As a lawyer who believes in the benefits of family businesses, I also believe in the benefits of collective investment of family wealth in a family limited partnership ("FLP") or similar business entity. Sometimes, however, there is a temptation to use an FLP solely for purposes of reducing federal transfer taxes (i.e., gift taxes, estate taxes, and generation-skipping transfer taxes). If you are thinking of using an FLP to take advantage of transfer tax exemptions that may be eliminated after 2020, be sure also to give the FLP a legitimate business purpose that serves other family objectives.
What is an FLP?
A limited partnership is a business entity that has two classes of ownership: general partners and limited partners. General partners have the right to manage the entity, and limited partners have no management rights. If you wanted to start a business but you needed investors to help you fund it, you could set it up as a limited partnership, with yourself as the general partner and the investors as limited partners.
An FLP is simply a limited partnership that is owned solely (or predominantly) by family members. Often, an FLP is funded with real estate or a marketable securities portfolio that is contributed by a senior family member, who serves as the general partner. The senior family member then transfers limited partnership interests to his or her children and grandchildren (or trusts for them), so they can enjoy the economic benefits of the FLP while the senior family member continues to manage it.
An FLP can provide a convenient way for family members to own investments together. If the senior family member ceases to serve as the general partner, he or she can be replaced by other family members and the FLP can continue. While the FLP operates, the limited partners enjoy income from its assets, and a portion of the appreciation of the value of the FLP's assets accrues to the limited partners. Also, holding an interest in an investment as a limited partner provides protection against claims of creditors and sometimes makes it easier to prevent the investment from being transferred to a spouse in a divorce.
Why is an FLP used for transfer tax planning?
As described above, a limited partnership interest in an FLP does not permit its owner to participate in management. For that reason, a limited partnership interest is valued at a discount for transfer tax purposes. The discounted value often is 25-35% less than the pro rata liquidation value of the FLP.
For example, if an FLP holds real estate that has a fair market value of $1 million, then a 10% general partnership interest might be deemed to have a value of $100,000 (i.e., 10% of $1 million), but a 10% limited partnership interest might be deemed to have a value of only $70,000 (i.e., 10% of $1 million, discounted by 30%). Under such circumstances, a gift of a 10% limited partnership interest in the FLP would use only $70,000 (rather than $100,000) of the donor's gift tax exemption, and thus would allow the donor to gift more of the asset without incurring gift taxes.
Such FLP gifts, of course, would reduce the amount remaining in the donor's taxable estate at death, which would otherwise be taxed at a rate of 40% under current law. If transfer tax savings, however, is the only reason why the donor established the FLP, then the IRS might view the transaction as a sham and impose much higher estate taxes on the donor's estate by treating the FLP assets as if the donor still owned them at the time of his or her death.
Consider a recent tax court case, Estate of Moore(April 7, 2020). This case involved a self-made farming millionaire, Howard Moore. In his late eighties, Moore began to consider selling Moore Farms to his neighbors. Before negotiations concluded, however, Moore fell ill and was diagnosed as terminal.
In his weakened state, Moore contacted an attorney and asked him to create an estate plan that would allow Moore to maintain control of his assets during his life while minimizing estate taxes at his death. The “keystone” of the estate plan, as the Tax Court described it, was the Moore Family Partnership, an FLP.
Moore contributed 80% of Moore Farms to the FLP, then sold the limited partnership interests to a trust for his children, at a discounted price of $5.3 million. The children did not negotiate the price, and the trust did not actually pay most of the purchase price to Moore. Five days after Moore set up the FLP, the neighbors bought Moore Farms. The terms of the sale of Moore Farms provided that Moore would be permitted to continue to reside on and control Moore Farms until his death.
After Moore's death, the IRS asserted that the FLP transaction between Moore and the trust for his children was not a bona fide transaction and thus should be ignored for estate tax purposes. The Tax Court agreed because the FLP seemed to have no credible purpose other than to create a valuation discount for transfer tax purposes.
In particular, the Tax Court noted the following: The FLP was not created as a means to manage Moore Farms because Moore Farms was sold right after the FLP was established; the FLP did not function as a mechanism to protect the family wealth against creditors because the family did not have existing or likely creditors; the FLP did not pay full and adequate consideration for its interest in Moore Farms; and after the FLP bought its interest in Moore Farms, Moore retained possession and enjoyment of the property.
For these reasons, the Tax Court held that the FLP assets should be included in Moore's estate and valued without a discount for purposes of calculating Moore's federal estate tax liability.
Are FLPs still viable for 2020?
If you have an asset, such as real estate or a marketable securities portfolio, that you would like your children and grandchildren to own and manage together, an FLP has many advantages, including transfer tax valuation discounts. If you are reading this on or about 11/30/2020, you may still have time (just barely) to transfer assets to a new FLP and then gift or sell limited partnership interests to your children and grandchildren. If you do so, however, make sure that you establish and respect the business purposes of the FLP and make a plan to relinquish all control and ownership of the FLP before you die. Otherwise, you may eventually lose the transfer tax benefits that you thought you had secured before the end of 2020.