Client Affairs

Family Limited Partnerships - Loathed By Tax Collectors, Loved By HNW Individuals

Tom Burroughes , Group Editor, April 13, 2011

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People looking to minimize tax should consider Family Limited Partnerships now – increasingly popular outside the ranks of the ultra-wealthy – in case lawmakers erode their benefits, said a US lawyer specializing in this area.

People looking to minimize tax should consider Family Limited Partnerships now – increasingly popular outside the ranks of the ultra-wealthy – in case lawmakers erode their benefits, said a US lawyer specializing in this area.

FLPs, which are legal entities such as corporations or trusts, are recognized in all 50 states of the US and have been so for a century. But they are unpopular with tax collectors who dislike the ability of persons to legally discount, or reduce, the value of their taxable estates via FLPs, Asher Rubinstein, a partner at Rubinstein & Rubinstein, told this publication recently.

The key discounting rule operates because FLPs are illiquid - there is no real market for them - and there are restrictions on what partners can do with the assets once they are held in an FLP. But while these structures have not been widely known in the past, their benefits are reaching a wider audience, he said.

"They are increasingly popular because of their estate planning and asset protection benefits. They have been under the radar in the past as rather esoteric structures, but that is changing,” he said in a telephone interview.

It is not known how much money is held in FLPs, but anecdotal evidence suggests the figures are very big. Some of the wealthiest families in the US, such as the Walton family (owners of Wal-Mart), have used Family Ltd Partnerships to minimize estate taxes. "I have clients who set up partnerships from thousands of dollars to the millions," Rubinstein continued.

A popular state for FLPs is Nevada. Under that state's laws, limited partners - unlike general partners - do not have to be disclosed, so Nevada FLPs are good for protecting anonymity of beneficiaries, such as children of FLP founders, he said.

At a time when lawmakers are looking to squeeze tax avoidance, as well as evasion, it is perhaps inevitable that structures such as FLPs – which have so far withstood attempts to breach their protections by attacking their asset discounting rule – should draw political ire.

Protection from creditors

Besides the discounting rule, FLPs appeal because they also offer protections against creditors, Rubinstein said.

“Creditors do not like these structures as they provide debtors with an element of protection; the IRS dislikes them because, as has been proven in a number of legal cases, FLPs allow taxpayers to legally reduce the value of their taxable estates, he said, and leave more to their heirs rather than to the IRS,” he adds.

“However, the general partner of the FLP can decide not to make a distribution, in which case the judgment creditor with the charging order is forced to wait for a distribution which may never happen. Meanwhile, the creditor is obligated to pay income tax on the distribution he may never receive, as `phantom income’,” Rubinstein continues.

“Paying tax on a distribution never received would likely result in the creditor settling with the partner on favorable terms.  Thus, the effectiveness of FLPs is in protecting assets and encouraging settlement of claims,” he says.

Proposed legislation in Congress would limit the tax benefits of FLPs, Rubinstein has warned. Lawmakers have tried to clip the wings of these vehicles before, as in 1990. There have also been court challenges to them, as in the late 1990s.

As explained in an article in International Business & Economics Research Journal as far back as 2002, when there were appellate court decisions about FLPs, they have been under attack for some time.

Key points to consider

A publication called The Asset Protection Book (to view link, click here) lists out some of the key points to consider with FLPs. For example:

Limited partnerships – which are what FLPs are - require payment of annual fees, so non-payment can mean the entity will eventually fall foul of state laws. Also, if FLPs do not observe similar formalities as corporations, such as having an Operating Agreement, the FLP can be disregarded by a court as if it never existed.

Another issue is that FLPs are fundamentally business entities and not meant for personal use, so a family residence should not be held in an FLP.

A common error, the book says, is where a parent is nominated as a general partner, in what the publication calls “the single most common mistake in FLP structuring”.

“The reason is that charging order protection relies on the GP to not make distributions to a limited partner’s interest for the benefit of a creditor. However, if the parent gets sued, the creditor could probably persuade the court to enter an order compelling the parent to make a distribution to the parent’s LP interest, thus totally subverting the charging order protection,” the book said (see chapters 19 and 20).

Another issue is that if the parent is both the general partner and the only limited partner, then a court may deem that since the parent owns all the interests, there is no partnership and the parent simply owns the FLP's assets outright, undermining the tax benefits of an FLP in this case.

The FLP structure clearly carries many benefits, but as Rubinstein and other lawyers argue, for how long?

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