Obama eyeing changes to FLP rules

For years, the wealthy have found an attractive vehicle to transfer family assets to the next generation through family limited partnerships (FLPs). The legal entities often allow future generations to bypass gift and estate taxes but have come under scrutiny from the Obama administration, which may change the rules of the game.
An FLP allows general partners, usually parents, to provide limited partners, usually children, assets without any legal control over the partnership. Under current law, limited partners can mark down, or “discount,” the value of their holdings for tax purposes under the theory that because they have no control over the partnership their stake is worth less than the actual dollar amount. But the Obama administration says some are gaming the system by shoveling in nonbusiness-related assets such as stocks into the FLP and then marking them down without justification.
Now, the administration is considering proposing to Congress rules similar to ones once floated by the Clinton administration that would limit or abolish discounts of nonbusiness assets.
“That will certainly put a crimp in family limited partnerships,” said John Harpootian, a partner at Paster & Harpootian in Cranston who specializes in estate planning.
Still, FLPs are unlikely to go away. Estate-planning lawyer Robert Petix, a partner at Hinckley, Allen & Snyder in Providence, said the partnerships will still make sense in some situations, even sans the discounts.
Petix said a business owner looking to transfer wealth to his children while retaining control might find an FLP attractive. And the assets held by limited partners such as children are usually more difficult for creditors to reach. An FLP also can help avoid squabbling among heirs after a death and provide a standing vehicle to keep wealth moving from one generation to the next. “I do think [the potential elimination of discounts] does somewhat detract from the benefits of the technique, but on the other hand I think if you have significant nontax motivation for creating the FLP anyway you might want to do it,” Petix said.
An FLP could provide some stability as lawyers anticipate Congress will yet again change the federal estate tax. Under the current law, the federal estate tax will go away altogether in 2010, but return in 2011 for those with estates valued at more than $3.5 million.
Harpootian said he and others in the field believe Congress will not allow a gap year and will continue the current taxes applicable for those with estates greater than $3.5 million. That’s why lawyers are not ready just yet to abandon the FLP concept. (For those considering an FLP, there is also no way of knowing if someone will die in 2010 when the tax goes away or 2011 when it returns.)
Petix said FLPs can also help insulate people from the gift tax. Because the tax is a percentage of the amount given, it makes sense to gift low amounts. Business owners normally see their investments grow as they age. Those that transfer it at the end of their lives pay on the end balance, along with all its appreciation. But those that let the investment grow within an FLP avoid the necessity to “gift” the end amount. An FLP is a good fit for those that have reached a comfortable net worth and are young enough to have time to let the investment grow. Adding other wealth also helps. “I would say the ideal client is somebody who is going to pool assets maybe with children and putting them in a vehicle,” Petix said.
Such a scenario must be handled carefully though, to avoid scrutiny from the Internal Revenue Service, said Helder Medeiros, a certified public accountant at Restivo Monacelli in Providence. Medeiros said he sees many clients run into trouble with the IRS after they start treating an FLP like a family bank account and use it to pay for living expenses or entertainment.
“It’s just mind boggling what’s happening now because people just don’t understand the accounting and compliance of these things,” he said.
A few years ago FLPs became the “buzzword” in estate planning and people rushed into them without understanding all the repercussions, Medeiros said. Then when the stock market crashed general partners started taking 100 percent of the disbursements from the FLP – a no-no under regulations that require limited partners to receive the share they are entitled to under the partnership agreement.
So now Medeiros recommends a complex setup of establishing an FLP or similar Family Limited Liability Company in conjunction with a Defective Grantor Trust. The FLP then sells a stake in it to the trust, which pays for the stake over time and with interest. In that way the FLP general partners continue to receive money through payments on the note, but the note itself is considered outside of the estate. Some clients, Medeiros said, are finding the complexity and possible scrutiny of an FLP not worth it and jumping straight to a defective grantor trust.
“We’re educating a lot of these clients on the complexity of these partnerships,” Medeiros said. •