Family limited partnerships (“FLPs”) give senior family members a tax efficient way to shift wealth to future generations while still exercising control over their assets. As an added benefit, by forming a FLP, senior family members remove assets out of their estate—generally at a reduced transfer tax value.
The FLP structure consists of a general partner and limited partners who typically hold a 1% and 99% interest, respectively, of the total FLP equity. For illustration, senior family members—“the parents”—initially hold both the general partner[1] and limited partner interests. Over time, the parents transfer their limited partnership interests to their children and/or grandchildren as gifts. Even considering the transfer of their LP interests, the general partner parents maintain complete control of the FLP, a role similar to a CEO of a corporation. Meanwhile, the limited partners are considered passive participants and have no control over the FLP. Moreover, transferring their LP interests reduces the parents’ taxable estates and they can avoid the gift tax (and use of the application exclusion amount) as long as the value of each unit transferred to each child does not exceed the annual gift tax exclusion amount ($14,000 per donee in 2015).
Here’s an example: David and Lisa Smith transfer assets valued at $12 million to a FLP, and collectively become the general partners through an LLC with a 1% interest. Simultaneously, the Smiths—as individuals—also become limited partners with a collective 99% interest. Eventually, the Smiths want to share their 99% LP interest evenly among their four children. To accomplish that, the Smiths annually transfer the maximum allowable gift to each of their four children. That’s a total of $14,000 from each parent to each child each year for an annual total of $112,000 ($14,000 X 2 parents X 4 children). In a decade (assuming no change in the annual gift tax exclusion amount), the Smiths can transfer $1,120,000 to their heirs while that amount is correspondingly removed from the Smith’s taxable estate.
If the Smiths wish to accelerate those transfers, possibly to move highly appreciating assets out of their estate sooner, they can use any portion of their applicable exclusion amount ($5.43 million per donor in 2015) for a total tax free transfer of $10.86 million. Recall that even as the parents transfer their limited partnership interests, they remain in control of the FLP and its assets.
Adding up the Benefits
One of the many benefits of the FLP structure is that valuation discounts are typically applied to limited partnership interests. That is because the limited partners have only a passive interest in the FLP. Specifically, because the limited partners have no management authority or control over the FLP or its underlying assets, they cannot authorize dividends, nor can they sell or transfer their LP interests without consent from the general partner. Because of this lack of control and lack of marketability, the LP interests are typically valued at a discount of as much as 30 – 50% to the FLP underlying assets. This means senior family members can use these valuation discounts to transfer larger amounts of assets each year without violating the annual gift tax exclusion parameters. This translates to additional tax savings.
Let’s go back to the Smiths: If the limited partner interests have an associated 30% valuation discount to the underlying assets, then each parent could actually gift $40,000 worth of FLP assets annually to each child ($28,000 / 70%). That brings the total to $160,000 worth of gifted assets per year and $1,600,000 in 10 years. The same concept applies to the applicable exclusion amount (“AEA”). Valuation discounts of 30% increase the parents’ collective AEA to $15.51 million ($10.86 million / 70%).
Other substantial FLP benefits include the following:
– A FLP has the ability to protect the family’s assets from creditors. For example, a creditor can latch onto a child or parent’s limited partner interest with only a “charging order.” Meaning, that if a charging order is obtained, creditors only have the right to receive limited partner distributions which the general partner can decide to withhold. That leaves the creditor with no money to gain. Moreover, creditors with a charging order have no power to force the FLP to liquidate assets.
– FLPs enable families to pool their assets, to simplify their estate administration, to create a joint system of family assets management, and in turn teach children how to manage assets.
– An FLP can ensure the extension of a business even after the senior family member dies, can limit the liability of individual owners, and consolidate the management of the family business into a sole entity.
– FLPs facilitate the process of gifting, protect assets from otherwise irresponsible family members, and minimize the expenses of asset management.
Care should be used
FLPs can, however, present a potential challenge for the Internal Revenue Service. Particularly, the IRS may challenge valuation discounts on transfers of FLP assets to family members. In the past, the IRS has used various strategies to disallow and/or reduce discounts. Namely, the IRS may declare that the FLP lacks economic substance and should be ignored. The IRS may also proclaim that the FLP formation is itself a gift, i.e. a transfer of the underlying assets, instead of a transfer of discounted partnership units. The IRS may also use its in-house valuation experts to contest the amount of discounts claimed by the taxpayer’s appraiser.
That means the FLP must be specifically structured and designed to fulfill a valid investment or business purpose. For instance, the FLP can be used to conduct a family business, gather and manage family wealth smoothly and coherently, combine family wealth to maximize growth and investment and devise a succession plan for transferring business management through generations. Also, valuation discounts should be well supported documented, and determined by a valuation expert.
As always, anyone wishing to create a Family Limited Partnership for themselves and their heirs should consult with an experienced advisory team that can assist them in constructing the FLP. Please contact Mckinnon Patten if you have any questions or wish to confer with our skilled team of accountants.
[1] As an added layer of liability protection, the parents typically form and operate an LLC to serve as the general partner.
