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What's All the Fuss About Family Limited Partnerships?
Major News – The Kimbell Case
The Fifth Circuit Court of Appeals recently dealt a major blow to one of the few successful lines of attack asserted by the Internal Revenue Service on the Federal estate tax benefits of properly organized and operated "family limited partnerships." Commentators were quick to point out that the summary judgment granted to the taxpayers in Kimbell v. U.S., 371 F.3d 257 (5th Cir. Texas 2004), was a significant victory for the many taxpayers using this technique nationwide.
The court agreed that family members can enter into a bona fide transaction and transfer assets in return for a prorata partnership interest. Under Kimbell, there must be some degree of business purpose, but the mere presence of tax planning motives will not prevent the transfer of assets from being a bona fide sale.
Family Limited Partnerships
In general, a family limited partnership, or "FLP", is a state law limited partnership documenting certain agreements between family members who contribute specific assets to the partnership in return for general and/or limited partnership interests. A typical FLP agreement usually provides that:
- The FLP shall exist for a term of a specified number of years.
- Partnership earnings may be retained by the partnership.
- Limited partners cannot withdraw before the end of the specified term and may receive distributions only then or at the discretion of the "managing" general partner.
- The "managing" general partner assumes special duties.
- All partners must agree before the partnership is dissolved.
- All partners must agree to any transfer of ownership by a partner.
- Involuntary transfers of interests are ruled by a buy-sell agreement.
- Transferees of partnership interests receive only limited partnership interests.
- Partnership interests can not be pledged for debts.
One FLP Benefit – Reduce Federal Transfer Taxes
Due to the restrictive terms of a typical family limited partnership, the amount that a willing buyer will pay for a partnership interest is less than the fair market value of the assets underlying that partnership interest. Substantial discounts for lack of management and liquidation rights have been approved by the courts. Consequently, appraisers typically compute discounts of 10% to 40% or more from the fair market value of the assets held within a properly drafted family limited partnership. The key is that these discounts reduce or eliminate the federal gift tax or estate tax that would otherwise result.
Other Reasons for Utilizing the FLP Technique
In addition to transfer tax-motivated reasons for holding assets in a properly designed and operated family limited partnership, other significant reasons include:
- Control over the partnership's distribution of its cash flows.
- Control over the management of historical family businesses.
- Protection of family assets from future creditors.
- Protection of family assets from failed marriages.
- Operational and investment flexibility.
- Flexibility in Federal income and state taxation planning.
- Simplification of programs for gift-giving.
- Simplification in sophisticated estate tax and trust planning.
FLP'S Must be Organized and Operated Properly
As in the case of any sophisticated technique, family limited partnerships must be drafted with particular care and it is vital that the FLP be both organized and operated properly. Over the past few years, the Internal Revenue Service has sought to limit the Federal tax benefits being obtained by taxpayers utilizing FLP's in connection with their estate planning. The cases to date, including Kimbell, have clarified the prerequisites for achieving the multiple tax and non-tax benefits available through the use of family limited partnerships.
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