Charitable Gifts of Family Limited Partnership Interests

At a Glance

Family limited partnerships (FLPs) have been used increasingly in recent years to minimize the transfer taxes of older-generation family members while arranging, in some cases, for successor ownership of a family business.

Assets that may have been held in the form of C or S corporation stock in the past now may be held as general or limited partnership interests in an FLP.

What Is a Family Limited Partnership?

A family limited partnership is a business created by an agreement between an individual and members of that individual's family. It is typically used when the owner of a business or farm, or perhaps other assets, wants to consolidate and centralize management of assets, while reducing estate transfer costs by shifting future increases in value to younger-generation family members.

The FLP utilizes the limited partnership form, which was the vehicle of choice in many syndicated tax shelters in the 1970s. Tax law changes curbed many tax-shelter investments, but the limited partnership form continues to enjoy planning applications. Today, instead of syndicating a cattle feedlot or an oil and gas drilling project, the limited partnership form has become popular in family estate planning.

Why People Use FLPs

People who employ FLPs in their planning are usually trying to accomplish one or more of the following objectives:

$image\bullet.jpg$ protection of assets from creditors

$image\bullet.jpg$ conservation and transfer of family wealth

$image\bullet.jpg$ minimization of gift and estate taxes on wealth transfer to younger family members

$image\bullet.jpg$ provision for successor ownership of a family business

$image\bullet.jpg$ splitting of income and capital gains among family members in order to keep such income in lower tax brackets.

Valuation Discounts

The recent surge in the popularity of FLPs is partly a result of valuation discounts that have been recognized by the courts (if not always the IRS) in the transfer of FLP interests. Property is generally taxed for federal gift and estate tax purposes at its fair market value. In the real world, the degree of control enjoyed by the interest being valued, and the degree of its marketability, can significantly affect what an informed buyer will pay for the interest. For a long time, however, the IRS resisted the notion of valuation discounts for ownership of a minority interest and/or lack of marketability.

Valuation discounts mean that FLP interests can be transferred at lower tax cost, e.g., by using the gift tax annual exclusion to shelter the gifts or drawing down less of one's applicable credit amount (unified credit) to avoid paying tax on the gift.

Minority Interest Discount: A minority interest discount may be available when the holder of a limited partnership interest does not have:

$image\bullet.jpg$ A management role or control over the operations of the FLP,

$image\bullet.jpg$ An ability to dissolve the FLP and/or to reach the value of its underlying assets, or

$image\bullet.jpg$ An ability to require a return of the limited partner's capital contributions, or to compel certain other distributions.

The value of a transferred FLP interest is determined in the hands of the transferee rather than the transferor. Obviously, the transferor may have held a larger interest than that transferred, and what the transferee receives may have a lower value in his or her hands than it did in the transferor's hands.

Lack of Marketability Discount: A lack of marketability discount may be available when there is no ready public market for the FLP interest. In an FLP there may be restrictions on transfer or assignment of the interest; or a right of first refusal by the partnership or the other partners; or a provision in the partnership agreement that no assignee will be admitted as a partner unless approved by the general partner or by other limited partners. Under such circumstances, a partnership interest will be difficult to sell and, consequently, reduced in value.

How a Typical FLP Works

Frank and Eloise are in their early fifties and own several properties. They have three children, all in their twenties, the youngest still in college. Frank and Eloise set up an FLP and make a capital contribution of their rental properties, which have a total fair market value of $3.8 million. In exchange for their capital contribution, they receive 100 partnership units. Thus, each unit is worth $38,000 in the hands of Frank and Eloise. Two of these units are general partnership units and the other 98 are limited partnership units.

Frank and Eloise begin a program of giving the limited partnership units to their children. Let's assume that the valuation discounts for lack of marketability and for a minority interest add up to an even 50%. This reduces the gift tax value of a limited partnership unit to $19,000 instead of the $38,000 fair market value (FMV) in Frank and Eloise's hands. If Frank and Eloise take advantage of gift-splitting [IRC Sec. 2513], they can give up to $38,000 ($76,000 FMV) to each child each year, and these gifts will be fully sheltered by their gift tax annual exclusions (as indexed—$19,000 per donee in 2026). In other words, without drawing on their unified credit amounts, Frank and Eloise could give two limited partnership units to each child annually, or six units total per year.

If Frank and Eloise continued this annual gift-giving program for several years, they could substantially shift the value of their rental properties to the younger generation, while retaining control of the properties as general partners. Without the valuation discounts, Frank and Eloise could only achieve half the tax benefits (in our example) over the same period of gift-giving.

The three children, meanwhile, have certificates of ownership that entitle them to share in partnership profits and in the potential appreciation of the partnership interests, but not to manage the partnership affairs.

Implications for Charitable Giving

Charity, as well as family members, could be the recipient of a gift of a limited partnership interest, provided that such a transfer is permitted under the terms of the partnership agreement. Most of the issues raised by such a gift have not been satisfactorily resolved because partnership interests have not been a popular form of philanthropy in the past.

For example, a basic unresolved issue is: what exactly is being contributed to charity? Is the gift a single item of property, the limited partnership interest itself, or is it an undivided interest in each and every asset of the partnership? We'll have to await clarification from the IRS, Congress or the courts.

Another issue involves partnership liabilities and their effect on the amount of the donor's contribution. In Rev. Rul. 75-194, 1975-1 C.B. 80, the IRS ruled that the amount of the contribution was the value of the partnership interest, less the donor's share of partnership liabilities assumed by the charity. In the case of a gift of a limited partnership interest, the donor's share of nonrecourse debt that is assumed by the charitable donee must be reported as sale proceeds by the donor. In other words, the gift takes the form of a bargain sale. The IRS has found support for this view in the Supreme Court [Comm'r v. Tufts, 461 U.S. 300 (1983)].

Bargain-sale treatment will result in taxable income to the donor because part of the donor's basis (if any) is allocated to the gift portion of the transaction and cannot be used to offset the gain on the sale. When the donor-partner has a negative capital account (meaning, deductions have been taken in excess of the partner's equity) it is likely that some or all of the gain generated will be ordinary income attributable to the deemed sale of unrealized receivables and substantially appreciated inventory and not just the capital assets of the partnership [IRC Sec. 751].

The valuation discounts that are desirable for estate planning purposes are undesirable from a philanthropic standpoint. A lower valuation would mean a lower contribution deduction. Can a donor-partner utilize the valuation discounts or forego them at his option? Will the IRS find itself in the strange position of insisting on valuation discounts for donated FLP interests? Would this open the floodgates for the use of FLPs to minimize estate and gift taxes? The answers are unclear at this time.

Finally, after receiving a gift of a partnership interest, the charity would face the potential issue of unrelated business income (UBI) from its status as a partner in a profitmaking enterprise. But one of the exclusions from UBI is for "investment income," which covers such things as dividends and interest. Would this exception cover distributions to a limited partner, which are somewhat on the order of a corporate dividend? Another unanswered question.

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