Family Limited Partnership: An Attractive Estate Planning Tool

Family Limited Partnership: An Attractive Estate Planning Tool
by:James Lange, CPA and Steven T. Kohman ,CPA, CSEP, CSRP

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Family Limited Partnerships (FLPs) serve as an attractive estate-planning tool for wealthy individuals. FLPs are best suited for clients who can justify forming an FLP for business reasons and who want to make significant gifts to family members. FLPs allow the donor to retain substantial control over the gifted assets and protect the gifts from potential claims of the donee's creditors.

The Concept

In its simplest terms, the client 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 powers. 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 client then gifts the limited partnership interests to his children or grandchildren (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 partnership interests 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.

A Family Limited Partnership Permits Gifts while Retaining Control of the Transferred Assets

The general partners 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/or manage the partnership assets. This lack of rights causes the value of limited partnership units to be less than the general partnership units.

In most cases, the children, as limited partners, can not

  • vote on how the partnership is run or when it will terminate.,
  • use the funds or assets in the partnership, and typically the partnership agreement will limit their ability to sell or transfer their interests.
  • get distributions unless the general partners approve.
  • use the partnership interest as collateral on a loan.

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. The control includes the power to invest and reinvest partnership assets, but more significantly, 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.

Discounting the Value of Gifts through Family Limited Partnerships

A family limited partnership permits the donor/parent to significantly discount the value of gifts to the donee/children, thus making it possible to save fortunes in gift and estate taxes. A gift of similar value might not be discountable if made outright. Valuation experts generally discount the value of limited partnership interests to reflect the reduced value associated with their limited rights and controls.

For example, let’s assume husband and wife donors create a FLP with $320,000 worth of assets. The general partners (husband and wife) hold a 10% general partnership interest and the other 90% interest is held in limited partnership interests. The parents then make a 10% limited partnership interest gift to each of their three children. What is a 10% limited partnership share worth to each child?

You might assume that the 10% limited partnership interest would equal 10% of $320,000 or $32,000. However, most valuation experts will estimate the value of limited partnership interests at a maximum of $24,000 (reflecting a 25% discount) and in some cases, depending on the terms of the partnership and the nature of the underlying assets, at $16,000 or lower (reflecting a 50% or greater discount).

Some FLP valuators assign a discount from the net asset value of the underlying securities, as is reflected in the prices of some closed-end mutual funds and real estate investment trusts.  The discount is increased for higher levels of risk when the underlying assets warrant it. For instance, for cash and treasury bills, a small discount may be appropriate; slightly higher for corporate bonds and publicly traded large capitalization equity securities, higher discounts for small capitalization stocks, and up to 25% to 45% discounts for real property. For investments in foreign securities, the discounts vary but can be quite large, as indicated in various closed-end mutual funds. For closely held business interests, the discounts can also be quite large in terms of percentages, depending on the size of the interest, the nature of the business, and the marketability of its stock.

There are two types of discounts frequently associated with family limited partnerships as well as valuations of many business interests.

  1. The discount for lack of control.  In a family limited partnership the limited partners have virtually no control over the operations of the partnership or the distributions.  Since investors prefer having some control, an investment like a limited partnership interest would be less attractive and therefore would need to be sold at a lower price or a discounted price before an investor would purchase the units.
  2. The discount for lack of marketability. The second discount reflects the problem of attempting to sell the limited partnership interest on the open market. There are a slew of studies that quantify the reduced value of an investment if there are restrictions on selling the investment. The restricted stock studies show that limitations on publicly traded stock reduce the value of the stock on the open market. Attempting to sell a privately held interest, particularly with a lot of restrictions, poses an even greater difficulty than selling a publicly traded security with restrictions.

Technically the two discounts should be applied one after the other rather than being summed and applied to the partnership interest. Most attorneys, valuation experts, and the courts do not understand this concept.

Example:
Assume that the total assets in the partnership are $1million and that the valuation expert is assessing a 1% limited partnership interest.

The valuation expert determines that for this investment there should be a 25% discount for lack of control and a 25% discount for lack of marketability. The proper way to value the interest is as follows:

$10,000 per unit before discount (1% times $1,000,000)

Less 25% (lack of control discount) = $7,500

Less 25% (lack of marketability discount) = $5,625 per unit.

Throughout this article and in real practice, the reference is made to a combined discount.  But, according to Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs in their book, Valuing A Business:  The Analysis and Appraisal of Closely Held Companies, Third Edition, (Irwin Professional Publishing), the combined discount should be calculated according to the above methodology.

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 parents who want to transfer assets to their children but are concerned a child might be sued or that a child's spouse might obtain such assets in the event of a divorce.

FLPs can also provide creditor protection for founding partners. For example, physicians, who in the course of their daily work face liability, may consider forming a FLP not with the idea of making gifts but with the idea of limiting their exposure to a lawsuit.

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 parents’ high rate to the lower income tax rates of the children. This is true even if there are no actual distributions to the children. 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.

A Family Limited Partnership with Non-Business Property is Riskier, but Still Probably Sound

The IRS hates FLPs. Too bad! The government has been getting clobbered in tax court when it has challenged the discounts in FLP interest transfers. This is especially true if the donor’s FLP was set up for the correct reasons and supported by a well-prepared valuation report that was not too greedy and did not attempt a discount of over 25%.

In order to successfully win an IRS challenge of the discounts, the FLP must have a legitimate business purpose. Avoiding gift or estate tax is insufficient justification. Therefore, most tax advisors prefer putting some type of business property in a FLP to demonstrate the business purposes for the partnership and to support the rationale for the discounts. Many advisors never recommended that clients put only cash and securities in a FLP. The thinking is that the IRS may be able to successfully challenge the partnership’s purpose and disallow the discounts. However, there are other advisors taking those chances.

Though I prefer using business assets or even business assets combined with cash and securities to fund a FLP, funding a FLP with just cash and securities is often done. Upon challenge by the IRS, clients make out well in tax court if the documents are properly executed and used.  A rule of thumb is that if the discount is 25% or less, the IRS rarely challenges the partnership or the valuation of the gift. During a conference at the annual Philip E. Heckerling Institute on Estate Planning speaker after speaker hammered home two points:

  1. Many good business reasons exist for creating and funding family limited partnerships or other entities that use discount techniques, beyond the substantial savings in transfer taxes.
  2. It pays to have a good valuation report on the gifts to the limited partners.

We now have another weapon to defeat the IRS. Congress passed a law that creates a statute of limitations 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 the annual gift tax exclusion limits (for 2007, the limits are $12,000 per person or $24,000 if married). Let’s assume a single individual is worth $3,000,000 and wants to gift away his lifetime gift tax exclusion amount in the current year. He could just give his children $1,000,000 in year one and by using his lifetime gift tax exclusion amount, he does not have to pay any gift tax. Alternatively, he could create a FLP with $1,500,000 and make a gift of a 90% limited partnership interest to his children. He could then file a gift tax return showing a $1,000,000 gift ($1,500,000 times 90% = $1,350,000 less a 26% discount of $351,000 = $999,000 ¾ 26% is a conservative discount). In effect, he is able to get an extra $351,000 out of his estate in one year.

Another strategy is to fund the partnership with well over $1,500,000 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 for a spouse’s as well) unified credit shelter amounts and file a gift tax return showing a 30% discount. For example, assume a gift of $1,000,000 and file a gift tax return showing a gift of $700,000 (i.e., a 30% discount). 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 lifetime gift tax exclusion 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 taxpayer’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 $12,000 (or $24,000 including a spouse’s) exclusion. In many cases, I often combine a variety of of leveraged gifting techniques such as second to die irrevocable life insurance trusts and grantor retained annuity trusts as well as FLPs.  Of course if you really want to have some fun, you can combine several of these leveraged gift techniques and have one of these types of entites own another entity to enormously reduce estate taxes in the future. For example you can get fabulous leverage when you establish a grantor retained annuity trusts (a GRAT) inside a FLP. 

IRS Court Cases and Settlements Give FLP Discounts Legitimacy

Although the IRS can be eager to challenge the discounts in FLP valuations, there are numerous examples of their unsuccessful challenges to the wealth saving discounts inherent in FLP valuations.  Challenges by the IRS begin with the IRS taking the position that a much lower discount or no discount at all is warranted. However, the settlement frequently ends up with substantial discounts applied to the asset values, sometimes equal to or near the taxpayer’s initial discount amount. These allowed discounts significantly reduce transfer taxes for families.

Although the facts and circumstances are different for each case, the trend is clear. FLP valuation discounts are real, and the IRS is not successful in eliminating them when cases are based on properly drafted and executed documents, proper legal operation of the partnership, and well-documented valuation reports with reasonable assumptions and sound valuation practices. 

Disadvantages of a Family Limited Partnership

FLPs are complicated and muck up what might otherwise be 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—an additional expense. (Although our firm does not draft FLP agreements, the business valuation side of our CPA firm values family limited partnerships and FLP interests and prepares the needed reports to justify the valuation positions taken.)

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 assets being transferred, there may be transfer taxes in transferring the assets, such as real estate, 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 an increase in the unified credit shelter amount to the point that he does not have an estate tax problem, even if he had never formed the partnership. 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. I rarely recommend a FLP if the value of the underlying assets is less than $250,000. 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,
  • has legitimate business purposes for partnership formation,
  • 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.

About the Authors

James Lange, CPA educates and provides specialized retirement and estate planning services to financial professionals and individuals with significant IRAs and other retirement plan accumulations.  Jim has been serving clients since 1978 through CPA and law firms in the tax, retirement and estate planning areas.  You can contact Jim by phone at 1-800-387-1129 or via e-mail at admin@paytaxeslater.com.

Steven T. Kohman, CPA, CSEP, CSRP works with James Lange and Associates.  He has been a Certified Public Accountant since 1984, and a Certified Specialist in Estate Planning since 1998.  Steven “runs the numbers” for the firm’s retirement and estate planning clients to see how their estate monies will grow and be spent during the owners’ lifetimes and how they can best provide for their beneficiaries.

 

 

 

James Lange, CPA

Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania.  He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again.  He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger's Retirement Reports and The Tax Adviser (AICPA).  Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.

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