Estate Planning Idea: Family Limited Partnerships (FLPs)

Greg A. Raffaele CPA CVA FCPA

FACT: One way to establish a viable succession plan over time is by transferring interests in your business to a Family Limited Partnership (FLP or 'Partnership'). An FLP is a 'pass-through entity' or an entity not taxed at the entity level. An FLP has general (managing) and limited (non-managing) partners and assignees that consist mainly of family members. These partners are liable for income taxes on their proportionate share of any Partnership income, whether the profits, either in cash or not, are distributed or not. An FLP agreement (the 'Agreement') is created and controlled by the Revised Uniform Limited Partnership Act (RULPA or 'Act') in the state the Partnership was formed. The Act is different in each state.

FLPs have grown more popular as a estate and gift planning tool for taxpayers with businesses, which reduces the estate value of the business interest transferred by the transferor into the Partnership and its resulting tax to the transferor. It is also a popular way for taxpayers to maximize transferability while maintaining control of the businesses until the transferor is ready for a successor to takeover.

Tax Benefits

The estate tax planning benefits of an FLP are as follows:

  • Assets can be kept in the family by restricting the transfer of FLP interests, especially in the event of divorce, bankruptcy or death of a partner;

  • The transferor can indirectly transfer an ownership interest of a family-owned asset into the Partnership without losing control of the asset;
  • A partner's creditors are legally unable to gain access to family-owned assets in the Partnership;
  • When family-owned real property, for instance, is gifted to several individuals, problems dividing the interests can be avoided;
  • Economies of scale and diversification is achieved as more assets are placed into the Partnership;
  • The Agreement may contain broad investment and business powers language for flexibility. As the family's needs change and as long as the general partners agree, the language can be changed;
  • As a pass-through entity, the Partnership does not pay income taxes; and
  • A gifted or transferred ownership interest may be made at a lower value than that interest's proportionate share of its net asset value because an FLP interest is likely both non-controlling and non-marketable.

Tax Requirements

An FLP interest and its valuation are also affected by various sections of the Internal Revenue Code (IRC). The Internal Revenue Service (IRS) regulation defines 'family members' as the transferor or the transferor's spouse. This definition also includes the lineal descendants and their spouses of the transferor or transferor's spouse and the adopted children or offspring of the transferor's children. It does not, however, include aunts, uncles and cousins.

Taxpayers can prepare their own FLP interest valuation because IRS regulations do not require them to engage valuation analysts. However, IRC §6662 imposes monetary civil penalties, computed as a percentage of the underpaid tax, for undervaluing estate and gift assets. The IRS will not apply any penalties if the reported value was made in good faith and had reasonable basis. The IRS may see a valuation by an analyst as support for 'reasonable basis'. IRC §6701 imposes monetary civil penalties on an analyst 'aiding and abetting' the understatement of a tax liability. The IRS also imposes administrative sanctions barring an analyst from submitting probative evidence in future IRS proceedings.

Analyst's Role

Valuation analysts must base their valuation adjustments in arriving at the fair market value of a transferred FLP interest on the basic characteristics of the interest, specific provisions found and not found in the Agreement and provisions under State law. Valuation analysts must determine the fair market value of an FLP interest and not the fair market value of its underlying assets. Analysts must also be aware of the valuation issues involving FLP interests. Many of the issues in valuing FLP interests are legal interpretations of the Agreement, instead of straightforward valuation issues that an analyst should leave to attorneys. If the analyst doubts the nature of the assignment or the terms of the Agreement, the analyst should have the client's attorney explain it, not vice-versa.

Valuation analysts must prepare a report less likely to be challenged by the IRS or more likely to be resolved in the taxpayer's favor if challenged. The report must be carefully prepared and documented and its valuation conclusion understood by the intended parties. Before giving an opinion of value, an analyst needs to analyze the Agreement and other Partnership documents (see below) and focus on what discounts can be used to reduce the value of the FLP interest. The final report must at least contain the nature of the interest being valued, the terms of the Agreement and the financial condition of the entity.

Documents Needed

The valuation analyst should obtain the following Partnership documents before beginning the assignment:

  • Copy of the Agreement or other type of business agreement depending on the entity;

  • Copy of the Certificate of Limited Partnership filed in the state the Partnership was formed. Without the certificate, the IRS may not recognize the FLP. The certificate includes the formation of the Partnership, the liability of the limited partners and some terms of the Agreement. The valuation analyst must be familiar with the Act in the state the Partnership was formed;

  • List of assets contributed before and after the Partnership was formed;

  • Copies of valuations of real estate and other assets (for example, marketable securities) as of the valuation date. The valuation analyst must separately value interests in other closely held businesses or partnerships before the FLP interest can be valued (see Master FLPs below);

  • Copies of financial statements and tax returns since the Partnership began or for a reasonable number of years. Notably, a new Partnership will not have these;

  • General partner's anticipated policies regarding distributions or IRC §754 election;

  • History of distributions made to partners and information; and

  • Copies of minutes of partner meetings or of other documents that give the valuation analyst insight into the intent of the donor at the time the Partnership was formed.

Valuation Approaches

When valuing an FLP interest, depending on the circumstances, one or more than one approach may be appropriate: Income, Market or Asset-Based. The FLP's underlying assets or historical extent and consistency of its dividends could determine the approach used. The Court has accepted both income and asset-based approaches to determine the value of decedent's minority interest in a limited partnership1. The same Court also found that relying on one approach, especially the asset-based approach, is not always sufficient or relevant.

When valuation analysts use the asset-based approach to value an FLP interest, the restrictions in the Agreement often justify the discount amount. If the analyst uses this approach, the IRS has argued to disregard the restrictions by demonstrating that the terms of the Agreement are burdensome and not at arm's-length. If the IRS wins the first argument, the IRS then argues to invalidate the Agreement for valuation purposes, resulting in an increased gift value based on the FLP's underlying assets and not the FLP interest. Based on this 'two-step' argument, the IRS has successfully negotiated with taxpayers for increases in the amount of gift and estate taxes. If the valuation is determined using the income and market approaches and does not rely only on the restrictions in the Agreement, it would be more difficult for the IRS to dispute the valuation2.

For the asset-based approach, valuation analysts obtain the fair market value of all assets and liabilities on the balance sheet and apply discounts for lack of control and marketability. For the income approach, analysts capitalize or discount the cash flow available to partners and apply a discount for lack of marketability. A discount for lack of control is unnecessary because the cash flow is the amount available to a minority owner and so the capitalized or discounted cash flow is a minority value. For the market approach, analysts determine valuation multiples from comparable publicly traded interests. The appropriate multiple could be price to net asset value (NAV) adjusted for related risks. Only a discount for lack of marketability is applied since this data is based on trades of minority interests resulting in a minority value.

Master FLPs

Some taxpayers have formed Master FLPs to own limited interests in other FLPs. Valuation analysts should use two tiers of discounts for lack of control and marketability because two layers must be penetrated to access the underlying assets of Master FLPs.

Chapter 14

Chapter 14 of the IRC only has four sections, but the Agreement should comply with Sections 2701, 2703 and 2704. If the Agreement does not comply with the provisions, the IRS may conclude that the Partnership does not exist for tax purposes and use the underlying asset values (instead of the FLP interest values) to calculate the gift or estate tax. Although the IRS is concerned with excessive discounts, recent case law3 has centered on whether the Partnership really exists. The IRS has raised this issue by either attacking the reason for the formation of the Partnership (i.e., business purpose) or by raising Chapter 14 issues. If the IRS can win on these issues, then the Partnership is not seen as a valid FLP; therefore, the gifts become gifts of the underlying assets rather than the FLP interests.

Other than in FLPs, valuations by a CVA (or other valuation analyst) are important in financial, tax and litigation matters.

1 Estate of Etta H. Weinberg, et al. V. Commissioner (TC Memo 2000-51)
2 Jay E. Fishman, et.al., Guide to Business Valuations, 10th edition (2000: Practitioners Publishing Company, Texas), p. 14-11
3 Estate of Albert Strangi v. Commissioner, 115 TC 35 and
3 Ina F. Knight v. Commissioner, et vir v. Commissioner, 115 TC 36 and
3 CHURCH v. U.S., 85 AFTR 2d 2000-804


Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

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