Second Place Winner 2006

Donee Beware:
Collateral Consequences of Family Limited Partnership Planning
Timothy A. Dufault
University of Arizona
James E. Rogers College of Law


A. The Donor:  FLP Planning
1. Basic Structure

2. Objectives and Benefits

B. The Donee:  Implications of FLP Interest as an Asset
1. Benefits

2. Drawbacks


A. Income Tax Impacts
1. Phaseouts

2. Kiddie Tax

3. Liquidation

B. Other Financial Impacts
1. Federal Financial Aid Qualification

2. Divorce:  Support Obligations

3. Consumer Lending

C. Non-Financial Impacts
1. Management Inexperience

2. Forced Business Partners

A. Awareness, Communication & Involvement

B. Independent Representation

C. Compensation to Donee

1. Enhance Rights

2. Distributions of Current Net Earnings

3. Gift to Trusts

4. Outright Gifting

Family limited partnership (FLP)[1] planning furthers many estate planning, asset protection and business succession objectives of the donor of FLP interests.  While the primary objective of such planning is to promote the interests of the donor, in many respects the future interests of the donee parallel those of the donor.  However, ownership of FLP interests creates unintended and overlooked consequences for the unwary donee, who may bear the present costs of reporting a distributive share of FLP income without enjoying the present economic benefits of asset ownership.
Not surprisingly, legal scholarship on the topic of FLP planning focuses almost exclusively on the interests of the primary client—the donor.[2]  By contrast, this Article examines the effects of FLP planning from the standpoint of the donee—the passive recipient of FLP interests.  It explores how a common planning technique, partly intended to promote the long-term interests of the donee, actually may result in collateral costs to the unsuspecting donee who receives FLP without a proper heads up as to the unintended consequences.  Accordingly, the author contends that FLP planning may create a conflict of interest between the donor and the donee—a situation in which the donee could benefit from the advice of independent legal counsel.  Finally, the author suggests that the donor should act affirmatively to minimize the unintended costs to the donee, perhaps through the recommended strategies of awareness and communication, independent representation, compensation and management training.
This Article identifies potential unintended costs of FLP planning and recommends strategies to minimize the consequences to the donee.  Part I introduces the general framework of FLP planning by discussing the planning motivations of the donor and the ownership implications for the donee.  Part II examines the contexts in which FLP planning is problematic for the donee.  It suggests that the donee potentially bears the costs, yet does not enjoy the present economic benefits of owning shares in the FLP.  Finally, Part III recommends strategies to ameliorate the concerns of the donee and to promote family harmony.  The Article concludes that donors should acknowledge and respond to the unintended costs of FLP planning.  It suggests that donors should adopt an empathetic approach to FLP planning by embracing situations where rigid planning objectives should yield to the present economic needs of the donee.
Although a detailed analysis of FLP planning techniques and tax implications is beyond the scope of this Article,[3] a basic understanding of the FLP framework is necessary to conceptualize how its structure and operation may impose unintended costs on the donee.  This Part describes the general structure of the FLP and introduces the planning objectives and benefits to the donor.  Then, it acknowledges the future benefits to the donee, yet explores how passive participation in the FLP causes the donee to bear the present costs of the distributive share of income without a corresponding present economic benefit.
A. The Donor:  FLP Planning
Family Limited Partnerships may provide attractive planning opportunities by allowing the donor client to make discounted gifts of partial interests in property while retaining control over the gifted assets and protecting them from potential claims of creditors of the donee.[4]
1. Basic Structure
The concept of FLP planning is simple.[5]  Initially the donor transfers assets into a limited partnership, in exchange for both general and limited partnership interests, and assigns the majority of the initial capital contribution to the limited partnership interests.  For example, the partnership agreement could assign one percent of the initial capital contribution to the general interests and the remaining ninety nine percent to the limited interests.  The donor then retains the general partnership interests directly or through a corporate or limited liability company general partner, and eventually makes gifts of the limited partnership interests to selected donees over planned intervals.  Most importantly, the donor-general partner retains exclusive control over the assets and management of the partnership.[6]
2. Objectives and Benefits
Family Limited Partnership planning may facilitate wealth transfer, asset protection and business succession objectives by virtue of the donor’s ability to transfer interests in partnership property while retaining control over the underlying assets or family business.[7]  Such control includes the powers to invest partnership assets and to control the timing and amount of distributions.[8]  In the wealth transfer context, the FLP provides a relatively simple technique to transfer partial interests in diversified assets to several donees without the need for more extensive conveyance documentation.  Additionally, it furthers estate and income tax planning objectives by reducing the donor’s taxable estate and shifting taxable income and capital appreciation to donees in lower tax brackets.  The FLP may even provide a vehicle to convert real property into intangible personal property so as to eliminate ancillary administration.[9]
Another estate planning advantage of the FLP facility is the potential for substantial discounts in the value of the limited partnership interests gifted to the donee.  This complex and controversial topic is the subject of much IRS and judicial scrutiny[10] and academic commentary,[11] and is beyond the scope this discussion.  However, the basic concept is that a restricted limited interest in an asset is worth less than its proportionate value of the whole, due to such factors as lack of control and lack of marketability.[12]  The potential for discounted gifts permits the donor to transfer larger amounts of wealth at lesser gift tax values and thus, to maximize both the annual exclusion[13] and the unified credit.[14]
Family Limited Partnerships offer asset protection advantages as well, because creditors of the limited partners may have difficulty reaching the underlying partnership assets in the event of a lawsuit or a divorce.[15]  Although a judgment creditor may obtain the right to receive the debtor limited partner’s share of distributions, such right may be of little consequence because the general partner controls the amount and timing of partnership distributions.  Another hindrance is that the judgment creditor may be treated as the owner of the partnership interest for income tax purposes under Revenue Ruling 77-137[16] and thus, may incur the pass-through income tax liability without the benefit of cash distributions (ironically, facing collateral consequences similar to those of the donee, as discussed herein).
Finally, the FLP supports business succession goals by providing a means for the donor to transfer business assets to successor donees while retaining management control during the donor’s lifetime, or until a management transition is effectuated.  Thus, the donor retains the benefit of management control, yet shifts the burden of the taxable income produced by the partnership assets.
B. The Donee:  Implications of FLP Interests as an Asset
Under the FLP structure, the donee must report a taxable share of partnership income without enjoying the corresponding present benefits of owning the income-producing assets.  The donee plays a silent role by serving as the passive recipient of limited partnership interests.  Although many of the benefits to the donor similarly benefit the donee, most advantages to the donee are contingent or deferred, due to the restricted nature of the limited partnership interest.  Thus, the donee anticipates certain benefits, yet, does not enjoy the typical present economic benefits of outright asset ownership.
1. Benefits
The donee benefits initially by a net worth increase through the receipt of a gifted interest in partnership assets without a corresponding capital contribution.[17]  The magnitude of such benefit obviously changes over time in proportion to changes in the value of partnership assets.  Additionally, through the previously mentioned discounts, FLPs may help to maximize the net value of wealth eventually transferred to the donee by minimizing the potential wealth transfer taxation of the donor.
Another potential benefit to the donee is the asset protection attribute of FLPs, which could make it relatively more difficult for creditors or a former spouse of the donee to reach partnership assets than if the donee owned the underlying assets outright.  A final example of an advantage to the donee is the potential income tax benefit of reporting a distributive share of partnership losses, deductions, or credits, if any.[18]
2. Drawbacks
Incidentally, many of the attributes that make FLP planning attractive to the donor also may create difficulties for the donee, who has no real ability to obtain current value from the FLP interest.  The primary drawback to the donee—and the root of the concerns raised in this Article—is that, although the donor-general partner retains complete control over the partnership assets and cash distributions, the donee-limited partner’s gross income includes a distributive share of partnership income, as determined under the partnership agreement.[19]  Importantly, the distributive share merely consists of a proportionate share of the partnership profits for tax purposes, rather than the actual cash distributions received by the donee (i.e., “phantom” income in the sense that the distributive share represents a “paper” allocation, and not true cash flow to the donee).  The donee essentially is taxed on income that is not actually distributed to the donee, and that is derived from assets over which the donee has no control, pursuant to a governing document likely drafted without the donee’s input.  Thus, the donee recognizes taxable income even though the partnership agreement so restricts the use and enjoyment of the limited partnership interests that the donee has no real present economic benefits of asset ownership.
An example of the restrictive nature of limited partnership interests is that even though the donee is entitled to a proportionate share of the income presently distributed by the partnership, if any,[20] the donee has no power to control the timing or amount of distributions; a general partner is under no obligation to distribute partnership income.  Although the Treasury Regulations prohibit the donor from retaining unrestricted power to withhold distributions of net income, they do allow the creation of reserves to meet the reasonable needs of the business.[21]  Importantly, they recognize that the general partner ordinarily will be able to determine the reasonable needs, and therefore, what the reserve requirements should be, without the consent of the limited partners.[22]  Partnership agreements also commonly require the retention of some or all of the net partnership income during the early years of a partnership as reserves for future capital needs.  The regulations permit such provisions because they do not give the general partner unrestricted power to withhold distributions of net income.[23]
The donee additionally lacks the economic benefit of alienability.  In drafting the FLP agreement, planning objectives encourage the donor to restrict the abilities of the donee to transfer FLP interests and to draw upon the donee’s capital account.[24]  While these restrictions benefit both the donor and the donee by enhancing creditor protection, they also prevent the donee from obtaining current value from the FLP interest.  To be sure, if the restrictions are so great that they deny the donee a present interest, the donor may jeopardize the availability of the annual exclusion for gifts of the limited partnership interests.[25]  However, donors may avoid this planning obstacle by drafting the FLP agreement to give the donee a Crummey type withdrawal power whenever a gift of a limited interest is made.[26]  Although the donee then theoretically may “put” the limited partnership interest to the partnership at the time of gift, such benefit is only temporary, and is limited severely by the donee’s desire to fulfill the donor’s wishes.
The nature of FLP interests potentially creates unintended—and often overlooked—consequences for the unsuspecting donee.  This Part identifies income tax and other potentially less obvious contexts in which the donee could face the collateral costs of FLP ownership.
A. Income Tax Effects
The donee is at risk of certain income tax costs by virtue of owning FLP interests, including loss of itemized deductions, increased tax liability for a child’s income, and recognition of capital gains on the liquidation of partnership assets
1. Phaseouts
A potentially costly income tax consequence to the donee is the phaseout of tax deductions and credits if the distributive share of FLP income causes the donee’s adjusted gross income (“AGI”) to exceed certain applicable amounts.  Thus, the distributive share of FLP income may increase the tax liability of the donee not only by increasing taxable income, but also by causing the loss of otherwise available tax relief.  Importantly, for tax years beginning before December 31, 2009, the distributive share of income may cause a phaseout of itemized deductions[27] and deductions for personal exemptions.[28]  Furthermore, in the retirement account context, for married taxpayers filing jointly, the ability to fund a Roth IRA phases out after modified AGI exceeds $150,000,[29] and deductions for contributions by active participants into qualified retirement accounts phase out after modified AGI exceeds $75,000.[30]
Other common examples of phaseout risks from increased AGI include:  (i) the child tax credit;[31] (ii) the amount excludable for employer-provided adoption assistance;[32] (iii) the credit for higher education expenses;[33] and (iv) the deduction for interest on education loans.[34]  Thus, the donee could face unexpected income tax costs well beyond simply the marginal tax increase caused by the FLP distributive share of income.
2. “Kiddie” Tax
Another income tax risk to the donee-parent potentially exists if donor-grandparents also gift FLP shares to donee-grandchildren:  payments of unearned income to beneficiaries who are under age 14 can result in the income taxes being calculated using the parent's income tax bracket—not the child's bracket.[35]  Thus, while the donor benefits from the income-shifting attribute of FLP planning, the donee-parent faces the collateral cost of income tax liability for both the donee’s and the child’s distributive share of FLP income.
3. Liquidation
A final example of collateral income tax costs to the donee is in the context of termination of the partnership and distribution of partnership property.  Such transactions may cause adverse income tax consequences for the donee, especially if they occur during the seven-year waiting period after which the built-in gain on contributed property can escape tax if distributed to partners.[36]  Commentators have covered in detail the tax consequences of early terminations and distributions,[37] which are beyond the limited scope of this Article.  However, the basic concern is that the donee potentially must recognize capital gains on property contributed to the FLP by the donor.[38]  This tax consequence may prolong the donee’s exposure to the collateral costs of FLP planning if it prevents the donee from liquidating a presently burdensome asset.  One commentator described this predicament succinctly:  “. . . [E]ven if the [donee] is unhappy about the returns it is getting from an illiquid investment, it may find that the tax cost of unwinding the partnership too soon will be too high to bear.”[39]
B. Other Financial Impacts

Donees face other unexpected, non-tax costs by virtue of owning FLP interests, particularly in contexts where it is necessary to calculate the donee’s ability to meet financial obligations.

1. Federal Financial Aid Qualification
Application for federal financial aid for higher education is a context in which the increased AGI from the distributive share of FLP income may prove costly for a donee who otherwise could not afford to pay for college.  Consider the prototypical example of a donee-single-mother with two college-age children, whose total household earnings consist of a $25,000 salary; yet, her AGI for the taxable year is $85,000 as a result of her $60,000 distributive share of FLP income.  Clearly her modest salary would not cover all household living and education expenses.  Yet, the government considers her full AGI for its calculation of the Expected Family Contribution (“EFC”), which measures the family’s financial strength for federal financial aid purposes.
The information reported on the Free Application for Federal Student Aid (“FAFSA”) is used to calculate the EFC.  The EFC is calculated according to a formula established by law, which includes all of a family’s income (taxed and untaxed), assets, and benefits.[40]   Importantly, the formula uses the donee’s AGI in calculating the EFC,[41] and under the FAFSA rules, the family’s AGI includes more than wages earned.  For example, it can include alimony, Social Security, and business income.[42]  The prospective school then uses the EFC to determine a student’s federal student aid eligibility and financial aid award.[43]  Thus, the increase in AGI from the distributive share of FLP income potentially imposes a true economic cost on the donee by disqualifying the donee’s children for certain need-based financial aid[44] due to the donee’s apparent ability “on paper” to pay for education expenses.
2. Divorce:  Support Obligations
A similar difficulty arises with support calculations in the context of the divorce of a donee, if a judge uses the donee’s balance sheet and AGI to determine the ability to pay child or spousal support obligations.  Clearly, the potential exists for “paper” assets and earnings of the donee to exceed the true liquid assets and cash flow available for support payments.  Thus, a donee could face the economic costs associated with support obligations that do not represent the economic realities.  For instance, the donee’s support obligation could be too high, or the obligation of the donee’s former spouse could be too low, because the donee’s AGI is artificially inflated due to the “phantom” FLP income.
At least one practice guide indicates that, for purposes of calculating the assets of the parties to a divorce, asset categories include partnerships and other business interests.[45]  Moreover, for purposes of calculating child support, gross income generally is defined as money from any source, and may include partnership income.[46]  Notably, however, some courts have recognized that, in the context of closely-held businesses, the calculation of income must reflect the actual available financial resources of the payor spouse; thus, the court cannot consider undistributed pass-through income that is not actually available to, or received by, the party.[47]  Similarly, at least one commentator distinguished between AGI and cash flow by including actual “partnership distributions” in a list of gross income items, while excluding “distributive share of partnership income” from the same list.[48]
Although the donee’s distributive share of FLP income should be excluded from the calculation of available resources, in practice, many judges and litigants are not financially sophisticated or diligent enough to look beyond the AGI figure in determining support obligations.  Accordingly, one commentator noted:
Anecdotal evidence suggests that most litigants will neither seek nor consent to income amounts other than those appearing on the relevant tax returns.  This is probably unfair.
As with S corporations, legitimate questions arise regarding the inclusion of undistributed partnership income in family law's definition of income.  The funds are not actually available for support, and they may not even be effectively available.  For example, the partners may elect to retain profits for use in funding capital improvements.  Such choices and elections affecting the determination and the timing of income occur at the entity rather than the individual level.  Thus, the individual partner/spouse may have no real power to seek current or even near-term distributions of retained profits.  Hence, questioning and undoing such deferrals are arguably unfair considering that the owner/spouse may not be responsible for them.  Nevertheless, most authorities would likely argue that the reported taxable income is indeed the correct amount of family law income.[49]
  Furthermore, if the donor-general partner makes cash distributions to the donee-limited partners to help with income taxes, then such cash distributions may be considered “available” resources (thus, exacerbating the collateral cost), even though the donee pays the cash directly to the IRS.
3. Consumer Lending
Another unexpected context in which FLP ownership may be troublesome for the donee is the application for consumer financing, particularly if unscrupulous or unsophisticated lenders evaluate repayment ability blindly based only the AGI of the donee.  Inclusion in AGI of the donee’s distributive share of FLP income or loss creates the risk of artificially overstating or understating the donee’s earnings; thus, the pass-through income or loss from the partnership may cause the donee’s AGI to be an inaccurate reflection of true earnings available for debt service.
Indeed, such risk could cut either way.  An artificially high evaluation of the donee’s repayment capacity due to a distributive share of FLP income, for example, could lead to over-qualification for a home loan and, thus, inability of the donee to service the debt.  On the other hand, an artificially low evaluation of the donee’s repayment capacity due to a distributive share of FLP loss may cause the donee to under-qualify and lose the opportunity to purchase a more valuable home that the donee’s true cash flow could support.
C. Non-Financial Impacts
In addition to the suggested financial costs, FLP planning also may impact the donee unintentionally in other ways, primarily in the contexts of management succession and family harmony.  Such speculative impacts obviously will vary among families.  However, the FLP concept may cause a donee to feel disillusioned by a planning tool that apparently (i) excludes the donee from current management of the same family business that the donee eventually must manage, and (ii) forces the donee to become business partners with family members with whom the donee otherwise would not associate.
1. Management Inexperience
Ironically, a planning mechanism used in part for its business succession attributes actually may leave the donee-younger generation unprepared to take over the family business.  Typically the donor-general partner retains all management control.  In fact, the donor must retain a certain level of control in order to preserve the limited liability status of the donee.[50]   However, if the donor absolutely excludes the donee from involvement in the family business, then the donee likely will not develop the skills necessary to manage the business in the future.  Such exclusion seemingly creates a contradiction where the donor utilizes a planning tool to preserve a family business and to maximize the transfer of wealth, yet the donee is not allowed to develop the management skills needed to carry out the plan.
2. Forced Business Partners
Another unintended consequence of the donee’s passive role in FLP planning is the likelihood that, by gifting FLP interests to various family members, donees will be forced to become business partners with disagreeable siblings or relatives.  Obviously this risk largely depends upon the nature of the relations of the particular family involved.  However, a potential difficulty arises if some donees have experience with the family business and the others do not.  Such imbalance of business knowledge could increase the likelihood that the experienced donees could take advantage of the more naïve ones.  Unfortunately, due to the illiquid nature of FLP shares, it may be very difficult for discontented donees to escape such a precarious situation.
In this Part, the Author suggests FLP planning and operational approaches intended to minimize the adverse collateral impacts on the donee.  This discussion presumes that most FLPs make cash distributions to the donee-limited partners in the minimum amounts necessary to pay income taxes attributable to the distributive share of FLP income.  However, the Author recommends further collaborative strategies to improve communication, educate and empower the donee, and compensate the donee for costs of participation.
A. Awareness, Communication & Involvement
A logical initial effort to reconcile the potentially divergent interests of the donor and the donee is for the donor to take off the “planning hat” and to consider how the FLP structure impacts the donee.  While the donor may believe that the FLP tool maximizes the benefits to the donee in the long run, the donor should consider the possibility that the donee’s present needs may outweigh the future benefits of the planning technique.  The donee should encourage the donor to adopt an empathetic approach by communicating with the donor and bringing to the donor’s attention situations in which the donee incurs the costs of FLP ownership.  After all, the donor must be aware of such unintended consequences in order to mitigate them.  Finally, the donor should educate the donee and involve the donee in business operation and strategy discussions, so as to facilitate the eventual management transition and to reduce the likelihood that one donee could take advantage of another.
B. Independent Representation
Family limited partnership planning creates a conflict of interest between the donor and the donee when the unilateral planning decisions of the donor give rise to adverse effects on the donee.  To the extent that the risk and magnitude of the costs on the donee are significant, the donee should have the benefit of independent counsel.  Furthermore, given the likely inexperience and typically passive nature of the donee’s participation in FLP planning, the lawyer for the donor should advise the donee of the potential benefits of independent representation.  Independent counsel for the donee may help to empower the donee to bring concerns to the forefront and to assert the need for compensation or other mitigation strategies.
In particular, the donee’s lawyer should encourage the donee to improve communication with the donor and should educate the donee about the legal rights of limited partners.  For example:
Limited partners are entitled to inspect and copy partnership records and, upon reasonable demand to the general partners, to obtain true and full information regarding the state of the business and the financial condition of the partnership, a copy of the partnership's income tax returns promptly after they are available, and whatever other information regarding the affairs of the partnership that is just and reasonable for them to have.[51]
Additionally, unless waived by the partnership agreement, a limited partner has the right to seek judicial dissolution of the partnership if it is not reasonably practicable to carry on the partnership business in conformity with the partnership agreement.[52]
Finally, the lawyer for the donee may be in a more authoritative position to effect actions by the donor to mitigate the adverse consequences to the donee.  The lawyer could bring the mentioned strategies to the donee’s attention and assist in the relevant discussions with the donor.
C. Compensation to Donee
An obvious way to ameliorate the unintended consequences to the donee is to compensate the donee when such costs occur—especially if the costs cannot be prevented within the confines of the FLP planning structure.  The parties may select from several forms of compensation to meet the needs of the donee, including enhancements of the donee’s rights under the partnership agreement as well as other planning techniques and direct cash compensation.  Notably, the independent lawyer for the donee could help to suggest and to facilitate possible compensation techniques, and the counsel for the donor could assure that the proposed solutions do not jeopardize the planning objectives of the donor.
1. Enhance Rights
One way to compensate the donee is to enhance the donee’s rights under the partnership agreement in ways that allow the donee to escape or shift the collateral costs.  For example, if the present financial burden on the donee is too great, and cash compensation to the donee is implausible, then perhaps the donor could amend the partnership agreement to allow the donee to make a gift of the FLP interests to a willing transferee subject to donor approval.  Thus, gifting may allow the donee to escape the present financial burden of FLP ownership, while at the same time assuring that the donor approves of the transferee.
Another way to enhance the rights of the donee is to give the donee a "put" right, allowing the donee to require that the partnership or the donor buy the donee’s interest for its gift tax value, adjusted to reflect the discounts claimed on the gift.[53] The advantage of this approach is that it does not reduce the valuation discounts for gifts of partnership interests, as would a general withdrawal right.[54]
2. Distributions of Current Net Earnings
Yet another strategy to minimize the economic costs to the donee is to require the general partner to distribute net income currently.[55]  The donee, then, would have the benefit of cash distributions to mitigate the adverse effects of reporting a “phantom” share of income.  Clearly the donor may resist the requirement of distributing all net income currently.  However, the definition of “net income” could be sufficiently flexible to allow the donor to retain the amount of earnings reasonably necessary to meet the capital needs of the business.
If the donor absolutely opposes such a requirement, then perhaps the donor could compromise by making annual cash distributions to the donee in the amount necessary to cover the entire adverse income tax consequences to the donee.  The amount of compensation should reflect a true “before and after” analysis to capture the entire income tax cost of reporting a distributive share of FLP income.  Specifically, the amount should reflect the tax impacts of the discussed phaseouts and not merely the marginal tax increase.
3. Gift of FLP Interest to Defective Grantor Trust
Perhaps the best method to alleviate collateral costs to the donee is for the donor to gift FLP interests to an intentionally defective grantor trust for the benefit of the donee, rather than outright to the donee.  The donor-grantor then is treated as the owner of the trust for income tax purposes[56] and, therefore, is responsible for paying the income tax on trust income whether or not the trust income is distributed to the donee-beneficiary.[57]  Granted, this mechanism would not meet the income-shifting objectives of the donor.  However, it would avoid the collateral costs to the donee and create a second layer of creditor protection.
By paying the income taxes, the donor provides a real benefit to the donee—effectively making an additional tax-free gift of the income taxes that the donee or the trust would have had to pay absent grantor trust status.[58]  In addition, the donor can achieve additional flexibility by drafting the trust with a “toggle switch” provision, such that the intentional grantor trust status can be terminated by the donor (or by a third party) if it is no longer necessary or desirable.[59]
4. Outright Gifting
Finally, the donor should look beyond the strict FLP planning objectives and show more sensitivity to the present economic needs of the donee.  Perhaps the donee’s present needs outweigh the potential long-term benefits of owning FLP shares.  For example, a donee may have a more pressing need for outright gifts of cash in lieu of limited partnership interests, in order to help cover the costs of a child’s college tuition.  Moreover, as discussed previously, the child of the donee could qualify for a more valuable financial aid package if the donee’s AGI does not include the “phantom” partnership income.  In such a situation, through a more empathetic approach to estate planning, the donor might realize that the donee would prefer to receive wealth transfers presently rather than in the future when there may be fewer pressing financial demands (i.e., give the money to the donee when the donee really needs it, rather than compromising the donee’s present financial situation in order to promote future benefits).
The donor best alleviates collateral consequences through an empathetic approach to FLP planning, by communicating with and empowering the donee, preparing the donee for future management, and compensating the donee for the collateral costs of participation.  Although the donor can mitigate the collateral costs through the methods suggested in this Article, an empathic approach ultimately may call for the donor to abandon strict planning objectives—focused on the future benefit of the donee—in favor of meeting the present economic needs of the donee.
[1] This article applies equally to family limited liability companies.
[2] See e.g., John A. Bogdanski, Must a Family Limited Partnership Run a Business in Order to Achieve Transfer Tax Discounts?, 32 Est. Plan. 41 (2005); Edward D. Brown, Maximizing Minority Discounts for Limited Partnerships in an Integrated Estate Plan, 93 J. Taxn. 306 (2000); J. Joseph Korpics, Qualifying New FLPs for the Bona Fide Sale Exception:  Managing Thompson, Kimbell, Harper and Stone, 102 J. Taxn. 111 (2005); Michael D. Mulligan, Current Status of Use of Limited Partnerships in Estate Planning, 30 T.M.E.G.&T. J. 199 (2005).
[3] Commentators have covered the subject extensively.  Id.; see also Howard M. Zaritsky, Tax Planning for Wealth Transfers:  Analysis with Forms ch. 10 (W.G.& L. 2005) (available at 1999 WL 1032125).
[4] But see In Re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005) (Bankruptcy Court treated a limited liability company interest as an asset subject to the control of the bankruptcy trustee).
[5] RIA Checkpoint, The Family Limited Partnership Concept, Estate Planning, Practice Aids & Special Studies, Estate Planning ¶ 5,152 (2006).
[6] Id. at ¶ 5,155.  However, retention of control can create an estate tax concern.  See Strangi v. Commr., 417 F.3d 468 (5th Cir. 2005) (partnership assets included in gross estate of donor under I.R.C. § 2036 due to retention of substantial present benefits by donor).
[7] See Kathryn G. Henkel, Estate Planning & Wealth Preservation: Strategies & Solutions ¶16.01, 1 (W.G.&L. 2006)(available at 1999 WL 1017583) (discussing “numerous reasons to establish a partnership to manage family assets as they pass through succeeding generations”).
[8] Treas. Reg. § 1.704-1(e)(2)(ii).
[9] Jere D. McGaffey, “Formation of the Partnership,” Partnerships, LLCs, and LLPs:  Uniform Acts, Taxation, Drafting, Securities, and Bankruptcy, ALI-ABA Course of Study, July 10-12, 2003, Santa Fe, New Mexico.
[10] See e.g., Strangi, supra n. 6; see also John A. Bogdanski, From the Editor, 9 Valuation Strategies 03 (W.G.&L. 2006) (available at 2006 WL 540548):
[I.R.C. § 2036(a)]—bringing back into an estate assets transferred by the decedent during life, but with “strings” attached—has become the government's most powerful weapon in its combat against FLP discounts.  Where it applies, the discounts are disallowed entirely.
. . .
In case after case, the IRS has prevailed over purported FLP discounts, relying heavily (though not exclusively) on the grounds that the decedent's relationship to the assets contributed to the FLP did not change; that there was no real pooling of investments between the decedent and younger family members; and that the FLP was operated for the primary benefit of the decedent.
[11] See supra n. 2.
[12] Henkel, 1999 WL 1017583 at 4:
A discount for a limited partnership interest is appropriate because the general partner has so much control over the management of the partnership.  The limited partner typically has little voice in partnership operations, cannot obtain his pro rata share of partnership assets by compelling the partnership to liquidate, cannot (until the partnership dissolves) obtain the value of his interest in a term partnership by redeeming it, cannot transfer his management rights in the partnership without the consent of the other partners, cannot compel distributions in most cases, and must pay taxes on his allocable share of the income of the entity whether or not it is distributed to him.  This lack of control over so many aspects of the partnership may make the limited partner's interest worth considerably less than his pro rata share of the partnership assets.
[13] I.R.C. § 2503(b) (Westlaw current through P.L. 109-169, P.L. 109-73 approved Feb. 15, 2006).
[14] I.R.C. §§ 2010, 2505.
[15] RIA Checkpoint at ¶ 5,156; but see supra n. 4.
[16] 1977-1 C.B. 178.
[17] However, this is merely a “paper” benefit to the donee, because, as discussed below, the donee does not enjoy the typical present benefits of asset ownership.
[18] I.R.C. §§ 702, 704; see William S. McKee, William F. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships and Partners, ¶ 10.01[1], (W.G.&L. 2006) (available at 1997 WL 396090) (“. . . [U]nder § 704, each partner reports his ‘distributive share’ of [income, gains, losses, deductions and credits] on his personal income tax return.  Section 704 distributive shares are thus the interface between the partnership and its partners.”).
[19] I.R.C. §§ 704(a), (e)(2).
[20] RIA Checkpoint at ¶ 5,155.
[21] Treas. Reg. § 1.704-1(e); see Zaritsky, ¶ 10.09[4][a], 2002 WL 1970952 at 4-5.
[22] Zaritsky, ¶ 10.09[4][a], 2002 WL 1970952, citing Treas. Reg. § 1.704-1(e)(2)(ii)(a) and Reddig v. Commr., 30 T.C. 1382 (1958).
[23] Id.
[24] RIA Checkpoint at ¶ 5,155.
[25] Zaritsky, ¶ 10.06, 1999 WL 1032130 at 3, discussing Hackl v. Commr., 118 T.C. 279 (2002), aff’d, 335 F.3d 664 (7th Cir. 2003), citing Fondren v. Commr., 324 U.S. 18, 20-21 (1945); Ryerson v. U.S., 312 U.S. 405, 408 (1941) and U.S. v. Pelzer, 312 U.S. 399, 403-404 (1941) (denying the annual exclusion unless the donee receives a “substantial present economic benefit,” and rejecting the argument that future gains from partnership property created a present interest).
[26] RIA Checkpoint at ¶ 5,155, referring to Crummey v. Commr., 397 F.2d 82 (9th Cir. 1968).
[27] I.R.C. § 68(a), (g).
[28] I.R.C. § 151(d)(3)(A), (F).
[29] I.R.C. § 408A(c)(3).
[30] I.R.C. § 219(g).
[31] I.R.C. § 24(b).
[32] I.R.C. § 137(b).
[33] I.R.C. § 25(a)(h)(2) (Hope and Lifetime Learning Credits).
[34] I.R.C. § 22(b)(2)(a)1.
[35] I.R.C. §1(g).
[36] I.R.C. §§ 704(c), 731, 737.
[37] See e.g., Paul Carman, Unwinding the Family Limited Partnership:  Income Tax Impact of Scratching the Pre-Seven-Year Itch, 96 J. Taxn. 163, (W.G.&.L. 2002) (available at 2002 WL 355990); see also infra n. 38.
[38] Zaritsky, ¶ 10.01[2][b], 1999 WL 1032125 at 5:
A partner recognizes gain on the distribution of property from a partnership to the extent that the money distributed (including marketable securities and any reduction in the partner's share of partnership debt), exceeds the partner's basis in his or her partnership interest.  [citing I.R.C. § 731(a)(1).]  Thus, if the partnership holds a substantial amount of cash, marketable securities, or encumbered assets, the distribution of assets in exchange for a partner's partnership interest, may generate a taxable gain.
Gain may also be recognized on the distribution of property from an FLP if partnership distributions are not made pro rata to each partner, there have been prior taxable transfers of partnership interests, the partnership holds substantially appreciated assets or unrealized receivables, or the partner made transfers of assets to the partnership within the two years preceding the distribution.
[39] Carman, 96 J. Taxn. at 163.
[40] U.S. Dept. of Educ., FAFSA on the Web, (accessed March 31, 2006).
[41]See 2006-2007 FAFSA on the Web Worksheet, 4-5, (accessed March 31, 2006).
[42]U.S. Dept. of Educ.,FAFSA on the Web, (accessed March 31, 2006) (emphasis added).
[43] See Funding Education Beyond High School:  The Guide to Federal Student Aid, (available at and THE EFC FORMULA, 2006-2007 (available at
[44] E.g., a Federal Pell Grant.
[45] See e.g., Marion Dobbs, Determining Child and Spousal Support §§ 2:47, 2:48 (DCSS § 2:47, 2:48, Westlaw current through September 2005).
[46] Id. at § 4:16, citing Faerber, Empirical Study:  A Guide to to the Guidelines:  A Longitudinal Study of Child Support Guidelines in the United States, 1 J. L. & Fam. Stud. 151, 152-153 (1999).
[47] Dobbs, DCSS at § 4:16, citing Fitzgerald v. Kempf, 805 A.2d 529 (Pa. Super. 2002); Zold v. Zold, 911 So. 2d 1222 (Fla. 2005) and Weis v. Weis, 572 N.W.2d 123 (Wis. App. 1997) (under Wisconsin statute, undistributed partnership income is included in support calculation if (i) the spouse has control or access; and (ii) there is no valid business reason for retained earnings).
[48] Paula Woodland Faerber, Empirical Study:  A Guide to to the Guidelines:  A Longitudinal Study of Child Support Guidelines in the United States, 1 J. L. & Fam. Stud. 151, 184 (1999), citing Indiana Child Support Guidelines (1998).
[49] Steven J. Willis, Family Law Economics, Child Support, and Alimony:  Ruminations on Income, pt. II, 78-MAY Fla. B. J. 34 (2004).
[50] See RULPA §  303(a).
[51] Henkel, ¶ 16.02[2][a], 1999 WL 1017582, citing RULPA § 305.
[52] Id., citing RULPA § 802.
[53] Zaritsky, ¶ 10.06, 1999 WL 1032130 at 5.
[54] Id., noting:
It may, however, be more useful to include the right in the deed of gift by which a donor transfers partnership interests.  A put right included in the deed of gift applies only to the transfer to which the deed of gift relates, whereas a put right included in a partnership agreement normally applies to all transfers of partnership interests.  A donor may not wish to continue granting a put right if
. . . a donee exercises the put right with respect to a prior transfer.
[55] However, such requirement may have the effect of reducing the discount applicable to the gift.
[56] See I.R.C. §§ 671-679 (the grantor trust rules).
[57] See Robert A. Esperti & Renno L. Peterson, Irrevocable Trusts:  Analysis with Forms ¶ 4.04[1][a] (W.G.&L. 2005) (available at 1999 WL 1017951).
[58] Id.
[59] Esperti & Peterson, ¶ 4.04[3], 1999 WL 1017951 at 5.