An FLLC offers some advantages, but an FLP may still be your safest option.

If you have substantial business, investments or real estate interests, you may be concerned about how to transfer your assets to your children before your death without losing control of your business and incurring a big tax bill.

For many years, one of the most popular ways of achieving those objectives has been to form a family limited partnership (FLP). In more recent years the FLP's close cousin, the family limited liability company (FLLC), has gained favor. While the two have many benefits in common, each has some advantages over the other, and you should be aware of the differences between you commit to a course of action.

FLLC. An advantage of the FLLC is that the assets of all FLLC members are generally protected against exposure to the entity's liabilities. In contrast, an FLP must have at least one general partner that is exposed without limitation to all of the entity's liabilities. In addition, an FLLC is generally easier than an FLP to set up and operate, since there is no need to establish an S corporation or LLC to act as the general partner.

FLP. While the family limited partnership, compared to the FLLC, is not as simple to create and operate, it may stand up better under IRS scrutiny, especially when questions of control arise.

To maximize the taxable value of a person's estate, the IRS has, in recent years, used Internal Revenue Code Section 2036 to challenge some "pass-through" entities (i.e., FLPs and FLLCs). Section 2036 provides that, after a "donative transfer," an asset remains a part of a decedent's estate if, during his lifetime, the donor retained significant control over and/or enjoyed the benefits from it.

How might this affect your choice between an FLLC and an FLP? Consider the following:

In a family LLC, Dad and Mom (who contributed the assets that the FLLC now owns) are usually designated as the FLLC's managing members. More important, in exchange for the assets that they contributed, they initially own a controlling - if not a majority - interest in the FLLC. Their direct control over the FLLC and, by extension, its assets makes them ripe targets for IRS challenges.

In contrast, in a family limited partnership, the general partner is usually an S corporation or LLC that owns a 1% interest. That entity is often owned by the parents and their children, with the parents owning just less than 50% in order to avoid control issues.

Red flags. The way in which an FLP/FLLC operates may also indicate that the parents have, in effect, retained control. Here are some red flags that you will want to avoid:

• There are inordinate delays in funding the entity with assets.
• Cash distributions to the senior person(s) are in excess of their pro rata capital interest entitlement.
• Actions by senior person(s) indicate that they are running the entity for personal benefit.
• All, or nearly all, of the decedent's assets (including his residence) are placed in the FLP or FLLC.
• The decedent, in acting as the entity's manager, failed to fulfill his fiduciary obligations.

Overview. A pass-through entity can still be an excellent planning tool. If, after considering these factors, you believe that an FLP or FLLC is the way to go, you should familiarize yourself with some basic information.

Estate and gift tax considerations. Whether you form an FLP or an FLLC, interests previously gifted to the younger generation are generally not included in your estate for estate tax purposes unless the IRS disputes the gift transactions themselves. Thus, any post-gift appreciation will escape estate tax when you pass away.

Transfers of FLP and FLLC interests generally constitute gifts of present interests and are eligible for the annual gift tax exclusion privilege (currently $11,000).

And, because the interests are subject to numerous restrictions, they should qualify for substantial discounts for gift and estate tax valuation purposes. In some cases, the IRS may find gift tax valuation discounts (for minority interests and/or lack of marketability) appropriate for gifted interests even when the younger generation owns, in the aggregate, 100% of the entity.

Even when the IRS objects, taxpayers claiming gift tax valuation discounts have prevailed in the courts when they (a) show a business purpose for setting up the FLP or FLLC in the first place, such as keeping a family business or family real estate assets in the family's hands, and (b) avoid deathbed transactions.

The ability to claim significant gift and estate tax valuation discounts has clearly been a big reason for the popularity of FLPs and FLLCs. However, they can be an efficient tax-saving vehicle even without such discounts, since the older generation can use the FLP/FLLC to gift away significant interests in appreciating assets solely by taking advantage of the $11,000 annual federal gift tax exclusion ($22,000 for joint gifts by a married couple). Annual gifts up to the exclusion amount will reduce the value of the older generation's estate and shift taxable income to the lower-bracket younger generation. Plus, the older generation can retain control over the assets used to fund the FLP/FLLC. Making recurring annual gifts to several donees up to the $11,000 exclusion amount can quickly generate tax benefits.

Estate, gift tax changes. The federal estate tax is scheduled to be repealed in 2010, but only for that one year unless Congress takes further action. In the meantime, the federal estate tax exemption is scheduled to increase in several stages and will reach $3.5 million in 2009.

Uncertainty regarding the ultimate fate of the federal estate tax creates understandable confusion among clients about the advisability of implementing estate tax avoidance strategies at this time. If permanent repeal occurs, there will no longer be any need to establish FLPs or FLLCs solely to avoid the federal estate tax. On the other hand, if repeal does not occur, these entities will continue to be viable estate tax avoidance vehicles.

Forming an FLP or FLLC now could turn out to be a really smart move, because the values of assets used to fund the entity may be depressed. If values rebound strongly, much of the appreciation could be kept out of the older generation's estate with the use of an FLP or FLLC.

Income tax implications. Under the partnership taxation rules, the FLP's taxable income can be allocated among its partners pursuant to the partnership agreement. Because an FLLC is also treated as a partnership for federal tax purposes, the same is true in the case of an FLLC.

However, the FLP/FLLC's allocations of taxable income, gains, losses and deductions must be consistent with the IRS's "substantial economic effect" principles. In addition, special allocation rules apply when appreciated or depreciated assets are contributed to fund the FLP/FLLC.

Other advantages. In addition to delivering estate tax and income tax benefits, FLPs/FLLCs can function as asset protection and business continuity vehicles. Thus, an FLP/FLLC can serve to better manage and protect from creditors the wealth accumulated by the older generation and, at the same time, offer protection from creditors of those to whom FLP/FLLC ownership interests have been given.

Gerald A. Shantzer, CPA, our Principal-in-Charge of our Family-Owned Business Services Group, has conducted seminars and published numerous articles on financial issues that affect family-owned and closely-held businesses. He can be reached at jshantzer@marg.com.