Funding - Appropriate Assets

Some assets are better suited than others for an FLP. Assets held by a partnership must be related to a trade or business, investment, or income-producing venture [IRC Sec. 7701(a)(2)]. Therefore, an FLP should not hold such assets as the family home or personal jewelry.

Marketable Securities. Investment assets, such as stocks, bonds, and mutual fund shares are generally good assets for an FLP. Some advisers have recommended that clients fund FLPs solely with marketable securities, primarily to obtain valuation discounts for gift tax purposes. Understandably, the IRS is quite concerned about this technique and would like to curtail its use. The authors strongly recommend that the adviser and client carefully document the nontax reasons for the partnership’s existence (such as taking advantage of investment opportunities), preferably in the partnership agreement.

Generally, if more than 80% of the partnership’s assets are held for investment and are in the form of stocks and securities (including money, foreign currency, futures contracts, and derivatives), mutual fund shares, and REIT units, the partnership may be classified as an investment company under IRC Sec. 721(b). If the partnership is treated as an investment company, the contribution of investment property will be treated as a sale by the contributing partner. However, this rule only applies if the capitalization of the partnership results in a diversification of the assets owned by the partners. Thus, it may not be an issue for many FLPs, where all property is effectively contributed by one partner (the parent) with subsequent gifts of limited partner interests to family members, because no diversification is achieved. The same would be true if jointly-owned (or community) property was contributed by a married couple, in exchange for their partnership interests.
3002.24 Real Estate. Ordinarily, real property, including mineral interests (but not the client’s personal residence), is appropriate for funding an FLP. However, the client should evaluate any risk, such as environmental risk or the risk associated with oil and gas working interests, when funding an FLP. Liability from such property could place other partnership assets, as well as the general partner’s assets held outside the partnership, at risk. This risk can be mitigated by using a limited partnership with a corporate or LLC general partner. Also, beware of an acceleration clause when funding a partnership with mortgaged real estate. The presence of such a clause may make the mortgage immediately due and may cancel the title policy when the real estate is transferred to the partnership.
3002.25 Closely Held Stock. Some practitioners suggest that an FLP is an ideal vehicle for owning stock in a closely held corporation. Contributing assets to a partnership where the donor is the general partner generally provides an estate tax benefit. However, the IRS has ruled that IRC Sec. 2036(b) causes the value of the contributed stock to be included in the donor-general partner’s gross estate under the theory that the donor has retained indirect voting rights over the stock (see paragraph 3005.10). Two strategies may alleviate at least part of the problem. The corporation could recapitalize before funding the limited partnership and issue voting and nonvoting stock. The donor could then fund the partnership with the nonvoting stock (which would hold the majority of the corporation’s value). Thus, only the voting stock that was held outside the partnership would be included in the gross estate. Alternatively, the partnership agreement could provide that all partners can vote the stock based on their partnership interests. In that situation, only the donor’s prorata share of the stock would be at risk under IRC Sec. 2036(b). Of course, this reduces the donor’s control over the corporation.
3002.26 Business Assets. Rather than contributing business assets to a C corporation, a better alternative is for an FLP to own the property and lease it to the corporation. This strategy provides several benefits, including spreading corporate earnings among the various partners; reducing the amount that must be paid out as owner compensation subject to a reasonableness attack by the IRS; reducing accumulated earnings at the corporate level, which could lead to a smaller taxable estate for the owners; and protecting the assets from the corporation’s creditors.

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