Family limited partnerships are being used to achieve significant tax savings in the area of transfer taxes (i.e., estate and gift taxes). The partnership is used as a mechanism to divide family assets among family members to take advantage of rules permitting reduced valuation of the amount being transferred for transfer tax purposes. The reduced valuation is the result of a discount applied to partnership interests because of the limited partner’s lack of control over the partnership and the resulting lack of marketability of that interest. Generally, because limited partners have no right to participate in the partnership’s management, a buyer will pay less for a non-controlling interest in a partnership than for outright ownership and control of the underlying assets. As a result, the value of the limited partner’s interest is reduced accordingly.
While family limited partnerships have historically been used to hold family real estate and operating businesses, a 1993 IRS ruling and a subsequent technical advice memorandum have indicated that the IRS will allow a minority discount for a transfer of an ownership interest in an entity to a family member even where the aggregate ownership interests of all family members provide them with control of the entity at the time of the transfer.
For example, assume you and your wife wish to begin gifting $2,000,000.00 in appreciated securities to your three children. The annual exclusion and spousal gift-splitting permits an annual gift of $20,000 to each child or an aggregate of $60,000 of securities each year without gift tax consequences. Instead of gifting the securities outright, you would contribute them to a limited partnership and each take back a 1% outright, you would contribute them to a limited partnership and each take back a 1% general partner interest and a 49% limited partner interest. Each year, your wife and you could gift a limited partnership percentage to each child. If a valuation discount of one-third can be justified for the limited partner interest, a 1.5% limited partnership interest can be gifted to each child each year. An interest allocable to $30,000 of family limited partnership assets (1.5% of $2,000,000) would have a $20,000 gift tax value. Thus, gifts of interests allocable to $90,000 (rather than $60,000) of securities could be transferred each year, fully covered by the gift tax annual exclusion. This also, of course, removes these assets from your estate so that they will not be subject to estate tax when you die.
Family limited partnerships may also be used as a means of protecting assets from creditors. If the transfer of assets to a family limited partnership does not violate applicable fraudulent conveyance rules, the creditors or bankruptcy trustees generally can not reach the assets transferred. Even though a creditor could seek a “charging order” against a limited partnership interest, the creditor may risk being treated as the taxpayer with respect to profits and losses allocated to the partnership interest. In such cases, the creditor may be taxed on “phantom” income with no assurances as to when distributions of cash would be made to cover the taxes due on such income. A creditor may instead wish to engage in negotiations which result in a favorable settlement to the debtor.