Thursday June 1, 2023
Family Limited Partnerships
A family limited partnership (FLP) is usually created by parents. It has several purposes. An FLP can save estate taxes and permit transfers to family members. While it is uncertain what the future exemptions and estate tax rates will be, large estates are nearly certain to face major taxes in the future. The FLP is a favored method for reducing estate tax.
Another benefit is protection of assets. The FLP interests can be given to children and other relatives. It is very difficult for any creditor to reach FLP assets. The protection also extends to limiting rights of in-laws if a child or grandchild is married and later divorced.
Parents typically are interested in transferring value but retaining control. With an FLP, they can retain the general partnership interest and control the management of the FLP assets.
There are several considerations with an FLP. First, there are legal and accounting costs to create the FLP. In addition to these costs, property must be transferred. There may be transfer costs or property tax consequences upon the funding of the FLP.
Because the FLP interests are frequently given to family members, there will need to be an appraisal by a person who holds himself or herself out to the public as an appraiser. In addition, the selected appraiser must have appropriate credentials.
Finally, the parents will need to consider succession. At the point they no longer wish to manage the FLP, a child or other person will typically assume the role of general partner.
How the FLP Works
Assume that Bill and Alice have been successful real estate investors. They hold a number of parcels of development land, commercial buildings and apartment buildings. Bill and Alice would like to maintain control of their investment assets, but would like to start transferring equity to children.
An excellent solution is to create the "Jones FLP." Bill and Alice will be 1% general partners and 99% limited partners. In some circumstances, children already have assets and may contribute them in exchange for appropriate percentages of the limited partnership interest. But in the case of Bill and Alice, they transfer all of the assets to the FLP.
Bill and Alice transferred 11 parcels of commercial real property to the partnership. These 11 parcels include development land, commercial buildings with leases and apartment buildings. After transfer of the real estate, they employed a qualified appraiser to value the limited partnership interests.
After the appraisal was completed, Bill and Alice then begin to transfer limited partnership interests to their children and to trusts for grandchildren. The appraiser reduced or discounted the gift values due to the lack of control and for lack of marketability. Because the limited partners only own a small interest in the partnership and cannot force distributions, they do not have a high level of control. The appraiser determined that there is an 18% discount for the lack of control.
Because a limited partnership interest in real estate also makes it very difficult to sell at full value, there is a discount for lack of marketability. The qualified real estate appraiser determined that another 17% discount on total value is appropriate for lack of marketability. The two discounts together add up to a total of 35%.
When Bill and Alice make gifts of limited partnership interests to children and to trusts for grandchildren, they make use of both their present interest annual exclusions and a portion of each person's gift exemption.
Over a period of years, Bill and Alice were able to transfer a substantial portion of the limited partnership interests to family. However, because they still own the general partnership interests, they control and manage the real property. After a majority of the limited partnership interests are transferred to children, the growth in value of the assets will largely benefit their children rather than Bill and Alice.
Through this method, they may reduce future estate taxes and also maintain control. In addition, because it is difficult for the children to transfer the assets or for spouses of the children to acquire control, there is a substantial level of asset protection.
Creditors of the children are very restricted in their ability to gain control of the assets. Generally, under most state law, a creditor can only attach rights to distributions from the partnership. This makes it very difficult for any creditors to acquire a significant right to partnership assets.
Benefits and Disadvantages of Jones FLP
There are several specific FLP benefits that Bill and Alice appreciate. First, they are general partners and they have control. Second, because of the discounts they are able to make much larger gift transfers with little or no gift tax. Third, the assets are quite well protected from any creditors or spouses of the children. Fourth, assets transferred to the trust will be outside the probate process. While federal estate taxes may apply, even those will be greatly reduced. Fifth, the centralized management of the real estate property can be transferred to a successor general partner when they are ready to retire. This will enable the assets to be preserved long-term for the benefit of the family.
There are some disadvantages of Jones FLP. First, there is the cost involved in creating the documents, transferring the assets and maintaining all of the business records. Second, if there is excessive control by Bill and Alice, then the IRS may claim that they in effect have too much control over the assets. In that case, the IRS may assess an estate tax based on the full value of the assets in their estate, including the value of the FLP assets.
Third, if there are too many limits on the sale of the FLP interests by children, the IRS may claim that there is no "present interest" annual exclusion. For transfers that exceed the lifetime gift exemption, the IRS may assess a gift tax. Finally, FLP valuations by the appraiser may be questioned by the IRS. That could lead to an audit and litigation with the IRS.
Jones FLP Do's
There are several actions that should be taken to make certain that the Jones FLP functions as intended.
- Written Document – The written FLP document must state all of the rights and duties of the general partner and of the limited partners.
- Business Licenses and Tax ID Numbers – The partnership must be treated like a business entity. There may be state business licenses and it will be necessary to obtain federal and state tax ID numbers for the partnership.
- Title Transfer – To function properly, the partnership must receive title to Bill and Alice's real property. They will deed the property from themselves as individuals to the partnership. There may be transfer taxes as a result of those deeds. However, it is essential that the title be properly transferred to Jones FLP.
- Retain Assets – Bill and Alice must retain sufficient assets for their lifestyle. If they transfer all of their assets into the Jones FLP, then the IRS will claim that this is not a business entity but is simply a personal entity. If it is managed as a personal entity, Bill and Alice's estates could face a very large estate tax on the full value of the assets.
- Avoid Commingling Assets – Jones FLP needs to have a proper business purpose and be conducted like a business. If business assets and personal assets are commingled, then the IRS may claim that this was not treated like a business.
- State Filing Taxes – There may be state franchise taxes or other taxes that apply to Jones FLP. The FLP should comply with all state requirements.
- Federal and State Income Taxes – While partnerships pass through income and deductions, it will be necessary to obtain the assistance of a CPA who is knowledgeable about partnership taxes and tax returns.
- Create FLP While Still Healthy – There have been "deathbed" FLPs created that the IRS contested. It is preferable to create Jones FLP while Bill and Alice are still healthy. It can then function for a number of years to demonstrate the business purpose of maintaining and operating their real estate enterprise.
- Transfer All Assets – If nearly all assets are transferred to the FLP, especially on the deathbed of the donor, then it appears that this is not a business investment but merely a substitute estate planning strategy. The IRS may contest the FLP discounts and could potentially win a claim for a very large tax deficiency.
- Transfer Family Home or Vacation Home or Personal Assets – The FLP is a business enterprise and family homes and personal assets should be retained outside the FLP.
- Unlimited Promise to Parents – If the children promise the parents that they can "take assets whenever needed" from the FLP, then the IRS may deny the discounts on the ground that the children and parents are not treating it like a business entity.
- Do Not Omit Business Meetings – The appropriate business meetings, minutes and reports should be filed to indicate that the FLP is being operated as a business entity.
If Bill and Alice make current gifts to charity, a very effective way of maximizing the benefits of the FLP is the "double discount" combination of a family limited partnership and a lead trust.
The first discount is due to the transfer of assets into the FLP. Bill and Alice could transfer $4 million in real estate assets into a family limited partnership. While the underlying rent or income from the assets could continue (and it is best if the assets have no debt and therefore no debt payments), there is a substantial discount for lack of marketability and for minority interest. This discount could reduce the FLP value from $4 million to $2.5 million.
If the limited partnership interests in the family limited partnership are then transferred into a lead trust, there is a second deduction. The deduction is based on the present value of the income paid to charity. While Bill and Alice thought about a 6% payment on $4 million in assets or $240,000 per year to charity, this percentage of the discounted $2.6 million value is much higher. Therefore, the gift tax charitable deduction is much more substantial. With a lead trust that lasts for approximately eight years, they are able to obtain sufficient "double discounts" to transfer $4 million in assets. With the use of part of their gift exemption, there is no gift tax.
The benefit of the FLP-lead trust is that Bill and Alice are able to provide a major inheritance for their family. They are significantly leveraging the use of their gift exemptions. This allows a reasonably short period of time for the payments to charity with a very large inheritance to family members at the end of that time.
Because the assets transferred to family members have a low basis to Bill and Alice, the children will receive FLP assets with a low cost basis. However, children could then use a tax-free sale and unitrust strategy to sell the appreciated assets with zero tax.
Bill and Alice are very pleased with this strategy and believe that this is going to be an excellent addition to their FLP plan.
After attending a weekend conference where they were encouraged to think about the best ways to assist children in "becoming better persons," Bill and Alice think it would be good if they can stretch out the inheritance to their children. They also believe that income and capital gain taxes for the children will continue to increase. Ideally, they would like to add a method or plan that would stretch out the inheritance and enable the children to reduce their future income and capital gain taxes.
One strategy to do that is to add a 5% charitable remainder trust to the end of the FLP-LT plan. The plan then starts with the Jones FLP interests that are transferred into a lead trust for eight years. At the end of eight years, the $4 million in assets may have grown to a larger amount. Assuming that they have grown to $5 million in value, then the two children of Bill and Alice would each benefit from a distribution of $2.5 million in assets to a 5% unitrust.
The unitrust would last for the life of each child. Each 5% unitrust funded with $2.5 million could produce an additional $125,000 of income for the life of the child. Because the trust may earn more than 5%, there may be inflation protection of this amount for the life of the child.
There are two major tax benefits for the child. When the appreciated assets of $2.5 million with low basis are transferred to the unitrust, they can be diversified tax free. In addition, earnings above the 5% payout compound tax free for life in the trust. Both of these benefits will save tens of thousands of dollars of income tax for each child.
Bill and Alice are delighted with the unitrust addition to their plan. The FLP-LT will leverage their transfers. After eight years, the lead trust principal is transferred to the unitrusts for the children. This will produce a long-term inheritance that they think is very helpful in encouraging the child to be a productive citizen.
In addition, there will be large savings in capital gains tax and future income tax for the children. With the belief of Bill and Alice that capital gain and income taxes will only increase in the future, these savings are a welcome addition to the overall plan.
Published May 5, 2023
Family Business - Sell and Retire