In the 1990s, before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was enacted, Family Limited Partnerships (FLPs) and Family Limited Liability Companies (FLLCs) rapidly gained popularity with estate planning professionals as the estate planning vehicles that offered their clients the greatest amount of flexibility, control and potential for significant estate tax savings. Since tax considerations are among the most influential factors when clients develop a comprehensive estate plan, it was not surprising that interest in FLPs and FLLPs waned as IRS challenges and the federal estate tax exemption amount increased. However, as real estate values continue to rise, the economy begins to recover and taxpayers continue to win in Tax Court, business owners will likely become more motivated to incorporate an FLP or FLLC into their estate plans.
 

Is Your Business at Risk? During the presidential election debates of 2000, the need for estate tax reform was often illustrated by the fact that many families were forced to sell family farms or family businesses to pay the estate taxes of the deceased farmer or business owner. This unfortunate situation arises when individuals own significant real estate holdings, business interests or other nonliquid assets, but lack adequate liquidity to pay any estate taxes that may be due. Fortunately, estate planning professionals have an arsenal of techniques available to combat the estate tax liquidity problem. One of the simplest and most-often recommended solutions is for the individual to purchase a life insurance policy payable to the individual’s estate in the amount of the estimated estate taxes and administrative expenses. Other techniques — such as installment sales, death terminating notes, private annuities, Grantor Retained Interest Trusts (GRITs, GRATs, and GRUTs) and Qualified Personal Residence Trusts (QPRTs) — may be able to produce desirable “estate freezing” effects. For individuals who find the above alphabet soup too restrictive or confusing, estate planning professionals have begun to renew their earlier recommendations that a family business entity serve as the cornerstone of a comprehensive estate plan.
 

Family Business Entities Are Versatile As estate planning vehicles, FLPs and FLLCs are extremely flexible entities that offer many benefits not found in the abovementioned planning techniques. Although FLPs and FLLCs may sound exotic to some, as business entities, they really are nothing more than standard limited partnerships or limited liability companies with the word “family” attached. The business owner, as general partner or managing member (depending on the choice of entity), retains complete control over the day-to-day operations of the business. He or she controls the timing and amount of income distributions and the designation of new partners or share owners. He or she has complete discretion in the management of the family business, subject only to the “business judgment rule,” which is far less strict than the “prudent person standard” to which trustees are held. Family business entities provide a mechanism in which a portion of the income generated from the family business, otherwise taxed at the owner’s marginal tax rate, can be shifted to the younger generation, where it would be taxed at a lower marginal rate, thus increasing the family’s after-tax income. Owners of family business entity interests who do not actively participate in the day-to-day management of the business enjoy limited liability for the business’s debts and obligations. Because the interests in these closely held family entities are not easily marketable and restrict the management of the family business, they are subject to valuation discounts — a feature that is arguably the most desirable and useful aspect of using FLPs and FLLCs as estate planning vehicles.
 

Desirable Valuation Discounts Applying valuation discounts to the family entity interests received may allow the business owner to immediately reduce the value of his or her taxable estate upon formation of the business entity. Additionally, valuation discounts allow the older family members to transfer larger percentages of family business entity interests to the younger family members, while remaining under the current annual gift exclusion amount of $11,000.00 per donee. By transferring discounted family entity interests to the younger generation, business owners are able to reduce the value of the assets includable in their gross estates much quicker and more efficiently than they could without forming a family business entity, while retaining complete control over the business operation.
 

The IRS says, “Abusive” Not surprisingly, the IRS has been vigorously attacking the aggressive use of valuation discounts to reduce the gross estates of decedents owning interests in family business entities and has tried to include the fair market value of all assets contributed to the entity in the decedent’s gross estate. Fortunately for taxpayers, the IRS has enjoyed only limited success in the Tax Court on these issues. Just last November, the Tax Court ruled in favor of the taxpayer in a case where the IRS had challenged the significant valuation discounts taken on the decedent’s estate tax return for his general and limited partnership interests in five FLPs. In this case, the decedent transferred significant family business assets to the FLPs shortly before he died. Under the facts and circumstances of the case, the court upheld the valuation discounts and further concluded that in exchange for his contribution of the family business assets, the decedent received general and limited partnership interests in “a genuine arm’s length transaction,” which excludes such assets from his gross estate. While the IRS has been successful in challenging some FLPs in recent cases, this significant taxpayer victory, as well as others, further indicates that with proper planning by qualified estate planning professionals, family business entities continue to be invaluable estate planning vehicles.
 

Cost/Benefit Analysis The risk of estate tax audits, Tax Court litigation, and the costs associated therewith, have to be considered when devising an estate plan that utilizes a FLP or FLLC. Given the IRS’s present attitude toward family business entities, and given the current estate taxation scheme under the EGTRRA, forming a family business entity as a comprehensive estate plan is not appropriate for every business owner. However, after fully evaluating your particular situation, you may conclude that incorporating an FLP or FLLC into your estate plan provides you with the most flexibility, control and potential for significant estate tax savings.