When I began my estate planning practice over 20 years ago, the strategy of choice for larger estates, particularly those owning land, was to create a family limited partnership.

These partnerships helped to prevent partition actions, kept the farming operations viable, increased family wealth through the retention of (ideally) appreciating assets, and transferred wealth to the next generation. But as they gained popularity, the IRS became increasingly concerned that family limited partnerships were being utilized solely to reduce federal estate taxes.

Carolyn Thompson is a estate planning attorney.

The general concept behind the use of the family limited partnership is this: Mom and/or Dad contribute a valuable asset to a family limited partnership. In exchange for that asset, Mom and/or Dad receive all the general partnership interests and limited partnership interests of the entity. The general partners control the assets of the partnership and hold voting rights whereas limited partners have no management control.

The federal estate tax benefit comes primarily from the lifetime gifting that occurs in this strategy. The assets contributed to the family limited partnership are appraised. The partnership value is also appraised. Generally, the value of the partnership interests are discounted, especially the limited partnership interests, below the value of the underlying assets due to the lack of control and marketability. Over time, parents gift these partnership interests to their family members in an amount valued under the annual exclusion amount, which is the amount an individual can gift to another individual each year during his or her life without being subject to gift tax or a reduction of their estate tax exemption. In this way, parents are able to reduce their taxable estate, not only through the transfer of assets but also by shifting a portion of the income from those assets to the next generation. Depending on your family and where you are at in your operation, there are different gifting strategies to employ and a qualified estate planning attorney should be able to discuss with you the pros and cons of gifting different interests (general or limited).

The IRS continues to scrutinize this strategy closely using many different arguments, not only attacking the valuation discounts, but also arguing that the rights of the limited partners are so limited they amount to having no present interest in the entity and therefore don’t qualify for the annual exclusion gift (currently $14,000 per year, per person). That being said – there is a time and a place for the use of the family limited partnership, but they can also be a breeding ground for trouble if not well thought out and diligently maintained.

The IRS requires that the gifted entity have a legitimate and significant non-tax reason for creating the entity.

Personally, I like to utilize family limited partnerships or other entity gifting strategies when the family, as a whole, has a vision of continuing the operations beyond the life of Mom and Dad. Many times there are less labor intensive estate planning tools that can be utilized which are less prone to audit than the family limited partnership. If you are considering this option, make sure to consult with a qualified estate planning attorney who not only has researched the pitfalls, but also will hold you accountable on the maintenance of such entity.

Estate planning is not a magic wand; you cannot make hundreds of thousands of dollars disappear by putting assets into a magic black box labeled "family limited partnership." You can, however, create good solid plans so children have great clarity on the who, what, and how to manage your estate during your disability or after you pass away. The key to whatever strategy you utilize is to you understand the pitfalls that exist and stay diligent in the maintenance and review of the components of your estate plan. Make sure you are working with a qualified estate planning attorney who can inform you of these concerns and work with you to create a plan that you will be able to maintain.

Thompson is an attorney with Thompson Law, Sioux Falls, S.D. For more information, contact her at 605-362-9100 or see cathompsonlaw.com.