Estate Planner Nov-Dec 2000
Family limited partnerships (FLPs) are an increasingly popular vehicle for managing and controlling family assets and for transferring wealth to younger generations. Unfortunately, the IRS is attempting to curtail this estate planning technique by challenging the technical structure of such partnerships as well as the valuation issues that arise when an FLP interest is gifted to children or grandchildren.
A typical FLP consists of at least one general partner and one limited partner. You transfer assets to the FLP, and generally, you (or an entity controlled by you) act as the general partner and, through your partnership interest, retain indirect ownership of a small portion of the assets. Placing your assets into an FLP transfers ownership — but not control — of the assets to the partnership. As general partner, you manage the partnership and have control over its operation, assets and cash flow distributions.
Creating an FLP can be complex. If improperly set up, it can stumble into many tax pitfalls. Here are 10 important steps to take when setting up an FLP:
1. Name the partnership. After you choose your partners, select a partnership name. To avoid calling attention to the fact that you are creating an FLP, consider naming it an “investment” or “management” partnership rather than a “family” partnership. Also, check the availability of the name with your local secretary of state or other governmental body that supervises the formation of business entities. Most states require that the designation “Limited” or “L.P.” be part of the entity’s name.
2. Consider the state of formation. Determining the jurisdiction where you create your partnership is critical. Why? Because the jurisdiction must have a limited partnership act that supports valuation discounts for FLP interests you may gift to family members. If state law relating to the transfer of partnership interests and the rights of a withdrawing partner are not restrictive, the tax code allows the IRS to disregard the relevant provisions of your partnership agreement for purposes of valuing partnership interests. This would reduce the marketability and lack of transferability discounts that would be otherwise available.
3. File a certificate of limited partnership. Once you choose a name, you must file a certificate of limited partnership. This is a critical step in the formation of your FLP. The requirements for a certificate vary from state to state but, generally, the certificate must list the partnership’s name, registered agent’s name and address, purpose of the partnership, and each general partner’s name and address. Until the state has accepted the partnership entity, the partnership is a general one — not a limited one — and different statutory rules apply relating to transfers of interests and partners’ rights.
4. Obtain a taxpayer identification number. An FLP is a legal entity even though it may not pay income tax. You need to obtain a taxpayer identification number from the IRS because the partnership is required to file income tax returns.
5. Sign a partnership agreement. Have your attorney draft a partnership agreement and have each partner sign it. The agreement should specify how the partnership:
- Shares profits and losses,
- Computes capital accounts,
- Defines its policy on admitting new partners and — if new partners are permitted — conducts its admission process, and
- Intends to manage and dissolve the partnership. The agreement should restrict transfers of partnership interests to support gifting discounts. Until you execute the agreement, the limited partnership statutes of the state will govern the partnership.
6. Funding the partnership. After you form the FLP and execute the agreement, transfer selected assets to the partnership. Generally, you recognize no gain or loss when you transfer property to an FLP in exchange for partnership interests. One exception to this rule is when the IRS views the partnership as an investment company. In this case, the IRS says you have a form of asset diversification and a deemed sale.
The IRS will classify your FLP as an investment company if more than 80% of the contributed assets’ fair market value consists of cash, securities and other types of investment property, and if the transfer results in diversification of the transferor’s interest. Diversification occurs when two or more persons transfer different assets — including cash — to the partnership in the exchange. You should be aware of these rules when you are considering creating an FLP.
7. Open a bank account. Open the account in the FLP’s name and maintain proper accounting records. Partnership assets, including bank accounts, must be owned in the FLP’s name — not in the name of individual partners. Only the partnership’s cash should be kept in these accounts.
8. File income tax returns. The FLP must file an income tax return. The return is primarily for informational purposes. The partnership is not subject to tax. Instead, the partners are taxed on their proportionate share of the partnership’s income.
9. Make distributions. The general partner controls the timing and amount of distributions of the FLP’s cash. Make distributions to partners in proportion to their ownership interests.
10. Respect the entity. The FLP is a distinct, separate entity — just as a corporation is an entity. You must respect the entity if it’s going to achieve your planning objectives. Steps you can take to help ensure success include conducting a formal, annual partner meeting and documenting actions taken or authorized. Don’t ignore the partnership and treat it as the general partners’ alter ego.
Seek Assistance When Setting Up an FLP
An FLP provides many estate planning advantages, but variables exist in setting one up. And because everyone’s situation is different, it’s best to work with a qualified advisor to develop a plan that’s right for you.