The Family Limited Partnership (FLP) is gaining increasing acceptance, and even popularity, among estate planners. For clients with substantial closely held business assets, real estate and investment holdings, estate planning professionals are using the FLP to accomplish a number of non-tax and tax objectives. For the closely held business owner, it is important to remember that stock in a corporation for which a subchapter S election has been made cannot be transferred to a family limited partnership, since a partnership is not a qualified shareholder of a Subchapter-S corporation. There are other qualifications and limitations to be considered in the use of the FLP, and careful consideration must be given to all relevant factors before its use is recommended to a client. Overall, however, as long as the family limited partnership was formed for a non-tax reason or the partnership did, in fact, engage in a business or investment activity, the IRS cannot ignore or disregard the existence of the partnership.

There are numerous non-tax reasons motivating the use of a family limited partnerships in the estate planning arena; there are, as well, many tax-dominated objectives for its use.

Non-Tax Reasons

Management of Family Assets.

Several of the primary motivations for clients to use family limited partnerships revolve around the very real advantages they provide in allowing family members to retain control of real estate, investment, and other assets held by family members. Though gifting assets provides an effective means of reduction of the client’s taxable estate, it also usually carries with it a loss of control of the transferred assets, both in terms of management and in terms of the income produced by the assets thus alienated.

A gift of a family limited partnership interest, as opposed to a transfer of the underlying partnership asset, avoids parting with the cash flow produced by that asset. The senior family member (the one that initially owns the assets and who hesitates to part with any meaningful dominion over it) can control the partnership, and thus the underlying assets. Younger family members (those that want to get their hands on dad’s money as soon as possible) receive only their proportionate share of the partnership income. If the patriarch or matriarch wants to manage the assets in such a way that most, if not all, of the earnings of the partnership are reinvested, he has every right to do so, leaving low, or nonexistent, cash flow distributions for holders of limited partnership interests. Furthermore, the retained right to determine the distributable cash flow of the other partners is not a power which will make any transferred partnership interest includible in the estate of the senior family member. This result is much more easily achieved with a family limited partnership than with a trust; if the grantor, as trustee, has the power to determine the amount of distributable income to be received by the beneficiary of the trust, the assets may be includible in the client’s estate.

Often a client owns diverse assets which are difficult to value and even more difficult to divide among children and other intended donees. Making gifts of different assets to different children is often unsatisfactory; making undivided gifts of those assets to each child is likewise difficult and often unmanageable. If the client contributes those assets to a family limited partnership, on the other hand, and assigns partnership units to his children, each receives an undivided interest in each asset without receiving any specific asset outright. This simplicity carries over to management of the assets, since the assets continue to be “centrally” managed and controlled through the family limited partnership.

The terms of the family limited partnership agreement can substantially enhance its effectiveness in accomplishing these management objectives. The family limited partnership agreement can be drafted to give the partnership or the other partners a right of first refusal in the event a family member seeks to transfer his partnership interest. Similar provisions can be included for disabled or deceased partners. In addition, by keeping the partnership interest in the name of the family member, rather than in joint names with a spouse, the partnership interest remains non-marital property in the event of a divorce. As such, there is little danger of the partnership interest falling into the hands of a non-family member.

Finally, flexibility is an important element of the FLP. A family limited partnership agreement can be amended at any time. The limited partnership can also be dissolved, usually without adverse tax consequences. In contrast, an irrevocable trust, by definition, cannot be amended or revoked. Likewise, changing various provisions in a corporation requires certain formalities, and a dissolution and liquidation results in at least one level of taxation, and perhaps two.

Reduced Expenses.

Families often have many members (or trusts created with prior gifts), each with their own assets. Keeping up with the investments of these various entities can be frustrating and time-consuming. Consolidating these investments into a family limited partnership, however, solves this problem. In addition, diversification of investment vehicles and money managers is often not possible with the individual accounts because of their size and the costs involved; consolidation enables diversification and reduction of fees and expenses.

Ownership of real estate located outside the state of residence of the partners by a family limited partnership, rather than by the individual partners, avoids ancillary probate proceedings in the state or states where that real estate is located.

As noted above, gifts of undivided interests in real estate are more easily managed through the use of a family limited partnership. The costs associated with making such gifts is therefore reduced in that the gift is accomplished with a simple deed of gift, rather than a deed, which requires recording. Shares of stock have the same benefit as limited partnership interests, but not without the income tax benefits associated with a family limited partnership.

A limited partnership agreement can provide that, in the case of disagreement among family members, binding arbitration must be used to resolve such a conflict. Such a mechanism avoids lengthy and costly litigation, and the often negative publicity attendant to such litigation. The partnership agreement can also require that any partner bringing an action against the entity or other partners will be required to pay all costs of arbitration if the party is unsuccessful. This often has the result of preventing frivolous legal actions brought for the sole purpose of harassment or to compel settlement on terms not otherwise achievable.

Protection from Creditors.

The ownership of shares of stock in an ongoing business and real property holdings carry with them substantial liabilities, such as injuries resulting from the operation of the business or environmental liability in the case of real estate. The limited partners in a family limited partnership are insulated from such liability, and the general partner can be a corporation or LLC, thus insulating that party from liability, as well.

Assets transferred to the entity are generally not subject to the claims of the creditors of the limited partners. In most states, Illinois among them, a judgment creditor of a partner in a partnership is only entitled to a charging order, which gives that creditor only the status of an assignee, not a full partner. In that capacity, the creditor has only the right to receive distributions to which the partner would have been entitled; he has no right to make management decisions or to cause dissolution or liquidation of the entity. A creditor in that position is then taxed on his share of the entity’s income even though some or all of that income is not distributed to the partners.

Investment Policies.

A different standard is used to judge the actions of a general partner than is used to govern the actions of a trustee. The managing family member has more freedom to make investment decisions since he or she is not burdened by the prudent person rule, but rather is subject to the more liberal business judgment rule. This lower standard reduces the probability of lawsuits by younger family members using 20/20 hindsight regarding investment decisions made years earlier.

The general partner, usually the senior family member, may use modern portfolio theory (approved under the prudent investor rule) in making investments. This avoids the conflict faced by many trustees in deciding on investment philosophies which must take into consideration both the interests of current income beneficiaries and remaindermen. Rather, the general partner can make investments with a view to total return, including current yield and growth in value.

Through the use of the family limited partnership, family assets or businesses can be institutionalized, giving the more senior family members an opportunity to educate and train younger family members with respect to management theories and investment philosophies, and prepare them to take over the decision-making role in the future.

Tax Reasons

Leverage of Annual Gift Tax Exclusion.

One of the most common devices to reduce a client’s estate is to encourage him or her to make annual per donee exclusion gifts. In that way, $12,000 per year ($24,000 if the donor is married and the spouses agree to make split gifts) can be transferred to each donee of the client. Thus, if a client has four children and eight grandchildren, an estate reduction of up to $288,000 per year can be accomplished. Such gifts escape both gift and estate taxation. Furthermore, any appreciation in the value of the property after the date of the gift also escapes the transfer tax imposed against the transferor. Finally, income produced by the asset after the date of the gift is charged to the donee rather then the donor, thus further reducing the ultimate size of the donor’s estate. Various valuation discounts may be available, depending upon the asset transferred. A minority interest in real estate may qualify for a small minority interest discount, for instance; a gift of an interest in a closely held business may be subject to discount for lack of marketability, and, if the gift is of a minority interest, a minority discount may also be available. If underlying assets are transferred to a family limited partnership before gifts are made, and then limited partnership interests are transferred to the donees, these same discounts apply, whether or not the underlying assets would otherwise qualify for discounts. Therefore, a gift of $20,000 of limited partnership interest may, in fact, include underlying partnership assets worth much more, since valuation discounts of from 25% to 60% (and in some cases even higher) may be available. The accompanying increase in value of the underlying assets after the date of the gift is also increased as is the income generated by those assets, all of which now escapes taxation in the estate of the transferor.

Leverage of Applicable Exclusion Amount.

This same reasoning for discounting annual exclusion gifts applies to the leveraging of the donor’s applicable exclusion amount, except the numbers are correspondingly higher. Assume that the current estate and gift tax laws are in effect, and further assume that the following scenario takes place: if a donor and spouse transfer $4 million to a family limited partnership, retain a 1% general partnership interest and take back the balance in limited partnership interests, they can then make gifts in excess of $1,500,000 each without paying any gift tax by utilizing their lifetime gift tax exclusion of $1,000,000 each, assuming a valuation discount of 35% (65% of $3,000,000 is $1,950,000, one-half of which is within the $1,000,000 gift tax exclusion for each spouse in 2008). Even though such a gift will reduce each of their applicable exclusion amounts of $2,000,000 upon their deaths by the amount of the taxable gift, any appreciation in the value of the gift after it is made completely escapes taxation, as does income generated by the underlying assets. Combined with annual exclusion gifts applying the same discount, the entire limited partnership interest may be able to be alienated by the donors during their lives.

Estate Freezes.

The donor may wish to retain control of, and the income from, the underlying limited partnership assets during his life, while at the same time reducing the size of his estate by transferring discounted partnership interests. This can be accomplished with a properly drafted family limited partnership agreement. The partnership agreement can create two categories of partnership interest: growth interests and “frozen” or preferred interests. The donor can then retain the frozen interests while making gifts of the growth interests. If such a scheme is desired, the family limited partnership agreement must be carefully drafted to take into consideration the valuation rules of §§2701, 2703 and 2704. The specific provisions of these sections and their application is beyond the scope of this article; suffice it to say, however, that in an appropriate situation, the senior family member, using this technique, can retain a stream of income during his life while alienating the entire growth of limited partnership assets, as well as a substantial amount of the present value of the partnership. Over the course of time, such an approach can have a dramatic effect upon the size of the donor’s estate and can substantially reduce the overall transfer tax paid by the senior family member.

Using a family limited partnership in an appropriate situation can achieve many of your clients’ estate planning goals and objectives, both non-tax and tax-related. Using freezing techniques still possible under §2701 further enhances the use of the family limited partnership for reducing the size of a grantor’s estate. Finally, combined with other estate planning vehicles such as minor’s trusts, dynasty trusts and grantor retained annuity trusts, the family limited partnership can substantially enhance estate planning flexibility and reduce the impact of the transfer tax system on the estates of many of your clients who are situated and motivated to take advantage of the benefits provided by the family limited partnership.