Avoid Estate Taxes with Family Limited Partnership
New Cases Provide Guidelines for Tax Benefits
By Robert J. Mintz, Esq
In our previous articles in this series about asset protection we discussed the unique liability risks faced by physicians. Our intent in these articles is to provide you, as a physician with a clear understanding of the most important asset protection issues and the guidelines you should follow in developing your plan to protect business and personal assets from these risks.
In this article we will focus more closely on one of these techniques, known as the Family Limited Partnership (“FLP”). This strategy has been popular for asset protection and tax planning for many years but the full scope of what could be accomplished has always been a source of debate among legal professionals and some of the case law has lacked a desirable level of clarity and direction. On the tax side, the IRS has consistently challenged the available tax benefits—losing most of the time-but with just enough success to add a dose of uncertainty into the planning process.
All this is now changed. In the case of Kimbell v. United States, decided May 20, 2004, by the Fifth Circuit Court of Appeals, the arguments by the IRS have been soundly rejected and the Court has created definitive law and clear instructions for achieving remarkable tax savings and asset protection. Because of the important opportunities now available it will be helpful to explore the background of the case and develop an understanding of the rules and framework for planning strategies with the FLP.
Family Limited Partnerships-Background
Stated briefly, an FLP is a type of limited partnership that is formed by an official filing with the Secretary of State where it is to be created. The FLP is a separate, legal entity, with its own tax identification number. Any income or loss flows through to the partners and is reported on their tax returns. The key provisions for accomplishing asset protection, tax savings and asset protection are set forth in an FLP agreement prepared by your legal advisor based upon your particular circumstances and objectives.
Usually family savings, investments and ownership of business and real estate interests are transferred into the FLP. When properly structured, these assets are protected from potential claims and lawsuits. A plaintiff with a judgment is not permitted to reach into the FLP to seize this property. The ownership of the interests in the FLP is usually protected in a trust designed for this purpose.
In addition to these significant asset protection advantages, sophisticated tax advisors have incorporated FLP’s into strategies designed to accomplish a variety of estate planning and tax reduction goals. In a typical case, limited partnership interests in the FLP are gifted to children or other family members. The value of these gifted interests are then discounted for estate tax purposes.
For example, parents transfer assets worth $1 million to an FLP, then give 40% of the limited partnership interests to their children. This allows the parents to maintain full control over the property. Because of this, these gifted FLP interests are not valued at $400,000 for tax purposes. Instead, since these limited partnership interests cannot control or affect management and cannot be sold or otherwise converted into cash, the tax law says that they are not worth $400,000. They’re worth something less, maybe $250,000. By using this technique the parents have transferred $400,000 in value out of their estate, to their children, and reduced future estate taxes by as much as $75,000 or more. Depending upon the actual value of the assets transferred into the FLP and the size of the gifting program adopted and the amount of the discount applied, many wealthy individuals have avoided the impact of the estate tax.
As might be expected the IRS has consistently opposed this strategy, although the results in court cases has been mixed. Generally, when an FLP was established near the time of death for the sole purpose of reducing estate taxes, or when the FLP was treated like the owners personal pocketbook, without regard for legal formalities, the challenge by the IRS has been successful (See Albert Strangi (TC Memo 2003-45 rem’d by 293 F3d 279 (5th Cir. 2002)). In Strangi, the Tax Court ruling significantly restricted the circumstances under which the FLP could achieve meaningful tax reduction. Many advisors felt that the new burdens imposed by the Tax Court would dampen the use of the FLP for these purposes.
Kimbell vs. United States
Then came the Kimbell case and the Fifth Circuit Court of Appeals handed the IRS a massive defeat. The Court stamped its approval on the basic FLP strategy, extended the range of available planning options and paved the way for sophisticated taxpayers to eliminate or substantially reduce the estate tax burden.
The case illustrates the savings which can be produced by FLP planning in even the most basic form. Mrs. Kimbell, a 96 year old woman, transferred property worth $2.5 million to a newly created FLP in exchange for a 99.5 percent limited partnership interest. Her son Bruce (through a limited liability company) was the general partner with the right to manage partnership assets. He had managed his mother’s financial matters prior to the time the FLP was established. Mrs. Kimbell retained the right to remove the general partner and replace him with anyone else (including herself), since she owned almost all of the limited partnership interests. As recited in the Kimbell FLP Agreement, the stated purpose of the FLP was to:
“…increase Family Wealth; establish a method by which annual gifts can be made…continue the …operation of the Family Assets and provide protection to Family Assets from claims of future creditors against a Family member..’ (Emphasis added.)
When Mrs. Kimbell died, soon after creating the FLP, her estate valued the 99.5% limited partnership interests at $1.25 million—a 50% discount from the value of the property she transferred—claiming that the lack of control and marketability associated with limited partnership interests reduced their value significantly. The Court did not discuss the specific amount of claimed tax savings, but in general, a reduction in value of this amount saved the estate approximately $500,000 in taxes.
The IRS took the position in the case that Mrs. Kimbell had not engaged in a significant business transaction and that she had merely changed her form of ownership over the property. According to the IRS, Mrs. Kimbell did not relinquish any substantive management or control over her property and therefore the transfer to the FLP should be disregarded for tax purposes.
The Court disagreed with the IRS and held that Mrs. Kimbell’s estate was entitled to the full benefit claimed. The Court detailed the analysis to be applied in these cases and the rules which must be followed;
1) The limited partnership interests in the FLP which Mrs. Kimbell received were proportionate to the amount of her contribution. If you form an FLP and contribute $90 and your children contribute $10, you must receive a 90% interest in the FLP. The records of the partnership must properly account for the contributions of each partner.
2) Partnership formalities must be satisfied. The FLP must be properly organized, the FLP Agreement must specify the rights and responsibilities of the partners and assets contributed to the FLP must be properly and legally transferred.
3) The FLP must serve a valid business purpose such as asset protection. The Court noted that the FLP was established because Mrs. Kimbell’s
“…living trust did not provide legal protection from creditors as a limited partnership would. That protection was viewed as essential by (Mrs. Kimbell’s business advisor)…because she was investing as a working interest owner in oil and gas properties and could be possibly liable for any environmental issues that arose in the operation of those properties.” Other business purposes besides asset protection could be the desire to consolidate management of family assets and to provide for a continuity of ownership for younger generations.
4) To avoid weakening the FLP for tax, business and asset protection purposes, assets and income from the FLP should not be used for personal or household living expenses. Use the income from your practice or set aside sufficient other assets to meet recurring expenses. Don’t put assets such as your residence, jewelry and personal effects into the FLP.
An additional point is that Mrs. Kimbell did not give away her ownership of the limited partnership interests. No transfer to her children took place (as reported in the case). She transferred substantially all her assets into a newly formed FLP, then claimed that the limited partnership interests which she received in exchange were 50% less than the property itself. We will need to see how this issue is handled by other courts in the future but for the present it represents a loophole of such significant proportions that the estate tax can almost be said to be voluntary in its application.
When the guidelines offered by the Court are followed and a solid business purpose such as asset protection is the foundation of the plan, the Family Limited Partnership may serve as the cornerstone for most advanced financial plans.