days, all partners agree in writing to continue the business of the limited partnership and to appoint one or more additional general partners.
To ensure continuation and to preserve valuation as a going concern (instead of a liquidation basis) for any gifted limited partnership interest, it is advisable to name either a corporate general partner or a successor individual general partner in the partnership agreement, so that the death or incompetency of a sole individual general partner will not dissolve the partnership. An LLC could also be used, if it does not dissolve upon the death of a member.
Current attacks by IRS on FLPs as an estate planning vehicle:
The IRS has often attacked partnerships formed shortly before death. They have argued that the partnership lacks business purpose or economic substance and should be disregarded for estate valuation purposes. This argument has been rejected in the following cases:
Strangi vs Comm63 and Church vs U.S.64
In these cases, the IRS argued for estate inclusion of the partnership interests under IRC §2036 and IRC §2033, under the theory that the donor had retained an interest in the partnership and its assets. However, in both of these cases the courts refused to ignore the partnership for valuation purposes as long as it was valid under state law.
Other attack strategies utilized by IRS:
Under similar code sections, the IRS has been successful in other cases in arguing that the underlying assets themselves (as opposed to the partnership interest) should be included in a decedent’s gross estate under IRC §2033 and IRC §2036, based on the theory that the donor had retained a degree of control and economic benefit:
Estate of Schauerhamer v Comm65 and Estate of Reichardt v Commissioner66
Although a nuanced argument from the Strangi and Church cases, the IRS was able to achieve success with this line of reasoning.
Burden of proof – an item for consideration:
If a taxpayer presents credible evidence on any factual issue relevant to ascertaining tax liability for any tax imposed by subtitle A or B of the Internal Revenue Code, the IRS has the burden of proof with respect to that issue.67
With proper planning, it is possible to effectively shift the burden of proof from the taxpayer, to the IRS. This potentially could have a great impact on valuation cases, by forcing the IRS to retain many appraisers or lose cases in which the taxpayer has supported his or her position with qualified appraisals.
Conclusion:
The FLP can be an effective tool to transfer wealth and assets out of an estate (liquid and illiquid assets – such a real estate).
It is extremely important for the tax practitioner to work closely with the client, as well as his or her attorney, and other professionals in developing a strategy and plan, which is effective in light of the clients’ goals, financial situation, and in light of the many complex areas of the tax law which impact the FLP.
It is also important for the FLP to be formed and operated with an awareness that IRS challenge is a distinct possibility. Careful and thoughtful planning is paramount if it is determined that the FLP is the proper vehicle for any particular client.
For some clients, effective use of a FLP affords the opportunity to save significant amounts of money in income as well as estate and gift taxes.
Table of cites and authority:
1 IRC §721(a) and Treas. Reg. §1.721-1
2 IRC §704(e)
3 Pub. Law No. 183, 82nd Congress, 1st session (Oct. 20, 1951)
4 Treas. Reg. §1.704-1(e)(3)(i)(b) & Ralph C. Gorrill v Comm, TC Memo 1963-168
5 Treas. Reg. §1.701-2
6 IRC §704(b)
7 Treas. Reg. §1.704-1(b)(2)
8 Treas. Reg. §1.704-1(e)(1)(iv)
9 IRC §704(e)(1)
10 Bateman v. U.S., 33 AFTR 2d 74-483, 490 F2d 549, 74-1 USTC P 9176
11 IRC §482
12 IRC §83 and §707(a)
13 IRC §2501
14 IRC §707(a) and §1001
15 IRC §2701
16 IRC §6031(a)
17 IRC §704(e)(1) and Treas. Reg. §1.701-1(e)
18 IRC §704(e)(1)
19 IRC §706(b)(1)(B)
20 IRC §706
21 IRC §444 and Rev. Proc. 2002-38
22 IRC §446
23 IRC §446(a)
24 IRC §446(b)
25 Treas. Reg. §1.703-1(b)
26 Treas Reg. §1.704-1(e)(2)
27 Treas. Reg. §1.704-1(e)(2)(ii)
28 Lizzie M. Manuel, et al, TC Memo 1983-138, PH TCM P 83138, 45 CCH TCM 981.
29 Joseph A Garcia, TC Memo 1984-380, PH TCM P 84348, 48 CCH TCM 425
30 IRC §2512(a)
31 Propstra v. US., 50 AFTR 2d 82-6153, 680 F2d 1248, 82-2 USTC P 13475.
32 Estate of Schauerhamer v Comm, TC Memo 1997-242 and IRC §2036(a)
33 IRC §2503(b)(1) and Treas. Reg. §25.2503-2
34 Crummey v Comm, 22 AFTR 2d 6023, 397 F2d 82, 68-2 USTC P 12541
35 IRC §7701(a)(2)
36 IRC §1361(b)(1)(A)
37 IRC §721(b) and IRC §351(e)(1)(A)
38 IRC §731(a)
39 IRC §752
40 IRC §469(h)
41 See examples at Treas. Reg §1.469-2
42 IRC §751
43 IRC §721(a)
44 Treas. Reg §1.721-1(a)
45 Announcement 95-8, 1995-7 IRB 56, 01/24/95, IRC Sec(s). 701
46 California Revenue and Tax Code §62(a)
47 California Revenue and Tax Code §64(c)(1)
48 Hawaii Revenue Statute §246A-2 Transfer of functions
49 Section 8-7.1, Revised Ordinances of Honolulu
50 IRC §2503(b)
51 IRC §2513(a)
52 IRC §2513(a)(2)
53 IRC §2505(a)
54 IRC §2010(c)
55 IRC §1014
56 IRC §1222
57 IRC §2032
58 Williams, Ellie B. Est, (1998) TC Memo 1998-59, RIA TC Memo ¶98059 , 75 CCH TCM 1758; Propstra, John v. U.S., (1982, CA9) 50 AFTR 2d 82-6153 , 680 F2d 1248 , 82-2 USTC ¶13475; Stewart, William Jr., (1934) 31 BTA 201; Campanari, Nina Est, (1945) 5 TC 488, acq; Murphy, Dorothy, exrx v. Granquist, (1954, DC OR) 48 AFTR 1974 , 55-2 USTC ¶11566 .
59 IRC §1014(a)
60 IRC §1014(b)(6)
61 Rev Rul 79-124
62 IRC §754
63 Strangi v. Comm., 96 AFTR 2d 2005-6895 (429 F.3d 1154), 11/07/2005
64 Church vs U.S., 88 AFTR 2d 2001-5352 (268 F.3d 1063) 7/18/2001
65 Estate of Dorothy Morganson Schauerhamer v Comm., TC Memo 1997-242
66 Estate of Charles E. Reichardt v Commissioner, 114 TC 144
67 IRC §7491
