Family Limited Partnerships
Have you heard about Family Limited Partnerships as an estate planning tool?
Family limited partnerships, or “FLP,” are an effective way of minimizing your estate tax burden, while at the same time transferring assets to family members at a lower value than in a direct transfer. While the IRS has investigated this type of estate planning tool for signs of abuse, the FLP is a perfectly legal way of reducing the value of your estate, as long as it is done correctly. Reducing the value of one’s estate has now become more important. With 2011 on the horizon, and Congress sitting on its hands, the estate tax is on its way back – with a vengeance!
What exactly is an FLP?
An FLP is a form of ownership that can be used to transfer land and other assets from one generation to another. It is an entity formed just like any other limited partnership, though in an FLP the partners are generally family members. The FLP is composed of two classes of partners: general and limited. General partners control all management and investment decisions and bear 100% of the liability. Limited partners cannot participate in the management of the FLP and have limited liability. The partnership itself is not taxable – instead, the owners of the partnership report the partnership’s income and deductions on their personal tax return, in proportion to their interests.
How is an FLP established?
The senior members of a family, generally grandparents or parents, initially form the FLP by drafting a written limited partnership agreement. The senior members then contribute land or other assets to the FLP in exchange for a small general partner interest and a larger limited partner interest. Though the senior members no longer retain the outright ownership of the land or assets, they still retain the right to use that land or those assets. Next, the junior members of the family, generally children or grandchildren, join the FLP as limited partners. As limited partners, they retain no voting rights or decision making authority in the partnership. The senior members then transfer large portions of their limited partnership interest to junior family members over time, retaining their general partnership interests.
What are the benefits of this type of entity?
As far as the senior members go, they have significantly decreased their possible estate and gift tax burden. Since they have transferred their assets to the FLP, those assets will only be taxed as part of their estate up to the extent that they have retained an interest in the FLP, which is generally very small. Also, transfers of limited partnership interests are eligible for the annual gift tax exclusion.
As for the junior members, since they hold partnership interests as limited partners, they have no control over the assets in the FLP. This decreases the value of that partnership interest. utting it another way, an asset purchased for $10,000 that you have full ownership and control of is worth more than a fractional limited partnership interest in that same asset, which you have no control over. In business valuation lingo, “lack of marketability” discounts are available because there is no market for these limited partnership interests. Total discounts that are deducted from the selling price of the “shares” can range as high as 40% in some cases.
Essentially, by using an FLP correctly, the senior family members have effectively gifted to their heirs an asset at a lower value than it would be had the transfer occurred directly between the family members, without the aid of a FLP.
Why might the IRS scrutinize an FLP?
The IRS has become wary of FLPs because of past cases of abuse. FLPs that have become too aggressive in discounting the value of the partnership interests ping loudly on the radar of the IRS. Some FLPs have gone so far as to place the value of their partnership interests at 90% below the actual value of the assets held in the entity. FLPs that establish a modest discount value for the value of partnership interests have not incurred the wrath of the IRS.
As long as a family’s motivation for forming an FLP is to protect or manage assets more effectively, the IRS will continue to honor the FLP as a disregarded entity. In order to treat the FLP like any other limited partnership, families should refrain from putting their primary residence in an FLP or paying for everyday needs like clothing, utilities, or educational expenses from the FLP. Families should also fund the FLPs upon creating them, but delay the gift transfers until several months later to avoid a “step transaction” challenge by the IRS. If the FLP is treated like any other limited partnership, by creating a valid business purpose, it will be taxed as any other limited partnership.
Could a Family Limited Partnership be right for your family? If so, it’s time to contact an estate planning specialist.
Jared Bellum is a contributing author to this blog. Jared recently passed the Washington state bar examination and has been admitted to practice in the state of Washington. He practices in the fields of bankruptcy, business start-ups, and estate planning. JD Bellum, Attorney at Law, PLLC works in association with the Law Offices of Richard D. Seward.