Family Limited Partnerships

A powerful but dangerous tool

With family limited partnerships we have arguably the most powerful tool in the estate planning arsenal.

Certainly the most dangerous! It is always used in conjunction with other tools, and must be implemented and operated very precisely to avoid the IRS scrutiny.

Its power comes partly from the wide range of benefits that can arise.

• Effectively shield assets from potential claims.

  But Charging Orders and Foreclosures are tools that creditors use to try to get around the protective shield. One point from our research really stands out - A Family Limited Partnership interest should not be held directly by an individual. The interest should be owned by a trust.

• Shift income taxes to lower bracket family members or corporations or trusts.

  A FLP is a partnership that comprises at least one general partner [who remains liable for partnership obligations], and one or more limited partners whose liability is limited. The general partner decides how to allocate income. A partnership is not taxed as such - the partners are taxed on the portion of income allocated to them. So the general partner allocates to lower-bracket limited partners.

• Minimize estate taxation on accumulated wealth and future growth by gifting discounted interests to children or trust established for them.

  It is well established that a minority interest in a partnership or corporation is worth less than its pro rata portion of the overall value. For example, if a partnership is worth $1 million, the pro rata value of a 10% interest would be $100,000.

  However, because that 10% interest lacks the ability to control the affairs of the partnership, and is generally not very marketable, it is usual to reflect the lack of control and marketability by discounting - sometimes in the vicinity of 30-40%. Thus, the value in our little example of a 10% interest might discounted by $30-40,000 and thus be worth $60-70,000.

  Obviously, expert business valuation will be necessary to establish the discounted value to be acceptable to the IRS and that value will need to be kept up to date during an ongoing gifting program.

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We aren't going to even begin to detail all the points and problems you might encounter with family limited partnerships, but here a few things that might come up in discussion with your advisors...

• Form the partnership earlier rather than later, hopefully when in good health, document its purposes
• EStablish it correctly under your state's laws and operate it in a businesslike manner - file returns and reports on time, have a taxpayer ID and separate books and records, hold required annual meetings with proper reports and disclosures to the partners;
• Probably only business - not personal - assets will be transferred in;
• Probably not all assets will go in - likely retain enough to enable living without relying on partnership distributions; distribute income according to partnership interest rather than to meet living needs of general partner;
• Possible that investor will not even be general partner - the less that investor appears to control, the stronger the family limited partnership.

On balance, a very powerful tool, but one that needs a lot of advice to plan and operate carefully.

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