As we are awaiting the outcome of the Federal Election, estate planners are facing a number of unknowns. 

First, what will the new estate tax exemption be? The Tax Cuts and Jobs Act of 2017 (TCJA) sunset amount (approx. 7 Million Dollars), the proposed 3.5 Million Dollar threshold according to the Warren plan, or perhaps the current amount of 13.61 Million Dollars, adjusted by inflation, provided the relevant provisions of the TCJA are reenacted? 

Second, what estate tax planning tools will continue to be both available and of value with new legislation? 

Third, once we know the election outcome, how much time do we have to implement tax-saving strategies for our clients before new legislation is enacted? Probably not much if one party controls both houses. As an example, the total time from the introduction of the TCJA to enactment was approximately 7 weeks (from November 2 to December 22, 2017). This may be an outlier, as major tax legislation usually takes longer. 

Many newer estate tax planners have grown up in a world where estate tax planning on the federal level was not required. Instead, they had to deal with the fallout of no longer needed A-B-Trusts. The situation may change dramatically or not much at all. However, it is prudent to dust off your knowledge of all potential planning tools, and the Family Limited Partnership is certainly one you should know about. 

Why Family Limited Partnership (FLP) in the first place?

Family Limited Partnerships (FLPs) are an established estate planning tool, but their utility and the strategies surrounding their use have evolved due to increased scrutiny from courts and the IRS. These partnerships allow family members to manage and transfer wealth while providing several benefits, including asset protection and potential tax savings through valuation discounts.

What is an FLP?

An FLP is a partnership in which family members can pool their assets. The general partners retain control of the assets, while the limited partners hold an interest without management rights. This structure allows families to pass wealth from one generation to the next while keeping operational control over businesses or assets. Typically, parents act as general partners, with children holding limited partnership interests.

History and Popularity for Estate Tax Savings

FLPs became popular in the 1990s as a method of reducing estate and gift tax liabilities by leveraging valuation discounts. The premise was simple: by placing assets into the FLP and transferring minority interests to family members, the overall value of the estate could be reduced through discounts for lack of control and lack of marketability. Courts, including in cases like Strangi v. Commissioner and Powell v. Commissioner, have closely examined these strategies, sometimes negating the tax benefits due to improper structuring or inadequate formalities.

Types of Valuation Discounts

1. Minority Interest Discount: This discount applies when a partner in the FLP holds less than a controlling interest. Because the limited partner does not have the authority to make decisions or control the management of the partnership, the value of their interest is often reduced. Courts have generally accepted these discounts if the partnership is properly managed and structured.
2. Lack of Marketability Discount: A limited partnership interest is not easily sold or transferred. The restrictions placed on the transferability of the partnership interest make it less appealing to potential buyers. As a result, the market value is discounted to reflect this illiquidity.
3. Portfolio Discount: This applies when the partnership holds a mix of assets that may be less attractive to a single buyer. For example, a partnership holding both real estate and securities may receive a discount because a buyer might only be interested in one of the asset types and not the whole portfolio.

Current Challenges and IRS Scrutiny

The IRS has challenged the use of FLPs in several high-profile cases, arguing that many partnerships were created primarily for tax avoidance. The IRS has succeeded in cases like Strangi and Powell, where courts found that the decedents retained too much control over the assets, invalidating the valuation discounts. These cases illustrate the importance of ensuring that FLPs are structured for genuine business purposes and that the formalities are strictly observed.

While FLPs continue to offer benefits such as asset protection, business continuity, and valuation discounts, their use has become more complex. Estate planners must carefully structure these entities, comply with strict formalities, and avoid the pitfalls that have led to unfavorable court rulings. Properly implemented, FLPs remain a valuable tool, but they are no longer the straightforward tax-saving vehicles they once were. In fact, valuation discounts may be legislatively curtailed in the future (see below).

Are FLPs “better” than Trusts?

There is no short answer to this question, except perhaps that if you cannot utilize a number of specific benefits of an FLP, trusts will usually be the better solution for estate planning. The table provides more context.

Table 1: Features of Trusts and FLPs in Estate Planning Compared

• Trusts are ideal for clients focused on long-term, multi-generational wealth management, with strong asset protection and control over distributions. Trusts can also provide strong creditor protection for beneficiaries.
• FLPs are more flexible, cost-efficient, and offer substantial tax benefits, including valuation discounts. However, FLPs generally provide less protection for general partners and are not as robust for multi-generational planning as trusts.

Do’s and Don'ts if you want to set up a Family Limited Partnership

Do's:

1. Establish a Clear Business Purpose:

• FLPs must have a legitimate, non-tax-related business purpose. A family-owned partnership without a valid non-tax purpose was disregarded, and the assets were included in the taxable estate. Courts often deny tax benefits if they believe the FLP was set up solely to avoid estate taxes.

2. Follow Formalities:

• FLPs are recognized as business entities only if they follow business formalities, including separate bank accounts, annual meetings, and appropriate documentation. Failing to observe these formalities can lead to the IRS disregarding the FLP, as noted in several cases where the IRS argued that the FLP was a "sham" due to informality in operation.

3. Fund with Active Assets:

• FLPs funded only with passive assets, like stocks and bonds, are more likely to be attacked as mere tax-avoidance tools. Active assets, like businesses, should be included to demonstrate a legitimate non-tax business purpose.

4. Proper Timing of Creation:

• Creating the FLP shortly before death can be viewed as a "deathbed transfer" designed solely to reduce estate taxes, leading to inclusion of the assets in the estate. 
   

5. Maintain a Bona Fide Sale:

• The sale of assets into the FLP must be bona fide and for full and adequate consideration to avoid inclusion. This reinforces the need for proportional interest and fair market value in FLP transfers.

6. Retain Enough Personal Assets:

• The transferor should retain sufficient personal assets to cover living expenses outside the FLP, otherwise a court may include FLP assets in the estate because the decedent had not retained sufficient funds for personal needs and relied on FLP distributions, which indicated retained control.

Don'ts:

1. Don’t Use FLPs for Estate Tax Avoidance Alone:

• Courts may disallow the tax benefits of an FLP set up solely to avoid estate taxes. The IRS has in the past successfully argued that the transfer lacked a valid business purpose, and the court included the assets in the taxable estate.

2. Don’t Include Personal Residences or Personal Use Assets:

• Personal residences or other personal use assets should not be included in the FLP, as doing so can lead to inclusion under IRC § 2036(a) because the transferor is seen as retaining control or benefit from the assets.

3. Don’t Retain Too Much Control:

• When a decedent retains control over the disposition of FLP assets or retains beneficial enjoyment, those assets must be included in the estate. 

4. Don’t Underestimate IRS Scrutiny:

• The IRS scrutinizes FLPs closely, especially when valuation discounts are applied. Aggressive discounting and improper FLP formalities allow the IRS to successfully include the FLP assets in the taxable estate.

5. Avoid Mixing Passive and Active Assets Without Justification:

• The IRS often challenges FLPs holding only passive investments (e.g., stocks, bonds) without clear business reasons.

Future Outlook

In our context, one of the most significant proposed changes in Elizabeth Warren’s Ultra-Millionaire Tax Act of 2024 (1) is the limitation or elimination of certain valuation discounts commonly used in estate planning, such as discounts for lack of control or marketability. As we have seen, these discounts have historically been used to reduce the taxable value of assets when they are transferred into family limited partnerships (FLPs) or LLCs, thereby lowering estate and gift tax liabilities. In other words, planned reductions in the estate tax exemption amount may be accompanied by diminished estate tax planning options.

Conclusion

Family Limited Partnerships (FLPs) have long been a valuable tool in estate tax planning, particularly due to their ability to leverage valuation discounts for lack of control and lack of marketability. However, recent judicial decisions like Strangi and Powell have highlighted the challenges associated with using FLPs primarily for tax avoidance purposes. As we anticipate changes in federal tax legislation following the next election, including potential reductions in the estate tax exemption, the viability of FLPs remains in question.

While FLPs continue to offer significant benefits such as asset protection, business continuity, and tax savings, estate planners must exercise caution. FLPs should be structured with clear, legitimate business purposes, and all formalities must be followed meticulously to withstand IRS scrutiny. Planners must also remain aware of potential legislative changes, such as the proposed elimination or limitation of valuation discounts under the Warren Plan and similar tax proposals.

Ultimately, FLPs can still play a critical role in estate planning when used appropriately, particularly for family-owned businesses and other active assets. Estate planners should be prepared to act quickly once the legislative landscape is clearer, ensuring that their clients can take full advantage of the available tools before new rules potentially curtail their effectiveness.

Reference

1. American Housing and Economic Mobility Act of 2024, S. _, 118th Cong. (2024). Available at: https://www.congress.gov/bill/118th-congress/senate-bill/4824/text

Further Reading

1. Matthew Van Leer-Greenberg, Family Limited Partnerships: Are They Still a Viable Weapon in the Estate Planner's Arsenal?, 25 ROGER WILLIAMS U. L. REV. 37 (Winter 2020).
2. Elaine Hightower Gagliardi, Estate Planning Choice of Wealth Management Entity: The Limited Partnership as an Alternative to the Trust, 53 CREIGHTON L. REV. 695 (2020).

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