Preserving Family Wealth: Family Limited Partnerships
and LLCs Are (Still) Valuable Estate Planning Tools
By William C. Hussey II
Family limited partnerships (FLPs) and family limited liability companies (FLLCs) have long been recognized for their ability to preserve and enhance family wealth, while at the same time resulting in significant estate and gift tax savings. The IRS, however, has recently won several cases that successfully challenged the establishment and operation of certain FLPs and FLLCs. As a result, the taxpayers’ had to include in their estates for death tax purposes the current fair market value of the assets they had previously transferred to the FLPs and FLLCs, rather than the discounted value of the FLP or FLCC ownership interests.
Not withstanding the IRS’ recent success in these cases, properly established FLPs and FLLCs remain a valuable financial and estate planning tool for many families. FLPs and FLLCs are similar to other business entities and exist under the same legal rubric as limited partnerships and limited liability companies formed by unrelated parties. In the case of an FLP, a second corporation or LLC may also be formed to act as the general partner (who has unlimited liability for the partnership’s obligations under state law). Typically, parents will contribute the majority of the initial assets, including cash, marketable securities, privately held business interests, real estate and other investments, to establish the entity in exchange for a majority of the interests in the FLP (primarily limited partnership interests) or FLLC. Younger family members, including children and grandchildren, will generally contribute fewer assets, or services, in exchange for a pro rata minority interest in the entity.
The day-to-day operations and management of an FLP are the responsibility of its general partner (or its designee), and in an FLLC, by a designated manager. Parenthetically, the general partner or manager should generally be one of the children (or a third party) rather than a parent in order to avoid the potential Section 2036 control issues discussed below. The limited partners of an FLP and members of an FLLC have no management responsibility but may retain voting rights with respect to certain issues, such as removal and appointment of successor general partners or managers, and changes in business purpose or liquidation of the entity.
Interests in an FLP or FLLC may be gifted or otherwise transferred during the owner’s lifetime subject to any restrictions contained in the entity’s governing documents. Any interests that are retained at death will be includable in the decedent’s estate for death tax purposes. One of the ancillary benefits of the formation of an FLP or FLLC is that the interests in such entity that may be transferred as a gift to another family member, or which are still held at death, may be worth less for transfer tax purposes than the corresponding value of a pro rata portion of the entity’s underlying assets. The fair market value of interests in the FLP or FLLC must generally be used for transfer tax purposes—i.e., the price at which the interest would be sold between a willing buyer and a willing seller. However, the fair market value of the FLP or FLLC interest may be less than the pro rata fair market value of the entity’s underlying assets due to the application of certain discounts which are generally applicable to determining the fair market value of all business entities. The most common discounts applied to determine the value of an FLP or FLLC interest are discounts for lack of marketability and a minority interest discount. The combined effect of these two factors can result in the value of an interest being 20 – 50% less than the pro rata value of the entity’s underlying assets. By way of example, assume that Mary and her three children form an FLLC by contributing assets with an aggregate fair market value of $1,600,000. If Mary later makes a gift of a one percent membership interest to each child as part of an annual gifting program, the pro rata portion of the FLP’s underlying assets attributable to each of the 1% membership interests is $16,000. However, if a qualified appraiser determines that a combined 35% discount for minority and lack of marketability should apply to the interest, the gift tax value of each 1% interest will be only $10,400 ($16,000 x 0.65). This amount is less than the annual gift tax exclusion amount of $11,000 per donee, and therefore the transfers may not be subject to transfer tax at all.
Due to the discounts commonly reflected in the transfer tax values of FLP and FLLC interests, the IRS had unsuccessfully attempted for many years to have the full fair market value of the entity’s underlying assets be used for gift and estate tax purposes. Recently, however, a number of court decisions have upheld the IRS’ position that the entire value of the assets initially transferred by a decedent should be included in his or her estate for death tax purposes under Section 2036(a) of the Code. Section 2036(a) generally includes the value of any assets transferred during lifetime in the decedent’s estate if the decedent retained for his life either (1) the possession or enjoyment, or the right to income from, the property transferred, or (2) the right, either alone or in conjunction with any person, to designate the person or persons who shall possess or enjoy the property so transferred, or the income therefrom. In other words, both subsections look at whether the transferor actually departed with dominion and control of the assets when the assets were transferred to the FLP or FLLC. If either 2036(a)(1) or (2) applies to a transferred asset, then the full fair market value of the asset as of the decedent’s date of death, rather than the value of the FLP or FLLC interest, is included in his or her estate for death tax purposes. As a perquisite, Section 2036(a) specifically does not apply to any assets transferred by a decedent in a bona fide sale for adequate and full consideration in money or money’s worth, including bona fide transfers to an FLP or FLLC for an interest therein.
On the other hand, a smaller number of recent cases have held in favor of the taxpayers establishing an FLP or FLLC, finding that the bona fide sale exception under Section 2036(a) was applicable to the formation of the FLP or FLLC. These protaxpayer cases, together with the cases holding in favor of the IRS, provide a revised roadmap for the successful formation and maintenance of an FLP or FLLC if the taxpayer is to realize the ancillary benefit of using the discounted value of an FLP or FLLC interest for transfer tax purposes. To qualify as a bona fide sale, the Courts now look at whether a taxpayer has a valid business purpose (other than tax benefits) for forming the FLP or FLLC. A valid business purpose may include (a) creating, preserving, and increasing family wealth, (b) lowering administrative costs and providing for coordinated, active management of family assets, (c) providing a mechanism for continuity of management, including active involvement of younger family members, (d) legal protection from creditors, (e) keeping wealth in the family by restricting non-family members’ rights to acquire interests, including provisions for retaining interests in the event of a divorce, (f) providing a mechanism for facilitating gifts to family members without fractionalizing individual assets, or (g) promoting family harmony and including formal dispute resolution provisions in the event of a disagreement.
In addition, careful reading in both the pro-taxpayer and pro-government cases shows that the following business practices should be observed when establishing and maintaining an FLP or FLLC:
i. All of the legal formalities in forming the FLP or FLLC
under state law must be observed.
ii. All of the family members should also participate
in the formation process, including the right to retain
separate counsel and to comment on the formal
governing documents.
iii. Each family member should transfer assets (or valuable
services) to the entity in exchange for a pro rata interest
therein, and such contributions should be credited to
each partner’s or member’s capital account at full fair
market value in accordance with regular partnership
accounting rules.
iv. Family members should not transfer too many assets
such that they would then own insufficient assets outside
the FLP or FLLC to independently provide for their
support.
v. Personal and partnership assets must not be commingled
—i.e., separate banking and brokerage accounts must be
maintained at all times. In particular, it is not advisable for
a principal residence to be transferred to the FLP or
FLLC.
vi. Gifts and other transfers of interests (other than a sale
for full and adequate consideration) should not occur
contemporaneously with the formation of the entity.
vii. Distributions from the FLP or FLLC should be made on
a pro rata basis to all of the partners or members, and
all decisions regarding whether or not to make a distribution
should be properly documented, including the
reasons for such decision.
In summary, an FLP or FLLC that is formed for a valid (non-tax) business purpose and maintained in accordance with the appropriate legal formalities can both increase family wealth and may also minimize transfer taxes. Ignoring these formalities, on the other hand, will leave the FLP or FLLC open to attack by the IRS, and the family will fail to fully realize all the intended benefits of forming, maintaining and participating in an active family business entity.
Bill Hussey is an associate in the Business Department and focuses on taxation issues.
He can be reached at 215-864-6257 or husseyw@whiteandwilliams.com.
If you would like to discuss whether an FLP or FLLC is appropriate for your family, or have any other estate planning questions, please contact Bill or Steve Zivitz (215-864-6240, zivitzs@whiteandwilliams.com).
