The family limited partnership (FLP) is the ice cream sundae of estate planning strategies. It collects a mound of mouth-watering ingredients (assets) into one bowl that satisfies any invited to taste it.
The recipe: Your client, as general partner in a limited partnership, gives assets away as limited partnership interests to heirs. Heirs don't own the actual assets, so they can't do anything with them. Creditors likewise have trouble penetrating the partnership structure. Your client also benefits from reducing by 20 percent, 30 percent or even more the value of FLP assets for estate tax purposes.
It's like a chocolate sundae--with a cherry on top.
"Family limited partnerships have become the estate planning tactic du jour," says Lewis Walker of Walker Capital Management/IFG Network Securities in Norcross, Ga. "They're great for clients with estates of several million who have significant private business interests or real estate they don't ever want to sell. It's also easy to gift partnership interests."
Brokers can benefit, too. "An FLP centralizes family accounts," says Rick Taylor, national director of LifeLine Planning Services at Clifton Gunderson, a Milwaukee accounting firm. "You get one tax return to deal with, centralized record keeping and only the general partner directs the investment strategy."
But even ice cream has drawbacks--it melts and adds pounds. So, too, FLPs are more complex than they seem. "It takes a special person to use a family limited partnership," says Randy Cox, a Dain Rauscher broker in Tucson, Ariz. "It must be someone who has a good business background and who can handle a more complicated personal financial picture going forward. When we set up an FLP, the attorney gives my client a two-inch- thick notebook."
The Basics What makes an FLP complex? Unlike a conventional trust, an FLP gives your client ownership of a business. The partnership must follow all annual record keeping regulations governing limited partnerships. And to avoid IRS scrutiny, the general partner needs to obtain valuations of the underlying assets and the limited partnership interests.
As a broker, you need to know which client assets belong in the FLP, a trust or other accounts, says Deborah Stavis of Stavis Margolis Advisory Services in Houston who has worked with FLPs for a decade. You must also know who the limited partners are and the share of the FLP assets each has. You must understand the rules on gifting partnership interests and ensure that distributions are made according to the agreement. You also need to understand how to work with valuation firms, she says. "People think of a family limited partnership as an event. It's a process."
The process begins by drawing up a partnership agreement. For a minimum of 2,500 dollars, Taylor says, a client can get a customized document that will protect the family in case of divorce or bankruptcy of a family member. The FLP can contain real estate, a family business or securities. Qualified retirement plan assets can never be put into an FLP. Certain securities are also disallowed, such as S-corporation stock and most stock options. Forget, too, about including personal assets, such as artwork or a vacation home.
Your client typically keeps a 1 percent to 2 percent ownership interest as general partner. The rest of the assets are given away as limited partnership interests to heirs--not as individual assets. They can be given all at once or gradually using the 10,000 dollars per person annual gift-tax exclusion.
If your client is concerned about creditors taking assets, an FLP is a good alternative to a trust, Taylor says. Creditors can only get their hands on assets if the general partner makes distributions. "The creditor has to work with the general partner to get paid, which gives some leverage to the general partner," he says.
Discounts and Costs Once transferred as limited partnership interests, your client's assets will be valued at a discount for estate tax purposes. Here's why: The IRS says you must value assets according to what a willing buyer will pay, Taylor says. "Would you rather have 100 dollars in cash or 200 dollars worth of pro-rata interest in a limited partnership?" he says.
Stavis explains the discounted value this way: "If all I own is a 1 percent interest in a partnership, I can't cash it in. I don't own assets in my name. I can't spend it at the grocery store or take it to my broker to cash it in. The partnership agreement says I can only sell my interest to another partner."
The size of the discount varies according to the type of assets in the FLP. The more illiquid and complicated the asset mix, the bigger the discount.
"The IRS argues that the discount on an FLP containing only securities must be much lower than when other assets are included," Taylor says. Be wary of anyone claiming that a securities-only FLP can get a discount of more than 30 percent, he says.
Because the discount won't be tested until your client and spouse die and the estate tax man comes, a lot of tax advisers just tell their clients they'll get a big discount when the estate transfers, Taylor says. But Taylor believes paying a minimum of 2,500 dollars for a professional valuation now saves money later.
"Think of it as buying insurance," Taylor says. "If the IRS audits the estate, the valuation agent who must come in then could charge as much as three times more because he knows his report will be questioned."
Overall, it can cost 5,000 dollars to 10,000 dollars to set up an FLP, Taylor says. That includes any attorney consultation beyond drafting the agreement, a professional valuation and the services of a CPA to ensure that the FLP fits into your client's overall estate plan.
That's only the beginning of the cost. Over the course of its life, an FLP will cost your client an average of 150,000 dollars, Stavis says. That includes the costs of setup, annual record keeping, and consultations with an attorney, CPA and valuation firm that the family will need to defend the FLP against the IRS at the second spouse's death.
Limited Use FLPs are not suitable for all clients with substantial assets. Remember, S-corporation securities, qualified plans and personal items can't be placed in FLPs. With those assets eliminated, a client must have at least 500,000 dollars left to contribute over time, and preferably 1 million dollars, Taylor says, or an FLP isn't cost effective.
Cox says one way he determines suitability is to compare the costs of an irrevocable life insurance trust and an FLP. "For one person, the cost of insurance could be so high that an FLP starts looking good at just above a 1.3 million dollars net worth," Cox says. "For someone else, it might not be until 2.5 million dollars net worth because insurance costs are lower."
Cox only recommends an FLP once he's consulted with what he calls his "mini board of directors"--an attorney, CPA and insurance agent who work on his team. He identifies the estate tax problem, then tells the client an FLP is a solution that's complicated but effective.
Walker uses FLPs for clients with several million in highly appreciated nonliquid assets. An FLP worked especially well for a client in his 70s who had many real estate parcels with low cost bases. The client was concerned that with a trust arrangement, he'd lose control and have difficulty dispersing the properties to his many children and grandchildren.
Asset and cost issues aside, some clients still shouldn't have an FLP, including those who want flexibility or don't want responsibility. "I have clients two years into an FLP say they want to move this asset into this account. I tell them that they'll have to distribute it as an interest to their kids," Stavis says. "They didn't remember that."
And Cox says he's had to undo some FLPs and switch to irrevocable life insurance trusts, particularly with widows who just didn't want to run a business. Stavis says no to those kinds of clients: "I won't recommend it to my wealthiest client because we know he wouldn't maintain it."
Since 1997, the IRS has publicly campaigned to squelch the use of discounts on family limited partnership (FLP) assets. It has yet to win an important case.
The Clinton administration proposed in 1998 that Congress eliminate valuation discounts for FLPs except where active businesses are involved, saying the change would raise 2 billion dollars over five years. The proposal failed.
"The IRS is going after sizable discounts," says Rick Taylor, national director of LifeLine Planning Services at Clifton Gunderson, an accounting firm in Milwaukee. "But you can keep a high discount if you hire good people before an audit."
In 1999, the IRS sent out memos identifying FLPs that it considers abusive. Here's what will raise a red flag:
* Setting up an FLP within a few days of the general partner's death.
* Distributing most of the assets immediately after setup.
* Failing to have a professional valuation done to support a discount.
* Putting personal-use assets in the partnership.
* Depositing income from FLP assets into a personal account.
* Claiming high discounts on securities-only FLPs.
"There needs to be a legitimate business purpose for the partnership," says Deborah Stavis, a Houston investment adviser. "The IRS won't look favorably on consolidating all your vacation homes and calling it a business." The longer an FLP is in place, the better chance it has of standing up to IRS scrutiny, Stavis says. Make sure the FLP makes good sense even if all the tax breaks are disallowed. And one other piece of advice: "Don't call the partnership by your name," Taylor says. "That's like walking around with a bull's-eye on the back of your neck."