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Relational Family Limited
by: James Lange, CPA, Esq.
A Family Limited Partnership (FLP) is a particularly attractive estate-planning tool for unmarried or same sex couples. Many of the techniques that estate-planners use for "estate tax and probate avoidance" when working with traditional married couples are not available or not beneficial for unmarried or same sex couples. For instance, the marital deduction allows unlimited assets to be transferred between spouses with no tax liability. Because current U.S. tax law favors traditional married couples, it is essential for unmarried and same sex couples to take advantage of every possible means of reducing their estate taxes.
The FLP is an enormously successful device to transfer wealth while escaping estate tax on the post-transfer appreciation of the property, and while also allowing the donor to retain control over the property. (Although the form is known as the Family Limited Partnership, there is no requirement that the partners be family members.)
Simply because the FLP proved to be such a popular and successful device, in 1990 Congress sought to discourage its use to transfer wealth between family members by making it more difficult to take discounts (explained below) when property is given to family members. However, these rules don’t apply to the unmarried or same sex couple. Depending on the particular type of transfer, the Internal Revenue Code defines “family” as including: a spouse, the descendants of the donor and of the spouse, grandparents, brothers and sisters, nieces and nephews -- but not your life’s partner, and not your life’s partner’s children.
You and your life’s partner have no legal relation that the IRS recognizes. You and your partner can take advantage of the full range of discounting techniques available. The law can’t have it both ways. Either you’re married—or you’re not. If you’re married, you can take advantage of the unlimited marital deduction and other tax advantages Congress provides to traditional married couples. If you’re not, then the family attribution rules don’t apply to you. FLPs work for unmarried couples by taking advantage of valuation freezes and discounting techniques in ways that traditional families can’t. Because of this, the family limited partnership entity is one that unmarried or same sex couples should consider as a way to transfer wealth.
In its simplest terms, the donor contributes assets to a partnership in exchange for both general and limited partnership interests. General partners have virtually all the power and determine what happens to the assets in the partnership. Limited partners, while enjoying an ownership interest, have few rights or power. Typically, the bulk of the initial capital contribution is assigned to the limited partnership interests. For example, the partnership agreement might assign 10% of the initial capital contribution to the general partnership interests and the remaining 90% to the limited partnership interests. The donor then gifts the limited partnership interests to his life’s partner, their children, or other beneficiaries (or to trusts for their benefit) while retaining the general partnership interest. The circumstances will dictate whether the general partner will immediately gift all or a large block of the limited partnership interests or whether the general partner will retain majority ownership of the limited as well as all the general partnership interests. The gifts are not cash or the assets themselves, but rather limited partnership units, analogous to non-voting shares of a closely held corporation.
Family Limited Partnerships Reduce the Value of the Transferred Assets
A family limited partnership permits the donor to significantly discount the value of gifts to the donee that might not be discountable if made outright. Valuation experts generally discount the value of limited partnerships—the sum of the parts does not equal the whole. For example, let’s assume a donor creates a FLP with $266,667 worth of assets. The general partner holds a 10% general partnership interest and the other 90% interest is held in limited partnership interests. The donor then makes a 10% limited partnership interest gift to three beneficiaries: his life’s partner, his nephew, and his sister. What is a 10% limited partnership share worth to each beneficiary?
You might assume that the 10% limited partnership interest would equal 10% of $266,667 or $26,667. However, most valuation experts will estimate the value of limited partnership interests at a maximum of $20,000 and in some cases, depending on the terms of the partnership and the nature of the underlying assets, at $13,000 or lower.
The beneficiaries, as limited partners, can’t vote on how the partnership is run or when it will terminate. They can’t use the funds or assets in the partnership, and the partnership agreement will typically limit their ability to sell or transfer their interests. They can’t get distributions unless the general partners approve. They can’t even use the partnership interest as collateral on a loan.
The focus of an eight-hour course that I teach for the American Institute of Certified Public Accountants is how to value the gifts of the limited partnership interests. Needless to say the IRS as well as the Clinton Administration hates FLPs. Too bad! The government has been getting clobbered in tax court, especially if the donor was not too greedy and did not attempt a discount of over 25%.
A Family Limited Partnership with Non-Business Property is Riskier, but Still Probably Sound
Tax advisors prefer putting in some type of business property in a FLP to help support the rational for the discounts and to attempt to show a business purpose for the transaction. As recently as two years ago, I never recommended that my clients put only cash and securities in a FLP. I thought the IRS would be able to successfully challenge the partnership and disallow the discounts. I knew there were other advisors taking those chances, but I thought it was too aggressive.
Now, I have changed my tune. Though I prefer using business assets or even business assets combined with cash and securities to fund a FLP, I am now willing to fund a FLP with just cash and securities. The reason for my change of heart is that taxpayers are doing so well in tax court. I will spare you a summary of the case law, but suffice to say the taxpayers have been doing quite well. The word on the street is that if the discount is 25% or less, the IRS doesn’t even attempt to challenge the partnership or the valuation of the gift. At the Heckerling Institute on Estate Planning in Miami, speaker after speaker hammered home two points:
We now have another weapon to defeat the IRS. Congress has finally passed a law that creates a statute of limitation for gift tax valuations. Let’s assume the donor files the appropriate gift tax returns. If the IRS doesn’t audit the gift tax return within three years of the due date of the filing of the return, the gift tax return is deemed accepted. The IRS has little motivation to audit a gift tax return showing $20,000 gifts, even if the gift represents a proportionate share of assets worth $26,667 or more. The FLP, even funded strictly with cash and securities, assuming a discount of 25%, is no longer a high risk venture but an excellent strategy for many individuals to leverage their gifts to their children.
Furthermore, we do not have to limit gifts to $10,000. Let’s assume a single individual is worth $3,000,000 and wants to gift away his unified credit shelter amount in the current year. He could just give his life’s partner $675,000 in year one and by using his unified credit shelter amount, he does not have to pay any gift tax. Alternatively, he could create a FLP with $1,000,000 and make a gift of a 90% limited partnership interest to his life’s partner. He could then file a gift tax return showing a $675,000 gift ($1,000,000 times 90% = $900,000 less a 25% discount of $225,000 = $675,000) (25% is a conservative discount). In effect, he is able to get an extra $225,000 out of his estate in one year.
Another strategy is to fund the partnership with well over $1,000,000 and continue making leveraged annual gifts that qualify for the annual exclusion in future years. Then, and this is one of my favorite techniques that works as a “safety play,” make a gift of one or two unified credit shelter amounts and file a gift tax return showing a 30% discount. For example, assume a gift of $675,000 and file a gift tax return showing a gift of $472,500 ($675,000 – $202,500 i.e., 30%). Even if the gift tax return is audited and the IRS wins and determines there is no discount (extremely unlikely), the IRS doesn’t walk away with a check. They only walk away with a smaller unused unified credit shelter amount for the taxpayer. As such, the IRS doesn’t have much motivation for auditing the return because there is no opportunity for them to walk away with a client’s tax deficiency check. With the desperate manpower crunch the IRS is experiencing, they are unlikely to use their resources for anything that does not promise immediate gain.
As time goes on and the exclusion amount increases, make additional gifts. Also continue using the annual $10,000 exclusions. In many cases, I prefer the FLP to other methods of leveraged gifting such as second to die irrevocable life insurance trusts or grantor retained annuity trusts. Of course if you really want to have some fun, you can combine several of these leveraged gift techniques to enormously reduce estate taxes in the future. I have seen grantor retained annuity trusts inside partnerships.
A Family Limited Partnership Permits Gifts While Retaining Control Over the Transferred Assets
The general partner(s) in a family limited partnership have exclusive control over, and management of, the partnership assets. The limited partners, on the other hand, are entitled to a proportionate part of the income distributed by the partnership, if any, and to their proportionate share of the partnership assets upon termination of the partnership, but they have no right to control and manage the partnership assets.
Because the general partner has exclusive management and investment control over the partnership assets, a client may reduce his taxable estate by making gifts of the limited partnership interests while maintaining control over the underlying assets by virtue of retaining the general partnership interest. Such control includes the power to invest and reinvest partnership assets. More importantly, it includes the power to control the timing and amount of distributions, as a general partner is under no obligation to distribute partnership income.
Moreover, the general partner (together with the limited partners) may retain the right to amend the partnership agreement without causing the partnership assets to be included in the general partner's gross estate. In contrast, if the grantor of a trust retains the right to amend the trust, the trust property would usually be included in the grantor’s gross estate.
Family Limited Partnerships Protect Family Assets from Creditors
Another advantage of the family limited partnership is that it is difficult for creditors of the limited partners to reach the underlying partnership assets. This is significant for people who want to transfer assets out of their estates but are concerned that their beneficiaries might be sued or that the assets might be transferred to an ex-spouse in the event of a divorce.
Income Tax Implications
A limited partnership, assuming it is properly drafted and executed, is a pass-through entity and partnership income and deductions are attributed directly to the partners. Since a proportional share of the partnership's income will pass through and be taxed at the limited partners' rates, the family limited partnership can shift income from the general partner’s high rate to beneficiaries in lower tax brackets. This is true even if there are no actual distributions to the beneficiaries. As the partnership grows, presumably outside of your estate, there are usually income tax implications for the limited partners. The limited partners could end up in a situation where they have taxable income generated from the partnership K-1 and no money to pay the tax on their share of the partnership income. In that case it is customary for the partnership to distribute enough money to pay the tax on the attributed income. For example, a K-1 indicates taxable income of $5,000. The limited partner is in a combined federal and state income tax bracket of 30%. The partnership should make a distribution for $1,500 so the limited partner can pay the tax bill attributed to the partnership
Disadvantages of a Family Limited Partnership
FLPs are complicated and muck up what might otherwise have been a simple estate plan. FLPs typically result in fees between $2,000-$10,000 to set up. Also, every speaker at the Heckerling Institute who addressed the issue advised getting a business valuation of the gifted partnership interests. Our firm does not draft FLPs, but the business valuation side of our CPA firm, does value family limited partnerships and FLP interests.
There are annual expenses for maintaining the partnership, there could be both legal and tax preparation fees and the tax returns for the partners will become more complicated. In addition, depending on the asset being transferred, there may be transfer taxes transferring the asset from the general partners to the FLP.
Perhaps the most significant disadvantage of the FLP is that there will be no step-up in basis for the assets in the partnership at the death of the general partner. If the assets have a low cost basis, the owner is giving away the potential step-up in basis at the owner’s death. For example, assume that an older frail client, Bill, is looking for ways to reduce estate taxes and you bring up the idea of a FLP. The assets available for transfer to the FLP are a fully depreciated building and highly appreciated securities. Upon your advice, Bill transfers the assets to the FLP. He pays the transfer tax for the building while he is alive. Bill survives long enough to see the unified credit shelter amount raised by Congress to an amount in excess of the value of his estate, so forming a partnership ultimately offered no advantages. Bill then dies. Bill’s heirs must take Bill’s original basis for both the building and the securities.
If Bill had done nothing, he would have saved the transfer tax while he was alive as well as passed on his assets with a full step-up in basis. Not only would the full step-up in basis be handy upon the sale of securities, but also if the heirs choose to keep rather than sell the building after Bill’s death, they could start depreciating it at the fair market value on the date of Bill’s death.
If you pursue a FLP, it is critical that it is properly set up and properly maintained. The April 1999 issue of The Tax Adviser, the peer reviewed CPA tax journal where I published my article on Roth IRAs, warns of a multitude of FLP traps. The article concludes with “…by avoiding these tax traps, …taxpayers can reduce the likelihood of an IRS challenge while accomplishing the objective of significantly lowering their tax burdens.”
I rarely recommend a FLP if the value of the underlying assets is less than $150,000. The costs are too high compared to the benefits.
In summary, FLPs are an excellent technique for many wealthy individuals if the donor:
wants leverage for significant current and/or future gifts,
wants control of the gifted assets after the gift is made,
wants flexibility to adapt to changes in the future,
wants protection of the gift from creditors,
can find the appropriate law firm to draft and help implement the FLP,
is willing to incur business valuation fees,
is willing to pay the set-up and maintenance costs,
will listen to the attorney setting up the FLP to avoid all the tax traps, and
has taken into account the cost of any transfer taxes or loss of step up in basis.
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