Sole Proprietorships / Limited Partnerships / General Partnerships / Charitable FLPs / Relational Partnerships
Family Limited Partnerships/FLLC / Limited Liability Companies / C Corporations / S Corporations  / 501(c)3
Garnishment as an Asset Protector / UCC 1 Connection




by Stephan R. Leimberg
Leimberg Associates, Inc.


Family Limited Partnerships (FLPs) and sophisticated charitable gifts are two exceptionally important and viable estate and planning tools. For some of our clients, either or both may form the centerpiece or foundation of their estate plan.

But when combined,  commonly known as the "CharFLiP", the planner and client both enter into unsettled areas of the tax law and the potential for litigation with the IRS and in the courts increases exponentially.   (Also see Relational FLP.)

To paraphrase the authors of the excellent article entitled, THE EVOLVING EDGE OF THE SPLIT DOLLAR ENVELOPE:


"Determining the edge of the charitable giving envelope is a lot like the study of geometry;

they both start with theorems of pristine simplicity -

but gradually progress - to caverns of complexity."


As the authors point out, the trick in analyzing the probability of success in any complex transaction, particularly transactions involving tax exempt entities, is to reduce the transaction to its basic components. Then, we must attempt to reconcile the purported results with fundamental tax and other legal principles.

Please: Consider these two questions:

Question 1: Do dollars move in circles? That is, do we have boomerang dollars, or property, or a business interest that ends up essentially back where it started?

Question 2: Do benefits appear to shift - without tax consequences? Does the promoter promise to get money or property from one party to another - with little or no tax impact or other cost?

Because whenever dollars seem to move in circles - or benefits appear to shift without tax consequences, we must illuminate the transaction - with basic tax principals - and common sense. Why? Because this is the acid test that the IRS and the courts will apply.

When we watch Starwars - or the next James Bond movie, to enjoy the picture, we must "suspend disbelief" and relax our critical thinking and analytical examination. But we can not afford to "suspend disbelief" when we advise clients.

Please consider the following comments, not only as a means of analyzing the CharFLP transaction, but also as a template to examine the leading - and the bleeding edge charitable and other estate and financial planning ideas - of the future.

The FLP/Charitable Gift: How it works: In its most basic form, a client gives an extremely large limited partnership interest in an FLP (family limited partnership) to a charity. At some later date, the charity sells it back to the donorís family or some other party.

In the more sophisticated versions of this technique discussed below, the prospective client is promised:

a large income tax deduction,

a largely tax-sheltered capital gain on the FLPís sale of business or investment assets,

a strong and steady stream of income, and

a technique to pass on substantial wealth to family members at little, if any, gift or estate tax cost.

Promoters claim that it not only can accomplish all these things. They also claim that: the deduction is higher than the client would get by setting up a CRT or CLT, age is irrelevant (unlike the case in a CRT), the stream of income to the donor is potentially greater than it would have been in a CRT, and within a few short years (unlike the case where a CRT is used) the charity is out of the picture.

Promoters will also tell you that - unlike an outright gift to charity, which once made is gone forever, the donorís family gets this gift back. And theyíll tell you, itís the clientís family who receives the bulk of the wealth rather than the charity - at little if any gift or estate tax cost.

To quote one promoter:

"Many clients are realizing large current income tax deductions while avoiding capital gains coming from growth within the FLPs."

Letís take a more detailed look at the mechanics. Please keep in mind that there are infinite varieties of these plans ranging from those obviously and blatantly abusive to those which - for some authorities - appear to have no trouble passing IRS scrutiny - and pose no problems:

Step 1: Client sets up an FLP. The FLP consists of a general partnerís interest and one or more levels of limited partnership interest(s).

Step 2: Client puts business and appreciated investment assets into the FLP.

Step 3: As general partner, client retains a management fee for operating the partnership.

As a practical matter, no matter how reasonable, this management fee enables the client to keep or control all partnership decisions - including control of the cash flow to the FLPs limited partners.

Typically, the managing partnerís fees range from 2 to 10% of the FLPís income.

As General Partner, the client also maintains the right to borrow partnership assets for personal needs at competitive interest rates.

Step 4: Shortly after forming the FLP, the client gives almost all- letís say 97% - of the limited partnership interests to one or more qualified charities.

This generates a large current income tax deduction - even after a downward valuation adjustment for lack of control and lack of marketability. (Some variations incorporate FLP provisions that tend to minimize the downward reduction in value in order to maximize the probability of the highest possible charitable deduction).

In most - but not all varieties of these plans - the charitable gifts carry a "put". This put gives the charity the legal right to "put" its interest to the FLP, i.e, to force the FLP or its partners to buy-back all or almost all of the limited partnership interest within a specified period of time (usually 5 to 8 years).

The kicker is that - in many of the agreements - the buyback price may be significantly lower than the price at which the interest was valued when the FLP limited partnership interest was received by the charity.

Step 5: At or about the same time as the donorís gift of 97% of his partnership to charity, he or she makes a gift of the remaining 3% of the FLPís limited partnership interests to his children/and or grandchildren or to a trust on their behalf.

In valuing these interests, for gift tax purposes, a large discount is taken because the limited interest lacks both control and marketability.

Step 5A: Hereís where life insurance comes in:

To fund the deferred buy-out, some of the arrangements call for the purchase of life insurance on the donorís life.

In some variations, the partnership itself splits the premium dollars with an irrevocable trust that represents the interests of its beneficiaries, the 3% limited partners.

Think about whatís happening here:

The charity holds 97% of the partnershipís limited interests. So the charity, as a 97% limited partner, is paying - indirectly - but quite surely - the bulk of the insurance premiums.

In other words the charity is funding the bulk of the premiums - that will be used to buy itself out.

In at least one variation, the charityís "put" enables it to sell its interest to the donorís irrevocable life insurance trust. Thatís the same trust for which charitable money invested in the FLP was used in a split dollar agreement to fund the life insurance that will be used to buy out its own interest at a deep discount. The trust would then receive the partnership interest with a stepped-up basis.

Step 5B: With all of the variations Iíve seen - even those few that donít have a put provision, the charity is given almost all the limited partnership units.

If the general partner - the client - choses to sell appreciated assets at any time before the trust buys back the FLP interests, in this example, approximately 97% of the gain is attributable to the charitable partner.

Whatís the point? 97% of the gain - is taxable to the charity.

The promoters argue that 97% of the gain on a sale of appreciated partnership assets is income tax free because of the charityís exempt status. Only 3% of the gain is taxed - to the other partners.

Let me repeat: The clientís family pays tax on only a small fraction of any gain realized by the partnership on the sale of partnership assets.

Of course, the donorís intent - from inception - is that his/her family will someday - own ALL of the FLP assets - and the charity will own none.

And a very important part of that intent is that the charityís tax exempt status has "washed away" the capital gain - so that when itís repurchased by the childrenís trust, the family never pays tax on that gain.

Step 6: Although the charity now owns a piece of paper that - someday - may provide it with significant capital - for many years - as limited partner - itís quite possible the charity is likely to get nothing or relatively little out of the deal for many years.

Why? Remember, the general partner (the client) has the right to take reasonable management fees. He, she, or it also has the right (within state fiduciary limits) to reinvest partnership income and gains into business or investment assets that pay relatively little income - and are mainly capital appreciation vehicles. So the annual cash flow to the charity unless and until the interest is sold by the charity may be minimal - or nonexistent - even under very legitimate and reasonable circumstances.

As a limited partner - even a 97% limited partner - the charity has absolutely no control over the size of the management fee or how the FLPís assets are invested.

So the charity has this paper that says itís a limited partner - but itís quite possible that the charity may not realize cash anywhere near equal to the present value of the donorís deduction.

Thatís why - at the first possible specified "put" date (or other opportunity if there is no put), typically, the charity will be very happy to exercise its option to sell its 97% interest back to the donorís childrenís trust.

Itís probable that the trust will claim that the price it pays to the charity for the limited partnership interest should be significantly discounted because of lack of marketability and control.

Iíve never heard a promoter tell a client that the trust will have to pay the charity a premium for the extra value inherent in the capital gains property that now has a stepped up basis or the capital gains tax that never has to be paid because the appreciated property was sold and turned into cash.

So eventually, the charity receives cash in return for the interest. The interest is sold back, either (a) to the partnership itself or to (b) the 3% owners or their trust.

Not incidently - after the sale, the family business and other holdings of the FLP are in the hands of the clientís children - at a discount - and - without paying any gift tax.

You may be wondering, "Whatís Wrong With This Picture?"

Iím very troubled by this transaction - particularly because - if you look at any one step - it appears to be perfectly acceptable. But a very different picture appears when you examine this series of transfers in its entirety and from the perspective of a tax-exempt entity that is supposed to exercise financial independence and control as well as deal with exceptional care and totally at armsí length with long-term "partners."

Letís start with a sure thing: Assume your client has made many sizeable gifts to a charity over a number of years. This year, she gives that same charity a small (say 5, 10, or 15 %) interest in a previously formed FLP. Period. She gives the gift with no current intent to buy it back. There are no strings and no "put." In my opinion, there is no problem. Her gift is deductible. Even if at some later point, the client or her childrenís trust buys back the interest - as long as each step is at armsí length and valuation formulas are fair, her gift will remain deductible.

Second scenario: The client - pursuant to a promoterís brochure and marketing - gives - not a small piece of the FLP - but almost everything - because she has read the promoterís script and knows and intends her family is almost assured to get it all back. And she implements the transaction knowing (among other objectives) that the tax exempt status of the charity will "wash away" significant capital gains built into the property.

Assume the "cleanest possible situation: The donor has not attached a "put" or any other string on the transfer. Assume the FLP agreement allows the general partner no more than a reasonable management fee, requires that the FLP pay the charity and its other limited partners at least a minimum guaranteed payout each year, and assume fair valuation formulas on both ends. In my opinion, this transaction is still suspect.

Why isnít it a sure thing? Promoters would point to the taxpayerís success in Grove, Carrington, and many other cases and rulings - which seem to indicate this variation will work.

Grove, Carrington, and an IRS acquiescence indicate that if an FLP interest is given to a charity - with absolutely no strings attached - and the gift is made with no expectation of any significant economic benefit, the donorís deduction should be allowed - even though some day the charity sells the interest back to the donor or a member of the donorís family or to the firm itself.

Of course, the central issues in those cases involved whether or not the taxpayer had received a dividend when the corporation bought back its stock from the charity.

They didnít focus on whether or not the taxpayer had a charitable intent: Was this a gift to charity - or a deal? Those cases didnít examine the use of the charityís tax exempt status to wash away the capital gains in the appreciated assets. Nor did these cases speak to the issues posed by the relationship of the donor to the charity or the charityís lack of financial decision-making independence or control during the period prior to the exercise of a put or other disposition of the limited partnership interest. Those cases didnít consider the issues of private inurement or private benefit. Yet in my mind, each of these issues poses a steep - and perhaps insurmountable - hurdle for those who would use the six step approach described above.

Beth S. Kaufman, an associate tax legislative counsel at Treasury, speaking at a conference on charitable organizations cosponsored by the American Law Institute and the American Bar Association,stated,

"Charitable family limited partnerships often involve overvalued gifts, estate and gift tax problems, and excessive management fees. For example, she said, a family might fund a limited partnership by donating a family business, retaining 1 percent general and limited partnership interests and requiring a put option whereby the charity would have to sell the business back at a low rate. Distributions to charities under those arrangements

tend to be small, and intermediate sanctions and private benefit issues may arise, Kaufman added. "No charity with its eyes open should participate in this kind of thing," she said.

There are, of course, the obviously abusive versions. But letís eliminate them from further discussion.

Letís focus on the "Most likely to succeed" variety of the CharFLP. Even in the most honest and most armsí length variation, everyone (promoters, client, and counsel) knows - and plans - from inception - that this is not merely a "no-strings attached" "give it and goodby" charitable gift.

No one ever intended or suggested to the client - that he make a transfer - solely to benefit the charity. No one intended totally detached disinterested generosity. No one intended that what the donor (or the donorís family) gets from the transaction is incidental and relatively insignificant.

Yes, the charity doesnít end up with an empty bag. The charity gets what I call a "play-along" fee. It gets that money - some (generally uncertain) partnership income - tricked out over many years. A presently indeterminate lump sum will eventually be received by the charity upon its sale of the interest - in return for allowing the donor to receive a large current charitable deduction for a "gift" that ends up back in the donorís childrenís hands.

Look at this for what it is - because the courts and the IRS will: The major driving and continuing impetus is to facilitate the clientís personal estate planning objectives. I predict the courts and/or Congress will view this as yet another example of how a promoter is showing prospective clients how to use a charityís special tax exempt status to serve the clientís private goals more than the charityís public purpose.

Thereís no question in my mind that here - the IRS and the courts - and if not them - CONGRESS - will put the pieces together and view it as a whole. Because that is exactly what the promoter is telling the client to do.

TRUE or FALSE? The typical prospective client who is approached by a promoter with this concept would not consider giving 97% of his business and investment assets to charity - if he didnít expect a large current deduction, almost total and absolute retention of control, a sanitization of capital gains, and a recovery of entire FLP interest back into his familyís hands, would he/she?

TRUE or FALSE? Thereís no way heíd enter into any portion of this transaction - unless he had more than a reasonable expectation that the whole scheme would work?

So Whatís The Bottom Line?

Although itís impossible to say at this point that it canít be done, I can say with certainty that at best, youíve got an invitation to litigation. Your client WILL become famous. And perhaps you will too.

I predict, if it does work, it will not last for long. Why?

For the simple reason that Congress intended the charitable deduction as a way to encourage charitable giving by reducing the cost of making a charitable gift. It did not intend to allow a charitable deduction for a "some for you, some for me" deal. Nor did it intend to encourage abuse of the charityís tax exempt status to wash away capital gains for private individuals. Congress certainly did not want to foster any type of long-term partnership between a charity and a private individual in which the private individual had almost absolute control over all major investment decisions.

In the Revenue Reconciliation Act of 1997, which amended Code Section 664, Congress stated that attempts to convert appreciated assets to tax-free distributions to noncharitable beneficiaries would be considered abusive. Why should this ploy be any different?

The IRS has echoed this thought with a statement in recent proposed regulations (REG - 115125-99) that essentially says, "A mechanical and literal application of rules and regulations that would yield a result inconsistent with the Congressional purposes and intent will not be respected."

Even the most pure strain of the CharFLP is, in my opinion, the application of a literal application of the rules governing charitable deductions that attempts to convert appreciated assets into tax free cash in the hands of the non-charitable beneficiary - and totally inconsistent with the purpose of the charitable deduction rules.

Promoters are fond of asking, "Whatís the worst that can happen if weíre wrong?"

Let me count the ways:

If they are wrong, and the deduction is denied:

First, your credibility and reputation suffer.

Second, your client is angry about being audited - and worried that the audit will go much deeper than he expected - and heíll want to know, "how many open years can they go back?"

Third, your client may forget that you warned him that his was an X rated risk - but may remember you saying that "grandfathering is a sure thing." Of course, thereís no grandfathering in the Charitable Split Dollar bill - nor is there any such protective language in legislation that would eliminate many 419A sales.

Fourth, heís shocked to find out that - in addition to his income tax deduction being disallowed - the IRS has told him his gift tax charitable deduction was disallowed. He didnít even know there was a gift tax charitable deduction - and now the IRS is charging him with gift tax for all open years - and claiming - since he never filed a return - all the years are open. And, oh yes, the IRS wants interest and penalties.

Fifth, he wants you to tell him what the term, "intermediate sanctions" is all about - since the IRS examiner is mumbling something about him being a "disqualified person" and saying there was some kind of "excess benefit transaction" between him and the charity.

"And is that 200% excise tax for real?" he asks.

As the authors of one of my favorite articles, "The Evolving Edge of the Split Dollar Envelope" stated, "To analyze any complex tax-oriented transaction, you must reduce it to its basic components. You must then reconcile purported results with fundamental tax and other legal principles. Suspect a problem when dollars move in circles or when benefits appear to shift - without tax consequences. Illuminate the transaction - no matter how complex - with the same basic tax concepts, common sense, and eye to Congressional purpose and intent - that the IRS and the Courts will apply."

Insist your clients make decisions about any estate planning tool or technique - without regard to what you - or they would like to happen - but rather on what is likely to happen - based on tax and economic realities.

And lastly, remember my "second-hand smoke" principal:

Certain things are wrong - and will harm others - even if you or your client may be able to get away with them.

"Wink and nod planning" stretches the fabric of the law - sometimes beyond repair. At that point, Congress will fabricate a new law - even more complex, arcane, restrictive - and often retroactive - and all of us will lose.

History shows that when Congress takes aim at aggressive tax planning, the odds are high that the resulting rules will impact on areas far broader than the abuse targeted. We all breath that "second-hand smoke" - and we will all be worse for it.

Steve Leimberg


                         Download our intensive "Introduction To Limited Partnerships":   PDF format |

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                         Download a "California LP Application w/ SS-4" document:            PDF format |

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C. Francis Baldwin
Updated Wednesday, May 26, 2004