Frequently Asked Questions about
the Family Limited Partnership

A family limited partnership is simply a limited partnership that is put to a specific purpose.

While it is important to draft the partnership agreement with certain characteristics, the initial written documents are not near as important as the ongoing operations of the partnership. The FLP MUST be run as a business. The FLP MUST NOT be used as a bank account. Therefore: do not impoverish the parent(s); do not create a situation where the FLP is paying the parent(s)' debts or current expenses; do not have a parent or a parent's revocable trust serve as the sole general partner; do not make partnership distributions other than proportionally in accordance with the partner percentages.

How does an FLP reduce gift and estate taxes?

    An FLP simply makes assets less attractive to potential third party purchasers. The buyer of a partnership interest (as opposed to a buyer of the partnership’s assets) forfeits a substantial degree of control and marketability. Because estate and gift taxes are based on the “fair market value” that a hypothetical third party buyer would be willing to pay for assets, placing them in an FLP decreases the value of the assets for gift and estate tax purposes. Note that gift tax does not become payable until a person gifts more than $1.0 million in his or her lifetime, and estate tax is not payable until the gifts in life and at death exceed an even higher figure.

Are these valuation discounts “real”?

    Yes. If a Family Limited Partnership works to decrease one's net worth for gift and estate tax purposes, it also decreases it for other purposes as well. For ex­ample, if you must maintain a certain net worth for commercial borrowing purposes, or for pur­poses of guaranteeing the debt of your closely held business, you should discuss the impact that valuation discounts may have on your net worth in dealing with your lender and other third parties, depending upon the nature of the property contributed, you may need two appraisals—one for the value of the property contributed to the partnership, and another for the value of the resulting partnership interests. Investment in a quality appraisal is money well spent. Most fights with the IRS regarding FLPs boil down to a question of value. Your appraiser must be able to provide convincing testimony that his or her valuation is well reasoned and supportable.

May I use an FLP to protect assets from creditors after creditor problems arise?

    Because Texas courts protect creditors with a concept known as the “fraudulent transfer” statute, the creation of an FLP will be of little or no use with respect to existing and reasonably anticipated claims against a debtor. If a transfer is found to be “fraudulent,” a creditor may per­suade a court to undo the transfer to the extent needed to satisfy the claim. Therefore, persons forming an FLP will have to retain sufficient assets outside the FLP to enable them to satisfy any outstanding (and reasonably anticipated future) debts and claims.

What happens to Family Limited Partnership interests in a divorce?

    An FLP can change the character of property owned by married persons—from separate to community, or from community to separate, depending on the circumstances. In addition, if, for example, only the husband is a general partner (if the spouse either has no partnership interest in his or her name or has only a limited partnership interest), then even if the court awards a substantial interest in the partnership to the wife, she will be in essentially the same situation as a creditor who becomes an “assignee” (as discussed above): she will have no voting power nor any effective ability to sell her interest but will, instead, be forced to rely on her ex-husband’s willingness to treat her fairly. These (and other) aspects of the FLP can make it a valuable tool when carefully coordinated with a marital property agreement. On the other hand, the careless use of an FLP can dramatically shift the spouses’ legal rights, with unintentional consequences if there is ever a divorce.

Will the IRS challenge the FLP?

    As you might guess, the value-depressing features of the FLP have been the source of considerable frustration to the IRS. It originally tried to argue that family members can be expected to act together, and therefore, the IRS should be entitled to assume away some of the discounts that appraisers apply to FLPs. The courts, however, have been unsympathetic to the IRS on this issue, and the IRS has announced that it has abandoned its “family attribution” theory. The IRS now wins when it is able to show that the parents have not sufficiently let go of the assets or the benefits from the assets.

What assets can I transfer to an FLP?

    Most people transfer income-producing assets to the FLP These include real estate, securities, business interests, and the like. Special precautions need to be taken if a closely held corporation is transferred to an FLP. If the corporation has elected to be taxed as an S corporation, transferring it to an FLP will terminate its S corp. status because a partnership is not permitted to be an S corp. shareholder. In addition, special precautions need to be taken before transferring stock in a corporation in which you and your family own 20% or more of the voting control. The IRS may try to tax the value of contributed stock in your estate unless you part with voting control. The safer course is to recapitalize the company with a nominal amount of voting stock (retained by you), transferring only nonvoting stock to the FLP. Other assets that warrant special scrutiny include an­nuities and property with debt in excess of the contributor’s cost basis.

Can the partnership own life insurance?

    An FLP may be used to shift life insurance out of the insured’s taxable estate. Unlike corporate-owned life insurance, which is 100% includable in the estate of the insured if he or she owns more than 50% of the stock, partnership-owned life insurance is included only to the extent of the insured’s percentage ownership of the partnership. For example, if the insured has given away 95% of the limited partnership in­terests while retaining control by keeping a 5% general partnership interest, only 5% of the in­surance proceeds should be included in the insured’s estate. While a life insurance trust can act to remove all insurance from an insured’s taxable estate, it has the disadvantage of being irrevocable. Some FLP owners are willing to risk estate tax inclusion of a portion of the life insurance proceeds to maintain the flexibility and control that an FLP offers.

What sort of paperwork is required after the FLP is formed?

    For an FLP to be respected by others, those who form the FLP must follow proper procedures. Thus, they should maintain separate checking and investment accounts for the FLP, keep partnership books and records, hold partners meetings, record votes on partnership matters, and otherwise treat the FLP as a separate business. In addition, proper documentation should be prepared and signed each time a partnership interest is transferred. And, of course, partnership income tax returns must be filed each year, with each partner reporting his or her share of partnership profits and losses.

This memorandum contains general information and while the information presented is accurate as of the date of its publication, it cannot be relied upon as legal advice, as that can only be obtained through personal consultation with an attorney with whom you share your specific facts.

 Copyright © 2008 by Sterling A. Minor. All Rights Reserved.

Last Updated: April 17, 2008