Family Limited Partnerships - Legitimate Tax Planning is Approved
In this article, we hope to provide you with a brief introduction to the concept of the family limited partnership (FLP). We will discuss the possible benefits of creating an FLP, the logistics of forming and operating it, and the current tax considerations if you choose to use it as part of your estate planning. An FLP can be a very useful business and tax planning tool, but it is not for everyone. Careful consideration must be given to your investments and circumstances to determine if it is something you should pursue.
Purpose of a Family Limited Partnership
The use of an FLP is a very efficient way to (i) create a business relationship with your children, grandchildren, or other persons (collectively referred to as your beneficiaries), (ii) consolidate management and supervision over your assets, (ii) protect your assets from claims of future creditors, (iii) pool your assets with the assets of your beneficiaries for increased business investment opportunities, (iv) limit the liability of limited partners for partnership debts, (v) provide flexibility in business planning, and (vi) provide a seamless transition of your business investments to your beneficiaries upon your death. In addition to these objectives, the use of an FLP is also an effective way to reduce estate, gift, and generation-skipping transfer taxes on the transfer of your investments during life or at death. Instead of transferring your assets to your beneficiaries directly, you will transfer your limited partnership interests. If the FLP is formed, structured, and operated properly, the value of these partnership interests is likely to be discounted for lack of marketability (because you can not sell your interest freely) and lack of control (because limited partners have no control over management).
Formation and Operation of a Family Limited Partnership
Formation of Limited Liability Company. An FLP is a limited partnership composed of one general partner and one or more limited partners. Generally, either a limited liability company (LLC) or an S corporation serves as the sole general partner of the FLP, typically with a one-percent general partnership interest. We usually recommend the use of an LLC rather than an S corporation to serve as the general partner because it is more flexible. Even though the general partner entity only owns one percent of the FLP, the general partner has sole and exclusive control over 100 percent of the partnership investments and distribution decisions. Just as in the case of the FLP, the LLC will be a flow-through entity for income tax purposes.
Formation of Family Limited Partnership. After the LLC is formed and capitalized, the FLP is created by the LLC and the individuals (or entities or trusts) who will be the limited partners of the FLP. You may own the entire 99 percent limited partnership interest at the beginning or beneficiaries who also contribute assets may own percentage interests at the outset. We recommend that one or more of your beneficiaries own more than 50 percent of the LLC, which means that they must contribute some capital in exchange for this interest. You may always gift or lend this amount to them.
Operation of a Family Limited Partnership. One of your beneficiaries should be the manager of the LLC. If you are the manager you will be treated as having complete control of the assets of the limited partnership for tax purposes, and thus not entitled to a transfer tax discount on valuation. The manager will make all general partner decisions. You will not have the power to remove the manager of the LLC except in extreme circumstances, such as gross negligence, certain felony convictions, fraud or a breach of a material fiduciary obligation. As a limited partner, you will have no rights or voice in the management of the FLP. Unless the partnership agreement provides otherwise, limited partners have no fixed rights to distributions from the FLP during its term of existence, even though they are always currently taxable on their pro rata share of the FLP’s income and gains.
The LLC alone decides when and if distributions will be made, and in what amounts, provided only that all partners must be treated fairly. The partnership agreement will provide that all distributions must be pro rata among partners. The manager of the LLC will make decisions regarding distributions. As a general guideline, only excess cash flow that is not otherwise needed for business purposes should be distributed. Additionally, distributions should be made only in cash and not in property.
Going forward, all formalities of the FLP’s operations must be respected. This includes maintaining minutes and formulating written business strategies. It will also be essential that you not mingle your personal assets with the assets of the FLP and that you do not use the FLP’s assets for personal expenses.
Transfer of Assets to a Family Limited Partnership. Title to the assets you intend to transfer to the FLP must be actually transferred to the partnership. The value of the assets you contribute to the FLP in exchange for your limited partnership interest must be exactly equal to your proportional share of all of the FLP’s assets, i.e., if you receive a 99-percent limited partnership interest, you must contribute 99 percent of the FLP’s asset value. You are not permitted to transfer assets that exceed your proportionate share of the FLP’s assets, i.e., if you receive a 99-percent limited partnership interest, you may not contribute 100% of the FLP’s asset value. You should contribute to the FLP only those assets that you do not need for ongoing personal use or maintenance. We suggest that your accountant prepare a cash flow analysis to determine how much money you will need each year for personal expenses so that you can determine how much should be held outside the FLP for your personal maintenance.
Tax and Estate Planning Considerations
The federal tax system imposes a tax on the transfer of wealth from one individual to another, whether that transfer be by gift or at death. Gift, estate, and generation-skipping transfer taxes (transfer taxes) significantly reduce the amount of value that an individual can pass to his or her children and grandchildren.
The estate and generation-skipping transfer taxes are scheduled to end for transfers occurring in 2010. However, unless Congress makes a further amendment to the tax laws, both the estate and generation-skipping transfer taxes will spring back into existence in 2011. In any event, the gift tax will remain in effect. Gift tax is imposed on the value of any gift to any individual other than a spouse to the extent the gift exceeds the annual exclusion amount per year, per donee, provided that the gift tax credit exempts the first $1 million of transfers. The annual exclusion amount for 2004 is $11,000 and will increase periodically for inflation. The estate tax is imposed on the value of assets transferred to a non-spouse at death to the extent the assets exceed the estate tax exclusion amount ($1.5 million in 2004-2005, $2 million in 2006-2008, and $3.5 million in 2009).
For illustration purposes, suppose you die in 2004 owning assets worth $6,000,000, and you wish to give everything to your children. Taking into account the $1.5 million estate tax exclusion for 2004, your estate will owe estate tax on the value of the remaining $4.5 million. Under the estate tax rates in effect in 2004, your estate tax liability would be equal to $2,145,000 leaving only $3,855,000 for your children.
Tax Valuation. The use of an FLP is an effective way to reduce estate, gift and generation-skipping transfer taxes on the transfer of your investments to your beneficiaries. Instead of transferring your assets, you will transfer your limited partnership interests. The value of these partnership interests is discounted for lack of marketability and lack of control because the rights of limited partners in an FLP are extremely limited. As a matter of thumb, these discounts can range from 25 percent to 45 percent off the underlying values of the assets held inside the partnership. In certain circumstances, the discount may be as high as 50 percent. When making lifetime gifts of limited partnership interests, or when valuing them for estate tax purposes upon death, it is imperative to obtain a comprehensive appraisal from a competent and respected firm, such as an accounting firm or a company generally engaged in the business of evaluating partnership interests. In some situations, appraisals by two different firms are advisable to bolster the discounts being taken in the event of an audit by the IRS.
It is important to note that a person who creates an FLP with no real business purpose or non-tax motive and who does not conduct the affairs of the partnership as a business, may be denied the tax benefits of the discounted value. The IRS will not respect a discounted valuation on a partnership interest when the partnership is nothing but a sham. The IRS has for several years challenged both (i) the valuation discounts asserted by taxpayers and (ii) in some extreme cases the existence of the partnership. Until recently, the IRS had limited success, but it has succeeded in challenging the existence of partnerships in some cases with particularly unfortunate facts. In those cases, the partnerships involved family members and were not operated with all of the formalities that unrelated partners would require.
Despite these successful attacks by the IRS, taxpayers enjoyed a significant victory in Kimbell v. U.S., 371 F.3d 257 (5th Cir. 2004), a May 2004 opinion by the U.S. Court of Appeals for the Fifth Circuit. This case essentially set forth the guidelines for determining whether an FLP is respected for tax purposes, and thus eligible for a discounted valuation. The court, while acknowledging that interfamily transfers are subject to heightened scrutiny, held that the transfer to an FLP (and the associated valuation discount) will be respected if the transfer is made in good faith. Good faith does not exist in the context of a sham transaction that is motivated solely by tax avoidance. Transactions that are simply the result of paperwork and a recycling of value will fail the good faith standard. While this case is a victory for taxpayers because it establishes that interests in FLPs can be successfully discounted, it is also a cautionary tale that FLPs should not be used outside the context of a true business purpose and without the commitment to operate the FLP with all of the formalities and management that would be present in an arm’s length situation. For example, you cannot commingle your assets with the partnership assets, you must set out a business strategy, and you should establish and maintain a sound management structure for the partnership.
Transfers of Family Limited Partnership Interests at Death. Transferring your interests in an FLP, rather than transferring your assets directly, may result in a lower estate tax burden at your death. Using the same facts from the example above, if $5 million of your $6 million in assets were held in an FLP, your estate tax liability may be significantly reduced. The value of your gross estate would be (i) $1 million (the assets held outside of the partnership) plus (ii) $3,465,000 (the value of a 99-percent limited partnership interest, with an assumed 30-percent minimum discount) plus (iii) $17,150 (the value of a 49-percent membership interest in the LLC that is the general partner, with an assumed 30-percent minimum discount). The total value of the assets transferred to your children for estate tax purposes would be $4,482,150 (compared to $6 million when the FLP was not used). After applying the $1.5 million estate tax exclusion, only $2,982,150 will be subject to estate tax (compared to $4.5 million without the FLP). The tax on this amount will be equal to $1,416,432 a savings of $728,568 from the tax that would be due without the FLP ($2,145,000). The higher the valuation discount, the lower the tax burden.
Gifts of Family Limited Partnership Interests. If you simply transfer your assets into an FLP, and do not make any gifts of any limited partnership interests during your lifetime, that alone should result in a significant savings in estate taxes at death (over $700,000 in the example above) because of the valuation discounts that may apply to the limited partnership interests. However, to maximize gift and estate tax savings, you should transfer limited partnership interests during your life.
After formation of the FLP, you could begin making gifts of limited partnership interests to your beneficiaries, directly or in trust. Making annual exclusion gifts ($11,000 per year, per donee in 2004) of limited partnership interests that are discounted because of their lack of marketability and lack of control allows a larger slice of the underlying asset values to be given than if the gifts were made in cash. For example, if the valuation discount is 30 percent, partnership interests that would have a liquidation value of $15,714 can be given to each of your beneficiaries and reported for gift tax purposes at a gift tax exempt value of only $11,000 (because of the 30-percent valuation discount). If you gifted limited partnership interests worth $11,000 to each of your beneficiaries each year for the next 15 years (total gifts of $165,000), you would transfer $235,710 of liquidation value to each such beneficiary free of gift tax.
If you wish to give your beneficiaries a larger partnership interest than what is permitted to be given tax free under the annual exclusion, you can use some or all of your lifetime gift tax credit ($1 million) to make gifts without incurring a gift tax. For example, if you still have your full $1 million gift tax credit available, and if the valuation discount is 30 percent, partnership interests that would have a liquidation value of $1,428,571 can be given free of gift tax (because of the assumed 30-percent minimum discount).
Sale of Limited Partnership Interests. The next level up in terms of sophistication in estate planning would be for you to sell some limited partnership interests to an irrevocable trust created for your beneficiaries. This does not necessarily require you to make taxable gifts or use any part of your $1 million gift tax exemption. A discussion of this technique is beyond the scope of this article, but it is something you may want to consider if you wish to maximize the tax savings leverage provided by an FLP.
We recognize that these concepts are sophisticated, tax-favored plans. If you believe an FLP is something that you could benefit from, we would be happy to provide additional information to you. When properly planned, implemented and operated, an FLP is a legitimate business vehicle for the management of family wealth and is not an abusive tax avoidance transaction.