Asset Protection Law - Book Chapter FLP

Parents are often confronted with reducing the size of their estate for estate tax purposes and to protecting their estate from creditors. Although the size of the estate is reduced by directly giving their children assets, they lose control and the assets remain liable to their children’s creditors. This is resolved by using the Family Limited Partnership (FLP). Parents will put their assets in their asset protected FLP and receive in exchange a 1% General Partnership interest which will constitute 100% control of the FLP and a 99% Limited Partnership interest. The parents will make annual gifts of their Limited interests within the $13,000.00 (for the year 2011) gift tax annual exclusion and thereby reduce the size of their estate for estate tax purposes without giving up control over the FLP’s assets. In addition, they can make gifts of their Limited interests up to their gift tax exemption amount of $1,000,000.00 each.

The following are the reasons most often given for forming a Family Limited Partnership (FLP):

• Increase my ability to gift by applying a valuation discount to the amount of the gift. With a 35% discount, I can gift 20,000 annually, not $13,000 (2011).

• Keep control of the assets I transferred into the FLP. I may not own them (for estate tax purposes) but I do control them.

A general partnership is created pursuant to the Uniform Partnership Act (UPA). The partners’ duties and rights are governed by the partnership agreement. However, in the absence of a partnership agreement, duties and rights are governed by the UPA.

A limited partnership has one or more limited partners and one or more general partners.

A limited partner relies on the general partner to run the business enterprise and make him money. Limited partners have no voice in management and no control over the partnership. However, limited partners have the right to inspect partnership records and obtain accounting information. [ULPA §304 (2001).]

Limited partners have no personal liability for injury or damages caused by the partnership. [ULPA §303 (2001).]

A Family Limited Partnership (FLP) is a descriptive term used in asset protection planning for a limited partnership that is owned by family members and is drafted to contain clauses that are more beneficial to protecting assets than a more standard limited partnership. These provisions enhance the FLP’s ability to withstand creditor attack.

Limited partnerships are created by state law (a state limited partnership act, or a state version of the Uniform Limited Partnership Act).

Each person admitted into a partnership owes a fiduciary duty to every other partner. That means each partner must deal with each other partner in utmost good faith regarding the partnership’s affairs.

However, there are differences between an admitted (substituted) limited partner and an assignee who is not an admitted (substituted) partner. [See, e.g., Cal. Corp. Code §15519 (substituted limited partner is admitted to all the rights of a limited partner; assignee has no right to require information of transactions, to inspect books, or to vote).]

An FLP may be formed under any state’s law. However, a contract or tort action is usually governed by the law of the place where the act took place.

For example, even though an FLP is established in Nevada, if the partners reside outside Nevada, the business is controlled outside of Nevada and the tort or contract action arose outside Nevada, the law where the act took place will most likely apply.

Since a limited partner is not active in the business and relies on the efforts of others (i.e., the general partner) to make him money, an FLP interest is a security.

The FLP interest is usually exempt under federal and state small offering exemptions (private placements). However, appropriate state exemption filings and Regulation D filings with the Security and Exchange Commission should be considered. [See, e.g., Cal Corp Code §25102(f) (providing exemptions from state filing requirements). The §25102(f) needs to be filed by California limited partnerships. By doing so, the full securities filing is not required. For more on Cal Corp Code §25102, see Chapter 8, Corporations.]

LLCs allow members to actively participate in the management of the LLC without jeopardizing the members’ limited liability.

FLPs do not allow limited partners to actively participate in management. [ULPA §406 (2001).] However, there are limits to the managerial rights of general partners. The consent of each general and limited partner is required for some specified actions. [ULPA §406(b) (2001).]

An individual general partner is personally liable for partnership debts and liabilities. [ULPA §404 (2001).] For this reason, an LLC is often used as the general partner.

The valuation of an FLP interest is similar to the valuation of an LLC interest. The interests are similarly discounted for gift and estate tax purposes.

[For valuing an FLP interest, see §§9:100 et seq. For LLC interests, see Chapter 10, Limited Liability Companies.]

The holder of a charging order against an FLP interest has only the rights of a transferee. [ULPA §703 (2001).] A transferee has virtually no rights. The transferee only gets those FLP assets that the general partner decides to distribute, often nothing. The holder has no right to attend partnership meetings or to vote at partnership meetings. [ULPA §702 (2001).]

Even if all they own is a one percent general partner interest, an FLP allows senior family members to keep total control and management of the FLP’s assets. A person can transfer his or her estate and yet still keep control over it.

For this diagram, see “Figure 9-10 General Partner Keeps Control.pdf” in the “Diagrams” folder on your CD.

• Allow intra-family income shifting, so that income can be shifted away from high tax bracket family members to lower tax bracket members.

• Allow the transfer of FLP interests more easily than transferring undivided interests in the underlying assets.

• Reduce the size and tax value of assets, thereby permitting “leveraged gifting” and “valuation adjustments” to reduce estate and/or gift taxes.

• Make it clear that the partners are family and outsiders are truly not wanted.

The retention of managerial powers as a sole general partner does not cause the transferred limited partner interests to be included in the donor’s estate or render a gift incomplete. [Priv. Ltr. Ruls. 9546007, 9546006 (extending to FLPs the rationale of United States v. Byrum, 408 U.S. 125 (1972), where the court interpreted Internal Revenue Code §2036 to mean that a donor’s retained right to vote a majority of shares of the stock given away did not cause them to be included in his estate, since that right was subject to a fiduciary duty to the minority stockholders).] However, if corporate stock is placed into an FLP there will be an estate tax issue unless the limited partners are given the right to vote their percentage interest of the corporate stock. [See §9:81.]

An FLP can provide estate tax savings because the value of FLP interests are reduced as a result of the limitations placed on a limited partner’s ability to control the operations of the partnership. Let us assume that I place $1 million on a table and offer to sell it to you for $990,000. Would you buy it? Of course! Now assume I placed it in an FLP and offered to sell 99% of the limited partnership interests to you for $650,000. Would you? Before you answer, consider the following: I basically have all the power as the general partner. I am not a very easy person to get along with. You will get the information you want concerning what is happening with your $650,000 investment, to the extent I decide to tell you, or not, or as a court forces me. How long till the investment is over and you can get your money back? I’m not sure. Perhaps your general partner will be more agreeable, but these are some of the reasons (you lack control, minority discount, etc.) that the IRS will generally allow a 35% discounting of your limited partnership interests.

However, special structuring is required to accomplish this. [See §§9:40 et seq., 9:101. See Strangi, 115 T.C. No. 35 November 30, 2000 (Strangi I), Estate of Strangi v. Commissioner, T.C. Memo. 2003-145 (2003) (Strangi II), Estate of Strangi v. Commissioner, No. 03-60992, (5th Cir. 2005) (Strangi III).]

In Estate of Dailey v. CIR, T.C. Memo. 2001-263 (Oct. 3, 2001), the Tax Court ruled that minority interests in an FLP holding marketable securities were entitled to a 40% combined discount for lack of marketability and control. According to the court, “Fair market value is the price at which property would change hands between a willing buyer and a willing seller.” But in this case, a willing buyer may only become an assignee under the Partnership Agreement.

This is a point worth noting. In Estate of Dailey, above, the partnership interests she transferred only gave the transferee the rights of an “assignee,” not the rights of a substituted limited partner. An assignee interest is worth less than a substituted limited partnership interest.

Mrs. Sam Walton has emphasized the importance of this factor in their family's partnership, which held their Wal-Mart stock:

It was great moneywise, but there was another aspect to it: the relationship was established among the children and with the family. It developed their sense of responsibility toward one another. You just can't beat that.

Sam Walton discussed the importance of his family's partnership in maintaining a sense of balance and control for all family members:

It's something that any family who has faith in its strength as a unit and in the growth potential of its business can do. The transfer of ownership was made so long ago that we didn't have to pay substantial gift or inheritance taxes on it. The principle behind this is simple: the best way to reduce paying estate taxes is to give your assets away before they appreciate.

It turned out to be a great philosophy and a great strategy, and I certainly wouldn't have figured it out way back then without the advice of Helen's father. It wasn't lavish or exorbitant, and that was part of the plan—to keep the family together as well as maintain a sense of balance in our standards.'

Insurance is the first line of defense against liability, and asset protection does not replace liability insurance coverage.

However, a properly asset protection designed FLP can complement insurance coverage by providing additional protection in the event that a judgment either:

The means by which a judgment creditor may reach a partnership (“FLP”) interest of a judgment debtor is a charging order.

Prior to charging orders, courts used collection procedures that discouraged the use of the limited partnership format. Despite the fact that individual partners did not have title to limited partnership property, FLP property could be seized under writs of execution and sold, resulting in compulsory dissolution and winding up of the FLP.

Things have changed! FLPs (and LLCs) now work for asset protection because of Lord Justice Lindley of the English Court of Appeal. Lord Lindley described the previous collection procedure as follows:

When a creditor obtained a judgment against a partner, the sheriff went to the partnership, seized everything, stopped the business, drove the solvent partners wild. A more clumsy method of proceeding could hardly have grown up.

The following legislation has developed to prevent such hold up of the FLP business and the consequent injustice done the innocent partners from execution against FLP property:

These statutes developed the charging order, which makes FLPs effective asset protection tools in the proper circumstances.

Because of the charging order, the FLP can turn assets that are attractive to creditors (e.g., cash) into assets that are unattractive to creditors.

Cash becomes unattractive because the judgment creditor’s remedy changes. The judgment creditor cannot execute upon cash in an FLP. Instead, the creditor gets only what the general partner decides to distribute, which is often nothing. As a result, FLP interests are much less attractive to judgment creditors.

• The judgment creditor’s attorney, if on a contingency fee arrangement, may need to wait years before he collects anything for his efforts.

• The attaching creditor will have significant tax issues. [IRS Rev. Rul. 77-137; see §9:92.]

This charging order concept prevents creditors of a partner from disrupting the FLP business.

A partner is not liable to creditors of the FLP. A creditor of the FLP is referred to as an “inside” liability.

An FLP is liable to its own creditors, but it is not liable to creditors of one of its partners. A creditor of a partner is referred to as an “outside” liability.

FLP creditors are entitled to all assets held by the FLP. For this reason, care must be taken to avoid mixing safe assets (stocks, bonds, and cash) with dangerous assets (apartment complexes, and businesses).

If one inside the partnership asset causes a lawsuit, all of the FLPs assets are at risk.

In many instances it may be advisable to create one FLP that owns several limited liability companies (LLCs). Each LLC can own one dangerous asset to avoid the domino effect that a judgment against that FLP (or LLC) could cause to all the assets held within that one vehicle. Don’t place all your liability prone assets in one basket, and never place them in the same basket as your safe assets.

Mark and Judy are married, have two children, and own a business and two apartment buildings. Mark’s business is high risk; Judy is a teacher. They place their business and each of their buildings into separate LLCs, and have the LLCs owned by an FLP in exchange for general and limited interests.

The general partner interests are held by each as sole and separate property. The majority of the limited partnership interests are placed into an irrevocable discretionary trust for their children.

The LLC that owned one of the apartment buildings is sued and the judgment exceeds the property’s liability coverage by $2 million. The LLC loses the building, but the only asset that Mark and Judy lose is that one building in that one LLC. All the other entities are unaffected. Mark and Judy did not have to lose even that one building. [See §§12:23 and 12:62, Equity Stripping With FLPs and LLCs.]

A creditor of a partner has no greater rights against FLP assets than the other partners.

Assume the same basic facts as in the above example regarding inside liabilities (Mark and Judy place their business and each of their buildings into separate LLCs).

Mark is sued and suffers a $1 million judgment. Mark’s only major assets are his general and limited FLP interests.

In a jurisdiction (e.g., Nevada) that prohibits foreclosure and limits judgment creditors to charging orders, the creditor can obtain only a charging order and hope that Mark’s wife will make distributions.

However, the holder of the charging order (the creditor) most likely will be taxed on its share of FLP income even though the income is not distributed. [See §9:92.]

In a jurisdiction that permits foreclosure (e.g., California), the result is considerably worse than what Mark achieved using a Nevada FLP. Although foreclosure of Mark’s FLP interests will not permit the creditor to access the FLP’s assets, the judgment creditor can now sell the foreclosed FLP interests. The sale will be at a discounted price because the purchaser will also not be able to do anything but wait for distributions to be made. However, if the purchaser pays $100,000 (at a bona fide sale) for an interest that is worth $1 million, then the purchaser can afford to wait, and the $1 million judgment against Mark is only reduced by $100,000 rather than $1 million.

The FLP must have a business purpose. Many FLPs have no business purpose other than protecting their assets. [See In re Turner, 335 B.R. 140, 147-48 (Bankr. N.D. Cal. 2005) (stating that an entity may not be created with no business purpose and personal assets transferred to them with no relationship to any business purpose, simply as a means of shielding them from creditors). But see ULPA §104(b) (stating that “this Act does not require a limited partnership to have a business purpose).] An FLP with a business purpose is more asset protective than one without. In practice, I have found that an FLP without a business purpose is still better than leaving assets exposed.

If the only purpose of the FLP is to protect assets, a court may determine that a creditor’s remedy is not limited to obtaining a charging order. [For more on charging orders, see §§9:90 et seq.]

There are multiple reasons for selecting the FLP as a planning tool [see §9:41], including:

However, FLPs that are created solely for asset protection or to avoid known creditor claims will probably not provide asset protection when it is needed most—in court.

On the other hand, FLPs that are created for valid business purposes, and that carry out those purposes in actual operation, should enjoy the ancillary benefit of asset protection.

An FLP is formed when a Certificate of Limited Partnership is filed in the Office of the Secretary of State of the appropriate state. [ULPA §201 (2001).]

Just as a corporation must be operated as an entity separate and apart from its owners to prevent a creditor from “piercing its corporate veil,” an FLP also must be operated separate and apart from its partners to prevent a court or the IRS from discarding its veil.

All filings and registrations must be undertaken properly, a written limited partnership agreement entered into, tax returns filed, and the assets of the FLP must not be commingled or treated as if they are assets of the general or limited partners.

Any of the following may be a partner of an FLP: individuals, corporations, LLCs, custodianships for children, trusts (foreign and domestic), and other partnerships. [See ULPA 102(14) (definition of person).]

Flexibility of who may be a partner of an FLP is quite unrestricted when you compare it with who may be a shareholder of an S Corporation. All S corporation stockholders must be individuals, estates, specifically described organizations, domestic trusts or foreign grantor trusts. [See instructions for IRS Form 2553 regarding who may elect to be an S corporation.]

The general partner manages the business of the FLP, its investments, and its day-to-day activities.

Limited partners are not responsible for partnership liabilities; general partners are liable for partnership debts. [ULPA §303 (2001) (limited partners); ULPA §§404-405 (2001) (general partners).]

An individual general partner is personally responsible for partnership liabilities. [ULPA §§404-405 (2001).]

Therefore, if the FLP is funded with liability producing assets, it is advisable to use a trust or LLC as a general partner rather than an individual family member.

A creditor of a shareholder who gains control of 51% of the corporate stock would control the corporation, and through the corporation, the FLP.

Therefore, great caution must be exercised when choosing a corporate general partner.

A children’s trust should rarely be used as a general partner for the following reasons:

• The trustee would owe a fiduciary duty to the children, and not to mom and dad.

Therefore, the FLP should provide for a successor general partner in case the general partner dies, becomes bankrupt or has his partnership interest charged or foreclosed upon by creditors.

Limited partners are dissociated on death [ULPA §601(6)] but not on bankruptcy. [See comments to ULPA §601 (2001).]

A donor may give a limited partnership interest to an irrevocable protective trust established for the benefit of family members.

Since the interests given away are limited partnership interests, the donor maintains control as the general partner. The donor might exercise some control over the interest given away by appointing a friendly trustee over the irrevocable protective trust, or using a protector [See Chapter 4].

If a client desires to make a minor a partner, then use either a guardian or a trust. [See Uniform Gifts to Minors Act; Uniform Transfers to Minors Act; IRC §2503(b) & (c).]

• Do not allow assignee to automatically become a substitute partner. [See §9:63.]

• Use an entity (perhaps an LLC) as the general partner to prevent any partner having personal liability. [See §9:51.]

• Authorize mandatory capital contributions. Creditors do not like to be required to contribute to an FLP from which they have not gotten any distributions [See §9:64.]

• Permit the redemption of interests seized by creditors (foreclosure) or subject to a charging order. [See §9:65.]

If the FLP agreement does not specify the time when partnership capital is to be withdrawn, partners may not withdraw their capital. [ULPA §505 (2001).]

Notwithstanding any other provision of this agreement, no Partner shall have the right to demand or to receive the return of all or any portion of such Partner’s Capital Account, Partnership Interest, or of such Partner’s Capital Contribution.

One of the advantages of the charging order procedure is the income tax consequence to the creditor who obtains a charging order. The creditor may find that he does not receive an income distribution, but is required to pay income taxes on undistributed profits. [See §9:92.]

Earnings shall be distributed at least annually, except those funds which, at the sole discretion of the general partners, are reasonably reserved for the conduct of the FLP business.

Since income may be held in the FLP at the sole discretion of the general partners, distributions may be able to be stopped when there is a creditor with a charging order. However, if a pattern of distributions has been established, then there may need to be business reasons (other than a charging order) before the court will allow that pattern to be changed.

Care must be exercised not to be in a situation where a client cannot pay his living expenses or taxes. If no distributions are made to one partner, unless the FLP Agreement has otherwise provided, no distributions can be made to any partner.

It has been suggested that as a contract, the partners could agree that to the extent a charging order is in effect, the allocation to those charged interests would be held in a special account fully vested in the charged partner. This would allow the non-charged partners to get distributions and the charged partner to have his share in a vested account. Draft the following clause into the FLP.

Example: Assume there are five equal participants in an FLP which has $100,000 in it ready to be distributed. If a creditor of your client has a Charging Order (lien) on your client’s partnership interests, they, not your client will get the $20,000 (20%) distribution. If this was a family owned limited partnership, the family could decide to withhold distributions so the creditor would get nothing. But here, the other four Members want their distributions. Can the FLP distribute to the four but not to your client? The answer is; the Partnership Agreement is a contract, the following should be drafted:

“Any other provision of this Agreement notwithstanding, the General Partner shall not make any distribution of Available Cash or in Kind to a Partner whose interest is being charged pursuant to a charging order, or whose interest is otherwise being pursued in a collection action by any third-party. In the event of a charging order or a collection action the General Partner is authorized to make all distributions solely to the other Partners; provided, however, that the Partner whose interest is being charged shall vest in the distribution (i.e., Available Cash shall be distributable to such Partner, but shall not be actually distributed until the collection action is terminated).”

In addition, the FLP agreement may provide for a “guaranteed salary” to the less vulnerable general partner (provided there is more than one, i.e. both husband and wife are General Partners) and by approval of the majority of the partners, this “guaranteed salary” may be increased or decreased.

Limited partners may freely assign their interests. However, it should be stated that absent unanimous consent of all other partners, the assignee is merely an assignee and not a substituted limited partner. [ULPA §702 (2001).]

Draft the FLP so that an assignee cannot become a substituted partner without the unanimous consent of all of the partners, as follows:

No person, corporation, trust, limited liability company, or other legal entity shall be admitted as an additional Limited Partner without the unanimous consent of all of the Partners.

This prevents a creditor from becoming anything more than an assignee. [See §9:04.]

Give the general partner the authority to require a mandatory capital contribution, with the provision that if a partner fails to proportionately contribute, then the percentage ownership of that non-contributing partner is reduced.

The general partner shall have the power to require the partners or assignees of partnership interests to contribute additional capital when additional capital is needed.

This provision will apply to a judgment creditor who obtains a charging order, so that the creditor’must either place cash into an entity from which he has not received a distribution or his s ownership percentage will be reduced.

A partnership is a contract between people. If they do not want an outsider among them, they can all decide that if an outsider is able to charge the interests or become an assignee, the partnership has the right to buy that person out on the terms stated in the partnership agreement.

In order to reduce a burden upon resources, the partnership has the option to pay anyone who has either charged a partnership interest or become an assignee its promissory note, payable in 360 monthly installments at market interest.

Draft an employment agreement with a minimum guaranteed salary for the general partner to manage the FLP’s assets.

Then, even if the individual is removed as a general partner, he will still maintain an income stream.

Be careful when you use spouses as individual general partners and one of them is high-risk. Make sure that their FLP general partner interests are held as sole and separate property and not community property.

This way, if one spouse/partners’ interests are charged or he suffers bankruptcy, the others spouse/partners’ interests cannot be charged and he or she is not dragged into bankruptcy and the bankruptcy trustee cannot force the dissolution of the FLP.

Provide that several “innocent” partners (aside from the initial husband and wife) be made limited partners of the FLP.

With limited liability companies there is risk if the only member of the LLC is the debtor is that the charging order limitation no longer serves any purpose, and a debtor may become a “substituted” member. [See In re Ashley Albright, 291 B.R. 538 (Bankr. D. Colo. 2003) (bankruptcy trustee became a substituted member). See Chapter 10, §10:33, Single Person LLCs—Disregarded Entities.]

Perhaps this rationale could be extended to FLPs where the only partners are spouses. Are there in this case really “innocent” partners? The insertion of your children should negate this potential issue. However, the “innocent” partners should be real partners, and not merely nominal ones. [See In re Ashley Albright, 291 B.R. 538 (Bankr. D. Colo. 2003) (noting in dicta that the law does not create an asset shelter for clever debtors because to the extent a debtor intends to hinder creditors through a multi-member LLC with “peppercorn” co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors with recourse).]

The FLP agreement should clearly state that partners will only look to FLP assets for distributions of cash, and repayment of contributions and loans.

Thus, no partner shall have the right to hold general partners liable upon dissolution of the FLP for these items.

This prevents a court from holding general partners liable to limited partners for a financial return on their investment.

The partners shall look solely to partnership assets for the return of their capital contributions. If this is not sufficient, the partners shall have no recourse therefore against the partnership or any other partners.

For tax purposes, an FLP will be terminated if no part of any business, financial operation, or venture of the FLP continues to be carried on by any of its partners. [IRC §708(b)(1)(A).]

To the strictest degree permitted by state law, the FLP agreement should not permit a partner to dissolve or liquidate the FLP. The partnership should provide for a long life that can be extended.

If partners can dissolve the FLP, then a creditor of a partner or a trustee in bankruptcy will be able to dissolve the FLP.

To minimize the ability to dissolve an FLP, provide in the FLP agreement as follows:

No partner shall have the right to institute any proceedings to, or to demand or require the liquidation or dissolution of, the partnership.

Upon forming an FLP, the partners (generally the husband and wife or entities controlled by them) contribute investment and/or business assets to the FLP.

If the assets contributed are risky assets (e.g., rental property), the general partner of the FLP could be an LLC. [For more on LLCs, see Chapter 10, Limited Liability Companies.]

• Making gifts of cash or other assets. The gift recipient can then contribute the cash to the FLP for FLP interests.

FLPs should be funded with business and investment, not personal assets. After all FLPs are business or investment vehicles.

A quitclaim is not advised because it may make it more difficult for the FLP to transfer the property.

Since only business or investment property should be placed into the FLP, FLPs should not be used to protect a personal residence. If a contributor continues to use the home, then he or she must pay rent to the FLP. Rent is not tax-deductible to the client, but the income to the FLP is taxable. This FLP income then is taxable to the FLP partners through the K-1 according to their percentage ownership.

In addition, putting a personal residence into an FLP will cause the loss of the homestead exemption and loss of the $250,000 capital gains exclusion.

Use caution in transferring real property to an FLP. Areas of special concern are:

• Due on sale clauses. In my practice I have previously found only a few banks that do not want property to be transferred into FLP or LLCs. Recently, perhaps because of our recessionary times, I have found banks more interested in preventing transfers.

The sale of tangible personal property should be documented by a bill of sale and the FLP should pay for insurance on these items (as well as paying insurance on real property).

Often the FLP will then lease the equipment to the operating business. Since the equipment is only leased by the operating business, if the operating business loses a major lawsuit, the equipment is not lost.

Personal use property should not be held by an FLP unless the donor pays rent to the FLP for his use or occupancy of the property. In discussions with colleagues, I have been informed that some states allow FLPs to hold personal use property. The planner should consult his state’s law.

A transfer of closely held stock to an FLP, where the transferor retains the right to vote the stock, will cause the stock to be included in the transferor’s estate at death. [See IRC §2036(b) (providing that the retention of the right to vote shares of stock of a controlled corporation is a retention of the enjoyment of transferred property, and that a “controlled corporation” is a corporation that the decedent had the right to vote stock possessing at least 20% of the total voting power).]

This can be a problem because senior family members like the ability that FLPs give them to control the FLP. They also know that making completed gifts to family members removes those interests from their estate.

The rule applies if voting shares of a closely held business are transferred to an FLP of which the transferor is a general partner. [See TAM 199938005 (IRS concluded that §2036(b) applied to bring the stock back into the decedent’s estate).]

However, this issue can be overcome by inserting a clause into the FLP agreement requiring the general partner to permit the limited partners to vote the stock of the controlled corporation in proportion to the percentage they own in the FLP, as follows:

If the partnership holds stock in any IRC §2036(b)(2) controlled corporation, the general partner shall notify all partners of their right to vote the stock of such corporation in proportion to the percentage owned.

Generally, no capital gain is recognized when an individual transfers appreciated assets to an FLP in return for an FLP interest. [IRC §721(a).] However, this general rule does not apply when the FLP is deemed an investment company. [IRC §721(b).]

The investment company rules were designed to prevent individuals from diversifying their holdings without paying capital gains tax.

If you plan to fund an FLP with marketable securities, be careful not to inadvertently trigger portfolio gains by violating the investment company rules. If you transfer your portfolio into the FLP and its holdings become diversified as a result, you may be required to include the gain on the investments in your income even though the partnership has not sold any of them.

A owns 100 shares of ABC, Inc., and B owns 100 shares of XYZ, Inc. Each has a small tax basis in his shares and would like to diversify his holdings to reduce risk, but doesn’t want to sell because capital gains tax would be owed. Instead, they form an FLP and contribute their respective shares to it. As a result, each has diversified as each now owns a 50% interest in the FLP (assuming the value of the contributed shares was equal). This technique could have been used to get around the capital gains tax rules were it not for the investment company rules.

A transfer of property to an FLP is considered a transfer to an investment company if both:

• The transfer results in diversification of the transferors’ interests, and

• More than 80% of the value of the FLP’s assets (excluding cash and nonconvertible debt obligations) are held for investment and are “readily marketable stocks or securities.”

Gain may be triggered if the liabilities assumed by the FLP upon transfer exceed the basis of the property transferred. [IRC §752(b).]

A partner recognizes gain on the distribution of property from an FLP to the extent that money distributed (including marketable securities and any reduction in his share of FLP debt), exceeds his basis in his FLP interest. [IRC §731(a)(1).]

A creditor cannot force an FLP to pay legitimate debts of its members or partners. A creditor must wait until the general partner of the FLP authorize a distribution to the partners and thereby to the partner with creditor attachment. And knowing that a distribution made to the charged interests will be lost to the creditor, generally no distributions will be made.

Until the manager of the entity (often the debtor) makes a distribution, the creditor is limited to a “Charging Order” and nothing more. Well, there is something more: The creditor is forced to pay the income tax due on the undistributed funds which are subject to his Charging Order, even though the funds have not been distributed.

The mounting abuses of charging order protection cause judges to make exception to the statutory language. Do not rely on charging order protection by itself. FLPs are most helpful with assets which cannot be moved offshore.

If you are forced to rely on charging order protection, make certain that it has a valid business purpose.

Assets that would otherwise be attractive to creditors are rendered unattractive by transferring them to an FLP in exchange for interests therein. Following the transfers, the transferor owns interests in the FLP rather than the transferred assets.

A judgment creditor’s remedy against a partner of an FLP is to obtain a charging order. The charging order directs the FLP that all distributions that would have gone to the debtor-partner must instead go to the creditor. After the charging order is issued, the debtor-partner remains a partner but is not entitled to receive distributions or liquidating proceeds until the order is satisfied. Instead, the FLP must deliver to the creditor any money or property that would otherwise be distributed to the debtor-partner.

However, if the FLP agreement gives the general partner discretion as to when and how much to distribute to the partners, the general partner may decide not to make distributions when a partner has creditor problems. Or he may, if the partnership agreement allows assets to be distributed to partners, but not distributed to a partner whose interest are charged. [See §9:62.]

If there are no distributions, then the creditor with the charging order gets nothing from the FLP.

The general partner does not owe a duty to the holder of a charging order because there is no fiduciary relationship between them. The holder of the order is a mere assignee and has not been substituted into the partnership. [See Kellis v. Ring, 92 Cal. App. 3d 854, 859-860, 155 Cal. Rptr. 297 (1979) (assignee cannot bring an action for breach of fiduciary duty).]

Most FLP agreements provide that a creditor of a partner does not have the right to:

• Become a substituted partner in place of the judgment debtor without the consent of all the partners.

• Demand that money or property be distributed from the partnership to the creditor or any other partners.

However, for income tax purposes, the holder of a charging order is treated as a partner. [See §9:92.]

The operative provisions for FLPs emanate from the Uniform Limited Partnership Act (ULPA).

The key ULPA provisions regarding the procedure for creditor remedies are as follows:

• A judgment creditor of a partner may obtain a charging order, charging the partner’s FLP interest. However, the judgment creditor has only the rights of an assignee. [ULPA §703(a).]

• An assignee is entitled to receive distributions to which the assignor would be entitled, but is not entitled to participate in the conduct of the partnership. [ULPA §702(a)&(b).]

• Only a partner can seek judicial dissolution. [ULPA §§801, 802.] Since an assignee is not a partner, an assignee cannot cause a liquidation of the FLP.

In some states by legislative act or by court order, a foreclosure upon the interest subject to the charging order can be had. Nevertheless, a purchaser at the foreclosure sale still only has the rights of a transferee. [ULPA §703(b).] Some states have not enacted the foreclosure procedure. [See §9:95.]

The FLP Agreement may provide that the FLP can buy the foreclosed interest (or the charged interest) at a reasonable value using an installment note payable over 30 years, like a mortgage.

Although a creditor with a charging order may get no money, he may get something that he does not want: an income tax liability.

Although for state law purposes a creditor is not recognized as a substituted partner, for federal income tax purposes, it would appear based on the fact pattern in Rev. Rul. 77-137 that a judgment creditor with a charging order is treated as a substituted partner in place of the debtor. As a result, a judgment creditor of an FLP has the tax consequences resulting from ownership without the capacity to force either the dissolution of the partnership, or distributions from it.

However, it is unclear to what extent Rev. Rul. 77-137 applies to a charging order. The Ruling applied to a situation where a limited partner had irrevocably assigned its interest to an assignee. With a charging order, the creditor owns the interest only until the debt is paid. The assignment is not irrevocable. Thus, it is unclear whether the creditor will be taxed during the period of time that the creditor holds a charging order.

FLP profits are passed through to the partners for income tax recognition on the partners’ individual income tax returns. However, FLP agreements can be drafted to give the general partner complete discretion as to whether he should pass that profit out to the partners or retain it within the FLP for future needs. If that cash is not distributed, the partners still recognize taxable income but do not have a cash distribution to pay the tax.

This concept of “phantom income” enhances the asset protection feature of the FLP because the creditor is taxed but receives no income. This has been called the “K-0 by K-1” (the K-1 is the IRS form that tells the “charging” creditor the proportionate amount of taxable income on which he needs to pay tax).

Assume that an FLP has $100,000 of taxable income in a tax year. If a judgment creditor has charged a 50% partner and the FLP does not distribute cash, the judgment creditor will have $50,000 of phantom income on which he must pay income tax. This potential phantom income tax problem can deter many creditors from obtaining a charging order.

On the other hand, if there is a distribution so that the creditor receives income from the FLP, then the income the creditor receives reduces the amount of the debtor’s debt and the debtor has paid his debt without paying tax because the tax was levied on the creditor. [Rev. Rul. 70-195, 1970-1 CB 265 (payments made to creditors of taxpayer included in taxable income).] Perhaps the creditor has not seen this point.

For a creditor to collect from a debtor who has assets in an FLP, the creditor must:

• Finally, if no distributions are forthcoming, apply to the court to foreclose on the debtor partner’s interest. With a foreclosed interest, the creditor has more than he had with a charging order. He can sell the interest, but he still is not able to attach partnership assets and may find that he is being taxed on income he may never receive. [See §9:96, Foreclosure: Erosion of Charging Order Protection.]

In addition to directing that the FLP must pay the debtor’s share of any and all distributions to the creditor, the charging order may require that the FLP:

• Is prohibited from entering into or consummating any sale or encumbrance of any interest without court approval.

The partnership had to forward copies of all its financial statements to the creditor as well as past tax returns and financial statements.

Order entered in U.S. District Court, District of Colorado, May 3, 1994 in E.J. and Muriel Rothwell v. Lisa Fertman, civil action # 92 Z1881.

Previously, Nevada was a sole remedy state. N.R.S. §88.535 adopted the ULPA (2001). Therefore FLPs formed before October 1, 2007, and those that elect out of ULPA (2001) are subject to the previous statute that provides for sole remedy asset protection.

Unlike other exclusive remedy approach states, the Florida statute provides that other remedies, such as foreclosure of the partner’s interest and orders for directions and accountings, are not available to the judgment creditor, in an effort to prevent them from affecting the management of the LP. See Fla. Stat. Ch 620.1703

Alaska Ala. Stat. §32.11.340. states: ”On application to a court of competent jurisdiction by any judgment creditor of a partner, the court may charge the partnership interest of the partner with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the partner's partnership interest. This chapter does not deprive any partner of the benefit of any exemption laws applicable to his partnership interest. This section provides the exclusive remedy by which a judgment creditor of a partner may satisfy a judgment out of the judgment debtor's interest in the partnership.”

There is a trend by courts to allow for judicial foreclosure of a charging order. Judicial foreclosure permits a judgment creditor with a charging order to sell his “assignee” interest. This creates a means by which the judgment creditor can at least partially satisfy his judgment.

Although foreclosure does not create rights in the purchaser of the assignee interest to participate in the FLP’s management, it does create significant asset protection issues: The judgment creditor is less likely to enter into negotiations with the debtor if he has the potential to receive a larger payoff via foreclosure followed by a sale.

• The interest will likely be sold at a considerable discount, the debtor will realize less than the asset was worth, meaning a substantial portion of the judgment indebtedness would remain post-sale.

Example: If FLP interests are valued at $1m and after foreclosure are sold for $200,000, your debt is reduced by $200,000. This outcome could be used to the creditor’s advantage in negotiations with someone who could lose a $1m asset and only receive a $200,000 liability reduction.

• The client may be in the uncomfortable position of having to negotiate to re-purchase the FLP interest that was lost in foreclosure. A buy-out in the FLP agreement could resolve this.

• The purchaser will have the right to receive distributions until the FLP is dissolved, whereas the original charging order granted the creditor solely the right to receive distributions until it was satisfied.

In California, a judgment debtor’s interest in an FLP may be foreclosed upon and sold if the foreclosure does not unduly interfere with the partnership business. [Hellman v. Anderson, 233 Cal. App. 3d 840 (1991).] In Hellman, the court concluded that foreclosure would not be allowed if it would cause a partner with essential managerial skills to abandon the partnership. However, it would be allowed if it would have no appreciable effect on the conduct of partnership business. The effect of foreclosure on the partnership needs be evaluated on a case-by-case basis.

And a bankruptcy court has held that the charging order limitation serves no purpose with a single member LLC because there are no non-debtor members to protect. The court thus allowed the bankruptcy trustee to cause the LLC to sell its assets. [In re Ashley Albright, 291 B.R. 538 (2003). However, the Court stated that the result would have been different if there were other non-debtor members in the LLC. [See§9:68].

The law regarding charging orders is evolving, and there is a definite trend toward allowing judicial foreclosures of charging orders.

Furthermore, In re Ashley Albright may have opened the door to penetration of multi-member FLPs where “there are no non-debtor members to protect.” The next case may very well be an FLP where the only partners are a husband and wife.

A major benefit of an FLP is that the value of the FLP’s assets is reduced both for:

Originally there was little difference between an FLP designed for asset protection and one designed to achieve valuation discounts for estate planning purposes. However, the Fifth Circuit Court of Appeals has provided a ruling favorable to the IRS, declaring that assets transferred to an FLP would be included in the estate at their full value. [Strangi, 115 T.C. No. 35 November 30, 2000 (Strangi I), Estate of Strangi v. Commissioner, T.C. Memo. 2003-145 (2003) (Strangi II), Estate of Strangi v. Commissioner, No. 03-60992, (5th Cir. 2005) (Strangi III).]

Strangi has caused changes in the FLP’s design to be made, if valuation discounts are the goal. In many cases these changes are detrimental to asset protection design goals.

This ruling appears to have no effect on the asset protection benefits the FLP affords.

In the context of estate planning, the advantage of FLPs is that the fair market value of a limited interest is less than the value of the underlying assets because limited partners do not have control, and their shares are less marketable do to restrictions in the partnership agreement that affect transferability. These “discounts” allow FLP shares to be valued at 60% to 70% of their full value, reducing the base on which gift or estate taxes are levied.

The IRS had been trying to attack FLPs formed shortly before death, where the “deathbed transfers” seemed to be purely a way to avoid estate tax.

With Strangi the IRS asserted that Strangi’s assets should be included in his estate under IRC §2036, claiming that Strangi had never actually relinquished the right to income from the FLP and that he also retained the right to designate who should enjoy the property.

• The FLP did not have substantial business or non-tax purposes to be eligible for an exception from the application of IRC §2036. Therefore, the Strangi FLP was subjected to §2036(a)(1) and §2036(a)(2).

• Under §2036(a)(1), Strangi was deemed to have an implied agreement to retain enjoyment of the transferred property’s income because he received substantial payments and without the payments could not have supported himself.

• Under §2036(a)(2), Strangi was deemed to have retained control to decide who should receive income from the property because he had indirect control.

To avoid inclusion in the estate under §2036, the transfer must meet the “bona fide sale” exception. That is, the exchange of property for FLP interests should be a fair value exchange, and there should be a substantial business or other non-tax purpose.

For clients who are willing to surrender rights and control over property and have legitimate business or other non-tax purposes, the FLP continues to be an excellent technique.

An appraisal is critical to support valuation discounts. Two appraisals are needed to value an FLP interest.

Sometimes these underlying assets themselves can be discounted from their face value. For example, the following might be discounted:

• Non-negotiable or interest lower than market or under secured promissory notes).

The second appraisal is an appraisal of the individual FLP interest. Interests may be discounted for:

Sometimes limited partnership interests have the power to liquidate an FLP (this is the case in a Collapsing or Withdrawing Bridge structure). [For Collapsing or Withdrawing Bridge Structures, see Chapter 5, International Asset Protection Trusts.]

If the interests that are being appraised have the power to liquidate the FLP, then (subject to any fiduciary duty the holder may have to other partners not to liquidate the FLP), the FLP will most likely be appraised at a liquidated value (the value of its assets) rather than a going concern value. This is the case with the FLP in the Collapsing Bridge Technique. [For Collapsing or Withdrawing Bridge Structures, see Chapter 5, International Asset Protection Trusts.]

There are rules regarding attribution of ownership that would attribute to partners the interests held by other family members for purpose of valuing the interests.

This is, however, not always true. For instance, if husband and wife own interests as community property, 50% each, neither owns a sufficient percentage as to have control. [See Rev. Rul. 93-12.]

If a donor transfers shares in a corporation to each of the donor’s children, the factor of corporate control in the family is not considered in valuing each transferred interest for purposes of §2512 of the Code. For estate and gift tax valuation purposes, the Service will follow Bright, Propstra, Andrews, and Lee in not assuming that all voting power held by family members may be aggregated for purposes of determining whether the transferred shares should be valued as part of a controlling interest. Consequently, a minority discount will not be disallowed solely because a transferred interest, when aggregated with interests held by family members, would be a part of a controlling interest. This would be the case whether the donor held 100 percent or some lesser percentage of the stock immediately before the gift.

Property transferred from a living trust, if not first transferred back into the grantor’s name, will be drawn back into the grantor’s estate if the grantor dies within 3 years of making the gift. [PLR 8609005.] This could have disastrous consequences on the manner in which the discount is calculated.

If the appraiser is retained by an attorney (and not by the client), then the work-product of the appraiser may fall within the attorney-client privilege and therefore not be obtainable by the IRS.

Appraisals support reasonable equivalent value for purposes of avoiding fraudulent conveyances to family members who purchase the interest at a significantly discounted value to avoid its falling into creditor’s hands.

However, irrespective of the appraisal, such a sale will be suspect because it is to insiders.

The insiders may want to bid for the interests from a public or bankruptcy sale where the price is likely to be lower still, and the nature of the sale will cause the price to be less suspect.

Interests that possess voting control may be valued at a premium for estate and gift purposes, even though the value of the voting premium may be offset by the fiduciary duty that the majority owes to the minority holders.

The Chapter 14 Special Valuation Rules [26 USC §§2701 et seq.] were added to combat manipulation of values in family owned business entities.

The anti lapse rules determine whether a gift has been made and the value of the gift when family members control the entity both before and after the lapse. (In an FLP context, “control” means a general partnership interest.) [IRC §§2704(a)(1)&(b)(1).] But see Valuation and Restricted FLPs, below.

Contractual restrictions rules do not apply unless the control exists before the transfer. [IRC §2704(b)(1)(B).]

Nevada has created a new type of LLC and FLP (herein called “entities”). These new entities are called "restricted", see NRS 86.161. A restricted entity is an ordinary Nevada LLC or FLP that elects to be "restricted" in its articles of organization. This election imposes restrictions on the entity's ability to make distributions. The statute provides that unless otherwise provided in the entities articles, a restricted entity shall not make any distributions to its members until 10 years after the date of formation of the entity. Existing entities can by amendment of their articles become restricted LLC).

The rationale behind NRS 86.161 is Internal Revenue Code §2704(b), which provides that when valuing an interest in an entity for gift tax purposes, the liquidation restrictions contained within the entity’s operating agreement have to be disregarded if the entity is owned by family members both before and after the transfer. Code §2704(b)(3)(B) provides however that a restriction that is imposed by state law cannot be ignored. Nevada believes that these restricted entities will attract estate planners seeking larger valuation discounts for transfers of entity interests between family members. As these restriction can be removed by amending the entity's operating agreement should distributions be wanted, these restricted entities should draw business to Nevada..

An FLP files only an information return that reports the items of FLP income and loss and apportions each item between its partners.

Each partner receives a K-1. [IRC §6031.] The IRS then taxes each on their share of gain or loss without regard to whether the FLP has actually distributed cash or property. [IRC §702(a).]

A cash distribution to a partner will not create taxable income (because the partner is taxed directly in each year on partnership profits). However, cash distributions in excess of the partner's basis in the partnership will result in recognition of gain to the extent of the excess.

An FLP terminates for tax purposes if there is a sale or exchange of 50% or more of its total interests. [IRC §708(b)(1)(B).]

Gifts, bequests and inheritances, and contributions in exchange for interests are not sales or exchanges under these rules.

The transfer of real property to an FLP can raise issues of triggering “due on sale” mortgage clauses and transfer taxes.

In California, a Proposition 13 issue may be raised if the transfer is not properly structured. Proposition 13 may be triggered if spouses own property and transfer it to an FLP owned as little as 1% by their children.

Under Proposition 13, there is a $1,000,000 appraised value exemption to and from the donor’s children. However, Proposition 13 is triggered by a gift of over 50% of an FLP. Thus, a parent may want to gift 51% of a property to the children, then both parents and children contribute their share of the property to the FLP, and then the parents gift the remaining 49% of the FLP to their children. This can be done without incurring a step-transaction concern. [1987 Stats., ch 48 §2.]

Controversy regarding the classification of entities has been eliminated for the most part by the “check-the-box” choice of entity regulations.

These regulations generally permit most non-corporate, non-publicly traded business entities with at least two members to elect for federal income tax purposes to be treated as either a partnership or a corporation. [IRC §7701.]

Gifting an FLP interest allows a person to transfer in excess of his or her lifetime exemption to children without paying gift tax. Furthermore, gifts of FLP interests are present interest gifts, so a donor may give the children in excess of $13,000 (2011) each year without gift taxation.

Giving an FLP interest also minimizes the value of the donor’s estate on death.

Gifts of FLP interests constitute “present interests” and thereby qualify for the gift tax annual exclusion. [Treas. Reg. §25.2503-3(b).]

If parents put additional property into an FLP they must on a proportionate basis receive more FLP interests and then make gifts of those interests in order to take advantage of the present interest gift exception.

Be sure that parents receive an appropriate amount of interests considering the fact that the interests are subject to “discounts.”

If the parents allow all partners to benefit by the additional contribution, they will be making a future interest gift, and will not be able to use the gift tax annual exclusion. [See Treas. Reg. §25.2511-1(h)(1).]

In the alternative, they could make gifts of the property directly to their children (thereby potentially losing the valuation discount), and then all parties could contribute the property to the FLP.

Beware of the “step transaction” doctrine, an IRS argument for frustrating plans of taxpayers. This doctrine permits the IRS to ignore the form of a transaction if it is one in a series of steps in an overall transaction. The doctrine has commonly been applied to transactions that are in form tax-free in order to re-characterize them as taxable sales. Interestingly the IRS used the doctrine to treat a two-step transaction, consisting of a taxable stock purchase and a subsequent merger, as an integrated transaction qualifying as a tax-free reorganization. [Rev. Rul. 2001-46, 2001-42 I.R.B. 1.] The ruling demonstrates that the doctrine can be a shield or a sword in the hands of the IRS.

Retention of certain powers over transferred interests will render a gift incomplete, and the gift will then be included in the donor’s estate for estate tax purposes. [IRC §§2036-2038 (deemed ownership rules apply if a decedent retains effective ownership or beneficial use or the power to affect enjoyment of the property).]

Leases of property from the FLP must be at a fair market rental and be properly documented. Failure to do so will render the gifts of FLP interests ineffective for estate tax purposes. [See Estate of Du pont v. Comm’r, 63 TC 746, 761-766 (1975).]

A general partner who gifts limited interests but retains the income from the gifted interests will find that the interests are still in his estate.

Similarly, if interests are transferred, but the general partner takes a large management fee from the entity, the IRS will consider the fee to be a disguised payment of income from the transferred interests. [See IRC §2036(a)(1).]

An FLP can shift income from a high-income wage earner to children, grandchildren, parents, and other family members in a lower tax bracket.

For this diagram, see “Figure 9-120 FLPs Can Shift Income to Lower Tax Brackets.pdf” in the “Diagrams” folder on your CD.

Some of the ways to shift income to the entity and, in effect, to the lower bracket taxpayer are:

• The FLP may lease equipment or automobiles to businesses or professions owned by the parents.

• Other income producing property or assets could be transferred from the parent to the FLP.

If the children have not reached the age of legal majority then a custodian or guardian must be designated to sign documents on their behalf and to represent their legal interest and rights. A common procedure is to set up a trust for minor children to hold the interests for their benefit.

Caveat: If your intent is to shift income to children be aware of the “kiddie” tax rules. The current Kiddie Tax affects children under 19, and dependent full-time students under 24.

For the donee partners to be recognized as partners for income tax purposes, capital must be a material income-producing factor for the FLP, and the donee partner must be the real owner of an interest in that capital.

Otherwise, FLP income will be taxed to the donor and others who invested their own capital or services, depriving the donor of the income-shifting advantages otherwise available through the FLP. [IRC §704(e)(1).]

The grantor transfers property to a trust (the GRAT) that provides that he will receive a fixed annuity each year, usually for a term of years. At the end of the term, the beneficiaries get what is left. The gift involved equals the theoretical value of the remainder, determined by using the discount rate specified in IRC §7520. It is an IRS approved technique for minimizing gift tax, and some believe it works well for asset protection purposes. A GRAT is set forth in the Treasury Regulations.

The grantor transfers future appreciation in stock, real estate, or partnership interests in excess of the IRS assumed rate of return to descendants at a significantly reduced transfer tax cost. This can improve tax efficiency by transferring non-voting stock or limited partnership units to the GRAT. The non-voting stock or partner units should permit the grantor to achieve a 30%-40% discount for lack of control and marketability on the value of the contributed assets.

• Reduce the value of their estate for gift tax purposes because of the very considerable valuation discount.

For asset protection purposes, the GRAT creates fractionalized interests; the remainder interest is no longer subject to the donor’s predators.

For this diagram, see “Figure 9-130 Funding a GRAT With an FLP.pdf” in the “Diagrams” folder on your CD.

The amount of the gift (provided the donor survives the period of the GRAT) is the value of the remainder interest on the day the gift is made. This is calculated actuarially by reference to tables and interest rates published monthly by the IRS. [IRC §7520.]

All of the appreciation on the property transferred into the GRAT plus the cash flow not distributed by the GRAT is outside the donor’s estate.

Upon termination of the GRAT in accordance with its predesigned number of years, the interests are transferred to the designated remainderman, without any transfer tax being imposed.

If the donor dies during the term of the GRAT, the value of the property transferred (plus its appreciation) is drawn back into the donor’s estate. However, any gift tax paid on the creation of the GRAT is restored. Because of this restoration, there really is little penalty to the donor if this technique is used (other than the costs incurred in structuring the transaction).

One strategy is to create several GRATs with several different periods. This way, a premature death does not adversely affect the entire plan.

The success of the GRAT is in large part dependent on whether the return on the trust assets outperforms the rate published monthly by the IRS (the “7520 rate”).

• If the actual asset in the FLP is worth $1 million and it is yielding 6% ($60,000), and

• Then the GRAT would receive an asset worth a discounted $666,000 and generating the same $60,000 it was generating before. The GRAT would have an asset generating 9%.

The GRAT is exempted from the estate freeze rules of Chapter 14. The payout is calculated as a fixed sum based on the initial contribution and no further contributions may be made.

Commutation (the right to distribute to the donor as a lump-sum his interest free of the trust) must be prohibited in the GRAT, and no payments may be made to others.

To the extent that GRATs are grantor trusts, they may be funded with S corporation stock.

The generation skipping tax is not available in the GRAT situation. Consequently, the remainder interest should not be given to a grandchild.

The computation of the gift tax on a $1 million asset in a sample GRAT is as follows, assume:

Therefore, the $1 million is subject to a gift tax on $188,537, an 81% discount.

An LLP is a form of ownership in which all the partners receive limited liability protection. However, an LLP is similar to a general partnership in that all the partners can take an active role in managing the day-to-day affairs of the business. The LLP form of ownership is limited in the State of California to persons licensed to practice in the fields of public accountancy, law, or architecture.

Features

The LLP is a flexible form of business.
It is designed primarily for specific professional services.
The partners will decide the structure of the organization and the distribution of profits and losses. A formal, written partnership agreement is advisable.
An LLP does not pay income tax. However an LLP must pay an annual tax (of $800 in California).
The items of income, deductions, and credits "flow down" from the partnership to each partner through the Schedule K-1. Each partner is responsible for paying taxes on their distributive share.
The LLP allows each partner to actively participate in management affairs.
The LLP provides limited liability protection to each partner.
A LLP remains in effect based on partners agreeing to a termination date.

Professional firms will often find it preferable to operate in the form of professional corporations, and S corporation status, rather than as LLCs, since all the earnings of a professional LLC will generally be subject to self-employment tax. If operating as an S corporation, only the salaries paid will be subject to FICA taxes (at the same rate as self-employment tax), and any remaining profit that is earned by the S corporation will be subject only to income tax, not to self-employment or FICA taxes, provided that the amount of salaries paid is not unreasonably low and subject to treatment as tax avoidance by the IRS.

A Limited Partnership is a partnership with two classes of partners: General Partners and Limited Partners. General Partners control the business of the partnership and are responsibility for it’s debts, liabilities and obligations. The General Partner has general (unlimited) liability and usually receives a fee for his management services. Limited Partners have no control of the business of the partnership and only have limited voting rights and can only be held to responsible for liabilities up to their contributed capital. If a limited partner takes part in the control of the partnership, he may lose his limited liability status with respect to a person who transacts business with the partnership reasonably believing that the limited partner was a general partner.

The difference between a Limited Partnership and an FLP is that an FLP’s Partnership Agreement is designed to protect against liability and partner are related to each other.

What Is The Difference Between A General Partnership And An FLP?

A general partnership is, one where all partners participate to some extent in day-to-day management. FLPs have a general partner(s) who control day-to-day operations and is personally liable. FLPs also have passive partners called limited partners. Limited partners contribute capital but have minimal control over the FLP’s business. Limited partner's have no personal liability, their personal assets are not at risk. However, if they stake a more active role in their FLPs business, they can lose their limited liability.

Generally, the senior family members, transfer assets to the FLP in exchange for a small general (1 or 2%) interest and a large limited interest (98-99%). Typically, you would hold your FLP interests as Trustee of your Revocable Living Trust. The general partner has control over the FLP’s investment and management decisions. The limited partners do not have a voice in management.

Usually families with business assets they want to own in common, and want to pass on to other family members. For example, parents owning a business who want to involve their children in its ownership and management. FLPs allow the family to have flexibility in dividing the business’s ownership and control.

Yes. The FLP’s Partnership Agreement can be drafted to make you the general partner with sole management control over it. Your children can have as much or as little control as you want them to.

The general partners will usually be an entity controlled by the parents. By using an entity, there is no loss of control when either or both parents die and the parents, depending on the entity used, asset protect themselves. The types of controlled entities used are:

A Revocable Living Trust
A Management Trust
A Limited Liability Company
A Corporation
An Asset Protection Trust

The initial limited partner will usually be the parents or their revocable living trust. Gifts will then be made to their children either directly or in a Pre-Inheritance Trust (See Chapter 4 §4:270 et seq).

The FLP is designed to allow you to transfer control of your business and property to your children immediately or over the time period you select. FLPs assist you in developing responsibility in your children by providing them with a small share of your business initially and a larger percentage as their business ability grows.

Your FLP can be a part of your estate plan to make lifetime discounted (see below) gifts to your children while allowing you to maintain control of the family business.

The value of the FLP interest you give to your children during your lifetime will be removed from your estate for estate tax purposes. Following your death, only the value of the remaining interests you still own will be includible in your estate for estate tax purposes.

The FLP interests gifted to your children provide protection from your child’s creditors and/or divorcing spouse. A child’s creditor will not be allowed to reach the FLP’s assets , but will only be entitled to the child’s right to distributions, if any.

A creditor’s only remedy against your FLP interests (unless, unfortunately you set your FLP up in a state which allows foreclosure) is the right to obtain a “charging order”. Unless you have made a fraudulent transfer, the creditor can’t reach your FLPs assets, he can only reach income, if distributed.

A charging order is an order by the Court ordering the General Partner that if and when cash distributions are made, the distribution which would have normally been made to the debtor partner, must instead be paid to the creditor. The creditor can not get FLP assets, nor may he obtain your interests in the FLP. The creditor can only get the distributions that you would have gotten, if the general partner decides to make a distribution. The creditor may not force the general partner to make any distribution. The law will not allow a creditor to cause a disruption of the FLP which would adversely affect the interest of the other partners.

In Revenue Ruling 77-137, the IRS noted that a partnership does not pay income tax, its partners pays tax on their pro-rata share of FLP income whether or not the FLP made distributions of the income. Further, the assignee of an FLP interest must pay the tax attributable to the assigned interest. If a creditor obtains a charging order he becomes an assignee and he, not the debtor partner, need pay the income tax, whether or not actual distributions of such income was made. The creditor may win but never collect anything more than a charging order with a negative tax consequence.

Additionally, the FLP’s Partnership Agreement can be drafted to provide that a transfer to a creditor is not permitted and that the transferred interest can be purchased by the FLP at a set price which will paid with an installment note over a term of many years.

As limited partners, your children have no liability, other than the investment they have in the FLP. As general partners, they would have personal liability. This liability could be protected against by having a trust or limited liability company owned by your children, act as the general partner.

Since assets owned by the FLP are not owned by the partners, these assets are not available to satisfy creditor claims.

You as the managing general partner make decisions as to when to sell the FLP’s property.

What Type Of Assets Should And What Type of Assets Should Not, Be Placed Into An FLP?

All kind of business or investment assets such as securities, cash, real estate, should be placed into your FLP. Personal assets, such as a home, IRA’s, other retirement plan assets and S-Corporations stock should not be put in an FLP.

A change in ownership for Proposition 13 tax reappraisal, does not include a transfer between any person and an FLP in which the proportionate share of that person’s ownership in the real estate remains the same (California Revenue & Taxation Code Section 62(2)).

Centralization of Management. FLP fractionalizes ownership and centralize management.
Facilitating Family Transfers. Parent are able to transfer a percentage of their business and/or investment assets rather than 100% of specific assets.
Discounts . Because FLP assets lack control and are usually transferability, FLP interests are valued at less than the underlying assets. This saves transfers taxes.
Resolve family disputes. FLPS provide a means to resolve family disputes.

Yes! An FLP is not a taxable entity Each partner must report it’s gain or loss on his tax return in accordance with his proportionate ownership. Therefore by gifting interests to lower tax bracket family members, you can reduce the overall family tax burden.

Assets are valued for gift and estate tax purposes at their fair market value; what a willing buyer would pay. FLPs generally:

Have restrictions on their transferability. Transfers to non-family members may be prohibited unless all members agree. This restriction will discount the value of the interests for gift tax purposes by reducing its marketability (“marketability discount”).
Have a smaller number of persons interested in buying FLP interests than there would be for their underlying assets.
Have centralized management. Persons buying interests have no say in how the FLP operated. Because of this, the value of the interests will be discounted to reflect this lack of control (“control discount”).

These factors make the price a willing buyer would pay less than what he would pay for the underlying assets. This difference reduces the amount of gift and estate taxes payable. 35% is a common discount, depending upon the above factors, the terms of the FLP agreement, the type of assets and how the FLP is operated.

Example: A 35% discount will allow you to transfer limited interests representing $20,000 in “underlying” FLP assets without exceeding your annual gift tax exclusion of $13,000 per donee.

Yes. However, at death you own shares in your FLP, not your real estate. It is the FLP shares that receive the step-up usually at a discount as discussed above.

Example: Real estate valued at $1 million is placed into your FLP. Assume a 35% discount is established for the value of your FLP containing the real estate. The total value of your FLP at the date of your death is $650,000. This represents the death basis of your FLP shares.

Organizational costs. After the initial start up cost, there are annual franchise taxes and tax returns to file.
Operating requirements. Personal and FLP finances must be kept separate.
Tax scrutiny. The IRS scrutinizes FLPs for estate and gift tax discounts.

At worst the lender will require you, as general partner, to obligate the FLP for any loan made to you. Before transferring property to your FLP, approval should be sought from its lender and property insurance should be changed to name the FLP as the loss payee.

FLP Book - Chapter 9

Features

What Is The Difference Between A General Partnership And An FLP?

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