The biggest challenge for estate planners is how to reduce estate and gift taxes but allow the client to retain control over his assets. Family limited partnerships (FLPs) provide a solution to this problem.

When you place investments, a business, or real estate holdings in a FLP, you retain control of the assets while at the same time making gifts of limited partnership interests to your beneficiaries so that they own part of the equity. Because the limited partnership interests that are given to the beneficiaries are not marketable, they are valued at a discount which maximizes the amount of the underlying assets that can be transferred free of gift taxes. The family limited partnership also provides other benefits for asset protection from creditors and providing for centralized control and management.

How does it work? The older generation members ("Mom and Dad") form a partnership and contribute assets to the partnership. The contributed assets now belong to the partnership. Mom and Dad are the general partners and control the partnership. Mom and Dad make gifts of the limited partnership interests to children, grandchildren, trusts for grandchildren, as they wish.

What can a child or grandchild do with the limited partnership interest? Nothing. The interest can’t be transferred, can’t be sold, doesn’t give the owner decision making authority or authority to exercise control over the partnership assets. It is documentation of an interest in the partnership which entitles the owner to partnership distributions if they are made, and to liquidation proceeds if the partnership is liquidated. The terms of the partnership agreement restrict the limited partners’ ability to transfer or, otherwise, enjoy the asset.

A FLP gives a two-fold benefit: (1) Mom and Dad stay in control even though they have made gifts, and (2) because of the restrictions placed on the limited partnership interest by the partnership agreement, the value of the gifts is much less than a pro rata value of the underlying assets. Thus, Dad can transfer more property by making gifts of limited partnership interests than by making outright gifts of the assets. Both the psychological goal of retained control and the estate planning goal of a reduced taxable estate are reached.

The gift and estate tax savings are a function of gaining IRS acceptance of the discount. Let’s say you form a FLP and claim a 45% discount on the gifts of limited partnership interests. The IRS objects and, rather than go to litigation, you agree on a 25% discount. What do you call that? I call that "victory." You won a 25% discount. (If you think that losing the whole 45% is failure, a family limited partnership is not for you.)

There are things you need to do to make your case for a discount compelling. The FLP has to be a "real deal." It must be operated as a genuine partnership with a business purpose. It is not just a document. It is an operating entity, and the entity must be respected.

Some tests of whether or not it is a real entity are: Do you follow the partnership’s requirements for votes, meetings, contemporaneous records, and other requirements set forth in the document? Do you file a Form 1065 – Partnership Income Tax Return? Does the partnership have its own bank accounts and investments, contracts for services and pay its own bills? Does the FLP maintain books and records? Also, make sure that there are sufficient assets outside of the FLP. Don’t use the partnership as your own personal piggy bank. It cannot be stressed enough that FLPs have to be planned, documented, implemented and operated.

Next, make sure you have the best possible valuation appraisals from a qualified appraiser. Two appraisals are required, at two different levels. One appraisal is for the assets owned by the partnership. The second appraisal is for the value of an interest in the partnership. The valuations are key to defending the discount, so they are not something to stint on.

There are considerable non-tax advantages as well. The partnership can protect property against claims. Creditors that may sue the partnership cannot reach the personal assets of the limited partners and the general partner (if the general partnership is a limited liability company or corporation). Creditors of the partners themselves may be more willing to settle than be saddled with limited partnership interests and non-controlling general partnership interests that will cause them to have income tax liability, but no guarantee of distributions with which to pay the taxes.

The partnership property can be managed through one account, thus consolidating and simplifying the management of the family’s investments. The partnership simplifies the manner in which you make gifts to your beneficiaries. Instead of being required to select and give several securities or other assets, you simply could transfer limited partnership units.

FLPs are not for everybody; but if you can abide by the constraints of the entity, this estate planning technique is an important one that can provide significant benefits.