Family Limited
Partnerships
A Family Limited Partnership (FLP) has been a popular business entity
for wealth management, tax  minimization and wealth transfer
maximization. Under the right circumstances, FLPs traditionally helped
taxpayers remain in control of their wealth even after transferring it
to their loved ones. Additionally, many of these transfers were made at
a significant discount, thereby further leveraging wealth transfer tax
savings. Not surprisingly, while FLPs have been employed as a planning
panacea by taxpayers, FLPs have received the evil eye from the IRS and
some courts with increasing frequency.
Background
Simply put, an FLP is a Limited Partnership among family members. The
FLP is often created by the wealth-owning generation, typically the
parents. The FLP creators are initially both the General Partners (GPs)
and the Limited Partners (LPs) at the time they contribute assets to the
FLP. The lion's share of the contributed assets is thereafter assigned
to the LP shares. Even so, the GPs hold all of the management control
over the FLP assets.
When the FLP assets generate income, the GPs are entitled to
compensation for their management services. LPs enjoy an ownership
interest only. They have limited authority and there are restrictions on
the transferability of their LP interests. This lack of control (minority
interest) and inability to
transfer the LP interests freely (lack of marketability) reduces
or discounts the value of the FLP assets. In turn, this
discounting enables the parents to transfer more wealth (and the future
appreciation of that wealth) via their LP interests to younger family
members, yet retain lifetime control over that wealth.
Other benefits include income splitting and asset protection, since FLP
income may be spread among multiple family members and creditors of the
LPs may be limited in their attempts to reach the underlying FLP assets.
IRS
& Judicial Attacks
Given
the powerful tax and wealth transfer benefits available through FLPs, it
is easy to see why the IRS and some courts do not like them. First and
foremost, an FLP must be created for a business purpose…not just for
estate planning. For example, a valid business purpose may be to
maintain family ownership and control of assets while they are
transferred between generations free from the claims of third-party
creditors and probate. Any
planning with an FLP must begin with a solid business purpose in
substance as well as in form.
Like most legal arrangements that offer both tax minimization and wealth
transfer maximization, FLPs are subject to an unwritten rule of law: pigs
live and hogs get slaughtered. Some examples of hoggish behavior
with FLPs include taxpayers who establish deathbed FLPs and/or taxpayers
who transfer substantially all of their personal assets and means of
financial support to their FLPs (i.e. leaving themselves no other source
for income and sustenance). Result: If an FLP is found to be hoggish,
then the entire value of the underlying FLP assets may be included in
the estate of the FLP creator by the IRS and some courts.
As you might imagine, in addition to the FLP's business purpose, the
IRS has traditionally scrutinized the valuation discounts claimed
by the taxpayer for the LP interests. Once these gifts are made, the
taxpayer must ensure that any discounts attributed to the gifts are
substantiated in writing by an appropriate valuation expert and that
these discounts are reported on a timely gift tax return. Expert
professional valuation assistance is critical to successful FLP
planning, implementation and maintenance. It is money well spent.
Practical
Considerations
FLPs are not for everyone. Between legal fees, valuation fees, required
state filings and reports, and tax returns (for the FLP, the GPs and the
LPs), FLPs may require a substantial commitment in time and resources.
Also, given the increasing IRS/judicial scrutiny, even the
once-favorable tax treatment of FLPs is in a state of flux.
Summary
This has been a brief, general overview of an extremely complex topic.
Accordingly, you must carefully weigh the costs versus the benefits of
FLP planning before proceeding, especially in light of the practical
considerations. Note: If you have created an FLP and/or are a GP or LP
of one, then you should consult with qualified legal counsel for a
thorough review of the arrangement.
Asset
Protection Strategies
Statistically and anecdotally, we all know that the number of divorces,
lawsuits and bankruptcies is  staggering. While no one believes lightning
will strike them, wealth created through a lifetime of work, saving and
investing can be lost overnight if these forms of man-made lightning do
strike. To protect your assets from such disasters, proper risk
management strategies should be given careful consideration. These
strategies include exempting your
assets from the claims of
creditors, limiting
your liability through legal entities, and transferring
your risk through insurance.
Exempting
Assets
State and federal laws may exempt some of your assets from the claims of
creditors. Depending on your state of domicile (i.e. your legal
residence), the equity in your primary personal residence may be
protected from creditors. Protection also may extend to your retirement
funds and even the cash value of your life insurance.
Once you have identified the protected asset classes available to you
under applicable law, it may be prudent to maximize your protection by
converting non-exempt assets into exempt assets. For example, if the
equity in your home is exempt from the claims of creditors under the
laws of your domicile, then using non-exempt resources to pay off your
mortgage may be a smart move.
Limiting
Liability
Many entrepreneurs operate their businesses
as sole proprietors rather than through a legal entity, such as through
a Corporation or a Limited Liability Company.
These
business owners are attracted by the informality of sole proprietorship.
They also do not want to incur legal fees to create and maintain a legal
entity. However, in addition to other advantages, conducting business
through a legal entity may offer substantial risk management benefits.
While lawsuits brought against a sole proprietorship are really lawsuits
against the owner's personal assets, lawsuits against a properly
created and maintained legal entity are really lawsuits against the
entity's assets. Nevertheless, the selection of an appropriate legal
entity is critical for managing your risk. For example, the personal
assets of a General Partner in any Partnership are subject to the claims
of the Partnership's creditors. For this reason many parents form a
legal entity to serve as the General Partner for their Family Limited
Partnership. Doing so may protect their personal assets from the
creditors of the Partnership.
Transferring
Risk
When was the last time you reviewed the details
of your liability insurance program with your insurance professionals?
Are your policies current? Are the coverage limits adequate and are the
deductibles reasonable? Have you scrutinized the polices for loopholes?
Remember: the fundamental philosophy of any insurance coverage is to pay
a premium you can afford to transfer a risk you cannot afford. Take time
to understand both the risks you have retained and the risks you have
transferred.
Closing
Thoughts
Managing your risk, like avoiding lightning, requires that you make
proper plans in advance of the storm. When a divorce, lawsuit or
bankruptcy strikes it is too late to exempt assets, limit liability or
transfer risk. Competent legal counsel should be sought to evaluate your
risk management options.
Copyright © 2005 Integrity Marketing Solutions. All rights
reserved. Some artwork provided under license agreement. This
publication does not constitute legal, accounting or other professional
advice. Although it is intended to be accurate, neither the publisher
nor any other party assumes liability for loss or damage due to reliance
on this material.
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