The use of family limited partnerships (FLP's) is a common tool used by estate planners to legitimately reduce estate taxes. Since 1993, their popularity has increased tremendously, and with good reason. Essentially, by restructuring the way assets are titled, the formation of an FLP allows senior family members to pass their assets to their beneficiaries at a discount to the asset's value, while maintaining control of those assets during their lifetime.

With their increasing popularity, it is only a matter of time before family law courts have to deal with the legal and valuation issues that are associated with FLP's. This article attempts to bring out these issues.

In order to address these issues, one must first address the following questions:

1. What is an FLP?

2. How are they formed?

3. What are the working mechanics of an FLP?

4. Should family law courts recognize the valuation discounts that are associated with FLP's?

The easiest way to address these questions is by example. Let us assume that John, age 55 and Jane, age 53 have been married for thirty (30) years. They have two (2) adult children, Don, age 28 and Katie, age 26. During the marriage, John accumulated two million dollars ($2 million) of marketable securities. There is no question of fact that these marketable securities are marital property. During 1997, John forms the JDK FLP. Initially John contributes the marketable securities to the partnership in exchange for a 99% limited partnership interest. Additionally, John forms an S Corporation of which each of his two children and John owns a one-third interest. This S Corporation holds the general partner interest in the FLP. The S Corporation contributes $20,202 in cash in exchange for its 1% interest in the partnership. The following details the partnership percentages immediately after formation:

Remember at this point all that has happened is John converted the $2 million worth of marketable securities into a 99% interest in the JDK FLP.

The agreement of limited partnership contains key provisions, which will impact the valuation of John's interest in the partnership. They are as follows:

1. Term of the partnership:

The partnership shall continue in existence until terminated upon the occurrence of the earliest of the following events:

a. The bankruptcy, liquidation, dissolution, or withdrawal of the General Partner;

b. The unanimous written agreement of the Partners to dissolve the Partnership;

c. Upon the sale or disposition of substantially all of the assets of the Partnership and the cessation of business; or

d. December 31, 2047.

2. Distributions of net cash flow:

Net cash flow for each fiscal year, defined as all cash receipts less all cash expenditures, and less amounts determined by the General Partner to be retained as cash reserves, shall be distributed to the partners based upon the sole discretion of the General Partner.

3. Management:

The General Partner shall be responsible for the management of the Partnership's business and affairs. The Limited Partners shall take no part in the management of the Partnership's business.

4. Transfer of partnership interest:

No Limited Partner may sell, assign, transfer, pledge, hypothecate, encumber or otherwise dispose of all or any portion of their interest without the prior written consent of each other Partner. Additionally, if a Limited Partner should receive an offer to sell all of his or her partnership interest, the Partnership will be granted an option to purchase the interest at the same price.

5. Limitations on withdrawal:

No Partner will receive the interest of a withdrawing partner in neither the assets of the Partnership nor the value of such Partner's interest in the event of withdrawal until Partnership is dissolved.

So what do these provisions mean to a limited partner in JDK FLP? Basically the following:

1. A Limited Partner who purchases an interest in this partnership will not be able to liquidate his or her interest and receive full value of the interest without the unanimous consent of all the partners;

2. A Limited Partner has no control over receiving cash flow distributions;

3. A Limited Partner has no control in management of the Partnership;

4. A Limited Partner cannot transfer his or her interest without the prior written consent of each other Partner;

5. A Limited Partner who withdraws from the Partnership will not receive the value of his or her interest until dissolution of the Partnership occurs. Quite possibly, not until the year 2047.

So how attractive would this investment be to a hypothetical buyer of John's interest? Obviously not too attractive and that is precisely the point. Accordingly, John's limited partnership interest will be heavily discounted when it is valued.

Now the plot thickens. During 1998 and 1999, John gifts away limited partnership interests to both Don and Katie (the children) in an amount equal to the $10,000 annual exclusion. In accordance with the partnership agreement, all the partners consented to this transfer. The gifts take place on each December 31 and are computed as follows:

Notes:

(1) For purposes of this illustration it was assumed the marketable securities appreciated since the partnership was formed.

(2) These discounts are for illustration purposes only and may not represent actual discounts taken in actual FLP's. Actual discounts would need to be computed after accounting for the facts and circumstances of a particular interest.

The following are the partnership percentages at the end of 1998 and 1999 after the gifts from John to the children occurred:

As a result of the formation of the FLP and John's annual gifting during 1998 and 1999, he has essentially shifted $76,614 ($2,520,202 x 3.04%) of value to his children gift tax-free over the two-year period. Assuming when John dies he will be in the 55% estate tax bracket, he has saved his estate approximately $42,000 of taxes. Additionally, there will be discounts applied to John's remaining 95.96% partnership interest when valuing it for his estate, thus enhancing the tax savings. These tax savings far outweigh the cost to create, maintain and annually value the FLP.

Now the question is should these same valuation discounts apply in a divorce context? If so, does it create inequitable allocations of the marital estate? If the majority of the other partners are related parties, then should the valuation discounts be ignored? These are some of the questions the family law courts will be grappling with in the very near future. Let us continue with our above example to illustrate.

It is now the beginning of year 2000 and John and Jane decide to get divorced. As part of the marital estate, John indicates on his asset disclosure statement a 95.96% limited partnership interest in JDK FLP. He values this interest as follows:

Remember, had John not formed the FLP, his pro-rata share of the cash and marketable securities would have been computed as follows:

So what is the correct value to use? The court will have to deal with valuing John's interest in the range of $1,349,459 and $2,418,386.

A family law attorney representing Jane might raise some of the following arguments:

1. The FLP was an estate planning device and should not be used for purposes of equitable distribution;

2. The other partners are related parties. John never would have entered into an arrangement like this with non-family members. Accordingly, this is not an arm's length arrangement. The valuation discounts should be ignored;

3. There is nothing to stop the FLP after the divorce from selling the marketable securities at their full value and distributing the proceeds to the partners. John would receive $2,418,386 if this were to occur;

4. The FLP is nothing more than John's alter ego. As such, John's pro-rata share of the value of the underlying partnership assets should be used for purposes of equitable distribution and not the fair market value of the partnership interest itself.

A family law attorney representing John might raise some of these arguments:

1. The FLP was created for viable business reasons. Specifically, limited liability and the ease of managing the assets for the next generation;

2. Tax courts have recognized and accepted valuation discounts under the definition of "fair market value" as defined in Revenue Ruling 59-60;

3. Tax courts have recognized family limited partnerships as viable business entities;

4. John, by himself, does not have the power to distribute assets or liquidate the partnership thereby preventing him from receiving full value of the partnership assets (prior to the application of the valuation discounts);

5. The standard of value is fair market value. A hypothetical buyer of John's interest would not pay John his full pro-rata value without applying discounts due to the restrictions in the partnership agreement which prevents the hypothetical buyer from getting to the underlying assets of the partnership.

What does the court do? If the standard of value is "fair market value" as defined in Revenue Ruling 59-60, then the discounts should be allowed. Would this be equitable in this case? Should the court's decision be dependent upon the value of other marital assets? Should the court use a value other than "fair market value"? What are the legal implications if the court ignores the restrictions in the partnership agreement in valuing John's interest? These are just a sample of the questions family law courts will have to address as more of these cases are presented in the future.

By Scott I. Shaffer CPA, CVA