Family limited partnerships invaluable tax-reducing tool

The family limited partnership is an extremely valuable tool for business and estate planning. What other tool can ease or even eliminate the tax bite often associated with transferring the veterinary practice — or its income — to family members, all while keeping the owner's current tax bills to a minimum?

Transferring assets or income-producing property to children or other family members can be an invaluable tax-planning and tax-reducing tool. Income can be shifted to an individual in a tax bracket lower than the donor. What's more, under our tax rules, the transfer of an interest in a partnership can represent a future increase in value, in other words, the legitimate deferral of taxable gain.

Since 1997, the Internal Revenue Service (IRS) unfortunately has been waging war on the estate and gift tax consequences of family limited partnerships (FLP). Initially, the IRS was unsuccessful in attacking these entities and their tax benefits. Recently, however, the IRS has achieved some success in the courts, successes that have had mixed results in appellate courts. However, because of its significant tax advantages, the FLP remains a popular entity, one that every veterinarian should consider. Naturally, the advice of a competent adviser should be sought, if only to avoid doing battle with the IRS.

Family foundation

An FLP is simply a limited partnership consisting of the members of a family. A limited partnership has both general partners (the ones who actually run the partnership) and limited partners (who are passive or non-involved investors). General partners have unlimited personal liability for partnership obligations, while limited partners have no liability beyond their capital contributions.

Typically, a partnership is formed by the older generation, usually the parents, who contribute assets to the partnership in return for both general partnership units and limited partnership units. The parents can then embark on a plan of giving unlimited partnership units to their children and grandchildren while retaining the general partnership units that actually control the partnership.

Any type of property can be contributed to an FLP. For example, FLPs have been formed to hold family compounds, rental real estate, marketable securities and, of course, the family veterinary practice or business. Thus, the parents might retain control of the practice and draw a salary or wages from it, all the while sharing the profits with other family members who are taxed on those profits at a lower tax rate than the parents/owners.

The partnership agreement usually governs how partnership income is divided among the partners. Generally, both the general and the limited partners will share income and cash flow based on their respective shares or percentage of interest in the partnership. Of course, although income tax liability passes through to each partner automatically, actual cash does not have to be distributed to the partners until the general partners decide to make a distribution.

In this manner, the general partners retain control over the assets in the FLP while the limited partners are granted very limited rights. Limited partners also have restrictions on their ability to transfer their partnership units to others so the general partners can prevent units from being transferred outside the family.

Value of FLP discounts

As part of establishing a partnership, property and assets are transferred into the partnership. Frequently, this involves a transfer tax at the state level. Because of the lack of an established market for the sale of limited partnerships and the lack of control that limited partners have, the limited partnership interests are often valued at a discount for transfer tax purposes, as well as federal valuation purposes.

Valuation discounts for limited partnership interests, such as reductions from the net asset value of the partnership, can range from 15 percent to more than 50 percent.

The tax benefit of the discounted value of the partnership interests coupled with significant non-tax benefits, such as liability protection and centralized management, contributed to the historical popularity of the limited partnership, as did the ability of the contributing partner to participate in the management of the partnership as a general partner.

John Doe is a principal in a veterinary practice, otherwise known as the "family business," that has been in the family for more than 50 years. The family business consists of a small parcel of land, some buildings and a couple of vehicles with a value of about $5 million.

John Doe is focused on keeping the practice in the family and avoiding the management issues usually associated with fractional ownership. With the assistance of an experienced professional, John organizes a limited partnership to hold the physical assets, the land, buildings and vehicles, of the family practice. John Doe and his son Ralph, who will manage the property after John's death, are the two general partners, together owning a 1-percent interest equally.

John contributes the family practice to the partnership for a 99-percent limited partnership interest, while Ralph contributes cash or other assets for his interest.

Assuming that a 40-percent discount can be sustained when valuing the partnership interest, the value of John Doe's estate is reduced by $2 million (the difference between the family business being valued at $5 million and the family limited partnership interest being valued at about $3 million after the 40-percent discount). That can mean estate tax savings of as much as $1 million — assuming, of course, that the estate tax remains a factor on the federal level.

As already mentioned, FLPs have many tax and non-tax benefits. Despite the repeal of the estate tax, temporary as it might be, the benefit of reduced asset value through significant valuation discounts remains for gift tax purposes. But the FLP has not escaped IRS scrutiny.

FLPs versus IRS

As family limited partnerships grew increasingly more popular, the IRS commenced a series of attacks on their tax benefits. The initial assault came in the form of Technical Advice Memorandums (TAMs), a series of IRS rulings questioning FLPs with a variety of legal arguments. For the most part, those attacks usually involved extreme situations involving terminally-ill individuals and transfers made by family members by power of attorney.

Typical of the arguments used by the IRS, they contended there was a gift of the limited partnership interest. Since assets transferred into the partnership and the limited partnership interest received in exchange was valued at a discount, the value of the assets transferred into the partnership usually exceeded the value of the limited partnership interest. The IRS argued that the reduction in net worth of the contributing partner was a gift by that partner on creation of the partnership.

In 2000, two separate rulings by the U.S. Tax Court shot down that argument as well as several others put forth in the course of the IRS's FLP crackdown. In one of those cases, the appellate court, the U.S. Court of Appeals for the Fifth Circuit, upheld the taxpayer's position.

The appeal revolved around the IRS's contention that the value of the assets the decedent transferred to the partnership should have been included in the gross estate because the transfer was not a bona-fide sale for full and adequate consideration.

The appellate court concluded: "There is nothing inconsistent in acknowledging on the one hand that the investor's dollars have acquired a limited partnership interest at arm's length for adequate and full consideration, on the other hand, that the asset thus acquired has a present, fair market value, i.e., immediate sale potential, of substantially less than the dollars just paid — a classic informed trade-off."

Also, the U.S. Court of Appeals for the Third Circuit agreed with the Fifth Circuit that it is not always necessary to have a so-called "arm's length" transaction. According to the court, "While a bona-fide sale does not necessarily require an arm's length transaction, it still must be in good faith. A 'good faith' transfer to a family limited partnership must provide the transferor some potential for benefit other than the potential estate tax savings that might result from holding assets in the partnership form."

The IRS continues to challenge FLPs in the courts, with mixed success. That should not deter any veterinarian with an honest desire to transfer his or her practice, or its income, to family members. After all, none of those IRS challenges have been successful in eliminating FLPs, nor have they severely affected the principal in any veterinary practice that closely adhered to the rules.

Obviously, using an FLP requires both careful analysis and strict compliance with IRS regulations — not to mention professional assistance. FLPs, however, are well worth the cost of investigating, establishing and maintaining from a variety of standpoints, not the least of which is taxes.

Mr. Battersby is a financial consultant in Ardmore, Pa.