In the past few years, the family limited partnership has been the focus of Internal Revenue Service efforts to curb abusive tax shelters. The IRS maintained that a family partnership wasn't real; it was a tax-dodge.

The agency had suddenly realized that family limited partnerships, sometimes called FLIPs, aren't just for the rich anymore. It's a solid tax strategy that advocates a way to protect a family's assets, potentially cutting in half or more what's owed on an estate-tax bill -- assuming there are any estate taxes to worry about. President Bush wants to do away with estate taxes.

That prompted the IRS to send out a flurry of "advisory notices", telling people that the agency may invoke a section of the tax code that allows it to disregard FLIPs because of potential abuses.

If you or your family members have created a FLIP or are considering one, don't let this get in your way. As long as your motivation is to, protect your assets from creditors, or manage your assets more effectively -- just as in any limited partnership -- you're starting out on solid ground.

To understand a FLIP, you have to understand the basic structure of any limited partnership. After all, a FLIP is merely a traditional limited partnership where all the partners are family members. Remove the family relationship, and a basic FLIP is the basic limited partnership.

All limited partnerships have one thing in common. They all are run by general partners only. Under the law of all 50 states, by definition, no limited partner has any vote or voice in the running of the partnership business. A general partner, who may only own 1% of the partnership assets, will control 100% of those assets.

In a family situation, the parents put their assets into the partnership. They start by being both the general partners and the limited partners. Then, under the most common and simplest form, they gift their limited partnership interests to their children. Let’s see what they have really done . . .

Several effects on the gift and estate tax. First, even though the parents have given away the limited partnership interests, they, as the general partners, still retain full control over all the assets in the partnership. The limited partners (who become the general partners upon the death of both parents) own and have title to the limited partnership interests. But they have no voice in the management of the partnership. In effect, the parents have given up ownership of the assets but have retained control. This does several things with respect to gift and estate tax.

Except for the 1% retention, the assets are out of the parents' estates. A completed gift has been made to their children.

Since the gift has been completed, all appreciation on the assets is out of the parents’ estates. Assuming both parents are age 40 when the transfer is made, and that one lives another 40 years, we have excluded 40 years of appreciation from the parents’ estates. Further assuming a $2 million transfer and a conservative rate of appreciation of only 7.2% per year, $32 million has been excluded from the parents’ estate and they have saved approximately $16 million in estate taxes. (Assuming there is an estate tax.)

Here’s where the IRS gets really annoyed. Even if the parents die immediately after making the transfer and even if there is no appreciation in the assets, there is an immediate and substantial transfer-tax saving. Stay with me on this -- it’s complicated. Remember that the parents gifted the limited partnership interests to their children, not the assets in the partnership itself. While the limited partners own the assets, they have no control over those assets. Because they have no control over those assets, the value of the limited partnership interests (the value of the gift) is less than the value of the assets transferred.

Look at it this way: If you can buy an asset for $1,000 and have complete control over that asset, it has to be worth more than a limited partnership interest where you have no control. The value of the limited partnership interest must be less than the market value of the asset because you don't control the money. All of the courts that have reviewed this, and even the IRS, agree that there must be a discount. The more liquid (meaning cash), the lower the discount. The IRS historically has allowed a discount of about 40%, depending on the assets transferred. That means that the parents can transfer as much as $3,333,333 in assets structured as limited partnership interests without paying any federal transfer taxes (60% of $3,333,333 is the $2 million credit exclusion). That’s $1,333,333 more than they could without the limited partnership.

The IRS argues that this is unfair to those who are unaware of the law or who can’t afford high-priced attorneys to draft partnership agreements for them. And anyone with an estate of $2 million in 2003 and $1.5 million in 2004 or less (married) can, if their will is appropriately structured, pay no federal gift or estate taxes. The FLIP is a real tax benefit only if your estate is more than $2 million. If you have that kind of money, you can afford to pay for competent estate planning.

!Lower tax brackets and asset protection

The IRS does have one legitimate concern. In some cases, taxpayers have tried to take outrageous discounts of as much as 90%. Unfortunately, some people try to cheat; that’s why we have audits.

Since the children as limited partners own 99% of the partnership, 99% of the income will be taxed to them. This also has concerned the IRS. Traditionally, the parents will be in a higher income tax bracket than their children. If the parents are in the 35% bracket (the top rate for 2003) and the kids are in the 25% bracket, we have reduced the tax bite by 10 percentage points. If the $2 million in assets generate a return of only 5%, that’s $100,000 in income, $99,000 of which is taxed to the kids at their lower bracket.

The FLIP also provides asset protection. Before the transfer, 100% of the parents' assets were subject to their creditors, now only 1% is exposed. But what if the kids were sued? Well, against a limited partner, a creditor can only get a judgment called a "charging order." This places the creditor in the same shoes as the limited partner. So if the partnership earns $100,000 and the limited partner owns 99%, the creditor is going to be taxed on $99,000. But as general partners, the parents decide whether to distribute any cash to the limited partners. So the creditors could then end up getting taxed on $99,000 in income every year, even though the general partners aren't giving them a single penny. This is a great motivator for creditors to settle.

Family limited partnerships are legitimate wealth-preservation and asset-protection structures. Just because they are costing the government tax money doesn’t make them bad. Remember, it’s your money, not theirs.

One should consult with a qualified tax professional prior to implementing any tax strategies.