The previous part of this article discussed how establishing a family limited partnership can help you make gifts that can reduce your estate tax liability while also preventing your children and other recipients from gaining access to large amounts of cash. Although using an FLP can be a successful strategy, you have to make sure you closely follow the instructions that your estate planning attorney gives you. Not doing so risks not only losing the benefit of the FLP, but also incurring a great deal of additional and unnecessary expense.

Practical details of using FLPs
In practice, before you complete gifts of FLP interests to your children, your estate planning attorney will advise you to obtain a formal appraisal of the FLP to determine the value of the limited partnership interests that you are planning to give. The appraisal can be costly, with some appraisers charging several thousand dollars for a detailed valuation report. However, the appraisal report provides formal documentation for your gift strategy, which is essential to establish your rationale for taking discounts for gift tax purposes.

Depending on the methods the appraiser uses, a wide range of discount amounts is possible. Although discounts ranging from 15% to 40% are fairly common, some aggressive planners and their clients have attempted to take discounts of 50% and above. While many of these ambitious positions have held up after protracted litigation, you need to weigh your desire to maximize your estate tax savings against the potential costs of a court battle that can take years to resolve. Unless your estate is particularly large, it may be unnecessary for you to take an aggressive stance to protect the bulk of your estate from taxation.

Managing the risks
Needless to say, the IRS isn't thrilled about people using family limited partnerships to reduce their estate tax liability. As happens with other methods of reducing tax, some taxpayers push the envelope with FLPs to try to get the most savings they can, and the IRS often takes a close look at those situations to see if the taxpayer did anything wrong that would give the IRS a strong argument against granting any gift tax discount at all. Although many court cases have allowed taxpayers to take discounts for gifts of FLP interests, other cases have struck down such discounts. Because each individual situation is different, it's important to do things in the manner that courts have approved and avoid mistakes that courts have identified as being problematic. In order to do that, you should maintain regular contact with your estate planning attorney and follow whatever instructions you're given. Below are a few things that your attorney will probably discuss with you at greater length.

First and foremost, because the FLP is created as a business entity, it's important that you follow all the formalities involved in running a limited partnership. You should make sure that you file all appropriate formation documents, annual reports, and other necessary documentation in a timely fashion with the appropriate state authorities. You should have annual meetings that include all of the general and limited partners of the FLP, and you should take minutes at those meetings. You should prepare written resolutions whenever you take major actions on behalf of the FLP, and these resolutions should be signed by whoever the partnership agreement designates. In general, you should follow any directions or instructions contained in the partnership agreement, and you should be consistent in your dealings with all of the limited partners. It's important to remember that once you give FLP interests to your children, they have legal status as limited partners that may require you to act in ways that are different from how you've discussed personal family matters with your children.

In addition, you should make sure that you respect the separate identity of your family limited partnership. For instance, when you first set up your FLP, do your best to transfer the assets you've selected for the FLP as quickly as you can. Although you may run into some snags with financial institutions, be patient and follow through with each asset to ensure you don't jump the gun on starting to make gifts. Similarly, set up separate bank accounts for the FLP to ensure that you never commingle a single dollar of limited partnership assets or income with your own personal funds. Having a bank account for the FLP will make it easier for you to run all of its income and expenses through the limited partnership, which will give you the records and documentation you may need if the IRS ever decides to challenge the validity of your strategy.

Finally, in operating the family limited partnership, it's important not to abuse your status as general partner, even if the partnership agreement gives you broad powers. For example, it's generally a good idea not to make distributions to any one partner without making similar distributions to all the other partners. Even though your partnership agreement may include provisions that allow you to make unequal distributions, doing so greatly complicates your records and requires you to determine the impact that the distribution has on everyone's proportional share of the FLP. The IRS pays special attention to situations in which the person who established the FLP deposits and withdraws money from the FLP for personal use, so most planners recommend that you keep sufficient assets outside of the FLP to meet your basic liquidity needs.

With the estate tax potentially here to stay, establishing a family limited partnership may be a good way to make gifts to family members and to reduce your estate tax liability. The level of complexity involved with using the FLP strategy correctly makes it prudent to enlist the aid of an experienced estate planning attorney in order to implement it. Nevertheless, we hope this series of articles has given you enough basic information about FLPs to have an intelligent discussion with your attorney about whether setting up a family limited partnership is the right move for you.

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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.