Fundamentals of Family Limited Partnerships
July 15, 2003
Alvin Geske - Washington
A family limited partnership (FLP) is a limited partnership
composed of a general partner and limited partners. The general partner, who
has the power to make virtually all decisions on behalf of the partnership, is
generally an entity (an S corporation or limited liability company (LLC))
controlled by family members. The general partner ordinarily has a very small
percentage interest in the partnership (usually one percent). The initial
limited partners are the members of the older generation, who have a very large
percentage interest in the partnership (usually 99 percent). Under the
partnership agreement, the limited partners have no rights to participate in the
day-to-day management of the partnership. The partners contribute investment
assets, and profits and losses are allocated pro-rata to the partners. The
limited partners may, and frequently do, make gifts of limited partnership
interests to the younger generation during their lifetimes.
Tax Advantages
The principal tax advantage is a valuation discount,
usually of from 30 to 48 percent on the value of the transfer subject to tax.
Discounts may exceed 50 percent in appropriate circumstances, but there is
penalty exposure if such a discount is completely disallowed. The transfer tax
savings is generally a highly important reason for a client to utilize a limited
partnership. The discount is generally greater for real estate and less for
publicly traded securities. It is also generally greater when the property does
not produce cash flow.
Valuation Discount. The valuation discount arises
because non-controlling ownership interests in business or investment entities
are not valued at the value of a proportionate interest in the underlying assets
(net asset value). Recognized valuation methodology provides that such
interests are entitled to discounts for lack of marketability and control.
These discounts recognize the economic realities that such interests cannot be
sold for net asset value because they are not marketable — that is, they cannot
be readily sold like shares of stock in a publicly traded corporation — and they
do not permit the transferee to exercise control over the activities of the
business or investment entity, thus resulting in the owners’ subjection to the
discretion and business judgment of another party both for operating results
and the timing of distributions (if any).
Trying to quantify the expected tax savings involves
determining when property is likely to be sold as well as determining effective
transfer tax and income tax rates. In general, the transfer tax savings must be
offset against the present value (as of the time the transfer tax would have
been paid) of the income tax cost resulting from the reduced basis step-up
(which applies only if the estate tax applies because the limited partnership
interest is included in the decedent’s estate). If property is expected to be
retained in the family for many years, the income tax offset can be ignored.
Also, when the property is sold there will be cash proceeds to pay the tax,
which is not the case with the transfer tax.
Example 1. Taxpayer owns raw land worth $5
million with a zero basis that will be sold five years after the taxpayer’s
death. The discount is assumed to be 50 percent. The estate/gift-tax rate is
49 percent. The combined federal and state income tax rate on the sale is
estimated to be 25 percent. The estate tax savings will be roughly $1,225,000
[49 percent of $2,500,000]. The loss of a full basis step-up will mean that the
capital gains taxes on sale would be $625,000 [25 percent of $2,500,000]
greater, but that figure would have to be reduced to the present value as of the
due date of the tax return to reflect that the tax has been deferred by about
five years. Stated another way, the savings would be $600,000, plus the time
value of having $625,000 for five years. Even at an assumed‑discount rate of
four percent this deferral is worth about $111,000.
Example 2. Taxpayer owns publicly traded stock
worth $5 million with a zero basis that will be sold five years after the
taxpayer’s death. The discount is assumed to be 40 percent. The
estate/gift-tax rate is 49 percent. The combined federal and state income-tax
rate on the sale is estimated to be 20 percent. The estate tax savings will be
roughly $980,000 [49 percent of $2,000,000]. The loss of a full basis step-up
will mean that the capital gains taxes on sale would be $400,000 [20 percent of
$2,000,000] greater, but that figure would have to be reduced to the present
value as of the due date of the tax return to reflect that the tax has been
deferred by about five years. Stated another way, the savings would be
$580,000, plus the time value of having $400,000 for five years. Even at an
assumed discount rate of four percent, this deferral is worth about $72,000.
Example 3. The facts are the same as Example 2
except there are two separate blocks of stock – Stock A, with a basis of
$2,500,000 and a fair market value of 2,500,000 and Stock B, with a basis of
zero and a fair market value of $2,500,000. For simplicity, it is assumed that
decedent retained a 90-percent limited partnership interest at death, with
respect to which the net asset value in the partnership was $4,500,000. As a
result of the 40-percent valuation discount, the interest is included in
decedent’s estate at a value of $2,700,000. The donor’s spouse receives a
45-percent interest in the limited partnership and the other 45 percent is left
to decedent’s children. Stock B is distributed to the spouse in liquidation of
the spouse’s partnership interest within two years of the transfer of the
interest to the spouse. The adjustment should increase the basis in Stock B to
$1,350,000 – the basis is the spouse’s inherited partnership interest under
Section 732(d) of the Internal Revenue Code. Note that this is better than an
election under Section 754, which would result in a basis step-up of only
$450,000 [$2,700,000 – 2,250,000 (2,500,000 x 90%)].
Example 4. Taxpayer owns a family business
corporation worth $5 million with a zero basis that will be not be sold for
many years. The discount obtained by placing the corporate stock in a family
limited partnership is assumed to be 50 percent. The estate/gift-tax rate is 49
percent. In this situation, the potential income tax offset can be ignored.
The estate/gift tax savings will be roughly $1,225,000 [49% x $2,500,000].
Non-Tax Advantages
The non-tax reasons to form a family limited partnership
include:
-
Transfer a group of assets into a form of ownership that
is simpler to transfer (to facilitate annual and other gift-giving programs).
-
Centralize management and obtain the benefit of
continuity of management over the partnership’s assets.
-
Provide protection to partnership assets from claims of
future creditors of the limited partners and to limit the limited partners’
liabilities for partnership debts.
-
Provide unified control (through the general partner)
over distributions of cash derived from earnings on the partnership’s assets.
-
Provide flexibility in business planning not available
through trusts, corporations or other business entities.
-
Conduct investment and business activities in an entity
that is not itself subject to federal or state income taxes.
-
Avoid the delay, publicity, inconvenience and expense
associated with probate administration of multiple separate investments of the
partners upon their respective deaths or liquidation.
Disadvantages
-
Locks assets in the partnership for a period of time,
generally not ending until the expiration of the statute of limitations for
the last year during which transfers were made.
-
Records must be kept, and annual tax returns must be
filed, for the partnership and the corporate or LLC general partner.
Appraisals must be made to establish the value of the gifted limited
partnership interest. The investment in legal, accounting and appraisal fees
for formation and administration of a FLP are significant, but the savings
achieved often exceed costs by a multiple of 20 or more.
-
Use of FLP clearly enhances the chance of gift or estate
tax return being examined, and perhaps contested in court. Many “traps for
the unwary” if partnership form is not respected.
-
Could create or increase liquidity problems of estate by
locking up assets that could otherwise be used to pay estate tax.
-
Could be problems if highly leveraged real estate is
being transferred to the partnership.
-
Could be income tax problems if property is distributed
to donees within seven years of contribution (see disguised sales rules of
Sections 731(c) and 737 of Internal Revenue Code).
For Whom Is this a Good Strategy?
-
Estate of at least $2.0 million for single individuals
and $3.0 million for married couples.
-
Generally requires ability to put at least $1.5 million
of securities or “non-personal use” real estate in a partnership and be
supported by non-partnership assets. There are situations in which personal
use property may be used effectively, but donor must not be put in a situation
where he or she must rely on invasion of partnership principal for support.
-
Donor must have a toleration for complexity of
maintaining assets of partnership separate from personal assets and for filing
separate tax returns for partnership and corporate or LLC general partner.
-
Usually works best with marketable securities or real
estate, although limited partnerships have been used successfully to hold
interest in closely held businesses, personal use property, or certain types
of tangible personal property (e.g., horses or cattle).
-
For greater estate tax savings, donor must not control
general partner at the time of death.
Comparison with other Estate Planning Techniques Like
Gifts or Family Sales
There is no requirement of surviving a particular period to
obtain benefits (as long as it is not a true “deathbed” transfer). Also, there
is an immediate reduction in the value of property, which will apply to lifetime
transfers and death time transfers.
The benefits do not require interest rate plays or that
property appreciate at a greater rate than an assumed interest rate.
Although FLP issues have been litigated frequently and
taxpayers win these decisions far more often than not, the availability of
benefits is less secure than benefits with specific statutory sanction, such as
Grantor Retained Annuity Trusts (GRATs).
When compared with use of undivided fractional interests in
real property, the advantages are often as follows: (1) the discounts generally
are higher (especially in cases where the property yields current income); and
(2) the FLP is much easier to use for periodic transfers because interests are
more easily assigned. A disadvantage of the FLP is that the undivided property
approach may make it somewhat easier to avoid IRS challenges to the structure of
the transaction. The IRS could still argue that there was no transfer in
substance if the donor retained all of the income from the property, even though
valuation of the interests may create a dispute.
Special Considerations
Gift on Formation. The IRS may argue that
diminution in value on formation of partnership results in an immediate gift.
So far this argument has been unsuccessful where documents are properly done.
Exposure is greatest where other parties control general partner at formation.
Qualification for Annual Exclusion. Gifts of
limited partnership interests qualify for the $11,000 per donee annual exclusion
only if they are gifts of present interests. If the recipients have no rights
to transfer the interests or to receive distributions, the gifted interests may
not qualify.
Retained Control Pulls Back Gifted Interests into
Donor’s Estate. Code Section 2036(a) generally requires inclusion in the
decedent’s estate of property transferred during lifetime if he retained
sufficient control over the gifted property. The IRS has argued, with some
degree of success that this provision applies when the decedent controlled the
general partner or had the power to remove the general partner and the general
partner’s power over distribution and transfers of interests are sufficient to
conclude that the interests were not completely transferred.
For more information, contact Alvin J. Geske via e-mail
at alvin.geske@hklaw.com or call toll free 1-888-688-8500.
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