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How Family Limited Partnerships Build Wealth
By Marc J. Lane

The family limited partnership is an increasingly popular and sometimes controversial tool for saving estate taxes, protecting assets and tax-efficiently shifting income from one family member to another. Its power to preserve and grow wealth is enormous.

The family limited partnership is a special breed of limited partnership, that unique form of ownership which has long attracted real estate promoters seeking to recruit passive investment capital. One or more "general partners" run the operation and are legally liable for its debts. Other participants, "limited partners," invest their money in the venture but have no role in its management. Their exposure to loss is limited to the capital they've placed at risk. Profits are shared between generals and limiteds as they agree and, all things going well, each gains the benefit of his or her bargain.

Now let's revisit the concept in the context of the wealthy family. Typically, members of the senior generation are interested in transferring certain of their appreciating assets to members of the junior generation. Parents or grandparents would like to see their assets continue to grow in the hands of their children or grandchildren - and thus avoid some eventual estate taxes - but they're unwilling to part with control over those assets.

So the assets are contributed to a limited partnership, where the older family members or an entity they own is the general partner. Limited partnership interests are then sold or gifted to younger family members.

All kinds of benefits can become available.

First, any taxable income derived from the partnership's assets can be spread among family members, taking advantage of lower tax brackets and thus reducing the family's overall tax burden.

Second, estate or gift taxes can also be slashed. The law recognizes that a limited partner whose interest in an asset is locked within a long-term partnership is deprived of the ability to sell his or her share of that asset on the open market today. A steep "valuation discount" reflects that lack of liquidity and marketability when the tax man does his calculation.

Not surprisingly, the IRS has resisted aggressive valuation discounts. Yet, the Justice Department has supported tax settlements reflecting discounts as high as 20% for partnerships holding only securities portfolios and as high as 40% for partnerships actively operating businesses. The IRS itself recently conceded a 52% discount for a partnership whose primary activity was managing its own investment portfolio.

Third, the family limited partnership can effectively protect assets from the claims of a partner's creditors. The law won't sanction the transfer of assets to avoid an existing debt or to defraud a creditor. Yet, creditors whose claims arise after a partnership has been formed may be discouraged from chasing assets held within a long-term partnership or, as might be the case, incurring taxable income by forcing the partnership to make good on a claim.

Many kinds of assets can fund family limited partnerships, and creative planners are having a field day with the wealth-building possibilities. Closely-held businesses, marketable securities and even life insurance have found their way into the structure.

Life insurance, in particular, can dramatically leverage family wealth - especially since only a portion of the eventual payout would he includible in the taxable estate of a parent or grand parent general partner. If at death he or she owns 5% of the partnership - and the children or grandchildren then own 95% - only $500,000 of the proceeds of a $10 million policy owned by the partnership would be subject to estate tax. The remaining $9.5 million would be available to the partnership, tax free, for its business purposes. To ensure this result, the general partner might be wise to relinquish policy control to another general partner, thus forestalling an IRS argument that all the policy proceeds should rightfully be included in the general partner's taxable estate.

Our observation suggests a broader one. Those who are attracted by a family limited partnership's prospects are well advised to cross all the t's and dot all the i's. Competent counsel is indispensable here and, even with careful lawyering, some tax risks may prove unavoidable. Yet, for many, the family limited partnership may present tax and economic opportunities simply unavailable elsewhere.

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Marc Lane is a business and tax attorney, a Master Registered Financial Planner, a Registered Financial Consultant, and a Certified Investment Specialist. He is an Adjunct Professor of Law at Northwestern University and an Adjunct Professor of Business at the University of Illinois. He is the author of 30 books on business organization, taxation, and personal finance. His newest book, "Advising Entrepreneurs: Dynamic Strategies for Financial Growth" draws from his experience working with those who have successfully built their businesses.

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