THE FAMILY LIMITED PARTNERSHIP - · PDF fileThe Family Limited Partnership - Marital Property...

Copyright © 1998, 99, Bernard E. Jones. The author gratefully acknowledges Michael Cenatiempo for his*

permission to incorporate his portion of Techniques for Preserving the Separate Estate Before Marriage andHow to Attack Those Techniques, 23rd Annual Advanced Family Law Course, State Bar of Texas, August 17-20, 1998, San Antonio, Texas, and Mickey R. Davis and Sarah Patel-Pacheco for their helpful comments andcontributions.

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:44

THE FAMILY LIMITED PARTNERSHIP

** ++

MARITAL PROPERTY & ETHICAL CONSIDERATIONS*

BERNARD E. JONESDavis, Ridout, Jones, & Gerstner, L.L.P.

600 Travis, Suite 7070Houston, Texas 77002-3072

(713) 229-0900FAX (713) 229-9400

STATE BAR OF TEXAS 23rd ANNUALADVANCED ESTATE PLANNING

& PROBATE LAW COURSE

San Antonio, TexasJune, 2-4, 1999

- C -


BERNARD E. JONESATTORNEY AT LAW

BOARD CERTIFIED,ESTATE PLANNING AND

PROBATE LAW, TEXAS BOARDOF LEGAL SPECIALIZATION

DAVIS, RIDOUT, JONES & GERSTNER, L.L.P.600 Travis, Suite 7070Houston, Texas 77002

(713) 229-0900FAX (713)229-9400

Education

University of Texas, Austin, TexasJuris Doctor, with honors, awarded May 1983Bachelor of Arts, with honors, awarded May 1980 (Major: Economics)

Professional Associations

Adjunct Professor of Law, University of Houston Law Center, Houston, Texas, 1995- (course:Estate Planning)

Fellow, American College of Trust and Estate Council

Member, Texas Bar Association (admitted 1983)Section on Real Estate, Probate and Trust Law (Council member, 1998-; Probate CodeCommittee, Subcommittee on Revocable Trusts, member, 1991-92, chair, 1993-94; ProbateCode Committee, member, 1995-96; and Subcommittee on Transmutation, member, 1995-)Section on Taxation, Chair: Community Property and Family Tax Committee (1992-93)

Member: College of the State Bar of Texas; Houston Bar Association and Section on Probate,Trusts and Estates; Disabilities and Elder Law Association, Houston, Texas; American BarAssociation and Sections on Taxation; and Real Property, Probate and Trust Law

Selected Publications

The Family Limited Partnership - Marital Property & Ethical Considerations, University ofTexas School of Law Texas Marital Property Institute, October 22 & 23, 1998 (outline andspeech)

Generation-Skipping Transfer Tax: Trust Severances and Exemption Allocations, 21st AnnualState Bar of Texas Advanced Estate Planning and Probate Course, June 4-6, 1997 (speech,outline prepared jointly with Mickey Davis & Jerry Scroggins)

Reality Check - Practical Estate Planning Applications, Texas Society of Certified PublicAccountants, 1996 Annual Advanced Estate Planning Conference, September 5-6, 1996

Anatomy of a Will, 20th Annual State Bar of Texas Advanced Estate Planning and ProbateCourse, June 5-7, 1996 (outline prepared jointly with Steve Akers)

Estate Planning for Incapacitated Individuals, 33 REAL ESTATE, PROBATE & TRUST LAWREPORTER 27, July, 1995 (State Bar of Texas)

Estate Planning For Incapacitated Individuals; Section 867 Trusts, 5th Annual State Bar ofTexas Advanced Drafting: Estate Planning and Probate Course, November 3-4, 1994

Revocable Trusts: Nuts and Bolts, 17th Annual State Bar of Texas Advanced Estate Planningand Probate Course, June 2-4, 1993

Revocable Trusts--Tax Issues, Perpetuities, When and How to Fund, 3rd Annual State Bar ofTexas Advanced Drafting: Estate Planning and Probate Course, November 12-13, 1992

Putting Revocable Trusts In Their Place, 129 TRUSTS & ESTATES 8 (September 1990)

Creditors' Rights To Your Retirement Plan, 17 THE TEXAS INDEPENDENT BANKER 22 (April1990)

The Family Limited Partnership - Marital Property & Ethical Considerations C-i


Table of Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1A. Scope of this Presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1B. Disclaimer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

II. Family Limited Partnership Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1A. Partnerships in General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1. Governing Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1a. Texas Uniform Partnership Act (“TUPA”) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1b. Texas Revised Partnership Act (“TRPA”) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1c. Texas Revised Limited Partnership Act (“TRLPA”) . . . . . . . . . . . . . . . . . . . . . . 1

2. Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. Partner Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

a. Personal Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1b. Interest in Partnership v. Interest in Partnership Assets . . . . . . . . . . . . . . . . . . . . 2

(1) Under TUPA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2(2) Under TRPA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2(3) Under TRLPA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

4. Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2B. Limited Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1. General Versus Limited Partner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22. Statutory Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23. Applicability of TUPA and TRPA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

C. Family Limited Partnerships (“FLPs”) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2D. The Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2E. Fundamental Effect of Creating and Funding Partnerships . . . . . . . . . . . . . . . . . . . . . . . . 3

1. At Common Law--The Aggregate Theory of Partnerships . . . . . . . . . . . . . . . . . . . . . . . 32. Under TUPA and TRPA–The Entity Theory of Partnerships . . . . . . . . . . . . . . . . . . . . . 3

a. TUPA Probably Adopted The Entity Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3b. TRPA Clearly Adopted The Entity Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

III. FLP Marital Property Considerations in General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3A. Partnership Interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3B. Marital Property v. Partnership Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1. Generally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32. Record Title v. Legal Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43. Roach v. Roach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

C. Partnership Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41. Generally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42. Marshall v. Marshall and the Return of Capital Argument . . . . . . . . . . . . . . . . . . . . . . 4

a. The Facts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4b. The Ruling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4c. Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

(1) The Holding Follows the Statute . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4(2) Reliance on Income Tax Rules is Misplaced . . . . . . . . . . . . . . . . . . . . . . . 4(3) Partnership Agreement Might Change Result . . . . . . . . . . . . . . . . . . . . . . 5

d. Application to FLPs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5D. Undistributed Partnership Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

1. Community Property Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52. Separate Property Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

a. Arguments Against Non-Partner Spouse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5b. Arguments For Non-Partner Spouse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5c. The Winning Argument? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

E. Partnership Management Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61. Generally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62. During Marriage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63. Death or Divorce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

F. Partition of Partnership Interest in Divorce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

C-ii 1999 Advanced Estate Planning and Probate Law Course


1. Partnership Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62. Specific Partnership Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

G. Claims of Reimbursement to Community Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6H. Right to Compel Partnership to Satisfy Child-Support Obligations . . . . . . . . . . . . . . . . . . 6I. Potential Attacks on Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

1. Alter Ego . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62. Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63. Failure to Make Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

IV. Uses and Abuses of FLPs to Alter Marital Rights and Duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7A. Avoid Receipt of Community Income from Separate Property . . . . . . . . . . . . . . . . . . . . . . 7

1. Generally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72. Only Undistributed Income is Protected . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73. Reimbursement Rights due to Excessively Low Distributions . . . . . . . . . . . . . . . . . . . . 74. Not for Minerals or Other Assets Producing Separate Revenues . . . . . . . . . . . . . . . . . . 7

B. Preserve Separate Character of Receipts with “Built-In” Partition Language . . . . . . . . . 7C. Transmute Separate into Community . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

1. No Direct Transmutation Under Current Texas Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72. Technique: Create FLP with Community, Augment with Separate and Waive

Reimbursement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83. Technique: Create FLP with Separate and Distribute Back In-Kind . . . . . . . . . . . . . . . 8

D. Withdraw Partnership Property as Separate Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81. Technique: Straw Man Sale and Redemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82. Technique: Manipulate Capital Accounts to Create “Return of Capital” . . . . . . . . . . . . 83. Technique: Multiple Controlled Entities to Create “Return of Capital” or Cross Sale

of Interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9E. Eliminate Mutual Fund Ambiguity; Render All Returns Community . . . . . . . . . . . . . . . . 9F. Pre-Divorce FLP Creation With Community to Impair Non-Partner Spouse’s Rights

and Avoid Child Support Obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

V. Representing and Advising Spouses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9A. Representing Both Spouses Jointly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9B. Representing Only One Spouse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

APPENDIX ONE: FLP “TOP TEN LIST” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

APPENDIX TWO: FAMILY LIMITED PARTNERSHIP “BASICS” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

I. Overview of Family Limited Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12A. General Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12B. Differences Between General and Limited Partnership Interests . . . . . . . . . . . . . . . . . . . 12

1. Limited Partners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122. General Partners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

II. Advantages of Family Limited Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12A. Creditor Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12B. Valuation Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13C. Other Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14D. Certain Disadvantages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

III. Planning Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15A. The Partnership Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15B. Management of the Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15C. Using Trusts as Donees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15D. Choice and number of general partners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

IV. Tax Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16A. Income Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16B. Estate Tax Inclusion Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16C. Income Tax Cost Basis Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

The Family Limited Partnership - Marital Property & Ethical Considerations C-iii


V. Operational Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17A. Formalities Upon Formation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

1. The FLP Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182. Certificate of Limited Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183. Conveyance of Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

a. Deeds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18b. Oil and Gas Interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18c. Mortgages, Notes and Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18d. Stocks and Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

4. Respecting the Conveyances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19B. Operating Formalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

1. Books and Records . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192. Partner Meetings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193. Votes on Partnership Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194. Other Operating Formalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

C. Formalities Of Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20D. Tax Formalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

1. Partnership Income Tax Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202. Taxation vs. Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

VI. Valuation of the Family Limited Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20A. Obtaining Independent Appraisals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21B. Valuation Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

VII. Frequently Asked Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21• How does an FLP reduce gift and estate taxes? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21• Are these valuation discounts “real”? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22• What assets can I transfer to an FLP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22• Can the partnership own life insurance? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22• What sort of paperwork is required after the FLP is formed? . . . . . . . . . . . . . . . . . . . . . 22• Do I really need to get an appraisal? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22• May I use an FLP to protect assets from creditors after creditor problems arise? . . . . 22• What happens to FLP interests in a divorce? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22• Will the IRS challenge the FLP? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23• Why doesn’t everyone use an FLP to hold assets? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

VIII. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

The Family Limited Partnership - Marital Property & Ethical Considerations C-1


THE FAMILY LIMITED PARTNERSHIPMARITAL PROPERTY & ETHICAL CONSIDERATIONS

Bernard E. JonesDavis, Ridout, Jones, & Gerstner, L.L.P.

b. Texas Revised Partnership Act (“TRPA”)I.INTRODUCTION

A. Scope of this PresentationThis outline contains neither a technical

discussion of the estate planning applications ofFamily Limited Partnerships nor a detailed analysis ofthe numerous federal income and transfer tax issuesrelating to family limited partnerships. Instead, thisoutline presents a summary of partnership lawfollowed by a discussion of Texas marital propertyrights in and to partnerships. It concludes with adiscussion of uses and abuses of family limitedpartnerships, all with an emphasis on ethicalimplications.

B. DisclaimerThis outline and the accompanying materials are

intended solely for other professionals and should notbe relied upon without independent verification.Numerous statements in this outline are intended toraise ethical and other issues and provokeconsideration of the matter by the practitioner and, asa result, the opinions expressed in this outline do notnecessarily reflect the opinions of the author.

II.FAMILY LIMITED PARTNERSHIP the partners in writing. The following factors suggest

BASICS

A. Partnerships in GeneralA partnership is an association of two or more

people, as co-owners, carrying on a business for profit.See TEX. REV. CIV. STAT. ANN. art 6132b §6 (Vernon1970). Once formed, a partnership is a legal entitydistinct from its partners. See TEX. REV. CIV. STAT.ANN. art 6132b-2.01(Vernon Supp. 1998).

1. GOVERNING LAW

a. Texas Uniform Partnership Act (“TUPA”)In 1961, the Texas Uniform Partnership Act,

TEX. REV. CIV. STAT. ANN. art 6132b (Vernon 1970)(“TUPA”) was enacted. (References in this outline toTUPA and sections of TUPA are to TEX. REV. CIV.STAT. ANN. art 6132b.) Prior to TUPA, partnershipsin Texas were governed by common law.

In 1993, the Texas Revised Partnership Act,TEX. REV. CIV. STAT. ANN. art 6132b-1.01 et seq(Vernon Supp. 1998) (“TRPA”), was enacted andapplies to (i) all partnerships formed on or afterJanuary 1, 1994, and (ii) all partnerships formedbefore January 1, 1994, as of January 1, 1999, unlessthe partnership elects to apply the TRPA sooner.Considering the very short remaining relevance ofTUPA, this outline will analyze the issues assumingTRPA is the applicable statute, unless otherwisespecifically indicated. (References in this outline toTRPA and “sections” of TRPA are to TEX. REV. CIV.STAT. ANN. art 6132b-1.01 et seq.)

c. Texas Revised Limited Partnership Act(“TRLPA”)In 1987 the Texas Revised Limited Partnership

Act, TEX. REV. CIV. STAT. ANN. art 6132a-1 (VernonSupp. 1998) (“TRPA”), was enacted. SinceSeptember 1, 1992, TRLPA has been applicable to alldomestic and foreign limited partnerships doingbusiness in Texas. See TRLPA §13.02(b).(References in this outline to TRLPA and sections ofTRLPA are to TEX. REV. CIV. STAT. ANN. art 6132a-1.)

2. CREATIONAn oral agreement can create a partnership.

However, it is preferable to set out the agreements of

the existence of a partnership:

C Right to receive a share of the profits;C Expression of the intent to be business

partners;C Right to participate in the control of the

business;C Sharing or agreeing to share in business

losses and liabilities; andC Contributing cash or other property to the

business.

See TRPA §2.03.

3. PARTNER RIGHTSA partner has the following rights in a

partnership.

C-2 1999 Advanced Estate Planning and Probate Law Course


a. Personal PropertyA partnership interest is personal property. See “To form a limited partnership, the partners must

TRPA §5.02 and TRLPA §7.01. enter into a partnership agreement and one or more

b. Interest in Partnership v. Interest in Partnership execute a certificate of limited partnership.” TRLPAAssets §2.01(a). “A limited partnership is formed at the time

(1) Under TUPA §2.01(b). Thus, if the partners “enter into aUnder TUPA a partner has an interest in specific partnership agreement” but never file a certificate, it

partnership assets; each partner is “co-owner with his follows that the resulting partnership is a generalpartners of specific partnership property holding as partnership.tenants in partnership.” TUPA §25.

(2) Under TRPA TRLPA is silent on many fundamentalUnder TRPA, a partner has an ownership interest partnership issues, focusing primarily on the issues

in the partnership entity itself, not the partnership’s specific to limited partnerships. Under TRLPAspecific assets. See TRPA §§2.04 & 5.01. Some §13.03, “the applicable statute governing partnershipscommentators have suggested that under TRPA it is that are not limited partnerships . . .” apply in any caseno longer possible for a partner to have an interest in not provided for by TRLPA. Thus, TUPA and TRPA,specific partnership assets. However, TRPA §1.03 as applicable, govern numerous aspects of limitedindicates that the partnership agreement can vary the partnerships. Almost all marital property issues inprovisions of TRPA in any way (except for certain limited partnerships are governed by TUPA andenumerated matters not relevant to this discussion), TRPA, not TRLPA.suggesting that even under TRPA, the partnershipagreement could be drafted to specifically give one ormore partners an interest in specific partnershipassets.

(3) Under TRLPASection 7.01 of TRLPA states flatly: “A partner

has no interest in specific limited partnership assets.”

4. TRANSFERUnless prohibited by agreement, a partner may

sell, convey or assign a partnership interest. Thetransfer does not automatically result in the dissolutionof the partnership. See TRPA §5.03. However, thetransferee does not step into the role of a partner oracquire the transferor’s right to participate inmanagement. The transferee is merely entitled toreceive the transferor’s distributions from thepartnership if and when made. See TRPA §5.03(b).

B. Limited Partnerships

1. GENERAL VERSUS LIMITED PARTNERA limited partnership is a partnership having one

or more general partners and one or more limitedpartners. General partners in limited partnerships(like their counterparts in general partnerships) havethe right to participate in the management and controlof the business and, as a result, they have unlimitedliability with regard to partnership debts andobligations. Limited partners, on the other hand, havelimited management and control rights. In return,limited partners have limited liability for partnershipobligations.

2. STATUTORY REQUIREMENTS

partners, including all of the general partners, must

of the filing of the initial certificate.” TRLPA

3. APPLICABILITY OF TUPA AND TRPA

C. Family Limited Partnerships(“FLPs”)A family limited partnership (a/k/a, “FLP”) is

simply a limited partnership formed among familymembers. In the last decade, families have used theFLP business entity with increasing frequency toprovide additional asset protection and as an estateplanning vehicle. The business of the FLP may benothing more than managing the real and personalproperty of members of the older generation or of theentire family. Often, an older generation member willcreate an FLP with his or her assets, such as anongoing business, stock, real property, etc. Theyounger generations may contribute addition propertyto the FLP or they may obtain their interests in theFLP by gift. Members of the older generation areusually the general partners, so they can retain control,and members of the younger generation are typicallylimited partners (although a younger generationmember sometimes serves as a general partner in orderto provide asset management for the older generation).The limited partners cannot compel a distribution butare entitled to a share of any partnership distributionif and when made. In addition, FLP agreements willfrequently contain significant restrictions on thetransfer or assignment of a partnership interest inorder to keep the business “in the family.” thecombined effect of these restrictions is to significantlyinfluence the value of partnership interests both duringa partner’s life and at death and protect the partnershipfrom a partner’s creditors by making the asset lessdesirable.

D. The AppendicesInasmuch as the preceding single paragraph

description of the FLP may leave out too many details,



two appendices are included in this outline. The first §25, TUPA’s adoption of the entity theory wasis a brief “Top Ten List” of FLP observations inartful at best.prepared by Mickey R. Davis. The second is adiscussion of the FLP, written in non-technical terms, b. TRPA Clearly Adopted The Entity Theorydesigned for the client who is interested in With 1993's adoption of TRPA the entity theoryunderstanding the basic principals of the FLP in some clearly became the applicable rule. TRPA has clearerdetail. wording as to partner interests in partnerships,

E. Fundamental Effect of Creating andFunding Partnerships

1. AT COMMON LAW--THE AGGREGATETHEORY OF PARTNERSHIPSCommon law conceives of the partnership as an

aggregation of its partners, not an entity apart fromthem. See Marshall v. Marshall, 735 S.W.2d 587 at593 (Tex. App.--Dallas 1987, writ ref’d n.r.e.). Fromthis perspective a partner who contributes an asset toa partnership still owns the asset, albeit “through” thepartnership vehicle. In the minds of many clients andpractitioners alike, this is a rare example of thecommon law making common sense; it is probablysafe to say that most people doing business inpartnership form consider the partnership property tobe “their” property, albeit jointly owned with theirpartners.

From the perspective of the aggregate theory, thecreation and funding of a partnership does not causeany fundamental change in property ownership rights.It merely pools or aggregates the previously separaterights of the partners. The partners still “own” theproperty contributed to the partnership.

2. UNDER TUPA AND TRPA–THE ENTITYTHEORY OF PARTNERSHIPS

a. TUPA Probably Adopted The Entity TheoryWith the adoption of TUPA in 1961, Texas

statutory law replaced the common law’s aggregatetheory with the entity theory, under which thepartnership is considered an entity apart from theindividual partners. See Marshall v. Marshall, 735S.W.2d 587 at 593 (Tex. App.--Dallas 1987, writref’d n.r.e.). According to the court in Marshall:

“With the passage of [TUPA] in 1961, Texasdiscarded the aggregate theory and adopted theentity theory of partnership. Under [TUPA],partnership property is owned by the partnershipitself and not by the individual partners. Apartner’s partnership interest, the right to receivehis share of the profits and surpluses from thebusiness, is the only property right a partner has. . ..”

735 S.W.2d 587 at 594. Whether TUPA reallycompletely discarded the aggregate theory is a matterof personal opinion. Suffice it to say that, by retainingsuch concepts as “tenants in partnership,” see TUPA

eliminating the “tenants in partnership” wording, andflatly states that “[a] partnership is an entity distinctfrom its partners,” TRPA §2.01, and that“[partnership] property is not property of thepartners,” TRPA §2.04.

From the perspective of the entity theory, thecreation and funding of a partnership is a verysignificant act. By contributing assets to thepartnership, the new partners give up ownership ofthese assets in exchange for ownership of a whollynew and distinct asset: partnership interests. Theyno more “own” the assets of the partnership than ashareholder in General Motors “owns” a Buickassembly plant in Michigan.

Many of the seemingly peculiar rules ofpartnership marital property make better sense whenthis fundamental concept is kept in mind.

III.FLP MARITAL PROPERTY

CONSIDERATIONS IN GENERAL

A. Partnership InterestsA partnership interest can be either separate or

community property. See TRPA §5.02. Generally, apartnership interest is characterized as separate orcommunity property under the same general rules ofany other interest acquired during the marriage. Thus,it is necessary to determine whether the partnershipinterest is acquired before marriage, as a result of agift, devise, or decent, or whether it can be traced toseparate property. See In re Marriage of Higley, 575S.W.2d 432 (Tex. Civ. App.--Amarillo 1978, no writ)(partnership interest acquired by husband prior tomarriage was separate property). Partnership interestacquired during marriage or which does not fit withinthe statutory definition of separate property ispresumed to be community property. See York v.York 678 S.W.2d 110 (Tex. App.--El Paso 1984, writref’d n.r.e.) (partnership interest acquired duringmarriage is community property).

B. Marital Property v. PartnershipProperty

1. GENERALLYGenerally, property transferred to and acquired

by a partnership is an asset of the partnership ratherthan any individual partner. Once a specific property

http://www.TexasBarCLE.com/CLE/PMCasemaker.asp?table=tx_caselaw&volume=735&edition=S.W.2d&page=587&id=48843_01









is transferred into the partnership, that property is no partnership as salary and of profits and surpluses arelonger capable of being either community or separate community property unless altered by a premaritalinasmuch as it becomes partnership property and is no agreement. Marshall v. Marshall, 735 S.W.2d 587longer property owned by the spouse or the spouses. (Tex. App.--Dallas 1987, writ ref’d n.r.e.). From theSee Marshall v. Marshall, 735 S.W.2d 587 (Tex. perspective of the entity theory of partnerships, thisApp.--Dallas 1987, writ ref’d n.r.e.). Further, rule is entirely consistent with the general Texas lawproperty acquired with partnership funds is presumed rule that income from property (from both separateto be partnership property unless a contrary intent property and community property) is communityexists. See TRPA §2.05(c). property.

2. RECORD TITLE V. LEGAL OWNERSHIP 2. MARSHALL V. MARSHALL AND THE RETURN OFIt is sometime difficult to determine what

property belongs to the partnership versus a spouse or Just as income from separate property is clearlythe marital estate. For example, a spouse may allow community property, the proceeds from the sale of aa partnership to use property and hold the property as separate property asset are generally separatea nominee but it is agreed that the spouse will remain property. The husband in Marshall made thisthe owner of the property. In this situation, it may argument, albeit unsuccessfully, in an attempt toappear to third parties that the partnership owns the characterize partnership distributions as separateproperty. However, the true owner remains the partner property.spouse. On the other hand, partnership property maybe held in the name of the partner spouse, a. The Factsindividually. However, the partner spouse does not In Marshall, the husband acquired a partnershiphave a legal interest in the property but holds it as interest before marriage. Following the marriage, henominee for the partnership. received several distributions from the partnership

3. ROACH V. ROACHBecause of the potential confusion that can result distributions to the husband were either salary or

in the characterization of marital property when profit. In the divorce proceeding, the husband arguedtransferred to a partnership, the partner spouse should that the distributions should not be included in theclearly delineate in the partnership agreement or other computation of the community estate because theyinstrument whether the property transferred will were a return, or mutation, of his separate propertyremain his or her separate property or ownership is interest in the partnership even though he reportedbeing conveyed to the partnership. them as income on his income tax return. The wife

On point is the case of Roach v. Roach, 672 asserted all the distributions and withdrawals wereS.W.2d 524 (Tex. Civ. App.--Amarillo 1984, no writ). community property.In Roach, the husband and wife each deeded separatereal property to a partnership. The wife deeded her b. The Rulingseparate real property to the partnership with the The court of appeals agreed with the wife andstipulation that the property could be used by the found that “a withdrawal from a partnership capitalpartnership but it would remain her separate property. account is not a return of capital in the sense that itThe husband conveyed his separate real property to may be characterized as a mutation of a partner’sthe partnership but did not request language in the separate property contribution to the partnership andpartnership agreement stipulating that the property thereby remain separate.” Id. at 594. Rather, thewould remain his separate property. partner spouse’s contribution becomes partnership

Upon divorce, it was determined that the wife’s discussion supra), that cannot be characterized asproperty, although held in the partnership’s name, either separate or community property. Id. Therefore,remained her separate property; however, the real the court held that the rule that mutations of separateproperty conveyed by the husband lost its separate property remain separate property when effectivelyproperty character when it was transferred and traced, did not apply to partnership distributions fromacquired by the partnership. The husband and wife, as a partner’s capital account. Id.partners, were co-owners of the husband’s former c. Commentsseparate real property. The court characterized thespouses as tenants in partnership. Id. at 524. (1) The Holding Follows the Statute

C. Partnership Distributions

1. GENERALLYRegardless whether the partnership interest is

community or separate, all distributions from a

CAPITAL ARGUMENT

which he characterized as withdrawals from his capitalaccount. The partnership agreement provided that all

property (unless expressly agreed otherwise, see

The holding in Marshall is absolutely consistentwith the general rules that (i) partnerships are entitiesin which partners own partnership interests and haveno ownership interest in partnership assets and (ii)income from separate property is community property.The partnership experienced a return of capital but







Mr. Marshall simply received income with respect to a community property asset held by the partnerhis partnership interest. spouse. The non-partner spouse, as a partial

(2) Reliance on Income Tax Rules is will then have the right to a pro rata share of all futureMisplaced partnership distributions, if and when made.

Although the husband argued that the withdrawalwas principal, not income, he reported taxable income The court cannot, however, compel thewith respect to the partnership. The wife (and, partnership to distribute the income. Rather, as aarguably, the court) believed that the federal transferee, the non-partner spouse or ex-spouse isgovernment’s alleged characterization of the forced to wait until the partnership elects to make awithdrawals as taxable income supported the distribution. See discussion supra.argument that the withdrawals were income forcommunity property purposes. The thoughtfulpractitioner will not rely on this argument because: When the partnership interest is one spouse’s(i) it ignores the distinctions between taxable income separate property, Texas law is arguably unclear onand accounting income, and (ii) it ignores the fact that, the rights, if any, of the non-partner spouse in anyunder the Internal Revenue Code, partnership income undistributed income.is taxable to the partners without regard to whetherthere are withdrawals. The wife won because of state a. Arguments Against Non-Partner Spousepartnership law, not federal tax law. Some have argued that undistributed partnership

(3) Partnership Agreement Might Change spouse in a divorce proceeding. There is increasingResult support for this argument. As discussed previously, a

The partnership agreement in Marshall did not partner’s ownership interest under the TRPA isaddress the characterization of partnership limited to his or her interest in the partnership as adistributions. Significantly, no Texas case was located whole and not to specific partnership assets, includingwhich considered partnership distributions that were undistributed income and profits. See TRPA §§2.04deemed to be a return of capital under the terms of the and 5.01. Further, the partner spouse has notpartnership agreement. It is unclear whether courts acquired the income or profits because the assetswill interpret the Marshall decision to apply to all remain partnership assets and the partner spousepartnership distributions or only those agreed to be cannot, without the joinder of the other partners,income [and treated as such by the partner for tax compel a distribution. Texas cases addressingpurposes]. distributions from trusts and corporations lend support

d. Application to FLPsTRLPA §1.02(13) essentially defines “return of b. Arguments For Non-Partner Spouse

capital” as any distribution to a partner to the extent Others, however, have argued that all partnershipthat, after the distribution, the partner’s capital income and profits, including any undistributedaccount is less than the partner’s aggregate amounts, are community property. In In re Marriagecontributions to the partnership. (For example, if a of Higley, 575 S.W.2d 432 (Tex. Civ. App.--Amarillopartner contributes $100 to a partnership, receiving a 1978, no writ), the husband owned a separate property$100 capital account credit balance, and then receives partnership interest. In dividing the marital estate, thea distribution of $20 that leaves his capital account court awarded the non-partner spouse a share of thebalance at $80, the $20 distribution would be a “return anticipated net income of the partnership for the yearof capital.”) This section of TRLPA appears to of the divorce. See Higley, 575 S.W.2d at 434.support the argument that all distributions from a Further, the unique taxation of partnership interestpartnership of profit and surplus are community, but lends support to this position. Recall that allthat distributions made by “dipping in” to a partner’s partnership income and profits flow through to theseparate property capital contribution may be partners for tax purposes even if the partnershipseparate. retains these earnings. Each partner must include his

D. Undistributed Partnership Income

1. COMMUNITY PROPERTY PARTNERSHIPIf the partnership interest is community property,

it is said that both spouses have an interest in theundistributed partnership income and the court canpartition the right to the income in the divorce decree.It is perhaps more accurate to say that the court maypartition the actual partnership interest--being as it is

transferee of the partner spouse’s partnership interest,

2. SEPARATE PROPERTY PARTNERSHIP

income is not subject to any claim by the non-partner

to this argument.

or her share of any income and profits in calculatingtheir taxable income and pay any related income taxes.

c. The Winning Argument?To date, the Texas Supreme Court has not

resolved this issue. The few cases that have addressedthis issue were decided when TUPA’s inartful entitytheory of partnerships provided that a partnergenerally had an interest in specific assets as a tenantin partnership. See Higley, 575 S.W.2d at 434.






However, effective January 1, 1999, all generalpartnership will be governed by TRPA which more A divorce court cannot partition specificclearly sets forth an entity theory of partnerships. It partnership property to either spouse. See McKnightseems highly likely that the provisions of TRPA will v. McKnight, 543 S.W.2d 863, 868 (Tex. 1976);result in the courts finding that a non-partner spouse Roach v. Roach, 672 S.W.2d 524 (Tex. Civ. App.--has no community property right in the undistributed Amarillo 1984, no writ).partnership income.

E. Partnership Management Rights

1. GENERALLYUnder TRPA §4.01(e), “each partner has equal

rights in the management and conduct of the businessof the partnership. However, “[a] partnership interestdoes not include a partner’s right to participate inmanagement.” TRPA §1.01(12). That is to say, theright of management is not a property right per se butis a right personal to each partner. As to limitedpartnerships, the right of management is vested in thegeneral partners. See TRLPA §4.03.

2. DURING MARRIAGEA partner’s management rights, if any, are not

community property. See TRPA §4.01(d). Thepartner spouse has the right to participate in themanagement and control of the partnership accordingto the terms of the partnership agreement. The non-partner spouse does not have comparable right eventhough the partnership interest may be communityproperty.

3. DEATH OR DIVORCEUpon the death or divorce, the non-partner

spouse will be deemed a transferee of any interestpartitioned or acquired by the non-partner spouse. SeeTRPA §5.04. As such, his or her sole right is toreceive distributions if and when made. See TRPA§5.03(b).

F. Partition of Partnership Interest inDivorce

1. PARTNERSHIP INTERESTA divorce court can partition a community

property partnership interest as it determines to be justand right. However, the partition of a partnershipinterest to the non-partner spouse will not result in himor her becoming a partner in the partnership. The non-partner spouse is deemed a transferee or assignee ofthe partitioned interest and is only entitled topartnership distributions, when made, by thepartnership. See discussion supra. The non-partnerspouse is not entitled to participate or interfere inpartnership management. See TRPA §5.03. As aresult, the non-partner spouse’s interest in thepartnership is diminished and frequently unmarketablebecause of his or her inability to participate in themanagement and control of the partnership.

2. SPECIFIC PARTNERSHIP PROPERTY

G. Claims of Reimbursement toCommunity EstateThe community estate is entitled to be

reimbursed for distributions used to satisfy onespouse’s separate obligations. See Marshall, 735S.W.2d at 587. In Marshall, the husband acquired apartnership interest prior to marriage. At the time ofthe marriage, the husband owed $125,375.50 inincome taxes. The partnership subsequently paid thehusband’s income tax debt and charged it as adistribution from the partnership. The couple includedthe distribution in their income. The Dallas Court ofAppeals held that the community estate was entitled toreimbursement equal to the amount of taxes satisfiedby the partnership. Id. at 596.

The community estate will also be entitled to aright of reimbursement for any income taxes paid bythe community estate relating to one spouse’s separateproperty partnership interest when the associatedprofits and income were not distributed during themarriage.

H. Right to Compel Partnership toSatisfy Child-Support ObligationsUnlike a trust, no statute exists which requires

that a partnership make distributions to satisfy apartner’s child support obligation.

I. Potential Attacks on Partnerships

1. ALTER EGOJust as with any other entity, a spouse may assert

that the court should disregard the partnership becauseit is nothing more than the alter ego of the partnerspouse.

2. FRAUDThe non-partner spouse could claim that the

partner spouse transferred community property to apartnership to defraud the community estate. SeeTEX. REV. CIV. STAT. ANN. art 6132b §28-A--comment (Vernon 1970).

3. FAILURE TO MAKE DISTRIBUTIONSSome partnership agreements provide that the

profits will be distributed at a certain time or based ona formula, taking into account reasonable reserves toprovide for anticipated partnership expenditures andobligations. Generally, partnership distributions mustbe made pro-rata to the partners. Review the terms ofthe partnership agreement to determine if the partnerhas a right to compel and receive distributions. Also





verify that the partner spouse has received a extent that the partner spouse receives distributionsproportionate share of any partnership distributions attributable to partnership income and profits, theremade during the marriage. will be community income (in the absence of a marital

IV.USES AND ABUSES OF FLPS TO

ALTER MARITAL RIGHTSAND DUTIES

Depending on one’s personal ethic, each of thefollowing techniques is either a useful tool to clarify,control and retain valuable property rights, or acunning device to perpetrate fraud, evade fundamentalmarital duties and defy public policy. However, thetechniques are presented with only limited ethicalcommentary because, in my view, it is the recognitionand discussion of the issues that leads to an ethicalpractice. Ethics cannot be taught by an outline’sdesignation of “ethical” or “unethical.” Rather, ethicsare learned by each practitioner’s making his or herown decision.

A. Avoid Receipt of Community Incomefrom Separate Property

1. GENERALLYThe FLP (or any other partnership entity)

essentially creates a brick wall between the property ofthe partner spouse and the property of the partnership.Assets inside the partnership do not belong to thepartner spouse. Neither the appreciation of nor theincome earned by those assets belongs to the partnerspouse. Instead, the partnership itself owns the assets,appreciation and income, and the partner spouse ownsonly his or her partnership interest in the partnershipentity.

So long as the partnership makes no distributionsto the partner spouse there can be no income withrespect to his or her partnership interest; thepartnership interest may increase in value (due to thepartnership’s retained earnings) but increases in thevalue of separate property are clearly separateproperty. Thus, a spouse or future spouse who willnot need personal access to the income from separateproperty assets can place those assets in an FLP and,so long as the income from those assets is retainedinside the partnership, that income will never be thepartner’s property, much less the community propertyof the partner and his or her spouse. Without thejoinder of the non-partner spouse, the partner spousewill have effectively converted the income from hisseparate property assets into separate property.

2. ONLY UNDISTRIBUTED INCOME IS PROTECTEDThe technique is only effective to the extent that

earnings are retained inside the partnership; to the

property agreement).

3. REIMBURSEMENT RIGHTS DUE TOEXCESSIVELY LOW DISTRIBUTIONSIt is arguable that a non-partner spouse could

make a valid reimbursement claim to the extent thatpartnership distributions are unreasonably low and thepartner spouse contributes personal time, talent oreffort to the partnership. This risk will be moresignificant in partnerships owning assets requiringsignificant management efforts and less of a concernin more “passive” partnerships (those holdinginvestments or other assets not requiring a significantcontribution of time from the partner spouse). Also,taking withdrawals for [community] living expensescan probably minimize the reimbursement claimwithout much risk of creating a significant communityestate.

4. NOT FOR MINERALS OR OTHER ASSETSPRODUCING SEPARATE REVENUESThe technique is not for assets that produce

separate property revenues, such as: (i) royalty andother fee mineral interests (note that interests in oil &gas partnerships produce community property income,not separate property royalties), (ii) non-incomeproducing real estate held for long term appreciation,and (iii) other “growth” assets. These assets alreadyavoid creation of community property without regardto actual receipt of the revenues. Placing them into anFLP effectively converts their separate propertyrevenues into community property income, to theextent withdrawn from the partnership. Planning withthese assets should revolve around a carefulaccounting to preserve tracing arguments, not FLPs.

B. Preserve Separate Character ofReceipts with “Built-In”Partition LanguageAn FLP agreement to which both spouses are

parties could effectively double as a limited scopemarital property agreement by including languageproviding that all distributions to either partner spouseare his or her separate property. This could be usefulwhere the spouses both wish to invest separateproperty in a single enterprise but wish to avoidcreation of community property. It could alsofacilitate non-pro rata treatment of the spouses to theextent that one of them is given compensation,guaranteed payments or other similar distributions.Obviously, in order to be effective, any partnershipagreement (or other instrument) which doubles as amarital property agreement would have to satisfy thegeneral requirements for a valid marital propertyagreement (disclosure or waiver, voluntariness, etc.).



C. Transmute Separate into Community

1. NO DIRECT TRANSMUTATION UNDERCURRENT TEXAS LAWUnder current Texas law spouses can convert

community property into separate property but cannotdirectly convert separate property into communityproperty. Rather, community property isconstitutionally defined and can be caused to existonly in compliance with the Texas constitution.However, there may be spouses who desire to “opt-in”to the community property system; e.g.:

C migrant spouses desiring to eliminateambiguity as to their separate andcommunity estates;

C spouses desiring to undo a prior partition ofcommunity property or an inadvertentpartition (such as one effectuated by a jointbrokerage account agreement including old“two-step” partition/survivorship languagein the boilerplate);

C non-citizen spouses desiring to reduce oravoid the need for a Qualified DomesticTrust in their wills (necessary to obtain a D. Withdraw Partnership Property asmarital deduction for bequests to asurviving non-citizen spouse but irrelevantas to the surviving non-citizen spouse’sretention of his or her ½ of the communityestate);

C spouses with non-taxable estates wishing toobtain a larger “step-up” in basis on thedeath of the first spouse (the deceasedspouse’s separate estate and ½ of thecommunity estate and the survivingspouse’s ½ of the community estate all geta step-up but the surviving spouse’sseparate estate does not); and

C spouses with substantial but unequal wealthwho wish to “equalize” their estates withoutrequiring the wealthy spouse to make anoutright gift and thus lose all managementrights over the gifted property.

2. TECHNIQUE: CREATE FLP WITHCOMMUNITY, AUGMENT WITH SEPARATE ANDWAIVE REIMBURSEMENTEither or both spouses can transfer community

property to a newly formed FLP and the partnershipinterest received in return will be community propertyunder general principals of tracing and inception oftitle. The spouses can then make additionalcontributions of separate property to the FLP withoutreceiving any additional partnership interests. Thiswill enhance the value of the previously obtainedcommunity property partnership interest and willprobably create a reimbursement claim; however,reimbursement claims are easily waivable. Thespouses can retain the partnership interest or take oneor more distributions from the partnership--including

in-kind and liquidating distributions--if they prefer toown the partnership’s assets directly. In either case,the property owned will arguably be communityproperty.

3. TECHNIQUE: CREATE FLP WITH SEPARATEAND DISTRIBUTE BACK IN-KINDAnother technique is for a spouse to create the

FLP with the separate property to be converted intocommunity property and then take the property backvia one or more non-liquidating in-kind partnershipdistributions. To the extent that all partnershipdistributions are in fact “income” and thereforecommunity property, all of the property (except,arguably, the final liquidating distribution) will becommunity.

This technique seems riskier than the otherbecause of the possibility that the distributions wouldbe treated as a “return of capital” and characterized asa separate property mutation or return of the initialseparate property partnership interest. See thediscussion supra.

Separate Property

1. TECHNIQUE: STRAW MAN SALE ANDREDEMPTIONIf the partnership interest is the separate property

of one spouse and that spouse desires to withdrawfunds from the partnership as separate property, he orshe could sell a partial interest in the partnership to athird party and the third party could then redeem theinterest (sell it back to the partnership) for the sameprice (plus a little something extra for his trouble).The proceeds from the sale of the separate propertypartnership interest would be separate; however, theunhappy non-partner spouse would probably have agood chance at characterizing the proceeds ascommunity by arguing that the sale to the intermediaryshould be ignored (this “step transaction” argument isoften used by the Internal Revenue Service in taxcases).

2. TECHNIQUE: MANIPULATE CAPITALACCOUNTS TO CREATE “RETURNOF CAPITAL”Another option for the partner spouse desiring a

separate property withdrawal from his or her separateproperty FLP relies on effective exploitation of thereturn of capital argument. Under that argument,withdrawals are separate property to the extent theyreduce a separate property capital account to anamount less than the aggregate capital contributions.With careful timing and coordination of distributionsand partnership receipts, community propertywithdrawals (which could be applied to livingexpenses) could be used to reduce the capital accountto the amount of the initial contribution; then, the next



withdrawal would be separate. Likewise, withdrawals FLP–with or without the joinder of the other spouse--could be made prior to the date the partnership as a pre-divorce planning technique. It is quiteanticipates a particular receipt of profit (which, when possible that the attorney drafting the FLP agreementrealized, would increase the capital accounts and thus will not be aware of the spouse’s motive. In the eventincrease the likelihood of subsequent withdrawals of a future divorce the court will be able to award thebeing characterized as community). non-partner spouse no more than a non-voting, non-

3. TECHNIQUE: MULTIPLE CONTROLLEDENTITIES TO CREATE “RETURN OF CAPITAL”OR CROSS SALE OF INTERESTSAlternatively, the partner spouse with a separate be proved, the non-partner spouse may or may not

property FLP could establish multiple partners which have good arguments to attack the FLP.are owned by him or her, e.g.: one or more revocabletrusts, corporations, etc. The partner spouse couldmake non-pro rata allocations of profit to the capitalaccounts of these different entities, always ensuringthat at least one of them has a capital account that isless than or equal to (or only slightly larger) than theaggregate contributions. Then, whenever the partnerspouse desired to take a separate property withdrawalhe or she could take it from that entity’s capitalaccount. An even more aggressive position would beto have one of those entities sell all or a portion of itspartnership interest to another, enabling the partnerspouse to claim that the proceeds of sale wereseparate.

The non-partner spouse would probably point to(i) the very precise manipulation of capital accountsby the partner spouse and (ii) the fact that, both beforeand after all the dust settled, the partner spouse hadtotal control of the partnership, as evidence that thetransactions were either shams or were made withfraudulent intent.

E. Eliminate Mutual Fund Ambiguity;Render All Returns CommunityMutual funds initially funded with separate

property of either or both spouses can present difficulttracing problems. The ambiguity can be resolved witha partition agreement, making the entire fund (and allincome) separate; however, the loss of the basis step-up (discussed supra) may be a high price to pay whengrowth stocks are involved. Placing mutual funds inan FLP arguably converts all returns into communityproperty--to the extent withdrawn from thepartnership. This eliminates the ambiguity withoutsacrificing the basis step-up or forcing the spouses totake the sometimes divisive step of executing a maritalproperty partition agreement. (Not all spousesdesiring to avoid ambiguity desire to maintain separatefinances.)

F. Pre-Divorce FLP Creation WithCommunity to Impair Non-PartnerSpouse’s Rights and Avoid ChildSupport ObligationA spouse can place his or her separate property

and sole management community property into an

marketable transferee interest in the FLP and will haveno authority to order the FLP to make distributions tosatisfy child support obligations. Depending on theextent to which the motive of the partner spouse can

V.REPRESENTING AND ADVISING

SPOUSES

Having before us an extremely powerful tool--theFLP–the question is: what do we tell our clients?

A. Representing Both Spouses JointlyRepresenting both spouses jointly in an estate

planning engagement is both historically accepted and,in my view, absolutely ethical and proper--not tomention economical--in the vast majority of cases.Representing both spouses in a divorce or in pre-divorce planning is ethical in only a very smallminority of the cases. Distinguishing between the twosituations can be problematic.

Obviously, the attorney’s “people skills” andability to read between the lines when conferring withthe spouses are crucial; the attorney who is ablediscern that what is ostensibly estate planning is reallyviewed by either or both of the spouses as pre-divorceplanning will have the opportunity to terminate therepresentation promptly--with luck, before anydamage is done. Thus, e.g., when a spouse with nochildren from prior relationships shows interest inusing an FLP to avoid child support obligations, theprudent attorney may wish to withdraw.

Potential conflicts can also be ferreted out with agood joint engagement agreement which clarifies thatall statements one spouse makes to the attorney maybe shared with the other spouse. I do not believe thata spouse with an ulterior agenda can be stoppedmerely by an attorney with a good engagementagreement; however, if that spouse is clearly informedthat the attorney intends to keep no secrets from theother spouse, it significantly reduces the chances ofthe attorney becoming an unwitting accessory to afraud or otherwise violating his or her ethical duties toboth spouses.

Assuming the attorney is satisfied that jointrepresentation is otherwise permissible, equaltreatment of the spouses is extremely desirable whereFLPs are involved:



Almost all of the marital property andethical problems with FLPs can be eliminated ifonly community property is placed into the FLPand both spouses receive and retain identicalgeneral and limited partnership interests.

This eliminates the separate/community issue,perpetuates a circumstance of joint management, andensures that neither spouse will be stuck with a non-voting, non-marketable transferee interest when themarriage terminates either by death or divorce. In thissituation it is very difficult to find any ethicalproblems with entering into a joint representationsituation.

When equal treatment is not possible, eitherbecause separate property will be funded into thepartnership or because the spouses or circumstancesdictate that either spouse (or both spouses) not have ageneral partner interest, the attorney has the moredifficult task of advising the spouses as to all therelevant legal consequences of the FLP--anddocumenting that advice. In some circumstances thiscan be very upsetting to the spouses even whendiscussed in hypothetical terms. (For example, ifclients want to use an FLP to “transmute” separateproperty into community property, the attorney shouldbe sure they understand: the potentially increasedexposure to the claims of the other spouse’s creditors,as well as the court’s authority to divide communityproperty but not separate property in a divorce.) Anylawyer--including an estate planning lawyer--who doesnot feel capable of giving advice that might beupsetting to his clients simply needs to find anotherprofession.

B. Representing Only One SpouseWhen only one spouse is to be a client the joint

representation issues of confidentiality and conflict ofinterest are replaced by one easy to ask (and difficultto answer) question: where is the line betweenpracticing law (albeit in a fashion that pushes the lawto its limits), and joining your client in unethical,fraudulent, or illegal conduct. As is the case with jointrepresentations, I believe it is incumbent on theattorney to ascertain the client’s wishes and be surethose wishes are consistent with the attorney’sstandards of ethical and legal conduct. It is certainlymy hope that this outline will help the reader todevelop and maintain a set of standards that reflectwell on all practitioners.



APPENDIX ONE: FLP “TOP TEN LIST”

10. FLPs are not an Olympic dive with a 2.8 degree insurance, which is 100% includable in the estateof difficulty. (Estate planning attorneys will tell of the insured if he or she owns more than 50%you that the degree of difficulty is more like 3.4.) of the stock, partnership-owned life insurance is

9. If an FLP works to decrease your client’s net percentage ownership of the partnership. If he orworth for gift and estate tax purposes, it also she has give away 95% of the limited interests,decreases it for other purposes as well. You but retained control by retaining the 5% generalshould be sure that your client’s lender knows partnership interest, only 5% of the insurancewhat is going on if, for example, your client is proceeds should be included in the insured’sguaranteeing the debt of his or her closely held estate.business.

8. FLPs really can do many of the things they are is apparently making an effort to apply the rulespromoted to do--dissuade creditors; avoid out-of- of Section 2703 of the Internal Revenue Code tostate probate; get the younger generation FLPs, saying that the agreements are really onlyinvolved in family investment decisions; elaborate “buy-sell” agreements. To come withinconsolidate undivided interests in family the safe harbor exception to Section 2703(b), theinvestments; simplify annual gifting with parting agreement must (1) be a bona fide businesswith cash; etc. arrangement; (2) not be a “device to transfer

7. For an FLP to work, you need an appraisal. (or, under the Regs, to the “natural objects of theOften, depending upon the nature of the property decedent’s bounty”); and (3) be comparable tocontributed, your need two appraisals--one forthe value of contributed property, and another ofthe value of the resulting partnership interests.This area is not one to scrimp on. Most FLPlitigation boils down to a question of value.Your appraiser must be prepared to testifyconvincingly that his or her valuation is wellreasoned and supportable.

6. If your client has a closely held business and however, and seem to work especially well when:wants to contribute it to an FLP, watch out: (1) if (1) The senior generation has diverse investmentthe business is an S corp.--a partnership is not a assets; (2) the children have assets of their ownpermitted S corp. shareholder; and (2) if the (perhaps acquired by earlier gifts from the seniorbusiness is a C corp. and the transferor retains generation), which they want to consolidate; (3)voting control of the stock owned by the the senior generation wants to retain control, orpartnership, the IRS may try to tax the value of they want control consolidated in one or more ofthe stock under Internal Revenue Code Section the children; (4) the client has the tolerance for2036 (transfers with retained control)--the safer the complexity and fees associated with thecourse is to recapitalize the company with a technique.nominal amount of voting stock (retained by thefounder), transferring only non-voting stock to 1. FLPs simply make assets “ugly”, and thusthe FLP. decrease the value of the assets for gift and estate

5. Internal Revenue Code Chapter XIV and theRegs thereunder, far from killing FLP’s, give ususeful guidelines by providing that restrictionsimposed by the Texas Revised Partnership Actwill be given effect. Plain vanilla limitedpartnerships can get some pretty substantialdiscounts (if they last for a term of years) simplybecause of these state law restrictions.

4. An FLP may be used to shift life insurance out ofthe insured estate. Unlike corporate-owned life

included only to the extent of the insured’s

3. Although the argument seems strained, the IRS

property to members of the decedent’s family”

similar arrangements entered into by persons inan arms’ length transaction. Although tests (1)and (3) are fairly easy to satisfy, test (2) is mightbe pretty tough.

2. FLPs are just one tool in the tool box. Despiteclaims to the contrary by their proponents, theyare not the solution for every estate planningsituation. They work in a variety of contexts,

tax purposes.



APPENDIX TWO: FAMILY LIMITED PARTNERSHIP “BASICS”

Limited partners are usually not required to makeI.OVERVIEW OF FAMILY LIMITED

PARTNERSHIPS

A. General ConceptsAs indicated by its name, a family limited

partnership (“FLP”) is a limited partnership, thepartners in which are members of the same family.Typically, the founders are senior-generation familymembers who transfer assets into the partnership andreceive both general and limited partnership interestsin return. They usually hold only a small interest(often as small as a 1% interest) as general partners--the remaining partnership interests are structured aslimited partnership interests. Despite the smallpercentage represented by general partnershipinterests, these interests represent control of the FLP;the limited partnership interests, which are usuallynonvoting, represent the bulk of the ultimate value ofthe partnership. The founders of the partnershipusually retain their general partnership interests. Theythen often make gifts of some or all of their limitedpartnership interests to younger-generation familymembers. Sometimes, younger-generation familymembers contribute some of their own assets to theFLP in exchange for a limited partnership interest.The founders frequently own the general partnershipinterests in their own names, individually. In somecircumstances, the general partnership interests areowned by a trust, a corporation, or a limited liabilitycompany controlled by the founders.

B. Differences Between General andLimited Partnership InterestsUnder Texas law, general partnership interests

and limited partnership interests differ in several ways.The most significant differences between generalpartners and limited partners are as follows:

1. LIMITED PARTNERSLimited partners are entitled to share in

partnership profit distributions on a pro rata basis. Inaddition, if the partnership is liquidated, the limitedpartner receives his or her pro rata share of liquidationproceeds. For example, if partnership profits aredistributed, a limited partner owning a 10% limitedpartnership interest would receive 10% of thedistributed profits. If the partnership were liquidated,that partner would receive 10% of the assets of thepartnership. However, limited partners do not takepart in partnership management (e.g., they cannot voteon whether to buy or sell a particular investment andcannot vote to liquidate the partnership). They aresubject to the control of the general partner and haveno assurance that distributions will be made to them.

contributions to the partnership, and they are notresponsible for partnership liabilities (i.e., they are notpersonally liable if the partnership is sued). State lawrestricts the rights of a person to whom a limitedpartnership interest is transferred. Unless the otherpartners agree to treat the transferee as a limitedpartner, the person will normally have only the rightsof an “assignee” which are described below.

2. GENERAL PARTNERSLike limited partners, general partners are

entitled to share in partnership profits based on theirpercentage ownership in the partnership. However,the general partners have complete managementauthority and control over the partnership andpartnership assets, including the power to decide ifand when to distribute partnership profits. Theytypically receive reasonable compensation forperforming their management duties. However, theprice under Texas law for having managementauthority and control over the partnership and itsassets is that general partners are personally liable forpartnership liabilities that are not paid out ofpartnership interests. In other words, if a generalpartner makes a bad management decision and, as aresult, the partnership is unable to pay its liabilities,the general partners may have to pay those liabilitiesout of their own pockets.

II.ADVANTAGES OF FAMILYLIMITED PARTNERSHIPS

Family limited partnerships offer numerous taxand non-tax advantages to their founders and tomembers of the founders’ families. To a certainextent, however, the benefits to be obtained depend inpart on the motives of the founders in creating theFLP. In most cases, the founders of the partnershipare seeking a variety of benefits from the FLP. It isfrequently helpful in future dealings with third parties(such as potential creditors and the IRS) to spell outthe objectives and business reasons for forming theFLP in the partnership agreement, while emphasizingthe continuing, ?going concern” nature of thepartnership. The following discussion highlights someof the effects of transferring assets to an FLP.

A. Creditor ProtectionIf a creditor wins a lawsuit against a debtor and

obtains a judgment, the creditor may take possessionof certain assets of the debtor. Family limitedpartnerships provide asset protection from potential



creditors of a partner because a partner’s creditor the price at which the propertygenerally cannot seize the partnership interest and would change hands between athereby become a partner. Instead, the remaining willing buyer and a willing seller,partners continue to control the partnership and the neither being under anycreditor typically receives only a ?charging order” compulsion to buy or to sell andagainst the debtor-partner’s interest. A charging order both having reasonable knowledgegives a creditor the rights of a mere ?assignee” of the of relevant facts. The fair marketpartnership interest to the extent of the debt. In this value of a particular item ofposition, the creditor receives only the partner’s share property . . . is not to beof income (as determined by the general partners) plus determined by a forced sale price.the right to inspect the books of the partnership. The Nor is it determined by the salecreditor gets no voting rights, control, or any other price of an item in a market otherpower in the partnership. The creditor cannot sell than that in which such item ispartnership assets, liquidate the partnership to satisfy most commonly sold to the public,the debt, or force a distribution of profits. Although taking into account the location ofthe creditor cannot require a distribution of profits, the item, wherever appropriate.the creditor is required to pay income tax on its prorata share of any income received by the partnership. A “willing buyer” of a partnership interest doesThis feature of partnership law makes an interest in an not become a partner under Texas law. Rather, like aFLP an ?ugly” asset to creditors. Consequently, most creditor, the buyer is treated as an “assignee,” unlesscreditors would rather negotiate a settlement favorable the other partners agree to admit the buyer to theto the debtor than become an assignee of the partnership as a partner. No buyer can be certain thatpartnership interest. he or she will be so admitted (in the context of a

The asset protection benefits of an FLP might third party as a partner would appear especiallyinduce a creditor to raise an allegation that the initial remote). Therefore, the prospective buyer has notransfer by the partner to the partnership was made to guarantee of any voice in partnership matters. This“defraud” the creditor. Texas law provides certain feature of the law regarding transferred partnershipprotections to creditors from debtors who attempt to interests substantially diminishes the price that atransfer property to defraud creditors. If the transfer willing buyer would pay for an interest in theis found to be “fraudulent,” a creditor may persuade a partnership. Suppose for example that a partnershipcourt to undo the transfer to the extent needed to contained assets valued at $1,000,000. The buyer ofsatisfy the claim. Generally, however, as long as 10% of the assets generally would be willing to paytransfers to the FLP are not made with an actual intent $100,000. A buyer of a 10% interest in theto hinder, delay, or defraud creditors, the transfer to partnership owning those assets, however, likelythe FLP should not be voidable. Therefore, persons would pay much less, since the buyer, as an assignee,forming an FLP should retain sufficient assets outside gets no voting rights, control, or any other power inthe FLP to enable them to satisfy any outstanding (and the partnership, and cannot sell the partnership assets,reasonably anticipated future) debts and claims. require a liquidation of the partnership to receive the

B. Valuation DiscountsValuation of FLP interests is important: if assets

are transferred to an FLP, estate and gift taxes aremeasured based upon the value of the partnershipinterests given during lifetime or retained at death.Because a founder exchanges contributed assets forFLP interests, the value of the contributed assets arenot taxed in the founder’s estate. Valuation of cash,stocks, bonds, and other readily tradeable assets is arelatively simple matter. When no public marketexists for an asset, however, its valuation becomessomewhat subjective. Since there is no public marketfor interests in an FLP, the tools used to valueunmarketable assets can contribute to a favorablevaluation for estate and gift tax purposes.

The Internal Revenue Code provides that estateand gift taxes are measured by the “fair market value”of transferred assets. Fair market value is defined as:

family partnership, the prospects for admission of a

assets, or even require a distribution of his or her“share” of partnership profits. This price-depressingfeature of limited partnerships substantially lowers thevalue of the property transferred by the founders of anFLP, and as a result, lowers overall gift and estate taxexposure.

Restrictions set out in the partnership agreementmay also affect the valuation of a partnership interestbecause they prevent the partners from freelydisposing of their interests. Historically, the ability offamily members to include severe transfer restrictionsin the partnership agreement provided an opportunityto obtain discounts on the value of partnershipinterests. Since 1986, however, Congress hasprovided that in a partnership controlled by familymembers, restrictions set forth in the partnershipagreement are ignored for valuation purposes to theextent that they are more restrictive than state law.Ironically, the limitations imposed upon partnershipinterests described above are imposed not by thepartnership agreement but by state law. These



restrictions have the most dramatic impact on the as limited partnership interests are gifted, the value ofvalue of the partnership interests; they give the underlying assets held by the partnership arepartnership interests a value much lower than their effectively removed from the donor’s estate, therebyvalue upon the liquidation of the partnership. decreasing the amount of federal estate taxes that

C. Other BenefitsFamily limited partnerships provide a number of

benefits beyond those associated with creditorprotection and estate and gift tax minimization. Forexample, an FLP allows the founders to keep controlof the assets as general partners. When property isgifted outright, the donee gains control over the giftedproperty. In contrast, with an FLP, when the foundermakes a gift of a limited partnership interest whileretaining the general partnership interest(s), he or sheretains control over all of the underlying partnershipproperty. An FLP also allows a simplified mechanismto make gifts of assets that might otherwise be hard todivide. Some donors view gifts made through the use1

of an FLP to be an excellent way to enable them tomake gifts which are “fair” to everyone. A particularasset is not set aside for a particular person. Rather,everyone is treated equally, since everyone receives apro rata portion of the same property. Family limitedpartnerships provide senior family members aconvenient mechanism to take advantage of the$10,000 annual gift tax exclusion. At the same time,2

otherwise would be payable at the donor’s death.Once gifts of partnership interests are made, not onlya percentage of the underlying property, but also acorresponding percentage of any appreciation in theproperty is effectively removed from the donor’sestate.

Other FLP advantages are as follows:

C A person in a high income tax bracketholding income-producing assets can giftlimited partnership interests to a personwho is in a lower income tax bracket, whichmay permit income to be reallocated amongfamily members and, thereby, decrease theoverall income tax burden.3

C At death, fewer assets are subject to probatecourt jurisdiction. As a result, partnershipreal estate located in a state other thanTexas avoids what might otherwise be anexpensive “ancillary” probate proceeding.

C Because many different types of assets canbe placed in one entity, accounting andmanagement of family wealth can beconsolidated.

C The partnership allows flexibility, since theterms of the partnership agreement can bemodified as needed (subject to anyrestrictions on amendment that the familychooses to place in the partnershipagreement).

Real estate is a good example of an asset for1

which gifting is simplified through the use of an FLP,especially if annual gifting is desired. Rather thanhaving to prepare separate transfer deeds and payfiling fees to record the deeds of fractional interestseach year, only one deed transferring the land to theFLP is required. Thereafter, the founders can executea simple instrument assigning limited partnershipinterests to family members each year. Thepartnership assignments need not be recorded. At thesame time, management of the real estate, instead of to any person in any year exceeds the annual gift taxbeing fractionalized among co-owners, remains in the exclusion, gift tax returns are required. No gift tax ishands of the founders, who hold the general actually paid, however, until the total of all suchpartnership interests. excess gifts exceed $650,000. The $650,000

The Internal Revenue Code permits each and gift tax until total taxable transfers, whether2

person to gift up to $10,000 per donee per year during life or at death, exceed this threshold.without any gift tax implications. Parents utilizingthis $10,000 “annual exclusion” are each treated as To avoid perceived abuses in shifting incomedonors, enabling married couples to make gifts of up among family members, the Internal Revenue Codeto $20,000 per year. Gifts of FLP interests enable provides that the donee of a partnership interest willfounders to make these gifts without parting with cash, be taxed on partnership income computed after anor with control of the FLP assets (as long as they allowance for reasonable compensation to be paid toretain the general partnership interests). In addition, the donor partner for any services provided by thebecause the valuation of the property is reduced by donor to the partnership. In addition, net profits, inhaving been placed in a partnership entity, more value effect, must be allocated based on the percentages ofcan be transferred than if the donor had instead gifted partnership property that the partners would receivethe partnership’s assets outright. If the value of gifts upon liquidation of the partnership.

“exemption equivalent” shelters property from estate

3



C Some donors use the FLP entity to teach FLP can alter the character of propertydonees to work together while gaining (from community to separate or frombusiness skills. separate to community, depending on the

C Transfer restrictions can be placed on the divorce court’s ability to make a meaningfullimited partnership interests to prevent property division.transfers to outsiders. These types ofrestrictions effect a type of ?spendthrift”provision because they act as a restraint ona partner disposing of his or her interest.

C Unlike other entities, FLPs are not currentlysubject to Texas franchise taxes.

C The FLP form can help preserve theseparate property character of a partner’sinterest in the underlying property.

C The senior generation may choose to focuscontrol in one or more younger-generationfamily members, while providing equalvalue to all younger-generation familymembers. For example, a couple mighttransfer a 25% limited partnership interestto each of three children, giving the fourthchild a 24% limited partnership interest anda 1% general partnership interest. Whileeach child receives one-fourth of the value,control is effectively given to only onechild.

D. Certain DisadvantagesFLPs, like every other estate planning tool, have

both advantages and disadvantages that must beconsidered and compared before deciding whether theFLP is right for a particular client.

FLP disadvantages include the following:

C FLPs can be costly. Creating an FLPgenerally involves lawyers, accountants,appraisers and other professionals, all ofwhom charge fees for their services.Additional ongoing professional fees aregenerally necessary to maintain the FLP.

C The discounts are real; creating an FLP willreduce your net worth. This may make itmore difficult to obtain credit and may evenviolate the terms of existing loanagreements (which frequently require that acertain minimum net worth be maintained).

C An FLP can significantly alter theconsequences of a divorce. Although thedivorce court can divide communityproperty interests in an FLP between thespouses, a spouse who was not a generalpartner will typically never have a vote inpartnership matters. Also, the use of an

circumstances), and this can impact on the

III.PLANNING CONSIDERATIONS

A. The Partnership AgreementThe principal document needed to establish an

FLP is the partnership agreement. In conjunction withTexas law and federal law, the partnership agreementgoverns the formation and management of the FLP.After the partnership agreement is properly executed,a one-page informational “Certificate of LimitedPartnership” is placed on file with the Texas Secretaryof State, and a one-time filing fee is paid (currently$760). Thereafter, the founders transfer property tothe partnership. These transfers are accomplishedthrough deeds, assignments, opening of new bank orbrokerage accounts, and other similar steps.

The partnership is established to continue for aspecific term, typically 25 to 50 years. Limitedpartners cannot withdraw before the end of thepartnership term unless the partners unanimouslyagree to liquidate the partnership. Limited partnersare not entitled to mandatory distributions until theend of the partnership term.

B. Management of the PartnershipThe partnership agreement can designate

someone to serve as the “manager” of the partnership.The manager acts somewhat like the “president” of acorporation, taking charge of the day-to-dayoperations of the partnership to the extent required.Frequently, the manager is one of the founders of thepartnership. The general partners of the partnershipare typically given the power to remove and replacethe manager by their unanimous vote. The manager istypically entitled to receive reasonable compensationfor services rendered on the partnership’s behalf.

C. Using Trusts as DoneesFrequently, instead of transferring limited

partnership interests to children or other familymembers directly, donors choose to establish trusts forthe donees’ benefit. They might select a trustee toassist younger family members. They frequentlyprovide that, at some specifically-designated time inthe future, each younger generation family membercan become a co-trustee or the sole trustee of his orher trust. If a trust is utilized, the trustee owns thepartnership interests that are intended to benefit thedonor’s family members. To the extent there is cashflow from the partnership, the trustees then use thatcash flow to provide for the health, support,



maintenance, and education of the donee familymembers and their descendants during their lifetimes.If the partnership is ultimately liquidated, theunderlying partnership assets pass into these trusts,and the assets are again available through the trust toprovide for the health, support, maintenance andeducation of the intended donees. The familymembers who are the beneficiaries of these trustsoften are given the power in their respective Wills todesignate who is to receive the property in his or hertrust. The advantages of using lifetime trusts to holdthe partnership interests include the following:

C An exemption of $1,000,000 per“transferor” (thus, $2,000,000 total for amarried couple) is available to minimizeestate taxes when property passes from thedonor’s children to their grandchildren.

C Even if the partnership is liquidated someday, the assets held in the trusts are notsubject to claims of a donee’s creditors;therefore, a large judgment will not causethe donee to lose the benefit of these assets.

C Holding assets in trust can preserve theirexemption from creditors’ claims and keepthem beyond the reach of a divorce court’sproperty settlement powers.

C Management assistance can be madeavailable to donees through the use oftrustees or co-trustees.

D. Choice and number of generalpartnersThe decisions of choosing general partners and

the number of general partners go hand-in-hand.Under Texas law, a partnership dissolves upon thedeath or withdrawal of its sole general partner. Alapse in control of the FLP can cause adverse taxconsequences at the time of the lapse of the partner'srights. Therefore, it is important to avoid a lapse incontrol of the FLP upon either a general partner'sdeath or withdrawal from the partnership. Severaloptions are available to avoid this occurrence,including having multiple general partners, successorgeneral partners and/or having an entity such as atrust, corporation, or limited liability company serveas one of the general partners. Determining whichapproach is best in any given situation depends onnumerous factors, including the number, age, andhealth of the founders; the nature of the activities to beundertaken by the partnership; and the overall estateplanning objectives of the founders.

IV.TAX CONSIDERATIONS

A. Income Tax IssuesUnder the terms of the Internal Revenue Code,

partnerships are not taxpayers. Rather, the partnersthemselves are taxed on the income recognized by thepartnership, whether or not the income is actuallydistributed to the partners. As a result, the generalpartners or manager of an FLP must be aware of theincome tax effects of the partnership’s income uponthe various partners. Frequently, the manger willdistribute at least enough cash from the partnershipeach year to enable the various partners to pay anyincrease in their income tax bills caused by having toreport their respective shares of partnership income.

Another income tax issue of which founders of anFLP must be mindful relates to the tax effect ofcontributing property to the partnership. Generally,no gain or loss is recognized on the transfer ofproperty to a partnership. There are, however, someimportant exceptions to this rule. For example, if twoor more persons transfer non-identical assets to apartnership, and more than 80% of the partnership’sassets are readily marketable stocks or securities heldfor investment, the effect to the partners may be thattheir respective securities portfolios are therebydiversified. Under those circumstances, the so-called“investment company” rules of the Internal RevenueCode may cause the partners contributing appreciatedsecurities to recognize gain at the time the securitiesare contributed to the partnership. For most Texasmarried couples forming an FLP, these rules shouldnot apply, since contributions are typically from thecouple’s community property (in which the spouseshold identical interests). If more than 80% of thepartnership’s assets will be in the form of marketablesecurities, however, these rules should be carefullyreviewed with your counsel. Certain other types ofassets have income tax characteristics that aredependent upon their being owned by qualifiedindividuals. These assets (notably, annuities and stockin closely held corporations that have elected to betreated as S corporations) generally are not suitable forcontribution to an FLP.

B. Estate Tax Inclusion IssuesOne important consideration in the formation of

an FLP is the treatment of the partnership assets andinterests upon the general partner’s death. One of theadvantages of an FLP is the ease of gifting thepartnership interests. Gifted partnership interestshave the effect of removing the value of thepartnership’s underlying assets (and any post-giftappreciation) from the donor’s estate. Accordingly,careful planning must be done to prevent the valuerepresented by the assets contributed to the



partnership from being inadvertently included in the By using an FLP, some portion of the partnershipgeneral partner’s taxable estate. interests usually will have been transferred to a donee

For example, special estate tax rules provide members. Since neither the gifted partnershipthat--if a donor gives away an asset while retaining too interests nor the partnership’s underlying assets willmuch control of the possession or enjoyment of the have been transferred from a decedent at death, a step-asset (or the right to income from it)--it will be taxed up in basis is lost to the donee. In addition, since thein the donor’s estate. In the partnership context, the partnership interests retained by the senior generationfounder’s retention of control through the general at death are subject to estate tax valuation discountspartner interests is subject to an obligation to maintain from the value of the partnership’s underlying assets,a fiduciary relationship with the other partners and to the cost basis of those assets in the hands of theact in the best interest of the partnership. This beneficiaries similarly will be discounted. In weighingfiduciary duty generally has been held to prevent the these divergent tax effects, most people conclude thatgifted partnership interests from being included in the the current potential gift and estate tax savingsfounder’s taxable estate under those special estate tax obtained by using an FLP outweigh prospective futurerules. As discussed above, only the value of capital gain taxes in the hands of younger generationpartnership interests still owned by a founder at death, family members. This conclusion is bolstered by thesubject to various discounts in value, will be included fact that estate and gift tax rates (which effectivelyin the partner’s gross estate. range from 37% to 55%) exceed capital gain tax rates

One important exception to the rule discussed appreciated assets to an FLP, however, the advantagesabove applies to stock in a “controlled corporation.” of valuation discounts and annual gift tax exclusionsIf a general partner owns an interest in a closely held should be balanced against potential capital gain taxescorporation which he or she transfers to the FLP, associated with the loss of basis step-up.while retaining the right to vote the corporation’sstock, either directly or indirectly, the transferredinterest in the corporation will be included in thegeneral partner’s gross estate. To avoid this result, weadvise persons who hold, alone or with their family,20% or more of the voting interest in a closely heldcorporation to recapitalize the corporation prior totransfer to the FLP, so that only nonvoting stock istransferred. If voting stock in a controlled corporationis transferred to the FLP, we advise the inclusion oflanguage in the partnership agreement that preventsthe contributing partner from voting the stock; rather,the other general partners (or if there are no othergeneral partners, the limited partners) would then votethe stock.

C. Income Tax Cost Basis IssuesProperty which is inherited from a decedent

generally receives a so-called ?step-up” in basis in thehands of the estate’s beneficiaries. This means thatthe cost basis of an asset in the hands of an estate’sbeneficiaries is equal to the asset’s estate tax value(normally, the asset’s fair market value at thedecedent’s date of death). The “step-up” is usuallyadvantageous to the beneficiaries because, if theinherited asset is later sold, the beneficiaries will avoidall capital gain taxes attributable to any appreciationin the value of the property during the decedent’slifetime.4

during the lifetime of the senior generation family

(currently capped at 20%). When transferring

V.OPERATIONAL ISSUES

An FLP is more than just a set of words on paper.Regardless of one’s motive for forming the FLP, itwill accomplish its objectives only if its form isrespected. If the goal is consolidation of investments,the investment assets must actually be conveyed intothe partnership. If one hopes to facilitate gifting, thenpartnership interests have to be given to familymembers. Using the FLP to teach investment policiesand values to the younger generation works only if thepartners actually meet and discuss investmentphilosophies, strategies and goals. If the idea is toensure that the FLP is respected not only by thefamily, but also by third parties, then undertakingthese steps alone is not enough. It is equally importantto establish and maintain an adequate record, whichshows that partnership formalities have beenobserved. The founders of an FLP should hardly besurprised that the IRS or a creditor may ask a court toignore the existence of an FLP if the family has doneso. The courts cannot be expected to give morecredence to the existence of the entity than do thosewho have formed it and are expected to benefit fromit. To paraphrase an old saw, if you walk like a duck,quack like a duck, fly like a duck, and are constantly

Although commonly referred to as a “step-up”4

in basis, the asset’s basis may actually “step-down” if of the decedent is simply ignored. The beneficiary’sthe value of the property at the time of the decedents’s cost basis is the estate tax value of the asset, whetherdeath is less than the decedent’s original cost basis. In that value is more or less than the decedent’s costgeneral, the former cost basis of the asset in the hands basis.



seen in the company of other ducks, then it isreasonable to suppose that you are a duck. By thesame token, if you expect others to treat the entity that Until assets are transferred to a limitedhas been so laboriously formed as a true partnership, partnership, the partnership exists in name only. It isthen it should “walk, talk and act” like a partnership. the actual transfer of assets from the partners to the

A. Formalities Upon FormationFLPs are formalized by the execution of an

agreement which sets forth the rights and duties of thevarious partners, and specifies the relationshipbetween general and limited partners. In addition, thepartnership must formally register as a limitedpartnership with the office of the Secretary of State ofTexas, and the partners must actually contribute assetsto the FLP.

1. THE FLP AGREEMENTThe partnership agreement designates the

original partners, describes their initial contributions,sets forth whether and how additional contributionswill be made, and describes how profits are to beallocated among partners. It also frequently sets forthlimitations on transferability of interests, and sets oursuch technical information as the formal address of thepartnership, and its “registered agent,” who acts toreceive official notices on behalf of the partnership.The agreement may describe in detail how books andrecords are to be maintained, what partnership mattersmay require a vote, whether more than a simplemajority vote is required for any matter, how and whenpartnership meetings are to be conducted--in short,any information relevant to describe how partnershipbusiness is to be conducted. Many clients view thesematters as mere “boilerplate,” which requires littleattention on their part either during the formation ofthe partnership or after its operation. On the contrary,however, and FLP is a business, and should beoperated in a businesslike fashion. These provisionsof the agreement outline exactly how those businessoperations are to be undertaken, and should beadhered to in the operation of the partnership.

2. CERTIFICATE OF LIMITED PARTNERSHIPIn Texas, no partnership may qualify as a limited

partnership unless and until it has filed with theSecretary of State of Texas a certificate of limitedpartnership. This instrument sets forth the name ofthe partnership, its address, the name and address ofits registered agent and registered office, and the nameand address of each general partner. The certificatemust be signed by each general partner, and filed,together with the payment of the appropriate filing fee(currently, $750.00). Until the certificate of limitedpartnership is filed, third parties without knowledge ofthe limited nature of the limited partners’ liability maytreat them as general partners. As noted above, it isthe unique features afforded limited partners underTexas law that provide many of the benefits of anFLP. As a result, it is imperative that the certificate befiled as soon as the partnership is formed.

3. CONVEYANCE OF ASSETS

partners that breathes life into the entity. As a result,it is critically important that appropriate conveyanceinstruments be prepared and filed. Conveyanceinstruments may take the form of deeds; mineral deedsor division orders; stock powers (or endorsement ofstock certificates); opening of partnership bank orbrokerage accounts into which checks or brokerageassets of the partners be convey; etc.

a. DeedsA deed from a partner to the partnership ensures

that the partnership is properly identified as the ownerof any real estate in the official real property records.Recording this deed thus adds an important link in thechain of title. It serves to establish ownership, andfixes liability for future property taxes. Occasionally,partners execute only special warranty deeds (or evendeeds without warranty). However, some titlecompanies reportedly argue that execution of a specialwarranty deed does not transfer insurance protectionsin the partner’s policy of title insurance, since itwarrants only actions by the partner, and not others inthe chain of title.

b. Oil and Gas InterestsOil and gas interests constitute interests in real

property. When partner wishes to convey minerals,those minerals are generally transferred by mineraldeed. Where a retained royalty is at issue, the royaltyis typically transferred by execution of new divisionorders (or issuance of letters in lieu of division orders)provided to the payor of the royalty.

c. Mortgages, Notes and CashTransfers of cash are generally undertaken by

issuing checks from the partners, which are thendeposited into a bank account established for the FLP.As to mortgages and notes payable to partner, theoriginal instruments representing those notes shouldbe transferred. Promissory notes are typicallyassigned by endorsement. If the note is secured byreal estate, then in addition to the endorsement of thenote, an assignment of the lien should be recorded inthe deed records where the real property is located. Inany event, the contributing partner should notify themaker of the note to ensure that future payments aremade directly to the FLP.

d. Stocks and BondsPartners frequently transfer stocks and bonds

held by them in a brokerage account held in “streetname.” Subsequent transfers of stocks and bondsregistered in the street name are substantially simplerthan the process required if original stock certificatesare owned by the partner, and then reissued to thepartnership. Typically, the manager of the FLP



creates an account in the name of the FLP with the Contributions, distributions to partners, sales ofsame brokerage firm or financial institution that holds partnership assets, purchases of new assets,the founding partners’ stock, so that a simple journal partnership income and expenditures, all should beentry can be utilized to transfer securities. If the stock documented. Frequently, the partnership maintains aissued is not publicly traded, the partners must relatively few number of bank and brokerage accountsdetermine what steps are necessary to transfer the whose monthly statements can form the basis of theseshares. In the case of a closely held business in which accounts. A formal set of “double entry” journals isthe partner is a shareholder, the partner (or perhaps his not required. Many partnerships utilize simplifiedor her counsel or accountant) likely has possession of accounting software such as Quicken or Microsoftthe corporate minute book and stock transfer ledger. Money. In any event, the partners in charge of theOld stock certificates in the partner’s name should be partnership should keep adequate records to report tocanceled, and new stock certificates should be issued the partners on the status of the partnership and thein the name of the FLP. The stock transfer ledger results of its operations. The manager or generalcontained within the corporation’s minute book should partner should give regular reports of partnershipbe appropriately updated. financial information to the partners. These same

4. RESPECTING THE CONVEYANCESA common mistake made by persons who form

FLPs is to forget that they no longer own the assetsthat have been conveyed to the partnership. For Regular meetings of the partners are usuallyexample, they undertake such careless actions as required by the partnership agreement. Even if thepaying personal expenses directly from partnership agreement doesn’t specify that the partners must meet,accounts. They prepare financial statements for good business practices suggest that they do so, atlenders which list the partnership's assets as their own, least annually. Partners’ meetings are a goodinstead of listing only the partnership interests that opportunity for the family to gather together to discussthey themselves retain. These types of actions give the operations of the FLP. Although such meetingsrise to claims by third parties, such as creditors or the tend to be less formal than the meetings of corporateIRS, that the FLP is a mere sham. They argue that boards of directors, they nonetheless should be carriedneither they nor the court should give the partnership out with a similar sense of importance. Partnershipany more credence than did the founder. books and records should be reviewed at the meeting.

B. Operating FormalitiesFormalities of formation and conveyance are usuallyoverseen by the attorney that assists with establishingthe FLP. Once the partnership has been set up, it isnot unusual for the attorney to take a much less activeroll. This reduced involvement helps keep legal feeslow. It is important to remember, however, that theformalities of operating the partnership are just asimportant as the formalities involved in the formationprocess. Most clients prefer not to incur the costsassociated with keeping their counsel on retainer toensure that operating formalities are followed. Theyfeel that they are able to take whatever steps arerequired to document the fact that the partnership isbeing operated in a businesslike fashion. When thepartnership regularly employs an accountant toundertake the keeping of partnership books and thepreparation of partnership tax returns, those steps helpdocument the partnership’s status as a separate entity.But preparing financial statements and tax returns areonly part of the formalities that should be maintained.And even in the case of partnership financialinformation, many clients prefer to adopt a “do ityourself” approach so that the professional oversightthat an independent account might bring is foregone.

1. BOOKS AND RECORDSThe partnership should keep a regular record of

its assets and its receipts and disbursements.

records are critical in enabling the FLP to prepare itstax returns, which are discussed below.

2. PARTNER MEETINGS

Important actions undertaken by the FLP since its lastmeeting, such as acquiring or disposing of partnershipassets, should be review. The partnership’s goals andobjectives, both in the short run and for the long term,should be discussed. As important as holding regularmeetings is documenting each meeting, and recordingthe important points discussed. Minutes like thosemaintained for corporate shareholders’ or directors’meetings should form a model for the record of partnermeetings.

3. VOTES ON PARTNERSHIP MATTERSThe managing partner or general partners attend

to the day-to-day business affairs of the FLP, andmost matters requiring a vote of the partners areundertaken by the agreement of the general partners.If the general partners are unable to agree, thepartnership agreement frequently sets forth the mannerin which partnership interests are to be voted toresolve the dispute. The partnership agreement mayprovide that some matters require the approval of thelimited partners, or a vote of all of the partners. It isimportant that the managers of the partnership reviewthe agreement to ensure that they understand what sortof vote is required for each matter that must besubmitted to a vote of the partners. Equallyimportant, the managers must hold and record votes ofpartners as required by the agreement to ensure thatpartnership matters are being tended to in abusinesslike way.



4. OTHER OPERATING FORMALITIES 1. PARTNERSHIP INCOME TAX RETURNSThe FLP can observe a number of other Despite the fact that an FLP does pay taxes, it

formalities to show that the partners respect the nature must nevertheless file an income tax return (Formof the entity. For example, some FLPs maintain their 1065) which reports to the IRS: (i) each item ofown separate business offices from which their affairs income, expense, deduction and credit incurred by theare operated. Frequently, the FLP establishes a partnership during the year; and (ii) the identity of theseparate mailing address or post office box to receive various partners, and how each item of income,mail for the partnership. The FLP might have its own expense, deduction and credit is allocated among thestationary printed (or might use current computer partners. The FLP must also deliver to the partnerstechnology to design and print correspondence on its the information necessary to enable them to reportown “letterhead”). their respective shares of partnership income, etc.

C. Formalities Of TransferMost FLP agreements limit the transfer of

partnership interests, so that interests are nottransferred to non-family members. In addition, underTexas law, the transferee of a partnership interest doesnot become a partner unless admitted as a partnerunder the terms of the partnership agreement and theTexas Limited Partnership Act. Therefore, partners inan FLP must be mindful of the limitations on transfer,and the formalities to be observed, to document a validgift or other transfer of a partnership interest. Mostcorporations issue certificates representing stock in thecompany. This stock is often freely transferable byendorsing the stock certificate. In contrast, most FLPsdo not issue certificates representing partnershipinterests. Instead, partnership interests are transferredby written “assignments” whereby the assignor agreesto transfer a specifically described interest in thepartnership, and the assignee agrees to accept theassignment, subject to the terms of the partnershipagreement. Unless the partnership agreementotherwise so provides, the assignee is notautomatically admitted to the partnership as a partneruntil the requisite vote of partners approve the transferand agree to admit the transferee as a substitutepartner. Thus, a valid transfer of a partnership interestand the admission of the transferee as a substitutepartner requires at least two pieces of formaldocumentation, one reflecting the assignment andanother reflecting the vote to admit the assignee as apartner. Some partnership agreements permit thepartnership to demand further documentation, such asan opinion of counsel that the transfer will not violatefederal or state securities laws or result in adverseincome tax consequences to the remaining partners.All required documentation should be prepared andsigned prior to treating any transferee as a new partnerin the FLP. The documentation should be maintainedas part of the permanent books and records of theFLP.

D. Tax FormalitiesAs indicated above, under current tax laws,

partnerships are not treated as taxpayers. Instead, thepartners are taxed on the income recognized by thepartnership. Likewise, partnership credits, deductions,and expenses are reported directly by the partners.

This reporting is undertaken through a Form K-1,delivered to each partner, which sets forth thatpartner’s share of partnership tax attributes. TheForm K-1 also tracks partnership contributions,distributions, and capital accounts.

2. TAXATION VS. DISTRIBUTIONAs noted earlier, each partner must pay tax on

his or her share of partnership income, whether or notthe income is actually distributed. Actual distributionsfrom the partnership have no tax impact on thepartners (unless distributions exceed a partner's totalcontributions plus profits). As a result, the generalpartners or manager of an FLP must be aware of theincome tax effects that the partnership’s income willhave upon the various partners. Frequently, themanger will distribute at least enough cash from thepartnership each year to enable the various partners topay any increase in their income tax bills caused byhaving to report their respective shares of partnershipincome. If no distributions are made, the partners mayhave to use other outside sources of cash to pay theincome taxes associated with their share of partnershipincome. In most cases, the partnership agreementpermits, but does not require, the distribution ofenough partnership cash to pay resulting tax liabilities.Potential buyers of partnership interests would likelypay less for a partnership interest if the agreementdoes not require distributions, since they could notensure that they would be able to compel distributionsin amounts sufficient to pay taxes arising from theirownership of the acquired interest.

VI.VALUATION OF THE FAMILY

LIMITED PARTNERSHIP

Valuation of FLP interests is a vital part of theprocess in creating an FLP. As noted above, valuationbegins with determining the price that a willing buyerwould pay to a willing seller for the partnershipinterest. For estate tax purposes, value is determinedat the date of death. For gift tax purposes, value ismeasured by the value of the property passing fromthe donor on the date of the gift. Although the InternalRevenue Code has endeavored to provide guidance fordetermining value, different methods of valuation havedeveloped based on that guidance. Consequently,



discrepancies may exist as to the value of an asset inability of the partners to freely withdraw from thedepending on who is seeking and who is making the partnership or transfer their partnership interests).valuation. In addition, several methods may exist for Appraisers frequently focus their analysis on twovaluing the same property. And the method used may prominent factors in fixing the discounts available forvary, depending on the specific type of property an interest in an FLP–the lack-of-control discount andinvolved. the lack-of-marketability discount.

A. Obtaining Independent AppraisalsDue to the complexities involved in valuing FLP

interests and applying appropriate discounts, thechoice of an appraiser is very important. With topestate and gift tax rates at 55%, the stakes can be high.The importance of obtaining a thorough appraisal isillustrated by several court cases involving disputesbetween taxpayers and the IRS regarding the value toplace on partnership interests. The courts often lookto the reports of the valuation experts of the parties.They focus in detail upon the qualifications of eachexpert, including general experience, background, andexperience in the particular industry at issue. Inaddition, courts frequently note the various factors andapproaches used by each expert in reaching an opinionon valuation, including the extent of investigation ofthe company and comparable companies, assumptionsmade by the expert, and valuation of the underlyingassets.

Because an appraisal is the evidence supportingthe valuation and corresponding discounts for theFLP, it is important to consider several factors whenhiring an appraiser. These factors include: (1)qualifications of the appraiser, (2) prior experience ofthe appraiser with similar assets or industries, (3)prior experience with similar appraisals, (4) potentialconflicts of interest, (5) the appraiser as a crediblewitness, (6) successes and failures of the appraiser inprior valuation work, and (7) the general valuationapproach of the appraiser. Courts are not bound tochoose one expert’s valuation. In fact, a court mayadopt only part of a valuation as determined by anexpert, or a court may find that none of the expertscame to the correct conclusion and adopt its ownvaluation. However, it is apparent from a review ofthe cases that courts frequently will adopt a valuationmade by an appraiser when the appraisal is wellresearched and supported by relevant facts.

B. Valuation DiscountsValuation of FLP interests is really a two-step

process. Most appraisers start the FLP valuation byvaluing the assets owned by the FLP. Once a value isplaced on the assets contributed to an FLP, appraisersmay apply various discounts in valuing the partnershipinterests themselves. Valuation discounts varydepending on factors such as the intent of the partnersto continue the business, the type of assets contributedto the partnership, and restrictions placed on thepartners under state law (such as lack of managementcontrol over the partnership, lack of unlimited accessby the partners to the assets of the partnership, and

A lack-of-control discount is based on theconcept that the holder of a minority or nonvotinginterest lacks control over the management andoperations of the entity. The holder of such an interestcannot compel distributions from, or a liquidation of,the entity. In the context of an FLP, a hypotheticalbuyer of a partnership interest becomes a mere“assignee.” Assignees of partnership interestsgenerally have no voting rights whatsoever, unlessadmitted as substitute partners. Since no buyer canensure that he or she would be so admitted, a buyerwould not be willing to pay an amount equal to theliquidation value of the partnership interest. Instead,the buyer would pay only the value of an assignee’sinterest, discounted to reflect its lack of control.

A lack-of-marketability discount applies whenthere is no current market for the interest being sold,making it difficult for a hypothetical buyer to convertthe purchased interest into cash. In other words, thevalue of the assets is discounted because it would bedifficult to find a hypothetical buyer to purchase theinterest in light of the restrictions placed on ownershipof the interest. Although there is a market for certainpublicly traded limited partnerships, FLP interests arenot registered to trade on public securities markets.As a result, they have no ready market. Even if anexception from federal and state securities laws isidentified, sales of privately held limited partnershipinterests are rare. A hypothetical buyer of a limitedpartnership interest would naturally take this lack ofliquidity into account in placing a price on thepurchase of an interest in an FLP.

VII.FREQUENTLY ASKED QUESTIONS

• How does an FLP reduce gift and estatetaxes?

An FLP simply makes assets less attractive topotential third party purchasers. The buyer of apartnership interest (as opposed to a buyer of thepartnership’s assets) forfeits a substantial degreeof control and marketability. Because estate andgift taxes are based on the “fair market value”that a hypothetical third party buyer would bewilling to pay for assets, placing them in an FLPdecreases the value of the assets for gift andestate tax purposes.



• Are these valuation discounts “real”? • What sort of paperwork is required after the

Yes. If an FLP works to decrease your net worthfor gift and estate tax purposes, it also decreases For an FLP to be respected by others, those whoit for other purposes as well. For example, if you form the FLP must follow proper formalities.must maintain a certain net worth for commercial Thus, they should maintain separate accounts forborrowing purposes, or for purposes of the FLP, keep partnership books and records,guaranteeing the debt of your closely held hold partners meetings, record votes onbusiness, you should discuss the impact that partnership matters, and otherwise treat the FLPvaluation discounts may have on your net worth as a separate business. In addition, properin dealing with your lender and other third documentation should be prepared and signedparties. each time a partnership interest is transferred.

• What assets can I transfer to an FLP?

Most people transfer income-producing assets tothe FLP. These include real estate, securities,investments, business interests, and the like.Special precautions need to be taken if a closelyheld corporation is transferred to an FLP. If the If you plan to make gifts of FLP interests, youcorporation has elected to be taxed as an S need an appraisal. Often, depending on thecorporation, transferring it to an FLP will nature of the property contributed, your may needterminate its S corp. status because a partnershipis not a permitted S corp. shareholder. Inaddition, special precautions need to be takenbefore transferring stock in a corporation inwhich you and your family own 20% or more ofthe voting control. The IRS may try to tax thevalue of contributed stock in your estate unlessyou part with voting control. The safer course isto recapitalize the company with a nominalamount of voting stock (retained by the you),transferring only nonvoting stock to the FLP.Other assets that warrant special scrutiny includeannuities and property with debt in excess of thecontributor’s cost basis.

• Can the partnership own life insurance?

An FLP may be used to shift life insurance out ofthe insured’s taxable estate. Unlike corporate-owned life insurance, which is 100% includablein the estate of the insured if he or she owns morethan 50% of the stock, partnership-owned lifeinsurance is included only to the extent of theinsured’s percentage ownership of thepartnership. For example, if the insured hasgiven away 95% of the limited partnershipinterests while retaining control by keeping a 5%general partnership interest, only 5% of theinsurance proceeds should be included in theinsured’s estate. While a life insurance trust canact to remove all insurance from an insured’staxable estate, it has the disadvantage of beingirrevocable. Some FLP owners are willing to riskestate tax inclusion of a portion of the lifeinsurance proceeds to maintain the flexibility andcontrol that an FLP offers.

FLP is formed?

And, of course, partnership income tax returnsmust be filed each year, with each partnerreporting his or her share of partnership profitsand losses.

• Do I really need to get an appraisal?

two appraisals--one for the value of the propertycontributed to the partnership, and another forthe value of the resulting partnership interests.Investment in a quality appraisal is money wellspent. Most fights with the IRS regarding FLPsboil down to a question of value. Your appraisermust be able to provide convincing testimonythat his or her valuation is well reasoned andsupportable.

• May I use an FLP to protect assets fromcreditors after creditor problems arise?

Because Texas courts protect creditors with aconcept known as the “fraudulent conveyance”statute, the creation of an FLP will be of little orno use with respect to existing and reasonablyanticipated claims against a debtor. If a transferis found to be “fraudulent,” a creditor maypersuade a court to undo the transfer to the extentneeded to satisfy the claim. Therefore, personsforming an FLP will have to retain sufficientassets outside the FLP to enable them to satisfyany outstanding (and reasonably anticipatedfuture) debts and claims.

• What happens to FLP interests in a divorce?

An FLP can change the character of propertyowned by married persons--from separate tocommunity, or from community to separate,depending on the circumstances. In addition, if,for example, only the husband is a generalpartner (if the wife either has no partnershipinterest in her name or has only a limitedpartnership interest), then even if the courtawards a substantial interest in the partnership tothe wife, she will be in essentially the same



situation as a creditor who becomes an “assignee” (as the founders have a certain tolerance for thediscussed above): she will have no voting power nor complexity associated with the formation andany effective ability to sell her interest but will, subsequent operation and management of theinstead, be forced to rely on her ex-husband’s FLP.willingness to treat her fairly. These (and other)aspects of the FLP can make it a valuable tool whencarefully coordinated with a marital propertyagreement. On the other hand, the careless use of anFLP can dramatically shift the spouses’ legal rights,with unintentional consequences if there is ever adivorce.

• Will the IRS challenge the FLP?

As you might guess, the value-depressingfeatures of the FLP have been the source ofconsiderable frustration to the IRS. Theyoriginally tried to argue that family members canbe expected to act together, and therefore, theIRS should be entitled to assume away some ofthe discounts that appraisers apply to FLPs. Thecourts, however, have been unsympathetic to theIRS on this issue, and the IRS has announcedthat it has abandoned its “family attribution”theory. Having lost that battle, the IRS recentlyhas tried to apply a new argument to FLPvaluations, saying that FLP agreements are reallyonly elaborate “buy-sell” agreements amongfamily members. A special statute restricts theuse of buy-sell agreements among familymembers for estate and gift tax valuationpurposes. Although their argument seemsstrained, this effort shows the frustration of theIRS with the success of FLP discounts, andindicates their resolve to continue to challengethe technique.

• Why doesn’t everyone use an FLP to holdassets?

FLPs are just one tool in the estate planning toolbox. Despite claims to the contrary by some FLPproponents, they are not the only solution forevery estate planning situation. They are veryeffective in a variety of contexts, however, andseem to work especially well when: (1) the seniorgeneration has diverse investment assets; (2) thesenior generation wants to retain control of giftedassets, or they want control consolidated in oneor more of the younger generation familymembers; (3) the founders have assets that aredifficult to divide (such as real estate), or assetsdifficult to part with in the form of annual gifts;(4) younger generation family members haveassets of their own (perhaps acquired byinheritance or earlier gifts from the seniorgeneration) which they want to consolidate; (5)the senior generation has a general concern aboutpotential future creditors who might seek toattach the assets of the founders or the childrenor other family members of the founders; and (6)

VIII.SUMMARY

The family limited partnership is an increasinglypopular estate planning and gifting tool. Bycontributing assets to a family limited partnership andgifting limited partnership interests instead of theunderlying assets, the value of the assets transferred(and related gift tax cost) is reduced. At the sametime, the family limited partnership enables seniorfamily members to retain control over the underlyingassets through retention of general partnershipinterests. The family limited partnership also hasadvantages in minimizing operational costs,simplifying annual gifting, providing investmentflexibility, and protecting assets from creditors.Through proper and careful planning, the familylimited partnership can be an ideal asset transfer tool.

THE FAMILY LIMITED PARTNERSHIP - · PDF fileThe Family Limited Partnership - Marital Property...

Documents

Transcript of THE FAMILY LIMITED PARTNERSHIP - · PDF fileThe Family Limited Partnership - Marital Property...