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Family Limited Partnerships in Estate Planning

By Mark J. Welch, Attorney at Law (written Summer 1995)

"Family Limited Partnership" is the common name for a limited partnership created primarily to shift ownership of assets, and sometimes some income, to family members.

Legally, there is no difference between a "Family Limited Partnership" and most other limited partnerships, although there are some types of limited partnerships (including those which are publicly traded) which have some very different characteristics.

Limited partnerships offer a number of benefits over other forms of ownership of real estate or business interests (and also some drawbacks). This article will focus on the estate and gift tax advantages.

Assume that Mr. and Mrs. Smith own $4.6 million of rental properties or a closely-held business. Even if the Smiths use conventional tax planning (such as an "exemption trust" or "bypass trust") to shield a combined total of $1.2 million from estate taxes after they die, there will be an estate tax of about $1.6 million so their heirs will receive only about $3 million of the $4.6 million estate.

The Smiths can also use lifetime gifts to reduce their estate before they die. Each of them can make a gift of $10,000 to each of their children every year, tax-free (larger gifts will start using up their lifetime "estate and gift tax credit"). If they have three children, they could gift away $60,000 per year, gradually reducing the value of their estate; if both they survived 47 years, they would give away $2.8 million -- all but a combined $1.2 million.

Unfortunately, the Smiths face a second "problem" in their planning: growth. If they are worth $4 million today, their property will probably grow in value faster than they spend it. Even assuming a modest 5% rate of growth, their estate would double in less than 15 years, increasing their estate tax. Even if they gifted away $60,000 each year, the growth would still far outpace the gifts.

In addition, if the Smiths own real estate or a business, making gifts could pose additional problems. Making gifts in $60,000 increments is difficult if they own rental properties worth $100,000 each. Splitting ownership of an unincorporated business is even more difficult. And if the children own real estate directly, they could face personal liability if a lawsuit erupts; each co-owner of real estate also has a legal right to compel the partition or sale of the property, which could result in poorly-timed sales or poorly-timed capital gains taxes.

A family limited partnership can offer a number of advantages. If the Smiths create a family limited partnership, they can remain the general partners and continue to manage the property without interference from the limited partners. However, each year, they can gift away "shares" in the limited partnership, thereby shifting ownership (and perhaps some income) to the children, free of estate or gift tax consequences. The children would have limited liability for any problems that may develop.

And finally, the limited partnership shares would be subject to a "discount" from the value of the underlying assets, because there is no ready market for such shares and because limited partners have very limited power to control the corporation, especially if they own only a tiny fraction of the whole partnership. While it is reasonably likely that someone would pay about $100,000 for a rental property which has been appraised at $100,000, no one would pay $1,000 for a 1% interest in that property, or for a limited partnership share that represented a 1% interest in the property. Since the general partner will be paid for managing the business, there may be little or no income from the limited partnership, further decreasing the value of its shares. (There is even a risk that the limited partnership might generate "phantom income" undistributed capital gains that result in taxes owed by the limited partners without any cash distribution to help pay the tax.)

Finally, state laws restrict the sales of most limited partnership shares, and the transfer of limited partnership shares may be further restricted by the partnership agreement.By combining the discounts available for lack of marketability, minority ownership, and lack of control over management and income, the value of each limited partnership share might be significantly less than the corresponding value of the underlying assets.

For example, if a limited partnership owns $4 million of real estate, and there are 2,000 shares, each share would represent $2,000 of underlying assets but might be valued at only $1,400. If so, then seven shares of the partnership could be gifted each year instead of five, passing $14,000 worth of underlying assets without any estate or gift tax consequences. Assuming that each parent make the maximum tax-exempt annual gift to each of three children, then $84,000 of assets are effectively transferred each year, instead of $60,000.

It is important to recognize that a limited partnership is a business enterprise, and both your attorney and accountant must be familiar with the business management and tax aspects of a limited partnership. (As an estate-planning attorney, I insist that a business attorney participate if a family limited partnership is being created as part of the estate planning process.)

It is also important to recognize that the "limited liability" available to limited partners can be lost if they actively participate in the business. Therefore, a corporation is a preferred organization for a "family business" if the goal is to gradually transfer management and control of the business to the next generation. However, a corporation and limited partnership may both be used to maximize the available discounts.

Limited partnerships offer a number of additional benefits and drawbacks. It is important to discuss these issues in depth with your attorney before deciding whether a "family limited partnership" is an appropriate tool in your estate plan. Finally, a family limited partnership is not a complete estate plan: you also need a living trust or will with tax planning features, as well as many other documents to insure that your desires are respected if you are incapacitated and when you die.