Excerpted from The Biggest Legal Mistakes Physicians Make: And How to Avoid Them
Edited by Steven Babitsky, Esq. and James J. Mangraviti, Esq. (©2005 SEAK, Inc.)
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Family limited partnerships (FLPs) are an excellent planning tool for physicians. They allow physicians to give to their children and relatives interests in their estate, including interests in their practice, at a discounted value, while allowing physicians to retain complete control over the partnership. Physicians must realize, however, that although they will maintain control of the assets in the FLP, they are giving away the interest, and no longer have an ownership right in anything they give away. Physicians should also be aware that certain actions can cause the FLP to be disregarded for tax purposes and the entire value to be included in their estate upon death, potentially triggering an estate tax liability. Other errors can cause gift tax liability to donors or recipients of FLP interests. To ensure that the FLP is properly formed and used, a physician should consult an experienced attorney.
Mistake 1 Not Following the Formalities of Partnership Law
Compliance with federal and state partnership rules, including those regarding fictitious names and business registration statutes, is essential to the FLP. The FLP must follow the rules set forth in the Internal Revenue Code, the Department of the Treasury Regulations, and local law. If the FLP does not act like a partnership, it may be disregarded by a court, and the value of the assets in the FLP will be included in the physician’s estate, potentially triggering an estate tax liability.
Action Step Physicians who establish an FLP should be sure that it maintains separate books, records, and bank accounts, and files the proper partnership tax returns. All assets used by the FLP should be held in the name of the FLP.
Mistake 2 Not Using a Valuation Professional
When fractional interests in an FLP are gifted to relatives, they are subject to a valuation discount—the divided interests are worth less than the FLP as one asset. (In other words, the sum of the parts is not equal to the whole.) A valuation expert can appraise the value of the gift to the relative and determine if it exceeds the annual gift tax exclusion amount, and if so, by how much. Failure to use a valuation expert may result in annual gifts that exceed the allowable limit, and the physician or his relatives will have to pay tax on the excess.
Action Step Physicians should be sure to hire a separate valuation expert to work in conjunction with their attorney to properly establish the value of their gifts to the limited partners. The attorney should be able to recommend a qualified expert. Physicians should be sure that the attorney who establishes the FLP is not the person who values the gifts.
Mistake 3 Retaining Incidents of Ownership in Transferred Interests
Physicians may not transfer assets or interests to an FLP and continue using the assets for free. In addition, they should not contribute personal use assets, such as a house, to an FLP and continue to use the assets for personal use. Physicians who contribute assets to an FLP should plan to pay reasonable rent or other value to the partnership for the use of the assets.
Action Step Physicians should transfer a building or a similar asset to the FLP. They will have to pay a fair rent to the FLP for use of the building, which not only helps to remove additional taxable assets from the physician’s estate (i.e., monthly rental payments), it is also tax deductible.
Mistake 4 Trying to Do It Themselves
Physicians should not try to establish an FLP without the assistance of a qualified attorney. If done improperly, the FLP may not be honored for estate planning purposes. If the FLP is ignored for estate planning purposes, the value of the assets in the FLP will be included in the physician’s estate, possibly increasing his or her estate tax liability.
Action Step Experienced estate planners are trained in establishing FLPs. They know how to structure them properly, and can advise physicians on how to use the FLP to reduce their estate most effectively.
Mistake 5 Using an Unqualified Professional
Physicians should not use unqualified professionals when forming an FLP. They should use a licensed, qualified attorney who has been practicing for years and knows how to form the FLP correctly. Using an unqualified person to form the FLP can result in the partnership being formed incorrectly and as a consequence, the FLP may be disregarded by the Internal Revenue Service or the courts, and the estate planning benefits negated.
Action Step Physicians should not follow the advice of an unlicensed, unqualified person when forming an FLP. They should consult a licensed attorney.
Mistake 6 Having Services, Not Capital, Be a Material Income-Producing Factor
Physicians must contribute more to an FLP than just personal services in order for the FLP to be honored. If a physician contributes only services, the FLP will be deemed an “assignment of income” and the entire amount will be taxed to the physician, who earned it. Treasury Regulation 1.704-1(e)(1)(iv) states: “Capital is a material income producing factor if a substantial portion of the gross income of the business is attributable to the employment of capital in the business conducted by the partnership. In general, capital is not a material income producing factor where the income of the business consists primarily of fees, commissions, or compensation for personal services performed by members or employees of the partnership…capital is ordinarily a material income-producing factor if the operation of the business requires substantial inventories or a substantial investment in plant, machinery, or other equipment.”
Action Step Physicians should contribute capital, such as buildings and equipment used in their practice, to the FLP. Services may be contributed to the FLP if capital is also contributed. As such, the Internal Revenue Service and the courts will not disallow the FLP of a physician who contributes his or her entire practice to the partnership, including office space and equipment, and continues to provide services to the FLP.
Mistake 7 Giving Too Much Control to a Managing Partner without
Physicians who are also the general partners in an FLP and transfer junior interests to relatives or children run little risk that the transferred interests will be included in their estate. However, the general partner’s management responsibilities should be fiduciary only. If a general partner is given unfettered control over economic and voting matters, the transferred interests may be included in his or her estate when he or she dies.
Action Step Typically, the general partner should be a corporate entity owned and controlled by the physician or another person who is trusted by the physician. An attorney should be consulted for the pros and cons of this method of control.
Mistake 8 Commingling Assets
Physicians should keep their personal assets separate from the FLP’s assets. They should not use personal accounts to pay bills of the FLP, nor should the assets of the FLP be used to pay personal liabilities. If assets in an FLP are commingled, the courts may disregard the entity and include the entire value of the FLP in the physician’s estate, potentially triggering an estate tax liability.
Action Step Physicians should maintain at least two separate accounts, one for personal assets and one for FLP assets, and take care not to confuse the two or use the assets of one to pay the liabilities of the other.
Mistake 9 Not Making Pro Rata Distributions
A physician who is the general partner of an FLP and makes distributions to the general and limited partners must distribute income pro rata with ownership interests. Often, a general partner will try to distribute more to the limited partners, and little or nothing to the general partner, in an effort to increase gifts to children and relatives and reduce the size of the estate more rapidly. This action may result in the FLP being disallowed for estate planning purposes.
Action Step Physicians who make distributions must be sure that the distributions are made pro rata with ownership interests in the FLP.
Mistake 10 Waiting Until It Is Too Late
Physicians err if they wait too long to form an FLP. But they also err if they contribute all of their assets to an FLP. Recent cases have disallowed FLPs where the decedent formed the FLP and contributed all of his or her assets to it, and died shortly thereafter.
Action Step Physicians should visit their attorneys to see if an FLP is appropriate for their estate planning needs; if it is, they should form an FLP as soon as possible. Forming the FLP earlier also allows a physician to donate assets over time, rather than having to donate them all at once.
Although family limited partnerships can be useful planning tools for physicians, there are complications and pitfalls that make an attorney a necessary part of organizing an FLP. When used properly, an FLP can reduce the value of a physician’s estate and result in lowered estate and income tax liabilities. If, however, an FLP is organized improperly, gifts of FLP interests may result in tax to the donor or donee, or in inclusion of the entire value of the FLP assets in the physician’s estate, triggering an estate tax liability. When organizing an FLP, physicians should consult a qualified attorney for the best result.
- Price, et al., Price on Contemporary Estate Planning, 2nd ed.
- Treasury Regulation 1.704-1(e)
James J. Everett, Esq.
Peer reviewed by:
Rex C. Leung, Esq.