Frequent changes in tax laws can make individual estate planning difficult and confusing. During turbulent tax times especially, individuals need to develop efficient methods of estate planning. Family limited partnerships (FLPs) can play a valuable and important role in the estate planning process.

All types of real estate are being included in family limited partnerships--single family homes, single assets, portfolios, investment-grade real estate--and it's important to know that assets held in FLPs have special valuation considerations.

The goal of this article is to provide a base of knowledge in order to understand the nature of the FLP and the methodology used in the valuation of their interests, and to assess their use for estate tax planning purposes.

One of the main incentives for the establishment of family limited partnerships is the absence of income tax at the entity level as opposed to a C corporation, whose dividends are subject to double taxation.

Typical FLPs have structures similar to traditional limited partnerships. Often family limited partnerships are set up and generally owned and controlled by the parents who then systematically gift interests in the partnership to their descendants. The descendants, who are designated as limited partners, are prohibited from participating in the management of the FLP.

The restricted rights of the limited partners have a significant impact on the value of the FLP units.

As these gifts are made by the parents, discounts are applied to the fair market value of the underlying partnership assets, resulting in lower estate and gift taxes on the transfer. These discounts reflect the general lack of liquidity of real property as well as the inability of the limited partners to control the use of, sale of, or liquidation of the partnership or its assets. The level of discount can accelerate the process of estate tax gifting by as much as 50 percent. Determining the approval discount for the FLP is an important valuation consideration in which qualified valuation expertise contributes substantially.

The partnership is managed centrally by the parents; however, the value is transferred to the descendants. This is especially appropriate for real estate assets, which are not always conducive to being divided physically among descendants.

The positive attributes of FLPs generally outweigh the negative attributes; however, all aspects should be considered on an individual basis, as FLPs can vary as much as the types of assets included in them.

Valuation Considerations

The valuation of family limited partnership interests that hold real estate as its underlying asset involves not only an understanding of the FLP's structure, but also any considerations that limit the transfer of restricted units. In addition, it's important to understand the real estate that the FLP holds since the real estate is the inherent value driver of the partnership.

Alternative Valuation Methods

There are two procedures that can be used to estimate the fair market value of the FLP or an interest in the FLP.

Method 1. The first method determines the fair market value of the underlying real estate assets. A discount is then applied to account for the lack of marketability of the Partnership units, and then the fractional interest of the pro rata share of the discounted value is calculated.

In estimating the fair market value of the FLP's real estate assets, customary valuation methods are used to determine the free-and-clear market value of the property. The operating history, local market parameters, and overall market expectations are analyzed in order to develop forecasted cash flows for the assets. In addition, Sales Comparison and Cost Approach methods may be employed.

The cash flows are then discounted at a rate that takes into consideration the risks inherent in the real estate being valued. Some of the primary factors that affect the discount rate include: location, occupancy, cash flow growth, and holding period.

After estimating the fair market value of the FLP asset, the equity value of the partnership is determined by adding any cash and other partnership assets as of the valuation date (e.g., receivables, etc. and subtracting the outstanding mortgage balance and other liabilities.

A discount for lack of marketability is then applied to the fair market value of the partnership equity. Since units of the FLP are not publicly traded, their fair market value is considerably lower then it would be if a trading market existed. Additionally, many partnership agreements include restrictions on the transfer of units. The discounts are based on the same principles used in valuing interests in closely held corporations, with specific attention to the provisions of the plan documents, inherent risk of the property, nature and growth characteristics of the underlying real estate, and the financial strength of the real estate.

Method 2. The second method used to calculate the fair market value of the partnership interest involves the analysis of historical distributions of the FLP, similar to the initial steps of the first method; however, the emphasis is to determine the trend of distributions to the partners.

Once the distributions at the partnership level are determined, they are capitalized to estimate the value of the FLP. This method converts the distributions into a value estimate through the use of a capitalization rate. The appropriate capitalization rate is based upon the relative risk of a particular investment in relation to other investment vehicles and comparable partnership multiples.

Since a typical FLP would compete with other investments for outside investor equity funds, it is logical that in determining the appropriate rate of return for the FLP, transfers of other investments, such as limited partnerships, be analyzed. Considerations in selecting similar partnerships and the appropriate yield should include a comparison of the quality of the real estate assets held by the FLP relative to the general real estate market, any restrictions on the transfer of the FLP units, and the diversification of the real estate portfolio. Through careful analysis of similar transactions, a yield or range of yields can be derived.

Concluding a Value

Selecting which valuation method to use depends on the type of real estate and the level of information available. In general, the first method is considered preferable.

Depending on the asset type and partnership structure, it may be difficult in the second method to find truly comparable limited partnership unit sales on which to base the overall rate.

With the recommendations of a qualified real estate valuation advisor and the careful preparation of partnership documents by legal counsel, the true value of a FLP can be concluded and significant tax savings can benefit the estate holding the real estate assets.

Positive Attributes

* Substantial tax savings

* Retention of control of asset

* Allows for systematic, controlled transfer of assets to descendants

* Partnership agreement may be amended as necessary

Negative Attributes

* Expenses incurred in the establishment of the FLP: Legal and accounting fees

* Historically, use of FLPs has been limited to high net worth individuals to avoid higher tax rates

* Possible changes in IRS positions

Mr. and Mrs. Smart-Parents own real estate with a fair market value of $10 million. If this asset were gifted to four Smart descendants, taxes would be paid on the full $10 million market value, and all control value of the real estate would be transferred to the Smart descendants. If a family limited partnership were established, however, with Mr. and Mrs. Smart-Parents acting as the general partner and each of the Smart descendants acting as a limited partner, individual interests--for example 25 percent of the total 100 percent interest--could be transferred to each of the Smart descendants. The following chart illustrates the possible tax benefits attributable to the establishment of a FLP.

Direct TransferFLP Transfer Total Market Value of Real Estate$10,000,000$10,000,000 Market Value of the Asset Transferred to the Descendent: Assume 25%$2,500,000$2,500,000 Less, Discount for Lack of Marketability: Assume 35% $0$875,000 Taxable Basis$2,500,000$1,625,000

As shown by the illustration, the taxable basis is substantially lower under the FLP scenario, which will result in substantial tax savings.

Suzanne Heidelberger is a member of the E&Y Kenneth Leventhal Real Estate Group, New York, NY, (212) 773-3743.