Family Limited Partnerships Funded with Personal Use Property

By Crayne, Ryan K. | Journal of Accountancy, April 2001 | Go to article overview

Family Limited Partnerships Funded with Personal Use Property


Crayne, Ryan K., Journal of Accountancy


Historically, CPAs have dissuaded estate planning clients from funding family limited partnerships with personal use property, such as a primary or secondary residence. In the past the IRS has attacked the transfer of such property to a family limited partnership on the grounds that the entity lacked a valid or bona fide business purpose and, as a result, should have been disregarded for federal transfer tax purposes. In a recent case the Tax Court clarified an unsettled area of the law.

On December 28, 1994, Herbert and Ina Knight established a family limited partnership and two children's trusts. The Knights also established a management trust to serve as the partnership's general partner. They transferred certain real property and financial assets to the partnership and placed the bulk of the limited partnership interests in the children's trusts. The IRS agreed the partnership, since its inception, satisfied all of the requirements of Texas law. The real property consisted of a 290-acre cattle ranch and two personal residences the Knights' two children occupied rent free. The fair market value of the real property was $494,201 while the fair market value of the financial assets (municipal bond funds, Treasury notes, insurance policies and cash) was $1,587,122.

The partnership kept no records, prepared no annual reports and had no employees. In fact, the partners never corresponded or met to discuss partnership operations. The partnership never conducted any business and did not prepare annual financial statements or reports. The general partner was not compensated for its management efforts. However, the partnership did file information tax returns for 1995 through 1997, and the management trust and the children's trusts filed fiduciary tax returns for the same period. The real property was used for personal purposes before and after the Knights formed the partnership. At no time did the children sign a lease or pay rent to the partnership on the residences. They paid all utilities while the partnership paid the property taxes and insurance. The annual cost of maintaining the residences was more than 70% of the partnership's total expenses. After transferring the ranch to the partnership, Herbert Knight continued to raise cattle and paid no rent until after litigation began. The partnership's only ranch-related revenue was an oral pasture lease which called for Knight to pay annual rent of $1,500.

The Knights filed a federal gift and generation-skipping transfer tax return for 1994. They reported that each had given a 22.3% interest in the partnership to both children's trusts. The couple maintained that a 44% valuation discount should apply to the gifts as a result of portfolio, minority interest and lack-of-marketability discounts. The IRS said, in part, that the partnership lacked economic substance and should be disregarded for' gift tax purposes, resulting in no valuation discounts.

Result. For the taxpayer. The Tax Court held that under Texas law the partnership should be respected because there was no reason to conclude that a hypothetical buyer or seller would disregard it. The court noted the Knights had burdened the partnership and underlying property with restrictions that were valid and enforceable under state law. …

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