• Family Limited Partnership Update
  • December 14, 2003 | Author: J. Eric Taylor
  • Law Firm: Trenam, Kemker, Scharf, Barkin, Frye, O'Neill & Mullis Professional Association - Tampa Office
  • Families create and operate limited partnerships and limited liability companies for a variety of family, business and tax planning purposes. One of the important tax planning attributes of these entities relates to the fact that interests in these entities are often valued for estate and gift tax purposes by applying valuation discounts. These discounts reflect the fact that interests in such entities are unmarketable and/or do not provide their owner with management authority or control.

    In a recent series of cases in the United States Tax Court1, the Internal Revenue Service argued successfully against such discounts in situations where the family member who created the entity and provided most of the entity's capital failed to respect the separate existence of the entity after its formation. In these cases, the Service demonstrated to the satisfaction of the Tax Court that the family member who created the entity retained a beneficial interest in the assets of the entity even after transferring ownership of those assets into the entity. As a result, the Tax Court ruled that the assets of the entity -- without any discounts whatsoever -- were includible in the gross estate of the family member for federal estate tax purposes. In other words, the existence of the entity was disregarded altogether for federal estate and gift tax purposes.

    The lesson to be drawn from these cases is that the existence of the limited partnership or limited liability company must be respected by the family members creating the entity and by the family members who receive interests in the entity. This principle can be reduced to a fairly straightforward set of "dos and don'ts."

    Do: Families who wish to avail themselves of the estate and gift tax advantages of limited partnerships and limited liability companies should have a clear understanding about the non-tax purposes for creating and operating the entity, and these purposes should be memorialized in the entity's governing documents.

    After the entity has been formed, the owners of the entity should be careful to keep personal assets separate from those owned by the entity. Thus, the limited partnership or the limited liability company should have its own accounts that are maintained, managed and accounted for separately from the owners' personal accounts. Books and records for the entity should be carefully maintained, and financial statements should be prepared regularly in addition to the tax return filed annually for the entity.

    Also, distributions from the entity should always be made strictly in accordance with the terms of the entity's governing documents, which typically will require that all distributions be made pro rata on the basis of each owner's relative ownership interests. Similarly, income from the assets of the entity should be deposited into the entity's accounts rather than the individual owners' accounts.

    Don't: Avoid commingling of the entity's assets with those of its individual owners. Also, do not permit any owner to unilaterally withdraw assets from the entity. No family member should contribute substantially all of his or her assets to the entity leaving them dependent on the entity for living or other personal expenses. Finally, be very cautious about creating an entity of this type in a "death bed" situation.

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    Family limited partnerships and family limited liability companies continue to offer important tax and non-tax benefits for families willing to respect the formal existence of these entities. Operating the entity as though its owners were not related -- that is, at arms length -- can help avoid an argument by the Internal Revenue Service that the entity should be disregarded for federal estate and gift tax purposes.

    1 Reichardt v. Commissioner, 114 T.C. 144 (2000); Harper v. Commissioner, TC Memo 2002-121; Thompson v. Commissioner, T.C. Memo. 2002-246.