Avoiding a Family Limited Partnership Tax Trap

by Joseph M. Liss

August 1, 2003

Family limited partnerships and family limited liability companies are regularly used to make gift and estate transfers from the older generation to younger generations at reduced gift and estate tax costs.

There have been many IRS challenges to family limited partnerships and family limited liability companies, particularly with respect to the amounts of discounts applied to underlying market values of partnership assets.  It is these discounts that cause the reduced gift and estate tax costs.  In spite of these challenges, the courts have regularly approved discounts so that the use of family limited partnerships is now a general accepted tax strategy.  Even so, there are traps to be avoided.

In one recent case (Hackl), the operating agreement for the limited liability company appointed dad as the manager-for-life and, further, provided that if a member transferred his or her shares without dad’s consent, the transferee would receive the share’s economic value but not any membership or voting rights.

Agreeing with the IRS and the Tax Court, the Seventh Circuit Court of Appeals ruled that the restrictions on the transferability of the shares meant that the shares were essentially without immediate value to the donees.  The significance of this ruling is that mom and dad could not use their annual gift exclusions, currently $11,000 each for mom and dad per child.

Many family limited partnership and family limited liability company gifting strategies involve gifts of shares equivalent in value, after applying discounts, to the annual gift tax exclusion.  Depending on the number of children and the number of years in the gifting plan, these strategies can result in a significant transfer of assets from mom and dad to their children, and even grandchildren, at little or no gift tax.

To avoid this and other tax traps, the drafting of family limited partnership and family limited liability company agreements should only be done by lawyers who are expert with respect to the tax laws that apply to them.  Please contact us if you would like to learn more about family limited partnerships and family limited liability companies.

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