FLP vs. LLC & Sam Walton's FLP Estate

Reprinted from The Estate Analyst, June 2008

By Robert L. Moshman, Esq.

f the family limited partnership concept were monetized and offered as publicly traded stock over the past 15 years, would one see it rising and falling in response to the Strangi I, Strangi II, and other major decisions by the Tax Court?

There have been "bull markets" and "recessions" for the FLP (at least in the professional literature covering the progression of cases on point). Indeed, there has been a succession of cases honing the rules on particular nuances of FLPs every few months. Meanwhile, the LLC has evolved from "novel" to being accepted and "fundamental."

So where does that leave the estate-planning professional? Is the old faithful FLP still the arrangement of choice? Or has the family LLC taken over that role? Let's compare.

For practical purposes an estate with various real estate investments and other assets may bridge the generational gap from parents to children by establishing one of several alternatives. How does the family limited partnership (FLP) stack up against the family limited liability company (FLLC)?

Old Reliable FLP

The foresight of Sam Walton setting up a family limited partnership in 1953, before the success of Wal-Mart, is the iconic model of FLP success. (See the discussion of the Walton FLP that follows.)

The basic principal allowed the family business to be operated by a general partner while revenues passed through the partnership entity to the individual limited partners. Among the advantages:

Simple to set up and maintain.
Owner can remain in control as general partner.
Ability to apportion revenues among partners in different proportion from control or percentage of ownership.
Tried and true technique with a long history.
At death, a partner's shares are typically entitled to minority and/or marketability discounts.
One downside is that the general partner ends up exposed to liability for the entity. To contend with this factor, the general partner can be set up as a corporation so that any liability to the general partner is trapped inside that corporation. However, that means the simplicity of the arrangement for tax purposes has been offset by all of the tax compliance attendant upon a corporation.

The FLP Revolution

The ability to a) create an FLP quickly and b) qualify a deceased partner's FLP shares for a minority discount prompted a number of practitioners to establish FLPs that truly maximized discounts despite the fact that FLPs were established only weeks prior to death. Taxable estates could be transformed overnight.

Or could they?

At first, the FLPs had a winning streak. Could an FLP be set up on behalf of someone incompetent using powers of attorney? Yes. Harrison v. Commissioner, 52 TCM 1306 (1987).

Could the FLP be set up shortly before death? Yes, several cases demonstrated this. Could the FLP be set up with cash and marketable securities rather than a conventional business? Yes. Estates that had been taxable were instantly qualified for valuation discounts.

In Strangi I, cash and marketable securities worth $10 million were transferred to an FLP just 62 days prior to death, and the owner retained almost all control over the FLP, yet the new entity qualified for a 31% discount and the assets were valued at $6.9 million in the grantor's estate. Pretty impressive result considering Dr. Strangi was terminally ill at the time. His son-in-law had attended a seminar on FLPs and used a power of attorney to set up the whole thing.

How Very Strangi

Over the past decade, even while significant cases were affirming the miraculous use of the FLP to provide last-minute valuation discounts to estates as a viable alternative to long-term planning, there were other cases in which FLPs were challenged.

For example, set up the FLP with a structural flaw, such as allowing partners to sell their shares very easily and the rationale for providing a marketability discount would be undermined. Or, retaining the ability to replace the general partner could invalidate the transfer of assets for tax purposes.

The IRS was looking for some way to reel in the FLP. For instance, Grantors retaining too much control over FLP assets were construed by the IRS as engaging in sham transactions. Shepherd v. Comm'r, 115 TC 376 (2000).

Bongard v. Commissioner arrived on March 15, 2005 with an estate tax deficiency of $52.8 million for an estate that relied upon an FLP.

And something rather Strangi took place. The IRS got a second bite at the apple, i.e., a do over, and this time they made some inroads.

By 2005, Strangi (Part IV) arrived from the Fifth Circuit Court of Appeals, which agreed with the Tax Court's conclusion that section 2036(a)(1) applied because of an "implicit understanding" among the parties that Dr. Strangi would continue to have access to his assets. It was a hostile climate for the new wave of FLPs that could transform estates overnight.

The Modern Estate Plan

Is the FLP a concept worth investing in, or has the "modern" estate plan moved on?

For FLPs, significant discounts are still accomplished as demonstrated from the classic example of Sam Walton right though the latest tax court case of Astleford.

However, the tax savings through valuation discounts that are most reliable are those associated with the traditional use of FLPs, i.e. setting up partnerships so that appreciation of value accumulates with the limited partners (the next generation of the family) over time and the testator's shares are entitled to a reasonable discount for marketability.

But there are also other practical considerations that affect the decision to utilize the FLP as opposed to an LLC. Is liability the dominant factor that tips the decision toward the LLC, or is the informal flexibility of the FLP the preferred course in a given setting?

Context and personal preferences govern the outcome. In some cases, designing a system of assets for family members may incorporate the best attributes of FLPs, LLCs and personal trusts, all of which have vital roles in the modern estate plan.

The LLC Alternative

In a broad array of respects, the LLC or FLLC resemble the FLP:

It is a "pass through entity" for tax purposes, just like an FLP.
Distinct classes or tiers of ownership can be established with a management class and a non-management class.
The transferability of assets can be limited to family members but assignability of assets can be provided for in the operating agreement.
A creditor's sole remedy is a charging order against the entity, not the owners.
For transfer tax purposes, an FLLC is entitled to the same minority interest and marketability discounts that apply to FLPs.

However, the LLC has several additional distinctions, some of them preferable to the FLP:

The benefit of an LLC is revealed right in its name. It limits liability. That essential attribute places the LLC nearly on a par with a C corporation. And because the LLC addresses liability, the personal assets of all the owners of the LLC are protected from business liability. This is particularly useful where real estate assets are involved.
An LLC does not require a general partner, so setting up a Corporation or LLC to the be general partner of the FLP is not necessary.
Limited partners cannot participate in management. Members of an LLC are able to fully participate in management without sacrificing liability protection.
Partnership losses such as the rental real estate loss allowance under IRC section 469 cannot be passed through to the limited partners due to the passive activity loss rules. By comparison, loss in an LLC can be passed through to members who meet the IRS definition of "active participant." Someone devoting more than 500 hours annually would qualify as an active participant.

Organizing Chaos

Both the family limited partnership and the family limited liability corporation can provide the organization of assets and asset protection that can serve as the foundation for the family's long-term financial stability and prosperity.

As with any complex plans, there are specific state rules to observe and unique family circumstances to incorporate into the plan. As opposed to selecting one or the other, it is the fine tuning of either an FLP or an FLLC that is the key to success.

Sam Walton's FLP Estate

It is a classic rags-to-riches American success story. Sam Walton was 27 years old and just out of the service when he borrowed $20,000 to open a variety store. It was a Ben Franklin franchise in an Arkansas town with a population of 7,000. The year was 1945.

Flash forward 17 years to 1962. Sam and his brother had opened numerous stores and their discounting approach would change the landscape of American merchandising. Now they opened their first Wal-Mart. By the time Sam Walton died in 1992, the family business was worth billions.

In 1985, Forbes magazine estimated the Walton fortune at $20 to $25 billion. By 1998, the estimate was $48 billion. By 2006, estimates of the estate had reached $80 billion.

The families of the four Walton children each have their own fortunes totaling, collectively, in excess of $81 billion as of March, 2008 (up from $69 billion in September, 2007. (Source: Forbes.)

What's remarkable about this $80 billion juggernaut of wealth? It might not be nearly as large but for excellent use of a family limited partnership (FLP).

With a top estate tax rate of 55%, The Sam Walton estate could potentially have been hit with a $13.75 billion federal estate tax. How did the Walton estate avoid paying any transfer tax whatsoever?

The main reason dates back to 1953, when the business was going well, but had not yet burgeoned into the largest retailing empire in American. Sam Walton took that opportunity to create a family limited partnership that included his wife and his four children.

Walton Enterprises acquired real estate, banks, a newspaper, and various other businesses, but all of the assets were included in the partnership. Eventually, the partnership financed a variety of businesses that Sam's children wanted to develop. At his death, Sam Walton only owned 10% of the partnership. That $2.5 billion went to a marital trust for his wife, Helen. This move deferred tax since interests transferred between spouses are not subject to estate or gift tax.

Helen Walton, the widow of Sam Walton, became the world's wealthiest woman at some point. She died on April 19, 2007 and her estate of $16.4 billion will go to family-run charities over the next several years.

Although Sam and Helen Walton's estate plan took advantage of the charitable estate tax deduction, if was drafted so that all voting shares remain within the family's control. The plan balanced transfer taxation, charitable giving, business control, and the inter-generational transfer of wealth.

Obviously, it helps to have the foresight to set up a family limited partnership half a century ahead of time and have the world's biggest retail chain grow at a phenomenal rate. Once the FLP was established, the appreciation of assets took place outside of Sam Walton's estate.

Yet family businesses have benefited from family limited partnerships that were established only a short time before the principal owner's death, taking advantage of minority and marketability discounts.

Today, LLCs provide another option. Had LLCs existed in 1953, it is possible the Walton estate might have employed them.