Family limited partnerships

In short

A friend of mine who farms three thousand acres once told me the hardest part of passing on land was not the paperwork but the fairness of it. If you hold a large estate, a family limited partnership is one way families organize what they own so it can move to the next generation in steps. The partnership is a legal entity, set up under state law, that holds assets such as land, a business, or an investment account. The parents usually keep the small general partner stake and give or sell the larger limited partner stakes over time. Because limited partners cannot run the business or sell their stakes freely, the law may allow a lower value on those stakes for gift and estate tax purposes. That lower value is the whole reason people look at this tool, and it is also the reason the IRS watches it closely. Talk with an estate lawyer and a valuation appraiser before you sign anything, because the details decide everything.

The whole of it

What it is

I once sat beside a man at a county fair who had built a trucking company from one rig. He worried less about taxes than about what would happen to his three children after he was gone. If you are in his shoes, with a large estate and more than one heir, you have probably wondered how to hand over ownership without handing over control all at once.

A family limited partnership, often called an FLP, is a partnership formed under state law among family members. It has two kinds of owners. The general partner runs the show and answers for the partnership's debts. The limited partners own a share but do not manage it, and their risk is usually capped at what they put in. In many families, the parents hold the general partner interest, often through a separate company, and they also hold most of the limited interests at first.

The partnership agreement is the rulebook. It sets who votes, who gets paid, and when a limited partner may leave or sell. State law governs how the partnership is formed, so the rules differ from one state to the next.

How it works

Think of a pie that the parents bake and then slice. They move assets into the partnership, and in return they receive partnership interests. Then they give or sell slices of the limited interests to their children, or to trusts for the children. Each gift uses part of the federal gift tax exemption, which is set by law at the current figure, which the official source publishes each year.

Here is where the valuation matters. A limited partner generally cannot force the partnership to pay out, cannot run it, and often cannot sell the stake to an outsider. A buyer would pay less for such a stake than for the same share of the underlying assets. Appraisers call these reductions a discount for lack of control and a discount for lack of marketability. The discount is a matter of professional opinion, and the IRS can challenge it.

The parents, meanwhile, keep management. They decide when to sell the land or reinvest the cash. That is a comfort to many families. It is also where the trouble can start, as the later section explains.

The numbers, and where to find yours

Three numbers shape the plan. The first is the annual gift tax exclusion, set by law at the current figure, which the official source publishes each year per recipient. Gifts under that amount do not need a gift tax return or use any exemption. The second is the lifetime exemption, the current figure, which the official source publishes each year, which covers larger gifts and the estate at death. The third is the top federal rate on amounts above the exemption, the current figure, which the official source publishes each year.

You can find the current figures on the IRS website, on its pages for gift tax and estate tax. Your lawyer will also know them. Your own numbers are different, and they are the ones that count. They are the appraised value of what goes into the partnership, the discount your appraiser supports, and the value of each gift. Ask the appraiser for a written report that shows how each figure was reached.

A worked example

Let me tell you about Margaret and Walter Brennan, a made up couple from Nebraska. They own farmland and a small bank of investments worth $40,000,000 in all. They have two daughters.

They form a partnership and put in all $40,000,000 of assets. In return, they receive partnership interests. They keep a 1 percent general partner stake, which is $400,000, because 1 percent of $40,000,000 is $400,000. The other 99 percent is limited interests, worth $39,600,000 before any discount.

Now they decide to give 30 percent of the whole partnership to the daughters, split evenly. Before any discount, 30 percent of $40,000,000 is $12,000,000. Suppose a qualified appraiser supports a combined discount of 25 percent on those limited interests. Twenty five percent of $12,000,000 is $3,000,000. The gift is then valued at $12,000,000 minus $3,000,000, which is $9,000,000.

So the Brennans report a gift of $9,000,000 rather than $12,000,000. The difference is $3,000,000 of value that does not count against their exemption. If the estate tax rate on that amount were 40 percent, the saving on paper would be 40 percent of $3,000,000, or $1,200,000. I use 40 percent here only to show the arithmetic. The real rate is the current figure, which the official source publishes each year, and the real discount depends on the facts and the appraiser.

That is a nice picture. It holds only if the partnership is run as a real business and respected by the family. The next section is about what happens when it is not.

Where it goes wrong

I have heard it said that the IRS has seen every trick twice. Whether or not that is so, it pays to be honest with yourself about what the tax agency will look for.

The biggest risk is the retained interest problem. If the parents keep too much control or use partnership money for personal bills, the IRS may argue that the assets belong in the parents' estates anyway. Federal tax law has a provision, Section 2036 of the Internal Revenue Code, that can pull transferred assets back into an estate when the giver kept the use or income of them. Courts have applied it in cases involving family partnerships.

Other pitfalls are plain to see. Assets moved in shortly before death look like a plan made only for taxes. Personal homes and cars sitting inside the partnership raise eyebrows. Skipped meetings, missing records, and mixed bank accounts hurt a family's case. A discount that rests on a weak appraisal can be thrown out.

Cost is another matter. A partnership needs legal fees to set up, appraisal fees for each gift, annual tax returns, and careful bookkeeping. For a family at this scale those costs may be small next to the amounts involved. They are still real.

Then there is the human side. Giving children ownership before they are ready can cause friction. A partnership agreement cannot make siblings get along. Think hard about that.

Questions to answer before you leave this page

Do you have a clear reason for the partnership beyond the tax savings, such as keeping a family business together or pooling land for easier management? Will you keep enough assets outside the partnership to pay your own living costs, so you never need to dip into partnership funds? Who will serve as general partner, and what happens if that person dies or becomes unable to act? Have you chosen an independent appraiser with real experience valuing family partnership interests? Will your family hold meetings, keep minutes, and run separate bank accounts, so the partnership looks and acts like a real entity? How will each child feel about the amount and timing of the gifts, and have you talked with them about it? What does your state's partnership law require, and which lawyer in your state has handled these arrangements before?