The following discussion is for informational purposes only.

The Family Limited Partnership (FLP) is a sophisticated family business planning entity. When structured properly, it allows for the senior generation (the parents) to maintain substantial control over the assets of the Partnership during their life.

Upon their death, it is possible to transfer those assets to the junior generation, while enjoying substantial discounts on the value of the property transferred.

How does all this Work?

The Family Limited Partnership is comprised of two parties: the general partners, and the limited partners.

The General Partners are usually the members of the senior generation, or a business entity - such as a corporation or limited liability company - may be used for this purpose. As in a regular limited partnership, the general partners are involved in the day-to-day management of the FLP, and retain personal liability.

The Limited Partners are the members of the junior generation - the children of the senior generation. They retain an economic interest, although not a management interest, in the business of the FLP.

The General Partners will transfer their assets - including real estate, securities, and ongoing business concerns - to the FLP, and then transfer the Limited Partnership shares to the junior generation. Gift taxes may be owed for the value of the property transferred, however significant discounts may be available to soften this blow.

When is a Dollar Not a Dollar?

The key economic benefit of an FLP is the valuation discounts that may apply to assets contributed to an FLP.

There are four main discount theories which may apply:

(1) Lack of Marketability - since FLP shares are not freely traded on the open market, the lack of marketability theory says that they should not have the same value as if the underlying assets (the securities or real property) were held free and clear of restrictions.

(2) Built-in Capital Gains - Often the securities or real property that are transferred to the FLP - and by extension to the Limited Partners - have a low cost basis, and a high built-in capital gain. Since the recipient of such investments are obligated to pay the taxes upon their sale - they are not worth as much as if no taxes needed to be paid.

(3) Lack of Control - since a Limited Partner, by definition, does not have management control over the company, his interest in the company is not as valuable as a partner who did have such control.

(4) Fractional Share Discount - with regards to real property, an owner of a fractional share of property has a less valuable interest than an owner who owned an undivided interest in that property.

Unfortunately, the discounts offered by these theories are not cumulative. All four discounts, taken together, may offer valuation discounts in the 25-33% area, depending on the underlying assets in the FLP.

The more unique and difficult to value the assets, the greater the discount. Therefore, timberland property subject to State law that limits quantities of timber that can be harvested annually will result in a greater discount than publicly traded securities, which have a readily ascertainable value.

Proceed with Caution

Needless to say, telling the IRS that a dollar is not really a dollar when it is contributed to an FLP is extremely controversial. Inattention to detail, inadequate valuation techniques, or inappropriately large valuation discounts will almost surely trigger an audit from the IRS.

Consultation with qualified legal counsel is indispensable. It almost always makes sense to request an advance ruling or administrative guidance from the Internal Revenue Service, before assets are contributed to an FLP.

Copyright (c) 2007 John Fraker