Engagement Status Letter ~ WARNING!  Privacy Statement  Disclaimer and Warning - From Bob Parrish CPA, P.C.

Dear Client:

You asked me to provide you with some information on the use of family limited partnerships in estate planning. Family limited partnerships are currently a popular topic in the estate planning field, and I have had a number of such requests from other clients.

Family partnerships have long been used as a tax reduction device by astute tax planners. In the pre-Reagan era of high marginal income tax rates, family partnerships were often used to shift income from family members in a high tax bracket (i.e., the parents) to those in a lower bracket (the children). In a typical case, a parent who owned an income-generating business or piece of real estate would transfer it to a partnership and then make gifts of limited partnership interests to his children. A portion of the income from the business or real estate could then be directed to the children, who would usually be subject to a much lower tax rate than their parent.

The use of family partnerships tapered off after the 1986 Tax Reform Act for two reasons. First, the lowering of the top income tax rates reduced the incentive to shift income to family members in lower brackets. The second reason was the enactment of the "kiddie tax," which subjected passive income received by children to the same tax rate that was paid by their parents. As a result, there was no longer a strong income tax incentive to creating a family partnership.
In the early 1990s, however, family limited partnerships were revived as an estate tax planning tool. The critical stimulus was the IRS's 1993 publication of Revenue Ruling 93-12, in which it abandoned its discredited "family attribution" theory. Before this ruling, the IRS had taken the position that the interests of all family members must be considered when valuing a gift of an interest in a family-controlled entity. For example, if Father, who owned 100% of a family corporation, made a gift of 10% of the stock to each of his three children, it was the IRS position that none of the gifts qualified for a minority interest discount since the family still owned 100% of the corporation.

After consistently losing on this issue in court, the IRS reversed itself in Rev. Rul. 93-12 and said that it would no longer apply family attribution. As a result, in the example above Father was now allowed to discount the value of each of the gifts to his children, thereby reducing the gift tax that he paid on the transfers.
Smart tax practitioners soon realized that the family limited partnership was an ideal vehicle for taking advantage of the discounts that became available with Rev. Rul. 93-12. Unlike the pre-1986 family partnerships, these new partnerships were used to reduce transfer taxes, i.e., the gift, estate, and generation-skipping taxes, rather than income taxes. The new family partnerships were no longer funded solely with businesses and real estate. Since the income from the property was no longer relevant to the decision to create a partnership, the new type of family limited partnership could be funded with a variety of assets, including investment assets and assets that produced little or no income.

Under current practice, a parent (or grandparent) creates a family limited partnership, naming himself as the general partner. The parent will generally contribute most of the assets to the partnership. Typically, he will receive a 1% general partnership interest (to ensure his control) and the rest as a limited partnership interest. His children (or grandchildren) will make modest contributions to the partnership in return for relatively small limited partnership interests. The parent will then begin to make gifts of his limited partnership interests to the children. These gifts will be subject to large discounts, sometimes of up to 70%, depending upon the size of the transfer and the restrictive features of the partnership agreement.

An example is the best way of demonstrating the tax savings that are inherent in family limited partnerships. Assume that Father contributes $980,000 in stocks and bonds to a family limited partnership in return for a 1% general partnership interest and a 97% limited partnership interest. At the same time, his two children each contribute $10,000 in cash to the partnership in exchange for a 1% limited partnership interest.

Several months later, Father decides to make a gift of a 10% limited partnership interest to each of the children. Each 10% interest represents $100,000 in partnership assets, but Father claims that the 10% partnership interest, because of restrictions imposed by the partnership agreement, is worth only $50,000. In addition, each gift qualifies for the $10,000 annual exclusion, reducing the taxable gift to only $40,000. By using the partnership, Father is able to transfer $100,000 of assets to each child, while treating it as a $40,000 gift for tax purposes. Over time, Father can transfer his entire 97% limited partnership interest to the children at a significantly reduced gift tax cost, while still maintaining control over the partnership through his 1% general partner interest. If the partnership works properly, only that 1% interest will be taxed in his estate at death.

Needless to say, the IRS has not been happy with the potential loss of tax revenue. As a result, it has instituted a number of audits of family limited partnerships. These audits, as well as related litigation, are still in a preliminary stage and it remains unclear whether the IRS will forced to allow significant discounts for gifts of family limited partnership interests. Before entering into any family limited partnership, you should be aware that there is an audit risk, especially if the partnership is funded with nonoperating assets.

Family limited partnerships remain a popular, albeit risky, tax planning device. You may wish to consider creating one as part of your estate plan. We will continue to monitor the IRS position in this area, and will prepare a plan that best meets your family's needs while still acknowledging the IRS' concerns. If you need any further information about this subject, please do not hesitate to contact me.