To:                  Our Clients and Friends

From:              Jane L. Brody, Esq. and Denise Walsh, Esq.

Date:               November 2005

Re:                   Family Limited Partnerships and Family Limited Liability Companies

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 For years, family limited partnerships (“FLPs”) and family limited liability companies (“FLLCs”) have been a  useful tool for one generation to shift certain assets at a reduced tax cost to their descendants while still maintaining control over the assets transferred . 

Traditionally, someone sets up an FLP/FLLC in which he/she is the general partner/manager.  As the general partner/manager, the person retains limited control of the assets transferred to the FLP/FLLC.  The person then makes gifts of limited partnership interests/membership interests to family members. 

Gifts of limited partnership/limited liability company interests have historically benefited from valuation discounts reflecting the fact that such interests cannot be readily sold (a discount for lack of marketability) and reflecting the inability of the limited partnership/limited liability company member to control the limited partnership/limited liability company (the minority discount).  These combined discounts can reduce the value of a gift by 30% or more.  In a recent case, the United States Tax Court approved a combined discount of 35%.  Consequently, for example, an asset worth $500,000 could have a value for gift tax purposes, taking into account a combined discount of 30%, of $350,000. 

The Internal Revenue Service (“IRS”)  has been challenging these family entities and has won a number of recent cases.  The recent court cases suggest that if a person transfers assets to a FLP/FLLC and thereafter retains (i) possession and enjoyment of the assets they contributed to the family entity, and/or (ii) the right to all of the income from the contributed assets, and/or (iii) the right to designate who will possess or enjoy the contributed assets or the income from the assets, it is as if the transfer never occurred and the assets are treated as still being owned by the  person for estate tax purposes.  Therefore, all the tax benefits outlined above are lost.

What can be done today in order to successfully enjoy the tax benefits of the traditional FLP/FLLC? 

Despite the recent court cases, FLPs and FLLCs are still viable estate planning techniques provided a person is willing to give up unfettered control and the income from the assets transferred to the family entity in accordance with the guidelines set forth below. 

First, the FLP/FLLC must be properly established under applicable state law.  A separate bank account should be established for the entity and all formalities for the entity for Federal, state and local law purposes should be maintained (such as the filing of tax returns).  These steps support the legitimacy of the FLP/FLLC as a legal entity. 

Each contributing party should be in relatively good health with a reasonable life expectancy when the FLP/FLLC is established.  In addition, the partnership/operating agreement for the FLP/FLLC should identify several legitimate non-tax reasons for establishing the entity.  For example, planning for business succession and maintaining familial ownership of long-held assets are two common, legitimate, non-tax rationales for setting up family entities. 

Further, all contributed assets must be re-titled in the name of the FLP/FLLC.  In transferring assets to the FLP/FLLC, one must be careful to maintain sufficient financial resources to live on outside of the FLP/FLLC.  Once transferred, the contributing party may not use the assets of the FLP/FLLC to cover personal needs.  In addition, one should not contribute personal assets to the FLP/FLLC (i.e., one’s personal residence, car or furniture).  Rather, one should contribute assets that can be held for business or investment purposes.

Due to the recent court cases,  the general partner/manager no longer can have unfettered management control over the family entity.  Instead, the general partner/manager must be subject to fiduciary duties under applicable state law and should share management powers with others (either the next generation or an independent third party), especially with regard to key issues, such as when to liquidate, when to borrow money other than in the ordinary course of business and when to issue additional limited partnership/limited liability company interests.  In particular, the general partners/managers should not have the sole discretion to veto the sale of limited partnership/limited liability company interests by non-managing family members.  Rather, a right of first refusal held by the other partners/members and/or the entity itself provides some means of controlling who receives partnership/membership interests, while also providing the partner/members with a present interest in the family entity. 

The general partners/managers should distribute cash from the FLP/FLLC in proportion to ownership interests and should avoid loans from the entity to themselves.  Further, the general partners/managers should make meaningful annual distributions to the partners/members, or at the very least provide the partners/members with the option to receive annual distributions.

Finally, if possible, arrange to have other family members or even non-family members contribute assets to the FLP/FLLC when it is formed (this is the hardest, and least likely to occur of the above steps, and while desirable, should not cause the FLP/FLLC to fail if it cannot be accomplished). 

While recent court cases have complicated the use of family limited partnerships and family limited liability companies as estate planning techniques, these techniques are still viable.  In fact, an October 2005 United States Tax Court Case suggests that the IRS may be retreating slightly.  In that case, the IRS conceded all of its arguments regarding the tax benefits of a family limited partnership, except as to the amount of the combined discounts on valuation of the deceased’s partnership interest.  The Tax Court held a combined discount of 35% was appropriate under the circumstances. 

If you have any further questions about this subject, please feel free to contact us.