In light of a recent tax court decision, West Palm Beach residents with substantial assets may want to take another look at limited family partnerships as an estate planning option for reducing tax liabilities.

Family limited partnerships are a popular estate planning tool because they allow a donor to make annual gifts of fractional partnership interests up to the limit of the annual gift tax exemption. Gifting fractional interests provides a convenient way to retain family ownership of assets, such as real estate, that cannot easily be divided otherwise.

A family limited partnership can also provide a mechanism for reducing gift tax liabilities because the value of the interests may be discounted based on the recipient’s limited rights to the use and control of partnership assets.

One of the challenges with using a family limited partnership to make discounted gifts is that the IRS may value gifted interests at a higher rate than that assessed by the donor. A higher valuation may result in unanticipated gift taxes that cut into assets the donor wishes to retain for living expenses.

The recent tax court decision provides a mechanism for hedging against valuation disparities. The court upheld a family limited partnership agreement that based the percentage of interests conferred upon the future determination of value by an independent auditor. The agreement set a limit upon the dollar value of the interests granted and provided that percentage interests in excess of the dollar value would revert to the donor’s estate. The reversion of interests to the estate reduced the donor’s gift tax liability.

Achieving the gift tax benefits of a family limited partnership requires a carefully drafted partnership agreement, and the terms of the agreement must be supported by some consideration other than the goal of reducing tax liabilities.

Source: Forbes, “Beating The Possible Estate Tax Increase Without Wwitching To Cat Food — The Midmill Dilemma,” Peter J. Reilly, May 2, 2012