All in the family

The Family Limited Partnership has proven itself an extremely valuable tool for both business and estate planning. What other tool can ease or even eliminate the tax bite often associated with transferring the toy, game or hobby business—or its income—to family members, all the while keeping the owner's current tax bills to a minimum?

Transferring assets or income-producing property to children or other family members can be an invaluable tax planning and tax-reducing tool. Income can be shifted to an individual in a lower tax bracket than the donor. What's more, under U.S. tax rules, the transfer of an interest in a partnership can represent a future increase in value. In other words, it's the legitimate deferral of taxable gain.

Unfortunately, since 1997, the Internal Revenue Service has been waging war over the estate and gift tax consequences of family limited partnerships, or FLPs. Initially, the IRS was unsuccessful in attacking these entities and their tax benefits. Recently, however, the IRS has achieved some success in the courts, situations that were reviewed by the appellate courts with mixed results. However, because of its significant tax—and non-tax—advantages, the FLP remains a popular entity, one that every toy, game or hobby retailer should consider. Naturally, the advice of a competent adviser should be sought, if only to avoid doing battle with the IRS.

A Family Limited Partnership or “FLP” is simply a limited partnership consisting of the members of a family. A limited partnership has both general partners (the ones who actually run the partnership) and limited partners (who are passive or non-involved investors). General partners have unlimited personal liability for partnership obligations, while limited partners have no liability beyond their capital contributions.

Typically, a partnership is formed by the older generation, usually the parents, who contribute assets to the partnership in return for both general partnership units and limited partnership units. The parents can then embark on a plan of giving unlimited partnership units to their children and grandchildren while retaining the general partnership units that actually control the partnership.

Any type of property can be contributed to an FLP. For example, FLPs have been formed to hold family compounds, rental real property, marketable securities and, of course, the family toy, hobby or games business. Thus, the parents might retain control of the business; draw a salary or wages from it, all the while sharing the profits with other family members who are taxed on those profits at a lower tax rate than the parents/owners.

The partnership agreement usually governs how partnership income is divided among the partners. Generally, both the general and the limited partners will share in income and cash flow based on their respective share or percentage of interest in the partnership. Of course, although income tax liability passes through to each partner automatically, actual cash does not have to be distributed to the partners until the general partners decide to make a distribution.

In this manner, the general partners retain control over the assets in the FLP while the limited partners are granted very limited rights. Limited partners also have restrictions on their ability to transfer their partnership units to others so that the general partners can prevent units from being transferred outside the family.

As part of establishing a partnership, property and assets are transferred into the partnership. Frequently this involves a transfer tax at the state level. Because of the lack of an established market for the sale of limited partnerships, not to mention the lack of control that limited partners have, the limited partnership interests are often valued at a “discount” for transfer tax purposes, as well as for federal valuation purposes.

Valuation discounts for limited partnership interests (i.e., reductions from the net asset value of the partnership) can range from 15 percent to more than 50 percent.

The tax benefit of the discounted value of the partnership interests, coupled with significant non-tax benefits such as liability protection and centralized management, contributed to the historical popularity of the limited partnership as did the ability of the contributing partner to participate in the management of the partnership as a general partner.

John Doe owns a toy, game or hobby business, otherwise known as the “family business,” that has been in the family for over 50 years. The family business consists of a small parcel of land, some buildings and a couple of vehicles with a value of about $5 million.

John Doe is focused on keeping the business in the family and avoiding the management issues usually associated with fractional ownership. With the assistance of an experienced professional, John organizes a limited partnership to hold the physical assets, the land, buildings and vehicles of the family business. John Doe and his son, Ralph, who will manage the property after John's death, are the two general partners, together owning a 1 percent interest equally.

John contributes the family business to the partnership for a 99 percent limited partnership interest, while Ralph contributes cash or other assets for his interest.

Assuming that a 40 percent discount can be sustained when valuing the partnership interest, the value of John Doe's estate is reduced by $2 million (the difference between the family business being valued at $5 million and the family limited partnership interest being valued at approximately $3 million after the 40 percent discount). That can mean estate tax savings of as much as $1 million—assuming, of course, that the estate tax remains a factor on the federal level.

As already mentioned, there are many benefits, both tax and non-tax, to FLPs. Despite the repeal of the estate tax, temporary as it may be, the benefit of reduced asset value through significant valuation discounts remains for gift tax purposes. The FLP has not escaped IRS scrutiny, however.

As family limited partnerships grew increasingly more popular, the IRS commenced a series of attacks on their tax benefits. The initial attacks came in the form of “TAMs,” or Technical Advice Memorandums, a series of IRS rulings attacking FLPs with a variety of legal arguments. For the most part, those attacks usually involved extreme situations involving terminally ill individuals and transfers made by family members by power of attorney.

Typical of the arguments used by the IRS was that there was a gift of the limited partnership interest. Since assets transferred into the partnership and the limited partnership interest received in exchange was valued at a discount, the value of the assets transferred into the partnership usually exceeded the value of the limited partnership interest. The IRS contended that the reduction in net worth of the contributing partner was a gift by that partner on creation of the partnership.

In 2000, not one, but two, rulings by the U.S. Tax Court shot down that argument as well as several others put forth in the course of the IRS's FLP crackdown. In one of those cases, the appellate court, the U.S. Court of Appeals for the Fifth Circuit, upheld the taxpayer's position.

The appeal revolved around the IRS's contention that the value of the assets the decedent transferred to the partnership should have been included in her gross estate because the transfer was not a bona fide sale for full and adequate consideration. The appeals court concluded: “There is nothing inconsistent in acknowledging on the one hand that the investor's dollars have acquired a limited partnership interest at arm's length for adequate and full consideration and, on the other hand, that the asset thus acquired has a present, fair market value, i.e., immediate sale potential, of substantially less than the dollars just paid—a classic informed trade-off.”

Also on appeal, the U.S. Court of Appeals for the Third Circuit agreed with the Fifth Circuit that it is not always necessary to have a so-called “arm's length” transaction.

According to the court, “While a bona fide sale does not necessarily require an arm's length transaction, it still must be in good faith. A 'good faith' transfer to a family limited partnership must provide the transferor some potential for benefit other than the potential estate tax savings that might result from holding assets in the partnership form.”

The IRS continues, with mixed success, to challenge FLPs in the courts. That should not deter any retailer, distributor or manufacturer with an honest desire to transfer their business, or its income, to family members. After all, none of those IRS challenges has been successful in eliminating FLPs nor have they severely affected any toy, game or hobbies business owner that closely adhered to the rules.

Using an FLP requires both careful analysis and strict compliance with IRS regulations—not to mention professional assistance. FLPs, however, are well worth the cost of investigating, establishing and maintaining from a variety of standpoints, not the least of which is taxes.