The Family Limited Partnership: Are the Rumors of Its Death Greatly Exaggerated?

By: Vance E. Antonacci

Most estate planning practitioners agree that the family limited partnership (FLP) is an advantageous estate planning tool.

In addition to the income, estate and gift tax benefits it offers, the FLP provides several non-tax benefits. For example, the FLP offers a family a way to consolidate the management of assets and provides creditor protection. The A FLP also avoids ancillary probate for out-of-state assets funding the FLP and provides an efficient mechanism by which senior family members can sell or gift property to junior family members.

The IRS, however, takes a dim view of FLPs and has successfully litigated several cases challenging the tax benefits claimed by taxpayers forming FLPs. Recently, Congress and the Treasury Department proposed ways to curb the perceived abuses of FLPs.

To properly advise clients, practitioners must do their best to keep abreast of case law development that interpret existing law and the legislative and regulatory proposals that may amend the existing rules of engagement. This article summarizes recent legislative and regulatory proposals and provides an assessment of whether the FLP is a viable planning option.

THE CERTAIN ESTATE TAX RELIEF ACT OF 2009

The Certain Estate Tax Relief Act of 2009, H.R. 436, was introduced in the House of Representatives by Rep. Earl Pomeroy, D-ND. The act proposes to limit claims by taxpayers of valuation discounts for lack of marketability and lack of control.

The application of the proposed legislation to a FLP is dependent upon a finding that the interest being transferred is not actively traded as that tenn is defined in Section 1092 of the code. Few if any FLPs will satisfy the active trading requirement.

Pomeroy's legislation addresses lack of control discounts head-on - a valuation discount based on lack of control or minority ownership is not pennitted if the transferee of the interest and the transferee's family members control the entity. The definition of the tenn "family" is as broad as possible under the code, and it includes the transferor's spouse and ancestors, the transferor's lineal descendants, the lineal descendants of the transferor's parents, and the spouses of any of the foregoing.

Therefore, this piece of the proposed legislation eliminates the lack of control valuation discount for any FLP unless the family is willing to grant a third party control over the FLP, which is unlikely.

The proposed legislation addresses lack of marketability discounts less directly, but nonetheless effectively. A valuation discount is not pennitted for the transfer of any interest to the extent the interest represents ownership of non-business assets. The tenn non-business asset is defined, generically, as any asset that is not used in the active conduct of one or more trades or businesses. Passive assets (with limited exceptions) such as cash and cash equivalents, debt instruments, and stocks (including interests in REITs and mutual funds) are non-business assets. Real estate is treated as a passive asset unless the real estate is used in a real property trade or business and the transferor is a material participant in such real property trade or business. Representative Pomeroy's proposed legislation, therefore, effectively eliminates lack of marketability discounts for the FLP.

TREASURY DEPARTMENT 2009 GREEN BOOK

On May 11, 2009, the Treasury Department released its "Green Book," which contains the executive branch's revenue proposals for the federal government's fiscal year of Oct. 1, 2009, to Sept. 30, 2010.

The Green Book contains myriad proposals. The second to last (but certainly not least) of the proposals in the Green Book is to amend Section 2704(b) of the code. The proposal creates a new category of "disregarded restrictions" that would be ignored for purposes of valuing transfers of interests in family-controlled entities for gift tax and estate tax purposes. A disregarded restriction is a restriction that will lapse or may be removed by the transferor and/or the transferor's family.

The proposal is short on details but long on impact. Disregarded restrictions would include limitations on an interest holder's right to liquidate that holder's interest that are more restrictive than a standard "defined in the regulations" (as opposed to a standard established by state law). In addition, a disregarded restriction would include any restriction on an interest holder from becoming a full partner or a holder of any equity interest in the entity. The proposal also provides that regulations would be adopted to establish safe harbors to avoid the application of Section 2704(b).

RULES OF THE ROAD FOR THE FLP

We are all familiar with the successful IRS challenges to FLPs in gift tax and estate tax cases. The theories presented by the IRS to "collapse" the FLP are many - Section 2036, gift on fonnation and economic substance, to name a few. Of course, even if the IRS cannot successfully challenge the FLP as an entity, the IRS may still attack the valuation discounts claimed by the taxpayer.

No matter what theory is pressed by the IRS, the bottom line is that under current law a properly established and administered FLP should withstand a challenge by the IRS as to the validity of the entity. In addition, a reasonable valuation discount should be respected. The IRS is successful when the taxpayer (or the taxpayer's advisers) is sloppy, greedy or unrealistic.

Examples of "bad facts" from cases in which the IRS successfully challenged a FLP include the following:

• A transfer of all or substantially all of the taxpayer's assets to the FLP; 
• The transferor is in poor health or terminally ill; 
• Commingling of personal assets of the transferor with assets of the FLP (e.g., no separate bank account for the FLP);
• Implied agreement that the transferor will retain the entire economic benefit of the assets transferred to the FLP (e.g., paying the transferor's personal bills and expenses directly from the FLP); 
• Failure to maintain separate books and records for the FLP;
• Disproportionate distributions to partners;
• Use of real estate without paying rent (or paying rent that is below market value);
• Failure to obtain a professional appraisal to value assets funding the FLP (such as real estate) and to value the FLP interests; 
• Contribution of a personal residence to the FLP; and 
• Unsecured or below-market interest rate loans from the FLP to the partners (or loans made when the FLP Agreement does not permit partner loans).

The IRS victories and the FLP cases that make the news involve FLPs that never should have been fonned in the first place or that are so poorly managed that there is no reasonable basis to believe the FLP will withstand an IRS challenge.

SUMMARY AND OUTLOOK

The IRS - and to a lesser degree Congress and the executive branch - dislike FLPs. Despite this animus, FLPs, if properly organized and administered, continue to be a valuable planning tool even with the legislation threatened in the Green Book and Pomeroy's bill. As outlined above, a FLP offers many non-tax benefits, including consolidation of the management of assets, creditor protection, and avoiding ancillary probate. Arguably, the tax benefits of a FLP are secondary to the non-tax benefits.

The legislation proposed by Pomeroy and the Green Book are of concern. However, estate planning professionals face a constant threat of proposed legislation intended to limit one planning technique or another.

Presumably, Congress will address the uncertainty of the federal estate tax law. The Pomeroy bill is one of severallegislative proposals introduced in Congress the purpose of which is to address the "death" of the federal estate tax in 2010 and its "resurrection" in 2011.

This author's belief is that any legislation passed will be limited to maintaining the applicable exclusion amount at $3.5 million with a possible sweetener such as the portability of the applicable exclusion amount between spouses. Congress will have enough trouble addressing the estate tax without tackling the additional challenge of legislation addressing the perceived abuses of FLPs.

Pomeroy's legislation is the only legislative proposal that includes amendments to the code aimed at FLPs. Any legislation aimed at FLPs likely will meet resistance from the business community and other interested parties. Furthermore, Pomeroy is the most junior of the legislators proposing legislation to address the estate tax laws and, unlike some other bills, his has no cosponsors. There are no legislative proposals implementing the proposed changes to Section 2704(b) laid out in the Green Book.

FLPs continue to be a viable planning option for clients if established for the right reasons and properly administered. A client interested in a FLP would be wise to implement the FLP soon, though, to hedge against the potential for legislative change.