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________________________________________________ Gifts / Estate Planning Many people use family limited partnerships (FLPs) to transfer
wealth from one generation to the next. Why? FLPs enable the older
generation to maintain control, and the family benefits from lower
estate taxes. Although many people focus on the estate planning
benefits of FLPs, they often overlook the income tax consequences,
which can be significant. The
"Investment Company" Issue A family usually forms an FLP by contributing cash, securities
and other assets to the partnership in exchange for interests in
the partnership. The FLP then owns the contributed assets. In general,
the partners recognize no gain or loss on property contributions
to the FLP. The Internal Revenue Code defines an investment company as a partnership
in which more than 80% of the value of the assets (excluding cash
and nonconvertible debt obligation) are investments such as marketable
stocks or securities. If a transfer to an investment company results
in the diversification of the transferor's interest, then the transferor
may recognize a current capital gain. When
Does Diversification Occur? Diversification generally takes place when two or more people transfer
nonidentical assets to the FLP. For example, if Paul and Linda create
an FLP, and Paul contributes 100 shares of A Corporation and Linda
contributes 100 shares of B Corporation - both publicly traded companies
- Paul and Linda will recognize gain. What is the diversification?
Paul and Linda each individually now hold 50 shares of A Corporation
and 50 shares of B Corporation. In this case, the FLP is an investment
company because it holds 100% of the partnership assets for investment
and the assets consist of marketable stocks. In reality, however, a family often creates a partnership with
the transfer of already diversified portfolios. Realizing that the
tax rules regarding recognition of gain generally were not aimed
at those situations where partners did not realize any advantage
by further diversification, Congress changed the law to broaden
the nonrecognition rules. What
Makes a Portfolio Diversified? A portfolio is considered diversified if not more than 25% of the
total value is invested in the stock and securities of any one issuer,
and not more than 50% of the total value is invested in stock and
securities of five or fewer issuers. While for the 25% and 50% tests
government securities (such as Treasury bills) are included in total
assets for purposes of the denominator, they are not treated as
securities of an issuer for purposes of the numerator. For example, assume Dad contributes his portfolio of publicly traded
stocks to an FLP, and no single stock accounts for more than 20%
of his portfolio's value. His children contribute Treasury bills.
Before the change in the law, Dad would've recognized gain on the
contribution. With the new provision, however, Dad will be considered
diversified before the exchange. The transfer avoids investment
company rules because no more than 25% of the noncash assets are
invested in any one issuer, and no more than 50% of the assets are
invested in five or fewer issuers. Avoiding
Recognition Rules Although the rules regarding the income tax consequence of FLP
creation can be confusing, they cannot be overlooked. Fortunately,
you can avoid the recognition rules before forming an FLP. For example, if Paul and Linda were married, they could have avoided
recognition in the original example by each giving the other 50
shares of their respective stocks. Because of the marital deduction,
this transfer would have had no gift tax consequences. Paul and
Linda then could have each transferred their 50 shares of A Corporation
and 50 shares of B Corporation to the FLP and avoided the recognition.
In nonspousal situations, however, you must carefully review the
assets before contributing them to the FLP. We would be pleased to assist you in creating an FLP that meets
your objectives and avoiding tax when funding it.
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Copyright 2001 Fahlman & Olson. All rights reserved.
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