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Flip Over FLPs: Part 2

As the first part of this article discussed, family limited partnerships are one method that estate planners use to help families reduce or eliminate potential estate tax liability. Since the recent election makes estate-tax repeal unlikely, estate-planning strategies like FLPs will probably remain an important tool in your fight against estate taxation.

After you've established and funded your family limited partnership, you and your estate-planning attorney can begin talking about how you should make gifts to children and other family members. Instead of making cash gifts or giving shares of stock or other assets, you will use limited partnership interests in your FLP to make gifts. For instance, if you put assets worth $1 million into your FLP, you might choose to give your children a 1% limited partnership interest in lieu of a $10,000 cash gift. There are two primary benefits to using your FLP to make gifts: You retain control of the assets within the FLP, and you are able to reduce the value of your assets more quickly, which can lead to substantial tax savings down the road.

You call the shots
The biggest concern that most parents and grandparents have when making gifts to their kids or grandkids is that once they've given the gift, it's out of their hands. If you write a check to your children, you can strongly urge them to invest it or save it for a rainy day, but there's pretty much nothing you can do if they decide instead to take a cruise or blow it all at the mall. Even if you take some of the responsibility for choosing an investment off their shoulders, by giving them shares of a broad-based exchange-traded fund like the iShares Russell 1000 ETF (NYSE: IWB  ) or the Diamonds Trust (AMEX: DIA  ) , there's nothing stopping them from going straight to their broker and selling every share you give them. Even with Crummey trusts, you have to worry about your children exercising their right to take a distribution from the trust.

By giving your children interests in your family limited partnership, on the other hand, you don't have to worry about whether or not they'll do the right thing. If you have a well-drafted partnership agreement, then your children will have relatively few rights as limited partners of the FLP. As the only general partner of the FLP, you will have the ability to make almost every major decision on behalf of the limited partnership, including the amount and timing of distributions from the partnership to the limited partners, the manner in which the assets of the limited partnership are invested, and the time at which the FLP shall be dissolved and a final distribution of assets made to all of the partners. You can also set out procedures to follow -- in the event that one of your children dies prematurely or gets divorced -- that can protect your child, as well as the rest of your family. You don't even have to maintain a majority of the economic interest in the limited partnership to retain this control; as long as you're the only general partner, you'll continue to have sole power over the FLP, even if the limited partners own 99% of the FLP to your 1%.

FLPs and valuation
The other primary advantage of using FLPs to make gifts to family members is that you can decrease the value of your estate more quickly by transferring FLP interests than you can by giving away cash or securities directly. The reason that this is possible is complicated, and it has to do with the way that the fair market value of a gift is determined for gift-tax purposes.

As you may be aware, you are allowed to give a certain amount of money or assets to someone each year without paying gift tax. For 2006, this annual exclusion amount is $12,000. So if you have four children, you could write each of them a check for $12,000 and reduce the value of your estate by $48,000. If you have a potentially taxable estate subject to estate tax at a rate of 45%, those gifts would reduce your estate tax liability by $21,600. That's not bad for a few minutes of writing checks.

However, you can get even better results with an FLP, because the value of the FLP interests you give to your kids is less than the value of the assets inside the FLP. For instance, again using a $1 million FLP, when you give a 1% interest to your children, that interest is worth less than 1% of the $1 million in assets inside the FLP. Although the math gets tricky, this makes sense intuitively. Think about it: how much would you pay for a 1% interest in someone's FLP that gave you no control over the FLP's assets, no assurance that you would receive income distributions on a regular basis, no ability to sell it to anyone else, and no guarantee of when you would get your investment back? You'd probably pay quite a bit less than you would for assets over which you had complete control. In technical terms, you would discount the value of the FLP interest due to its lack of marketability to other buyers and your lack of control over the assets.

This means that because of the discounts that apply in determining the value of limited partnership interests, you can increase the amount of FLP interests you give while remaining below the $12,000 annual limit. For instance, if you claim a 20% discount, then a gift of a 1% interest in a $1 million FLP would be valued for gift tax purposes at $8,000, rather than $10,000. Conversely, if you wanted to take full advantage of the annual exclusion by making gifts to four children, you could make gifts that would decrease the value of your estate by $60,000, because the 20% discount reduces the gift-tax value of the gifts to $48,000. That extra gift could save you an additional $5,400 in estate tax.

As you can see, using a family limited partnership to make gifts can make a significant impact on your estate and the resulting tax liability at your death. However, implementing the FLP strategy requires close attention to detail. The final part of this article points out the practical steps you must follow to get the most from a FLP.

Related articles:

The Motley Fool has several good sources for estate planning information. Rule Your Retirement is a comprehensive retirement service that helps you assess all aspects of your financial future, from savings to estate planning to asset allocation. Try it out for 30 days with no risk.

Fool contributor Dan Caplinger fondly remembers the hundreds of pages of partnership documents he drafted as an associate attorney. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy will have you turning somersaults.


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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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