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Written by Bradford B. Gornto, Esq.

Gornto Law, PLLC
310 Wilmette Ave., Suite 5
Ormond Beach, Florida 32174
Telephone (386) 257-2554

     A limited partnership is an excellent entity for the administration and management of family enterprises and investments since it can be designed or structured to fit family objectives regarding property and investment management and profit-and-loss sharing.  Further, in addition to other significant benefits which are discussed herein, a limited partnership can facilitate the transfer of family wealth from older family members (parents) to younger family members (children) at significantly reduced gift and/or estate tax costs. 


Overview of Family Limited Partnership


     A limited partnership is a legal entity established under the limited partnership laws of a particular state.  Generally, under the Revised Uniform Limited Partnership Act ("RULPA") there must be at least one general partner and at least one limited partner.  The general partners make all decisions regarding the administration and management of the limited partnership's business and affairs, while the limited partners are not entitled to participate in management.  In other words, limited partners are passive partners who do not have legal rights to actively participate in the ongoing management or administration of the partnership business.  


     Establishing a limited partnership entity as a family limited partnership ("FLP") is typically done by older generation family members transferring some of their property (ideally property with appreciation potential or a relatively high rate of return) to a newly created limited partnership.  These older generation family members would receive in exchange for the transfer of their property into the FLP both general and limited partnership interests in the FLP.  


     For example, John and Mary Smith, who have three adult children, might each receive a 1/2% or .5% general partnership ("GP") interest and a 49.5% limited partnership ("LP") interest in the FLP in exchange for transferring their property into the FLP.  By owning only the 1% GP interest, Mr. and Mrs. Smith retain control over the management of the FLP and the property held therein (e.g., authority to make all management and investment decisions, sell assets, and determine the amount and time of distributions to the partners, etc).  Part or all of the 99% LP interests initially held by Mr. and Mrs. Smith in the FLP would be transferred to their children through a systematic gifting program utilizing the annual gift tax exclusions ($20,000) and the one-time unified tax credits ($1,200,000 credit equivalent amount) available to Mr. and Mrs. Smith under the Internal Revenue Code ("I.R.C.").  In valuing the LP interests which Mr. and Mrs. Smith transfer to their children for federal gift tax purposes, discounts should be generally available for lack of control ("minority interest discount") because a LP is not entitled to participate in management and lack of marketability ("lack of marketability discount") because the LP interest is not freely transferable.  These two discounts, which are discussed in more detail below, usually range in the aggregate from 30% to 60%.  Therefore, by utilizing the FLP technique in their estate plan, Mr. and Mrs. Smith will be able to significantly reduce or discount for gift and/or estate tax purposes the value of the LP interest transferred to their children, and thereby realize substantial gift and/or estate tax savings.


Gift Tax Considerations


     The Internal Revenue Service ("IRS") has ruled in several private letter rulings that, notwithstanding the significant control retained by the transferor as GP, gifts of LP interests satisfy the "present interest" requirement of I.R.C. Section 2503(b) since they are direct or outright gifts of an ownership interests in property, and not a "future interest" gift, such as gifts transferred into a trust.  The basis of the IRS rulings was that the GP had a fiduciary duty to act in the best interests of the partnership and its partners, and distinguished the control of the GP over the FLP's property from a trustee's discretionary power to distribute or withhold trust income or principal.  


Estate Tax Considerations


     Generally, I.R.C. Section 2036(a)(2) requires that any property transferred during life by a decedent be included in the decedent's gross estate for federal estate tax purposes if the decedent retained the right to control the use, enjoyment, or income of such property.  Based on the holding of the United States Supreme Court in Byrum, 408 U.S. 125 (1972), the IRS has ruled that the authority of a GP over partnership assets is not retained control within the meaning of I.R.C. Section 2036(a)(2).  The Byrum case involved a decedent who had transferred common stock to a trust, but retained the right to vote the stock. The Supreme Court held that I.R.C. Section 2036(a)(2) did not apply because the decedent, as controlling shareholder and a member of the board of directors, was under a fiduciary duty to act in the best interests of the corporation and all of its shareholders.  Congress enacted I.R.C. Section 2036(b)(1) in response to the Byrum decision, which requires inclusion in a decedent's gross estate of all transferred stock in a controlled corporation if the decedent retained the right to vote the stock.  By its express terms, I.R.C. Section 2036(b)(1) applies to corporations, not to partnerships.  The decision of the Supreme Court in Byrum that the retention of voting rights does not cause inclusion in a decedent's gross estate remains good law with respect to partnership interests, and, as will be explained later, it is the basis on which the ownership of GP interests may be structured in order to achieve a minority interest discount for federal estate tax purposes.  Therefore, because this provision does not apply to partnerships, under the rationale of Byrum, transferred LP interests would not be brought back into the decedent's gross estate under I.R.C. Section 2036.  Finally, I.R.C. Section 2038(a)(1) requires the inclusion in the gross estate of a decedent any property transferred by a decedent who controlled the enjoyment of the property through a power to alter, amend, revoke, or terminate.  However, the IRS has ruled that the Byrum rationale also removes I.R.C. Section 2038 problems in the FLP context.  


Income Tax Considerations


     Generally, appreciated property can be transferred into an FLP free of income taxes.  However, under I.R.C. Section 721(b), if appreciated securities are transferred into a partnership and the partnership is deemed to be an "investment company" pursuant to I.R.C. Section 351, then income taxes will be incurred on the transfer.  A partnership will be deemed an investment company if: (i) the transfer results, directly or indirectly, in diversification of the transferors' interests; and (ii) more than 80% of the value of the transferee's assets (excluding cash and nonconvertible debt obligations) are held for investment and are readily marketable stocks, securities, or interests in RICs or REITs.  Treasury Reg. 1.351-1(c)(5) provides that, in determining whether there has been diversification, nonidentical assets are ignored if they are an insignificant portion of the total value of the assets transferred.  For an unmarried taxpayer who needs another family member to make a small capital contribution so the FLP will have two partners, this exception is critical.  As long as the additional contribution is insignificant, the taxpayer's investment has not been diversified and gain will not be recognized.  The IRS has ruled that diversification did not occur when a parent transferred marketable securities to an FLP and the children contributed cash representing less than 1% of the FLP assets.  If spouses want to establish an FLP with marketable securities, each should contribute identical assets.  A simple method to allow each spouse to contribute identical assets to the FLP is for each spouse to transfer his and her non-identical securities to a tenancy-in-common account and then have the securities transferred from that account to the FLP account.  Another method would be to contribute enough assets other than marketable securities to the FLP (such as real estate) so the 80% threshold of marketable securities is not satisfied.


     Unlike a corporation, a partnership does not incur income taxes at the entity level.  Rather, a partnership is a conduit entity whereby all income taxes on earnings, etc. are taxed directly to each of the partners.  Therefore, the FLP must be carefully structured to avoid classification as a corporation for income tax purposes.  Treasury Reg. 301.7701-2(a)(3) provides that an entity will be classified as a partnership for income tax purposes if the entity lacks at least two of the following four corporate characteristics: (i) continuity of life, (ii) centralized management, (iii) limited liability, and (iv) free transferability of interests.


Need for Business and Financial Purposes for Establishing FLP 


     Established judicial authority holds that an FLP cannot be disregarded by the IRS, even if significant gift and estate taxes are saved, if either business, financial or investment reasons exist for the creation and continuation of the FLP.  Recently, there was concern that the anti-abuse rule in Treasury Reg. 1.701-2 issued on 12/29/94 could be applied to FLPs used for estate planning purposes, with the potential loss of the use of valuation discounts.


     However, in Announcement 95-8, 1995-7, the IRS stated that the anti-abuse rule applies solely to income taxes and withdrew the two examples applicable to FLPs from Treasury Reg. 1.701-2(d).  Notwithstanding this Announcement, it is important, where possible, to always identify and document the non-tax, business and/or financial purposes of the FLP.  The following are some business, financial and investment reasons for creating an FLP:


    1.    Power to monitor and control wealth transferred to younger family members.


    2.    Reduce cost of administration of family wealth by consolidated management of assets.


    3.    Facilitate greater diversification of family investments.


    4.    Facilitate annual gifting to younger family members.


    5.    Maintaining assets within the family (buy-sell provision).


    6.    Protection from failed marriage (buy-sell and separate property). 


    7.    Flexibility allowed under partnership statutes. 


    8.    Substitute "business judgment rule" for "prudent investor rule" to provide flexibility in management and investment of FLP property.


    9.    May allow for arbitration of family disputes rather than litigation.


    10.    Discourage nuisance litigation among family members by requiring that loser pays all costs of litigation. 


    11.    Facilitates younger family members' education about investment and business principles.


    12.    Lower probate costs for out-of-state real estate.


    13.    Creditor or Asset Protection.


    14.    Allows utilization of modern portfolio theory for investments.


Valuation Discounts


     As explained above, one of the objectives for using the FLP technique is the significant leveraging made possible by valuation discounts.  I.R.C. Section 2512 provides that the gift tax value of transferred property is its FMV as of the date of the gift, and the property being transferred in the FLP transaction is the LP interest, not the underlying partnership assets.  Therefore, the significant limitations inherent in LP interests under the RULPA can justify the significant transfer-tax saving valuation discounts.


     Logically, a buyer would pay less for a noncontrolling interest in an entity than for outright ownership and control of the underlying assets.  Therefore, since the LPs generally do not have the right to participate in the management of a limited partnership, the gift or estate tax value of LP interests should be reduced accordingly.  Although the general concept of a discount for lack of control or minority discounts is well-established, until recently, the IRS took the position that a minority or lack-of-control discount was not available in a family-controlled entity.  However, in Rev. Rul. 93-12, 1993-1 CB 202, the IRS belatedly agreed that a minority discount was available even though family members as a unit controlled the entity.  This Revenue Ruling involved a simultaneous transfer of 20% stock interests to each of five children.  The IRS concluded that each 20% interest was to be valued as a separate asset without regard to family relationships.  The benefits of this Revenue Ruling should extend not only to planning for closely held business owners but also to taxpayers using FLPs.  A partial interest in a family-controlled entity can be extremely difficult to liquidate in an orderly or acceptable manner.  This lack of marketability must be taken into consideration in determining the transfer-tax value of a transferred LP interest.  The lack of marketability discount has two components.  The first component is the absence of a ready market for selling the LP interest to third-party buyers, and the second component is the "lock-in" discount as a result of the LP's inability to withdraw effectively from the partnership.  Both state law and limited partnership agreements often restrict the LP's ability to withdraw from or "put" the interest to the limited partnership.  Such restrictions would clearly reduce the purchase price of an LP interest sold in an arm's-length transaction.  However, in the context of a family-controlled entity, this factor may be affected by I.R.C. Sections 2703 or 2704, which provides that certain restrictions on transferring an interest imposed by the partnership agreement must be disregarded for gift or estate tax valuation purposes, unless an exception applies.  


     I.R.C. Section 2703 provides that property shall be valued without regard to any agreement or restriction to acquire, sell or use property, unless such agreement or restriction satisfies the following:


    1.    The right or restriction is a bona fide business arrangement.


   2.    The right or restriction is not a device to transfer property to the natural objects of the transferor's bounty for less than full and adequate consideration in money or money's worth.


    3.    At the time the right or restriction is created, the terms of the right or restriction are comparable to similar arrangements entered into by persons in an arm's-length transaction.


     In other words, if these requirements are satisfied, the restriction in the limited partnership agreement on transferring an interest will not be disregarded for valuation purposes.  Because of the income tax consequences relating to the necessity of restricting free transferability discussed above, having such a restriction in the limited partnership agreement would be appropriate since such a restriction would be generally included in a similar arrangement entered into by unrelated parties.  Therefore, it should be easy to demonstrate the limited partnership agreement's restriction on transfers and the assignee should not be disregarded under I.R.C. Section 2703.  


     Further, a limited partnership agreement can be designed to comply with the provisions of the I.R.C. Section 2704.  First, I.R.C. Section 2704(a) treats the lapse (if any) of an assignee's voting or liquidation rights in a family controlled partnership as a transfer subject to gift or estate tax.  However, if a lapse does not occur, or if a lapse does not affect the transfer value of the partnership interest, then I.R.C. Section 2704(a) does not apply.  Assignees of a general or limited partnership interest, whether from a living partner or an estate, never have voting or liquidation rights.  As a consequence, unless there is an unusual provision in the partnership agreement, the transfer value of a general or limited partner interest is the same both before death and after the transfer.  Second, I.R.C. Section 2704(b) requires that the devaluation effect of selected restrictions on liquidation and withdrawal rights that may exist under a partnership agreement be disregarded.  However, not all restrictions are ignored.  If the restrictions in a partnership agreement are no more restrictive than the default state laws, then I.R.C. Section 2704(b) does not apply.  Also, Treasury Reg. 25.2704-(2)(c) provides that a restriction that is subject to I.R.C. Section 2703 is not an applicable restriction subject to I.R.C. Section 2704.


     Notwithstanding the enactment of I.R.C. Sections 2703 and 2704,  Congress clearly stated in the legislative history that the "willing buyer, willing seller test" existing under prior law with its inherent fractionalization discounts was to continue to be applied in determining the transfer-tax value of limited partnership interests.  See Conference Committee Report, H.R. 5835, 101st Cong., at 157 (October 27, 1990).


     Because valuing interests in closely held entities is highly subjective, it is difficult to precisely determine the discount in any given situation.  Nevertheless, it should be substantial for any LP interest.  The Tax Court typically approves valuation discounts in the range of 30% to 60%.  Although many of these cases involved interests in closely held corporations, the reasoning should be applicable to FLPs as well.  For example, in Estate of Watts, TCM 1985-595, aff'd 823 F.2d 483 (CA-11, 1987), the decedent owned a 15% interest in an operating business conducted by a partnership.  The partnership interest was discounted by 35% to reflect its minority status and lack of marketability.  Moore, TCM 1991-546, involved gifts of minority interests in a real estate general partnership.  Focusing on the various restrictions imposed on the transferee partners, the court again allowed a combined minority and lack-of-marketability discount of 35%.  For valuation purposes, the Tax Court disregarded differences between minority corporate interests and minority partnership interests, stating that "the critical factor is lack of control, whether as a minority partner or as a minority shareholder."

In order to support the case for a sizable valuation discount, the limited partnership agreement should place maximum restrictions on a transferee LP, taking I.R.C. Sections 2703 and 2704(b) into account.  In addition, it is strongly recommended that a qualified and experienced business appraiser be engaged to assess the value of the LP interest, as distinct from the underlying asset value.


Example of Use of Irrevocable Trust to Retain Control of FLP


     In order to obtain a minority discount for the transfer of the controlling and remaining partnership interests held by Mr. and Mrs. Smith upon their deaths in our previous example, an irrevocable trust could be established for the benefit of the descendants of Mr. and Mrs. Smith living from time to time.  The trust might continue so long as either Mr. or Mrs. Smith is living.  Mr. and Mrs. Smith would have no beneficial interest in the trust.  The trust can be drafted to limit the trustee's discretion in making distributions by an ascertainable standard, and otherwise restrict the powers of the trustee, so that either Mr. or Mrs. Smith could act as sole trustee (or both of them could act as co-trustees) without causing the trust to be included in their estates for estate tax purposes.  Mr. and Mrs. Smith would transfer .60% general partnership interest into the irrevocable trust.  After this transfer, the initial partnership structure would be as follows:




Partnership After Transfer to Trust

(assumes capital of $2,000,000)


          General Partnership
        Interest (1% of Total)                                                                   Percentage                                                              Capital


                Mr. Smith                                                                                      .20                                                                     $ 4,000
                Mrs. Smith                                                                                    .20                                                                         4,000
          Irrevocable Trust                                                                               .60                                                                       12,000

          Limited Partnership
        Interest (99% of Total)                                                                Percentage                                                               Capital


              Mr. & Mrs. Smith                                                                          99.0                                                                 $1,980,000



     If Mr. and Mrs. Smith were named as initial co-trustees of the irrevocable trust, they would continue to control 100% of the 1% general partnership interest during their lives.  Upon the death of either of them, the survivor would continue to exercise control of the FLP. 


     Since Section 2036(b) applies to corporations, but not to partnerships, no portion of the general partnership interest in the irrevocable trust is included in either of Mr. or Mrs. Smith's estates by reason of their retained right to vote that interest.  For estate tax purposes, Mr. and Mrs. Smith are each considered to own only a .20% general partnership interest.  Because estate tax is imposed on the date of death value of assets included in the gross estate, the general partnership interest held by the irrevocable trust has no estate tax impact, even though such interest permits Mr. and Mrs. Smith to retain effective control of the FLP during their lifetimes.


     At death, Mr. and Mrs. Smith lose the right to vote in their capacity as trustees of the controlling general partnership interest held by the irrevocable trust.


     The loss of voting control at death does not constitute a lapse under I.R.C. Section 2704(a) because the vote of the general partnership interest held by the trust is not itself restricted or eliminated.


     The general partnership interest originally allocated to the irrevocable trust could be increased above .60%.  However, one or more individuals should continue to hold some of the general partnership interest, especially if the absence of limited liability under Treasury Reg. 301.7701-2(d)(1) is necessary to prevent the limited partnership from being treated as an association taxable as a corporation for income tax purposes.  If an irrevocable trust with no significant assets held the entire general partnership interest, the IRS would likely view the trust as affording limited liability.  Then, if the limited partnership possessed two of the three remaining corporate characteristics of Treasury Reg. 301.7701-2(a), it would be characterized as an association rather than a partnership for income tax purposes.  Association (corporate tax) status could cause I.R.C. Section 2036(b) to be applicable, even if the entity remains a partnership under state law.  If I.R.C. Section 2036(b) applied, Mr. and Mrs. Smith would be deemed to possess a controlling general partner's interest for estate tax purposes, and the minority interest discount would be lost.  If voting rights with respect to the interest held by the irrevocable trust are to be ignored in valuing Mr. and Mrs. Smith's interest in the limited partnership, Section 2036(b) must be avoided.




     An FLP may be utilized as an effective estate planning strategy for creating substantial estate and gift tax valuation discounts in regard to the transfer of family wealth from older family members (parents) to younger family members (children).  However, special attention should be given to the limited partnership agreement and the ownership of partnership interests to maximize and achieve the gift and estate tax benefits.



Unpublished Work, All Rights Reserved: 2015, Gornto Law, PLLC

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