Over the last 25 years, wealthy individuals have increasingly incorporated family limited partnerships (FLPs) into estate plans. Some of the benefits that FLPs offer include centralization of asset management, dispute resolution among family members, ease of gifting without fractionalizing assets and protection against future creditors’ claims, with the added possibility of valuation adjustments for transfer tax purposes—all attractive features.
As time has passed, the senior generation has transferred FLP interests to the next generation through inter vivos and testamentary transfers. As a result of these transfers, an increasing number of their descendants now own valuable interests in FLPs that are encumbered by transfer restrictions. Although the senior generation may not have anticipated it, the ownership interests in FLPs often create significant issues in the estate plans of the next generation, particularly for married individuals who own the FLP interests directly. Once next-generation clients learn about the transferability restrictions, they’re often surprised that the FLP agreements’ terms result in an unexpected estate tax liability on the first spouse’s death. In situations in which this discovery is made too late, even more draconian results can follow.
It’s essential to understand whether a client has an interest in an FLP and, if so, the FLP agreement’s terms. Accordingly, planning for next-generation clients who own FLP interests must encompass an analysis of the transferability restrictions in the FLP agreement, so those restrictions can be factored into an appropriate estate plan. Failing to take these steps could result in undesirable surprises for both the client and the estate planner.
The stakes are high when considering the transferability restrictions in FLP agreements. In some instances, a purported transfer to an unauthorized transferee can even result in the loss of the FLP interest through a buy-sell provision, thus depriving the client’s family from enjoying the appreciation on a valuable asset.
“I had no idea that’s what the agreement said!”
What you don’t know can hurt you. Almost every FLP agreement includes provisions that restrict a partner’s ability to freely transfer an interest in the FLP. For example, a partner may only be permitted to transfer his FLP interest to a defined class of persons (often referred to as “permitted transferees”). Transferability restrictions can protect the FLP interest from a partner’s personal creditors and add control over who can become a partner of the FLP, both of which add important safeguards against unintended future owners of the FLP. As such, these provisions benefit all of the FLP’s partners and are, therefore, considered beneficial.
Although transferability restrictions are generally beneficial, in most instances, the senior generation that created the FLPs didn’t involve their descendants in the structuring of the FLPs. As a result, the next generation wasn’t part of the decision-making process concerning the universe of permitted transferees. In fact, it’s not uncommon for the next generation to be entirely unaware of the transferability restrictions, which can result in unintended negative consequences.
Consider the following definition of a “permitted transferee” commonly found in FLP agreements:
Permitted Transferee means (i) any Partner;
(ii) a descendant of a Partner, including descendants by adoption, provided that such adoption was of a minor and the adoption occurred before the minor attained eighteen (18) years of age;
(iii) a Partner’s parent or sibling; (iv) a descendant of a Partner’s sibling; (v) a trust for the benefit of anyone described in (i) through
(iv) above; or (vi) any organization described in sec-
tion 170(b)(1)(A), section 170(c), section 2055(a) or section 2522(a) of the Internal Revenue Code.
This definition works perfectly in the estate plans of the senior generation because both spouses are undoubtedly founding partners. Problems can result, however, for an unsuspecting member of the next generation.
Take the case of an individual from the next generation who’s the outright owner of an FLP interest and is married with children. The obvious choice for the testamentary disposition of the FLP interest would be to allow it to pass to a bypass trust, a marital deduction trust or a combination thereof, for the benefit of his immediate family. Unfortunately, neither a bypass nor marital deduction trust complies with the scope of the permitted transferee provisions above. The FLP interest, instead, must specifically be given directly to descendants of the founding partners, either outright or in trust.
Consider the complications that could arise if the FLP interest is worth significantly more that the partner’s available estate tax applicable credit amount. In such a case, the partner may not be able to have a zero-tax estate plan if he predeceases his spouse. Rather, the partner will be forced to address the potential estate tax exposure resulting from the partnership interest.
In some cases, if there’s no liquidity available in the partner’s own estate or no other preventative planning has been implemented, the partner might even feel forced to sell the FLP interest to other partners or the partnership (likely at a discount). Alternatively, the partner might consider giving a portion of the FLP interest to charity at his death (if allowed in the “Permitted Transferee” provision) to manage the estate tax exposure. The remaining partners could always amend the FLP agreement to expand the definition of permitted transferee or could vote to admit a particular impermissible transferee as a partner on an ad hoc basis, but differing views among family members makes reliance on such actions unpredictable.
These issues will only grow more significant over time, as the senior generation transfers more and more equity to their descendants and asset values increase inside FLPs (sometimes explosively, in the case of oil and gas interests). They would be significantly compounded if future legislation denies valuation adjustments to FLP interests.
“Sorry honey—no spouses allowed.”
The senior generation often desires to keep the FLP ownership in their bloodline. As a result, FLP agreements often preclude a partner’s spouse or trust for their benefit from becoming a successor partner, as in the case of the sample permitted transferee language above. Often, however, failing to provide for a spouse is entirely inconsistent with a partner’s testamentary wishes. Accordingly, it’s crucial that clients with interests in FLPs consider any transferability restrictions to ensure that their estate planning complies with the FLP agreement.
For example, consider the case of a husband and wife who were high school sweethearts, have been married for decades and have several children. Years ago, the husband received an interest in an FLP that his father created. The couple desires to have wills prepared in which all of the predeceased spouse’s property will be given to the surviving spouse. On the surviving spouse’s death, the remaining property will pass to the couple’s children. Unfortunately for this couple, if the wife isn’t a permitted transferee under the applicable FLP agreement, their testamentary desires can’t be effectuated.
From a non-tax perspective, there are legitimate reasons for not including spouses in the definition of permitted transferees. Allowing spouses to become partners can cause problems in the event of a subsequent divorce (in the case of lifetime transfers to a partner’s spouse) or on a surviving spouse’s remarriage (in the case of interests received upon a partner’s death), as the surviving spouse could then transfer her FLP interest to the new spouse—undoubtedly an unacceptable result for other partners. Further, a partner’s inability to transfer an FLP interest to his spouse can cause significant family disharmony. (Not to mention the silent car ride home after the couple’s estate planner explains that the spouse isn’t a permitted transferee!) It’s not uncommon for the non-partner spouse to feel alienated from the partner’s family because of this restriction, which is particularly troublesome after the partner’s death. From a practical perspective, the couple may find it undesirable for their descendants to receive extremely valuable FLP interests on the partner’s death that are more valuable than the partner’s remaining personal estate available to the surviving spouse.
In addition to the non-tax consequences, a permitted transferee definition that excludes spouses can result in serious estate tax problems for the predeceased partner’s estate. For example, if the value of the partner’s FLP interest exceeds his applicable credit amount at the time of death, an estate tax liability would be due as a result of the transfer of the FLP interests to individuals other than the partner’s spouse because the unlimited marital deduction would be unavailable. Perhaps the partner’s estate has other liquidity that can be used to pay the estate tax liability resulting from such a disposition, but this loss of liquidity may then affect the surviving spouse’s financial security.
If anticipated early enough, a simple answer to the estate tax liquidity problem might be purchasing a life insurance policy on the partner’s life, likely through an irrevocable life insurance trust. The proceeds of the life insurance policy could be used to satisfy the estate tax liability resulting from the partner’s death. Of course, not only does this require that the partner be insurable, but also that he be aware of the issues and timely address the need for liquidity.
Naturally, both the non-tax and tax issues could be avoided if spouses are included in the definition of permitted transferee under the FLP agreement. First, this would help to reduce the marital disharmony and resentment that restrictions often cause. Second, it would defer the partner’s descendants from receiving valuable assets until after the surviving spouse’s death, which clients often desire. Finally, not only would the availability of the unlimited marital deduction provide for estate tax deferral, but also it could facilitate the use of the surviving spouse’s applicable credit amount to offset the overall estate tax burden caused by the FLP interest, which may be particularly beneficial if the surviving spouse wouldn’t have otherwise fully consumed her own applicable credit amount.
It’s important to acknowledge that there are downsides to including spouses in the definition of permitted transferees that shouldn’t be overlooked. Nevertheless, there are ways to mitigate these downsides (although not eliminate them entirely). For example, an FLP agreement could allow a spouse to only indirectly enjoy a beneficial interest in the FLP through interest in a trust. In such event, the FLP agreement could even require that for such trust to qualify as a permitted transferee, the trustee must be a descendant of the founding partners and the remainder interest must vest in the founding partners’ descendants. Alternatively, the FLP agreement could permit transfers of FLP interest to intervening entities that the senior generation’s descendants control, thus allowing a spouse to indirectly benefit by virtue of owning a non-controlling interest in the intervening entity.
Permitting the surviving spouse to own an indirect interest in an FLP could offer a compromise that maintains restrictions on the transferability of interests to a certain degree, yet allows for estate tax deferral and the potential utilization of the non-partner spouse’s applicable credit amount, not to mention maintaining family harmony. The spouse may still be in a position to assert herself, but she wouldn’t be permitted to sit directly at the FLP table. Further, assuming that the spouse’s children are the descendants of the predeceased partner, consideration of their current or eventual interests might help provide constraints on the overall arrangement. Even if the FLP’s creators aren’t comfortable with allowing a spouse to have outright ownership of the FLP interests, creative planning that also allows for the marital deduction can go a long way toward avoiding marital disharmony and the potential reduction in estate tax liability.
As a result, clients from the next generation who are considering forming their own FLPs may wish to consider the recurring issues that have arisen in the past when spouses aren’t included in the definition of permitted transferees. With creative planning and consideration of the issues, it’s possible to structure the FLP agreement so that the client can enjoy the best of both worlds.
“You mean I don’t get to keep it?”
When an FLP partner is unaware of the transferability restrictions in the FLP agreement or is aware of the restrictions, but doesn’t fully understand them, and purports to transfer his interest to a person who’s not a permitted transferee, many FLP agreements include a provision that grants the other partners or the FLP itself the unilateral right to buy the transferred interest from the impermissible transferee.
If the buy-sell provision is triggered by a transfer in violation of the FLP agreement, it’s likely that the purchase price as determined under the agreement will include a lack of control and/or a lack of marketability discount. This will result in the impermissible transferee (often a surviving spouse) receiving less value than she would have otherwise received if permitted to be a partner of the FLP. To add insult to injury, the FLP often has the right to repurchase the interest on an extended payout basis, meaning that not only will the estate/surviving spouse receive less than full value, but also, she’s not even entitled to receive the purchase price in a lump sum!
In addition, if a transfer in violation of the FLP agreement results in the exercise of the buy-sell provision, the deceased partner’s descendants aren’t able to benefit from the appreciation of the FLP interest that they would have otherwise eventually enjoyed when they received the interest (usually on the surviving spouse’s death).
Many times, clients are shocked to learn of the specter of buy-sell provisions. Knowledge of the transferability restrictions in the FLP agreement is essential to avoid the potential triggering of an automatic buy-sell provision.
“Son, you’re on a need-to-know basis, and you don’t need to know!”
Founders of FLPs were sold on the structure because of their ability to continue to manage the assets contributed to the FLP and, therefore, consider the FLP to be their deal. As a consequence, some, but certainly not all, founders aren’t very open to discussing the entity with their descendants or to providing copies of the agreement. If the senior generation hasn’t shared copies of the FLP agreement with the partners from the next generation, it’s nearly impossible to achieve the next generation’s estate-planning goals. As such, it’s often necessary to reassure clients who are uncomfortable asking the senior generation for a copy of the FLP agreement that they’re entitled to as much and that the failure to review and understand the agreement could have a significant impact on their own estate plans.