Donald M. Thompson - Wills, Trusts, and Estate Planning


Family Limited Partnership

This is a device which allows gifts to be made at discounted values for gift tax purposes.

A partnership is a consensual association of two or more persons or entities to carry on a business for profit. Each partner is fully liable for the debts of the partnership. In a limited partnership the liabilities of certain partners can be limited. They are called limited partners and their interests in the partnership are called limited partnership interests. They can lose what they invested in the partnership, but are not personally liable for partnership debts. There must be a general partner who is liable fully for all partnership debts. However, this can be a corporation or some other entity in which the owners have limited liability. The general partner controls the partnership and the limited partners do not, although in limited circumstances they can have a vote.

The family limited partnership is merely a limited partnership of family members with a few special features that allow it to be used to reduce gift tax. One of the main special features is that it must be created under the limited partnership statute in a state where the limited partner cannot get out of the partnership and get his or her or its share of the partnership assets. Transferability of the interests is also restricted by the partnership agreement.

One of the ways to reduce estate and gift taxes is to make lifetime gifts. All the appreciation in the assets given away after the time of the gift escapes estate tax. This is because it will not be in the estate of the donor on his or her death. The gift tax is also effectively at a lower rate than the estate tax because the amount of the tax is not included in the gift. For instance, if you die with $1,000,000 and there is a 50% estate tax, your estate pays a $500,000 tax. If during life you gave away everything, except enough to pay the gift tax at 50%, you could give $666,667 and pay a tax of $333,333, in effect a 33-1/3% tax.

Now suppose you have $1,000,000 worth of publicly traded stock. You put it in a family limited partnership and make gifts of limited partnership interests to your children. The interests entitle the children to 2/3's of the partnership distributions. You keep the general partnership interest and control the partnership. You can determine whether or not you receive a salary (which must be reasonable for what you do). You also determine whether or not and how much distributions will be. What is the value of the taxable gift you gave your children? $666,667? No. Since the children as limited partners do not have control of the partnership their interests are worth less than yours (per dollar of distribution entitlement). Furthermore, they cannot easily sell their interests so their interests are worth less. Their interests are subject to minority interest and lack of marketability discounts. Perhaps as much as 40% at the high end. As a result at a 40% discount the children's interest in $666,667 of partnership assets gets valued at $400,000. The $400,000 is what the tax is paid on, not the $666, 667. (When this works a lower discount is usually allowed - this example is towards the upper end of the discounts that have been allowed.)

When a family limited partnership is created with cash for the purposes of discounted giving it looks like magic. $666,667 becomes $400,000. Because of this IRS is challenging family limited partnerships whenever it can. The court cases show that the exact details of how the partnership is set up can be crucial. This means at a minimum that the general partner's fiduciary duties, imposed by law in absence of any agreement to the contrary, cannot be negated by the partnership agreement. For example the general partner cannot have absolute discretion over whether or not to make distributions and over their amounts. Also the restrictions on transfer of the limited partnership interests cannot be absolute. The partnership or the other partners can have a right of first refusal (i.e., the partner who wishes to sell must offer it to the partnership or other partners at the price the third party buyer has agreed to pay before the third party can make the purchase). If the transfer takes place the transferee can be denied partner status, but must be allowed to receive all distributions that would otherwise be made with respect to the transferred partnership interest.

The same discounted giving effects can be obtained without using a limited partnership if you have a corporation conducting an active business. You can create non-voting stock and make discounted gifts of that stock to your children. If the corporation is a regular C corporation (as opposed to an S corporation which does not pay tax) you can create all sorts of restrictions on the stock. This device does not draw challenges from the IRS.

The IRS has successfully challenged some of the family limited partnership transactions under Internal Revenue Code Section 2036 which provides that a decedent's taxable estate includes property the decedent transferred to the extent the decedent retained control of the property for life. IRS maintained that a decedent who creates a family limited partnership has retained control of the assets transferred to the partnership and those assets are in the decedent's estate at their full value.

Section 2036 contains an exception for transfers made as a bona fide sale for an adequate and full consideration in money or money's worth. Is the transfer of property to a family limited partnership in return for partnership interests (before some of the interests are given away to family members) a transfer for full consideration? So far courts have differed on this point.

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Donald M. Thompson * 55 W. Monroe #3950; Chicago, IL 60603
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