Is a family limited partnership the right structure for you? BY JENNIFER PELLET
Billed as one of the most effective asset protection tools in a financial planner's arsenal, family limited partnerships (FLPs) have been touted as a way to safeguard assets while cutting income and estate taxes. But recent IRS challenges suggest they can also be very risky.
So which is it? Ultimately, whether an FLP proves an effective wealth transfer method or a dangerous IRS magnet depends on its structure and operation. As a limited partnership established among family members, an FLP lets a donor place assets into a partnership and gift noncontrolling interests to family members. Because an FLP typically places substantial restrictions on the sale or transfer of these interests-known as partnership units or shares-their value is discounted by between 20 and 50 percent for tax purposes.
"In the case of a family ranch, for example, the senior generation could place that real estate in an FLP in which partners waive the right to transfer interest outside the family, cede day-to-day control to the general partners, and are bound to arbitration in the ease of conflict," explains Lee Garsson, a senior vice president at Bank of America. "Those burdens imposed by the FLP-the fact that the partnership interest is not as marketable as its underlying asset-account for the valuation discount. The standard of valuation is then not what a hypothetical buyer would pay for the underlying assets on the open market, but what lie would pay for the partnership units knowing all the restrictions and limitations set forth in the agreement."
Reasonable in theory, valuation discounts sparked IRS scrutiny-and for good reason. Many FLPs of the last decade were thinly veiled estate tax evasion efforts, claiming unwarranted discount valuations of as much as 90 percent. "The IRS has attacked FLPs both for a lack of business purpose and for the amount of discount taken," reports Julie Krieger, a financial principal at private wealth management firm Lowry Hill. "It also successfully attacked FLPs where the family didn't administer the FLP in accordance with the agreement or when there were deathbed transfers into an FLP."
In short, the IRS takes a dim view of partnerships solely as a means to minimize estate taxes. …