Advantages and Disadvantages

Advantages

There are many reasons for the increased use of FLPs. Some of the commonly cited reasons (many of which are overlapping) are as follows:

1. Transfer Tax Savings. Most partnership interests, especially noncontrolling interests, have a value that is less than the interest’s proportionate share of the value of the underlying business or assets. When such interests are transferred, their discounted value is often based on the estimated distributable cash flow and other rights and powers that inure to the interests. To the extent this discount in value is reflected in the transfer tax value of the gift, wealth can be removed from a senior generation family member’s estate on a tax-advantaged basis.

2. “Estate Freezes”—Diversion of Appreciation. Through gifts of interests in FLPs that own appreciating assets, a senior generation family member can remove future appreciation in value from his or her estate. This avoids the taxation that would result if the property were transferred after the appreciation occurred.

3. Income Tax Advantages. Although some of the unearned income of children under age 14 is taxed at the parent’s rate, FLPs remain useful for shifting income to lower bracket family members, especially when older children are involved. Unlike a C corporation, the partnership avoids the double taxation of earnings and gains. It is also relatively easy to put assets into and take assets out of a partnership without adverse tax consequences. Additionally, partnerships avoid the compressed tax rate structure of trusts, and the limitations of S corporations (e.g., types of shareholders and the one-class-of-stock limitation). Finally, partnerships are allowed to step up the bases of assets upon the death of a partner and are much more flexible than other entities with regard to distributions and tax allocations.

4. Asset Control. A senior generation family member can use an FLP to make gifts while maintaining control over the underlying assets. This control includes the power to invest partnership assets and to control the timing and amount of distributions. When properly structured, such retained control should not cause the underlying property to be included in the transferor’s gross estate.

5. Gifting Program Facilitation. An FLP can be used to make repeated transfers of limited partnership interests as part of a regular program of gifts to family members. This is a convenient way to take advantage of the federal gift tax annual exclusion. In addition, gifting of certain assets, such as real estate, is more easily facilitated by executing an assignment document to transfer partnership interests, as opposed to changing title to the underlying property (see item 8).

6. Management Flexibility. Compared to a trustee of a trust, a general partner of an FLP has more flexibility in managing assets. While often subject to fiduciary obligations, a general partner managing partnership assets will generally be judged against the “business judgment” rule—the standard of a prudent business person. This standard is less strict than the “prudent man” standard applicable to trustees.

7. Avoidance of Local Probate. When real property is involved, an owner’s estate would be required to probate the property in the state where the property is located, even if this differs from the state of domicile. If the property is owned through a partnership, the decedent would not own a direct interest in real property, but would own instead an interest in a partnership, which is intangible personal property and would be probated with other property in the jurisdiction of his or her domicile. This will simplify the probate process and minimize related costs.

8. Avoidance of Title Fractionalization. Especially when real estate is involved, there is a benefit to avoiding multiple undivided interests. Obtaining proper consents to leases and other agreements becomes cumbersome with multiple owners, and the likelihood of title problems increases significantly as the number of owners increases. Moreover, undivided interest owners often possess a right to partition the property. A partnership may be used to create a single owner, simplify property management, and avoid partition risks. Similarly, an FLP may be preferable to a series of trusts with multiple beneficiaries from an administration and recordkeeping standpoint.

9. Asset Protection. A creditor of a partner generally cannot reach the assets of the partnership or compel distributions. Accordingly, the opportunities for a partner’s creditor to benefit from a partnership interest are far less than when there is direct access to the underlying property.

10. Control of Donee Access to Wealth and Income. While senior generation family members often desire to transfer property to their children (and grandchildren), they have concerns over the children’s behavior and motivation if they have immediate access to the wealth. By transferring partnership interests, the wealth can be transferred, but liquidity can be controlled to some extent. The younger generation member cannot easily convert the partnership interest to cash. Moreover, subject to some limitations, the general partner can exert control over the extent and timing of distributions and income reinvestment decisions.

11. Investment Opportunities. Some investment managers will not work with portfolios that do not meet certain threshold values, or if they do, the management fees are often higher. A partnership is a convenient way to consolidate assets into larger blocks that might qualify for some of the benefits available to larger portfolios. In other situations, the consolidation of assets through a partnership may provide greater opportunities for diversification than if each partner separately held smaller portions of the same assets.

12. Maintenance of Family Control. An FLP with appropriate buy/sell provisions can be used to keep control of assets or a business within a family. Along the same line, this can provide protection against the disruption and acrimony that sometimes accompany failed marriages and the resulting property division.

13. Flexibility. Partners can retain the right to amend the partnership agreement without causing partnership assets to be included in a partner’s gross estate. Thus, FLP arrangements are much more flexible than irrevocable trusts (which cannot be subsequently amended). FLPs may also be preferable to revocable trusts, since assets of a revocable trust are includable in the grantor’s estate under IRC Sec. 2038.

14. Dispute Management. A partnership agreement can require arbitration of family and business disputes, and establish other ground rules, such as the sharing of expenses from a dispute.

15. Avoidance of Guardianship. The FLP agreement can be drafted to avoid costly and cumbersome guardianship in the event of incapacity of one or more of the partners.

16. Family Communication and Harmony. The FLP can be used to “institutionalize” communication on family business and financial matters. It can also facilitate the education of the client’s children in matters concerning the client’s philosophy of acquiring and managing wealth.

Disadvantages

Because of their many advantages, FLPs have received considerable attention in professional publications and in the financial press. Understandably, such publicity tends to focus on the benefits of FLPs, with little mention of the disadvantages. I advise evaluation of possible disadvantages. Some potential disadvantages of FLPs are as follows:

1. Administration Expenses. Setting up and maintaining an FLP involves drafting a partnership agreement, possibly setting up a corporation or LLC as general partner, filing fees, changing title to assets, appraising assets transferred to the partnership and interests transferred to partners, and filing gift tax returns and partnership income tax returns.

2. “Real” Discounted Value. The valuation discounts created by an FLP are real, at least in the short term. This may affect a partner’s ability to borrow or invest.

3. Potential Family Disharmony. What is perceived by many advisers and clients as one of the benefits of FLPs may actually backfire. If the younger-generation partners have their own ideas about financial matters and widely varying personal financial needs, a partnership arrangement might create family discord.

4. IRS Scrutiny. The Service has specifically targeted the valuation of “fractured entities” such as FLPs for increased scrutiny by its audit division and has issued several private rulings dealing with FLPs formed shortly before the general partner’s death. These rulings ignore the partnership entity and disallow the valuation discounts.

5. Reduced Fringe Benefits. Operating a business as a partnership (versus a C corporation) restricts the level of tax advantaged fringe benefits available to the owners.

6. Restrictive Income Tax Rules. FLPs are subject to certain rules for a transferee partner to be recognized for income tax purposes. Capital must be a material income-producing factor, and the transferee partner must be the “real owner” of the capital interest.

7. Difficult Trust Administration. Independent trustees may be reluctant to accept a trust or estate client that owns an interest in an FLP. A trustee’s fiduciary obligation to remaindermen as well as income beneficiaries may place him or her at odds with other partners.

8. Loss of Basis Step-up. The FLP interests held by a partner at death will probably be valued differently than the partner’s prorata share of the underlying value of the partnership’s assets. Accordingly, the partner’s estate and successors may lose a portion of the basis step-up for appreciated assets owned at death. This problem may be mitigated by a Section 754 election to step up the “inside” bases of assets. See Chapter 46 for details on the Section 754 election.

9. Underfunded Marital Deduction. The IRS could potentially use valuation discounts to its advantage by reducing the value of FLP interests passing to a surviving spouse upon a partner’s death. The IRS in at least one instance concluded that the value of closely held stock was a single controlling interest for gross estate inclusion purposes but a discounted minority interest for marital deduction purposes (TAM 9403005).

10. Potential Legislation. Congress has attempted to enact legislation restricting valuation discounts in the past and could make another attempt to do so.

11. Unknown Estate Tax Implications for Closely Held Stock Owned by a Partnership. If an individual gives away corporate stock during his or her lifetime and retains voting rights, directly or indirectly, at the time of death, the value of the stock will be included in the gross estate for estate tax purposes [IRC Sec. 2036(b)]. Whether the right of a general partner in an FLP to vote corporate stock owned by the partnership causes IRC Sec. 2036(b) to apply is unclear. Accordingly, it may be risky to hold closely held stock in an FLP and retain voting rights as a general partner.

12. Investment Company Rules. If the FLP is funded primarily with marketable securities, the investment company rules of IRC Secs. 721(b) and 351(e) may apply and subject partners to tax on precontribution appreciation.

13. Business Purpose Attack. The IRS may use a “business purpose” or step transaction argument to disregard the partnership for tax purposes. This is most likely with FLPs formed shortly before the general partner’s death. The result would be the loss of valuation discounts or possibly a reclassification of the partnership as a trust (which would be includable in the client’s estate). While the IRS was recently unsuccessful in this argument (see Church), there is no guarantee that it will not continue to advance this argument.

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