| Family Limited Partnership |
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Family Limited Partnerships The following is a general outline of some of the benefits of using family limited partnerships in family estate and financial planning and a discussion on a special concern related to the use of a partnership for holding family portfolio investments. Tax Benefits of Family Limited Partnerships In General The use of family limited partnerships in estate planning has gained popularity in recent years because of the discounts permitted for federal estate and gift tax purposes. Aside from other very real benefits, family limited partnership planning permits the family to take advantage of the gift and estate tax valuation rules (particularly "minority interest" and "lack of marketability" discounts) which will reduce transfer taxes. The federal estate and gift tax system rests on the concept of "fair market value." Fair market value, in turn, is defined in terms of a theoretical willing buyer and a theoretical willing seller. It is not defined with family attribution rules applying – in other words it is applied as if the various parties are unrelated. If a family limited partnership is created and a portion of the partnership – normally a limited partnership unit – is gifted, the value of the gift for gift tax purposes reflects discounts based on what a stranger to the transaction would demand if he or she were purchasing that interest. Obviously, someone is not going to pay full value for a minority interest in the enterprise and it is equally obvious that there is a soft market for an interest in a closely held business. A gift to a child of a partnership interest, because it is based on a fictional third party, reflects these deep discounts. Ironically, the best "thumbnail" description of this technique is a description by the Treasury Department that accompanied proposed legislation that the Clinton Administration floated a few years ago. Treasury proposed in a legislative "wish-list" the elimination of valuation discounts for real estate and stock portfolio entities. If this proposal became law (and, to my knowledge, it has never moved to the point of being drafted as specific legislation) then it would cover transfers made after the date of enactment. Given the present political climate, it is doubtful that this proposal will go anywhere. The description by the Treasury of the perceived "abuse" is as follows: "Under current law, taxpayers making gratuitous transfers of fractional interests in entities routinely claim discounts on the valuation of such interests. The concept of valuation discounts originated in the context of active businesses, where it has long been accepted that a willing buyer would not pay a willing seller a proportionate share of the value of the entire business when purchasing a minority interest in a non-publicly traded business. Without legislation in this area, tax planners have carried this concept over into the family estate planning area, where a now common planning technique is to contribute marketable assets to a family limited partnership or limited liability company and make gifts of minority interests in the entity to other family members. Taxpayers then claim large discounts on the valuation of these gifts." Under the Treasury's proposal, the use of family limited partnerships and other devices for real estate and/or portfolio assets would be eliminated. As I mentioned, this proposal never got off the ground. The Internal Revenue Service has attempted also to derail family limited partnership planning in the courts. To date, these efforts have not been very successful. It is critical, however, that the family limited partnership planning be done carefully – so that it takes into consideration the various litigation positions of the Internal Revenue Service to avoid or minimize exposure under the various theories propounded by the Internal Revenue Service. Non-Tax Benefits of Family Limited Partnerships From a non-tax planning perspective, family limited partnerships have a variety of attractive attributes that may motivate use of this technique regardless of the tax benefits: • Asset Protection: A creditor of one of the limited partners should not be able to force a sale of the partnership assets. Creditors will be restricted to attaching (by a "charging order") distributions, if any, otherwise going to the debtor/partner. Similarly because the limited partnership unit is separate, distinct property, a limited partnership interest should stay out of the mix divided upon a divorce in a State (such as Maryland) where the concept of "marital property" excludes gifts from consideration if the gift has not been blended into the common pot. • Portfolio Balancing: When the assets to be placed in a family limited partnership consist primarily of tradable securities, the retention of those assets in an entity such as a partnership will permit the portfolio to maintain its balanced character, as a whole. That belief would not be available if individual securities were gifted to a family member outside of the partnership. Additionally, by holding securities in one entity it may be easier to attract high caliber investment advisors and/or keep the attention of those advisors, whereas assets fragmented within the family may not produce the same result. • Management Training: By using the limited partnership form, the senior members of a family can introduce other family members to the responsibilities of asset management by having them participate as partners in a business venture without turning over direct control to them unless and until those family members become capable of taking over the management obligations. • Dispute Resolution: A partnership can provide for mediation and other alternative dispute mechanisms that will keep a family argument out of court. This is an attractive alternative given the costs and adverse publicity that could come from a court proceeding. • Other Benefits: A partnership can reduce probate costs with respect to real estate located in other jurisdictions as no ancillary administration would be required. Also, the use of the entity facilitates an institutionalization and an enhancement of family communication on family business and investment matters. There are additional benefits as well. Special Rule Regarding Combining Portfolios There is a potential income tax trap involved with setting up a partnership holding stocks and other portfolio investments. Under a partnership tax rule (IRC §721(b)), gain is recognized on the transfer of appreciated property to a partnership if the partnership constitutes an investment company. An investment company is generally a partnership where more than 80% of the value of the assets (excluding cash and nonconvertible debt obligations) are held for investment and are readily marketable stock or securities or other interests. The reason for this rule is to avoid a perceived abuse where two or more individuals would combine their portfolios as an indirect method of diversifying the portfolios rather than selling stock and reinvesting to diversify. There will be no deemed diversification if the portfolios being combined meet certain highly technical tests. Under a corporate rule (§368(a)(2)(F)(ii)) which is held to apply in the partnership setting, if not more than 25% of the value of the total assets are invested in stocks and securities of any one issuer and not more than 50% of the value of the total assets is invested in stocks or securities of five or fewer issuers, then the investment company will be considered not to have tripped the diversification rule. There are at least two letter rulings supporting this rule (Private Letter 9328035 and Private Letter 9310019). In these letter rulings, the contribution of property into a partnership was held not to create diversification for the transferors if they fell within the guidelines outlined above. Obviously, we will have to examine carefully the nature and value of the assets as we combine the portfolios in this partnership.
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