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Avoiding Defective Family Limited Partnerships

Posted Thursday, June 21, 2012 by John S. Palmer

FLPs are a popular way for families to transfer wealth between generations. If done properly, they can pass family assets to younger generation(s) while minimizing gift and estate taxes. Typically parents establish the partnership, contribute assets to it, and then gift partnership interests to their children. A child may contribute capital or services in exchange for a partnership share, but if the goal is to reduce the parents’ taxable estate, the children will acquire their interests primarily by gift from the parents. To minimize gift taxes, the parents may gift a small percentage of the partnership to the children annually. As the children’s ownership interest in the partnership increases, these gifts can significantly reduce the parents’ potential estate tax liability.

The U.S. Tax Court recently issued a decision illustrating the pitfalls of a poorly planned Family Limited Partnership. In Estate of Lockett v. Commissioner, TC Memo 2012-123, the court found that all of the assets purportedly held in a family partnership were actually owned by a parent (and subject to estate tax when the parent died). The court rejected her estate’s claim that two sons owned interests in the partnership, and found that the partnership had ceased to exist prior to the parent’s death for lack of a second partner.

The parent, Lois Lockett, filed articles of organization for a Limited Liability Limited Partnership (LLLP) in 2000. At the time no decision had been made regarding who would be partners, what their percentages of interest would be, or what assets would be contributed to the LLLP.

In 2002, documents were executed naming Lois’ sons as general partners and Lois, her sons, and a testamentary trust established for Lois’ benefit by her late husband as limited partners. Also in 2002, Lois contributed almost $360,000 to the LLLP and the testamentary trust contributed almost $685,000, while the sons contributed nothing.

The testamentary trust was dissolved in December 2002; as a result, Lois received its interest in the LLLP. In 2003 documents were signed stating that Lois was now the sole limited partner and her sons were the general partners. Until Lois’ death in 2004, tax returns and related documents were filed attributing all partnership income and deductions to Lois.

The issue before the court was whether the LLLP was in existence when Lois died, or whether all of its assets, valued at more than $1.1 million, were actually owned by Lois and therefore part of her taxable estate. The court found that under the applicable state law, the partnership was dissolved when Lois acquired the interests of all the other partners, which occurred when the testamentary trust was dissolved. The court found that the sons never acquired valid general partnership interests, either by contributing capital or services the partnership, or by gift from Lois.

In a related matter, the court sided with the sons and ruled that $470,000 they received from the LLLP were loans, not gifts; while that meant these loans were assets held by Lois at the time of her death (and therefore subject to estate tax), the transfers were not subject to gift tax, as the IRS contended.

It appears that a major factor contributing to the outcome of this case was family discord over how to set up and fund the LLLP, so perhaps the primary lesson to be learned is that family partnerships of this sort are not a good idea unless everyone involved is on the same page with respect to such issues as who the general and limited partners will be, their percentages of ownership (based on capital contributed, services to be performed, or gift from another partner) and the roles each will play in the management of the partnership.

Estate of Lockett v. Commissioner, TC Memo 2012-123, decided April 25, 2012.

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Law Office of John S. Palmer11911 NE 1st St, Ste. B204,Bellevue, WA 98005-3056