Forming and Funding the Family Ltd Partnership

I advise a partnership agreement, in addition to the required stat filings.  To the extent the partnership agreement is silent concerning a particular matter, state law will provide default provisions. The agreement should reflect the intent of the client and be structured in a way that achieves the client’s goals and objectives.

I advise that you understand each of the objective of a typical family limited partnership - relate each to your own objective - analyze and critique all transactions, events, circumstances, transfers, and recommendations to assure yourself you do not thwart your own objective.

Determining the rights and responsibilities (including the extent to which they can vote, admit new partners, transfer their interests, replace the general partner, withdraw, and force a liquidation) assigned to the general and limited partners is a critical part of designing an FLP. The partnership agreement is the proper vehicle for delineating the assignment of the various rights and responsibilities among the various ownership units. Such powers will also be considered in determining the value assigned to the transferred limited partnership units and may also be subject to close scrutiny by the IRS.

General Partner Considerations

The general partners in an FLP are usually senior generation family members or an entity, such as a corporation or LLC, controlled by senior family members. There is no limit to the number of general partners an FLP may have.

When naming the general partner, consideration should be given to the management duties involved, since limited partners can have no management responsibilities under state law (or their limited liability protection will be lost). Another factor to consider is how the partnership will continue in existence when the senior family member dies, since the death of a sole general partner will terminate the partnership unless the partnership agreement contains a replacement mechanism. Thus, if the client feels strongly about having a sole general partner, the authors suggest that the partnership agreement provide for a successor general partner upon the death of the original general partner, so that the partnership will continue in existence. Alternatively, the client can name multiple individual general partners. Avoiding a situation where the partnership will be terminated at the sole general partner’s death generally results in less value (i.e., greater discounts) being assigned to the limited partners’ interests, because there is less chance that the limited partners will receive cash or property due to the partnership termination.

Using a corporation or LLC as the general partner avoids the termination of the partnership upon the death of a sole individual general partner. An added advantage of having a corporate or LLC general partner is the liability protection for the corporate shareholders or LLC members. Generally, an S corporation or LLC general partner is preferable to a C corporation because of pass-through taxation.

Warning: The presence of a C corporation partner may require the accrual basis of accounting for the partnership (IRC Sec. 448). The impact of this requirement should be carefully evaluated before naming a C corporation as general partner.

If one of the primary objectives for considering or establishing an FLP is to minimize transfer taxes using valuation discounts, the following general principles apply to the general partner’s interest:

1. Keep the general partner interest as small as possible, since it will not qualify for a minority interest/lack of control discount.
2. Assign as many control features as possible to the general partner. Theoretically, the more powers assigned to the general partner, the greater the value of the general partner interest and the greater the minority interest discount for the transferred limited partner interests.

The Revised Uniform Limited Partnership Act (RULPA) (adopted in some form by most states) allows a general partner to withdraw from the partnership at any time and receive “fair value” for his or her interest (although the remaining partners may be entitled to damages for breach of the partnership agreement). The partnership agreement can be drafted to provide that any general partner’s interest will be converted to a limited partner interest upon withdrawal, and then the agreement’s provisions governing the rights of the limited partners would apply to such interests.

Limited Partner Considerations

When the FLP is formed, the contributing partners (e.g., parents) may own both general and limited partner interests. Later, limited partner interests are usually gifted or sold to other family members.

Parents may prefer to instead give FLP interests to a trust established for the benefit of an adult or minor child for several reasons—to restrict the child’s ability to use or consume the asset or to protect it from the child’s creditors (e.g., a teenage son with a bad driving record). Such an arrangement also provides a layer of privacy for the parent, since the child would not be involved directly in the affairs of the partnership. Trusts established to hold FLP interests for children are typically structured as Section 2503(c) trusts, Crummey trusts, or custodial accounts so that transfers to the trust qualify for the annual gift tax exclusion.

A minor child will be respected as a partner for income tax purposes only if he or she can demonstrate competency to manage his or her own property and participate in partnership activities. Thus, the minor must possess sufficient maturity and experience to be treated by disinterested persons as competent to enter business dealings and otherwise conduct affairs on a basis of equality with adult persons, notwithstanding legal limitations of minors under state law [Reg. 1.704-1(e)(2)(viii)]. In the authors’ opinion, FLP interests should not be transferred directly to minor children. Instead, a transfer of the interest to an independent trustee or guardian for the minor’s benefit is appropriate.

RULPA provides that new limited partners can be admitted to the partnership only with the unanimous consent of all other partners, unless the partnership agreement provides otherwise. By following this default provision, along with a provision in the agreement requiring an assignee of a partnership interest to have the unanimous consent of all partners to become a partner, the client can keep the partnership interests within the family, protect the family’s interests from creditors and ex-spouses of family members, and minimize the value of the partnership interests for transfer tax purposes (by increasing the minority interest and lack of marketability discounts).

To maximize transfer tax savings, you will want to structure the transferred limited partner interests in such a way that their value can be discounted for having a lack of control over partnership affairs. A lack of control can be established by requiring the consent of all partners to liquidate the partnership (i.e., since a sole limited partner could not unilaterally force liquidation and thereby have access to his portion of the assets, his interest is not as valuable as it would otherwise be). However, valuation discounts will be reduced if a partner or a member of the partner’s family (alone or collectively) can remove this restriction and actually cause a liquidation of the partnership or if the restriction lapses after the partnership interest is transferred [IRC Sec. 2704(b)].

 TIP - One solution to this problem is to admit a nonfamily member partner, combined with a provision requiring the consent of all partners to liquidate, which should restore the discount. The nonfamily member’s interest can be as small as one percent of the partnership, or even one percent of the stock of a one-percent corporate general partner (a .01% interest in the partnership), as long as all partners and all shareholders of corporate partners must consent to a liquidation of the partnership. “Family members” for this purpose do not include aunts, uncles, nieces, nephews, or cousins.

If a limited partner can withdraw from the partnership on short notice and receive his or her prorata share of the net fair market value (FMV) of the partnership’s assets, the limited partner interest is in reality a relatively liquid asset. Accordingly, it is doubtful that a valuation discount for the partner’s lack of control would be appropriate. RULPA provides that a limited partner may withdraw from the partnership upon six month’s written notice and receive FMV for his interest if the partnership agreement does not specify a definite time for the dissolution of the partnership. Therefore, in states that have adopted this provision as their default rule, the partnership agreement should provide for a fixed duration to prevent the limited partners from being able to “cash out” on six months’ notice, thereby preserving the valuation discounts. However, the IRS has challenged this approach, claiming that such restrictions should be disregarded because they are more restrictive than state law. It may be safer to form the partnership in a state that does not adopt RULPA as the default.

Other Considerations

Allocations

 The partnership agreement should specify how income and loss will be allocated among partners. Generally, partnership allocations must have “substantial economic effect” or be made in accordance with each partner’s “interest in the partnership,” pursuant to IRC Sec. 704(b). FLPs must comply with additional allocation rules that are intended to prevent abusive shifting of income from high-bracket taxpayers (parents) to low-bracket taxpayers (children). For the allocations to be respected, they must allow for reasonable compensation to the donor for services performed for the partnership and result in the donee-partner’s share of partnership income being proportionate to that of the donor when compared to their capital interests.

The partnership’s income allocations can trigger adverse gift tax consequences under the provisions of IRC Sec. 2701, which can cause the value of the parents’ retained general partner interest to be zero for gift tax purposes. This in turn causes the value of partnership interests gifted to the children to be equal to the entire FMV of the partnership assets. This harsh treatment can be avoided if the donor-partner’s interest retains the same proportionate rights (i.e., to income, deduction, gain, and loss) as the donee-partner’s interest, other than for management rights and limitations on liability. Accordingly, the authors suggest that all partners be given distribution rights and an allocation of partnership tax items in proportion to their percentage ownership to avoid IRC Sec. 2701.

Business Purpose Requirement. It is highly advisable to formally document the partnership’s purpose in the partnership agreement and on an ongoing basis wherever possible (e.g., minutes of partnership meetings). For a partnership to be valid for tax purposes, its assets must be related to a trade or business, investment, or income producing venture [IRC Sec. 7701(a)(2)]. If such reasons exist for its formation, the IRS should not be able to disregard the partnership even if a principal purpose is to save transfer taxes.

 In TAM 9723009, the IRS used a business purpose argument to ignore an FLP for valuation purposes. The IRS issued regulations in 1994 to prevent the use of partnerships in what it considered abusive situations. These “anti-abuse” regulations give the IRS broad powers to disregard the existence of the partnership if the IRS thinks the tax results are inconsistent with the underlying economic arrangements. The regulations initially included two examples dealing with FLP situations, and one in particular with the business purpose issue. These examples were later withdrawn by the IRS.

Buy/Sell Provisions. A buy/sell agreement, either incorporated into the partnership agreement, or as a stand-alone document, defines how partners can dispose of their interests. A buy/sell agreement restricts the transferability of the partnership interests, thereby ensuring that only family members are partners. This is usually accomplished by limiting the situations in which a partner’s interest can be disposed of to certain identifiable events, such as death, disability, bankruptcy, divorce, or retirement. Alternatively, the buy/sell agreement can restrict potential transferees to a specific person or class of persons (e.g., the partner’s children) or provide that transfers other than those specified are subject to a right of first refusal by the other partners. The buy/sell clause establishes an exit strategy for the partners at the inception of the partnership, which reduces the potential for conflict later, when a triggering event occurs.

Transferability restrictions help create lack of marketability discounts for gift tax valuation purposes. However, if a donee-limited partner’s right to sell his or her interest is subject to substantial restrictions, the IRS may ignore the interest for income tax purposes [Reg. 1.704-1(e)(2)(ix)]. (See section 3004 for more on income tax consequences of FLPs.) One way to maintain sufficient transferability while keeping the interests in the family is to give the remaining partners a right of first refusal that would allow them to match any outside offer to buy a limited partner’s interest.

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