WATCH FOR THESE TRIGGERS:
- Estates over $5 million
- Appreciated assets
- Desire for asset protection
Partnerships provide great flexibility in family income and estate tax planning. While the partnership vehicle has been around for a long time, there has been a recent surge in its use in family situations to shift income, wealth, and asset appreciation from higher-bracket, older generation family members to lower-bracket children and grandchildren. They are especially useful now that tax rate increases, including the Health Care Act’s additional .9% Medicare tax on wages and self-employment and 3.8% Medicare contribution tax on net investment income are effective in 2013.
In the typical situation, the senior family members (parents) transfer assets to an FLP in exchange for partnership interests, or units, which, under the terms of the partnership agreement, carry with them certain rights. This initial capitalization of the partnership is a tax-free event. Partnership interests are then gifted or sold to junior family members (children), or to trusts established for the children’s benefit, during the parents’ lifetimes.
An FLP can also be formed as a family limited liability company (FLLC), which offers legal advantages over an LP. The general partner of an FLP is personally liable for all debts and obligations of the FLP but no “member” (instead of “partner”) of an FLLC is personally liable. Furthermore, in an FLLC, there are no restrictions on members participating in management. An FLLC is often managed by a group of “managing members” or one or more “managers”.
Understanding the Potential Benefits Available through Family Limited Partnerships
There are many reasons for the continuing popularity of FLPs. Benefits of using an FLP to transfer assets includes the following:
Income Shifting – Although much of the unearned income of children under age 24 is taxed at the parent’s rate, FLPs continue to be widely used as income-shifting devices, especially to older children.
Estate Freezes-Diversion of Appreciation – Through gifts of interests in FLPs that own appreciating assets, a senior-generation family member can remove future appreciation in value from his or her estate. This avoids the taxation that would result if the property were transferred after the appreciation occurred. This is the classic goal of an estate freeze.
Discounted Gift Values to Shift Future Appreciation – Due to various limitations, especially the difficulty in selling a minority interest in a partnership, gifting of a non-controlling interest in a FLP or FLLC can be discounted. The gift itself has a value less than the interest’s proportionate share of the value of the underlying business or assets. This discount in value directly reduces the transfer tax value of the gift, thereby transferring appreciation in the underlying property out of the parents’ estate.
Maintaining Control over Assets – A senior-generation family member can use an FLP to make gifts while maintaining a high level of control over the underlying assets, such as a business operated through the partnership, property being developed through the partnership, or assets being managed through the partnership, as the case may be. However, the level and manner of maintaining such control has become an issue in transfer tax cases.
Facilitating Gift Programs – An FLP can be used to make repeated transfers of limited partner interests as part of a regular program of gifts to family members. This is a convenient way to take advantage of the annual gift tax exclusion ($14,000 per donee in 2013).
Avoiding Local Probate – The estate of an owner of real property would be required to probate the property in the state where the real estate is located, even if this differs from the state of the decedent’s domicile. If the property is owned through a partnership, the decedent would not own a direct interest in real property, but would own an interest in a partnership, which is intangible personal property. This would be probated with other personal property in the jurisdiction of his or her domicile, simplifying the process and minimizing costs.
Providing Protection against Creditors – In most situations, a creditor of a partner cannot reach the assets of the partnership or compel distributions. They can only obtain a charging order, by which the creditor may receive distributions that are made with respect to the interest, and in some circumstances, a foreclosure and sale of the interest. As a consequence, the opportunities for a creditor of a partner to benefit from the debtor’s partnership interest are far less than where there is direct access to the underlying property. However, some courts are viewing the situation with greater scrutiny and more sympathy to creditors. Buy-sell arrangements also can be used to discourage third-party creditors of partners.
Controlling Donee Access to Wealth and Income – While senior generation family members often desire to transfer property to their children and grandchildren, they sometimes are concerned about how these donees will behave if they have immediate access to the wealth. By transferring FLP interests, the wealth can be transferred, but liquidity can be controlled to some extent. The younger generation member cannot easily convert the FLP interest to cash. Moreover, a general partner can exert some control over the extent and timing of distributions and the reinvestment of income.
Maintaining Family Control – An FLP with appropriate buy-sell provisions can be used to keep control of assets or a business within a family. This can provide protection against disruption and acrimony that sometimes accompanies failed marriages and the resulting property divisions.
Avoiding Guardianship – The partnership agreement can be drafted to avoid the cost and burden of establishing guardianship in the event of incapacity of one of the partners.
Understanding Potential Disadvantages of Family Limited Partnerships
There are a number of potential problems with FLPs that need to be understood before making a decision to create one. Potential disadvantages of family partnerships include:
Incurring Additional Administrative Expenses – Setting up and maintaining an FLP involves drafting a partnership or LLC agreement, possibly setting up another entity (such as a corporation or LLC) to serve as a general partner, paying filing fees, transferring title to assets, obtaining appraisals for assets transferred to the partnership and interests transferred to partners, and preparing and filing gift tax returns and partnership income tax returns, all of which have associated costs.
Facing IRS Scrutiny – The IRS has taken a somewhat jaundiced view of FLPs, especially when significant amounts of tax revenue are at stake because valuation discounts are part of the scenario. The IRS has specifically targeted the valuation of fractured entities, such as FLPs, for increased scrutiny by its audit division; and it has issued several private rulings challenging FLPs formed shortly before the general partner’s death. In these rulings, the IRS ignored the partnership entity and disallowed the valuation discounts. It is important to understand that an FLP may be scrutinized by the IRS and it might be necessary to settle an IRS dispute through the courts.
Dealing with Trust Administration Issues – Independent trustees may be reluctant to accept a trust or estate client that owns an FLP interest. A trustee’s fiduciary obligation to remaindermen and current income beneficiaries may place the trustee at odds with other partners who may have differing agendas.
Losing the Benefits of Basis Step-ups – An FLP interest held by a partner at death probably will be valued differently than would the partner’s pro-rata share of the value of the underlying partnership’s assets. Accordingly, the partner’s estate and successors may lose a portion of the basis step-up that otherwise would attach to appreciated assets owned at death. In addition, any step-up will relate to the basis of the partnership interest and will not apply directly to the partner’s share of the partnership’s basis in the underlying assets, which would provide the greatest benefit. This problem may be alleviated somewhat by a Section 754 election at the partnership level to step-up the inside bases of assets.
Underfunding or Losing the Marital Deduction – The IRS could potentially use valuation discounts to its advantage, and to the disadvantage of the estate, by reducing the value of FLP interests passing to a surviving spouse upon the death of a partner. The IRS has successfully contended that the value of an interest passing to a surviving spouse would not necessarily have the same value as its value for gross estate purposes. For marital deduction purposes, the interest transferring to the surviving spouse must be valued separately based on its separate characteristics (e.g., controlling interest or minority interest).
For example, the value of closely-held stock may be a controlling interest to the decedent’s gross estate, but if only a portion of those shares constituting a minority interest are transferred to the surviving spouse, the shares may have a discounted minority interest value for marital deduction purposes.
Facing Potential Legislation – Congress has enacted legislation restricting valuation discounts in the past and could attempt again, either directly or indirectly, to restrict or limit their use.
Dealing with Liquidity Concerns – Once assets are contributed to an FLP and ownership interests are transferred to other partners, it may be difficult to make cash distributions to the contributing partner without making pro-rata distributions to all partners.
Lacking a Business Purpose – The IRS may attempt to disregard an FLP for tax purposes on the grounds that it lacks a business purpose. This is most likely to arise in FLPs formed shortly before the general partner’s death. The result could be the loss of hoped-for valuation discounts or possibly a reclassification of the partnership as a trust or simply a testamentary device (the assets of which would be includable in the client’s estate).
Respecting the Legal Entity – Failure to follow operational formalities can result in the entity being disregarded, causing inclusion in the donor’s estate. Failure to follow partnership formalities, such as a separate set of books and appropriate allocations, can establish the existence of an implied agreement among family members that the partnership exists only on paper, thus negating the FLP benefits at death. Properly forming the FLP and operating it as a true, separate entity is of utmost importance.
As you can see, there are both pros and cons in forming an FLP. If one closely follows the rules of forming, funding and operating an FLP, the FLP can be a viable and effective estate planning strategy. Anyone considering the FLP strategy should consult with his or her professional advisors, including estate planning counsel experienced in the use of FLPs.
Facing Unknown Estate Tax Implications for Closely Held Stock Held by Partnerships
If an individual gives away corporate stock during his lifetime and retains voting rights, directly or indirectly, at the time of death, the value of the stock will be included in his gross estate for estate tax purposes. While it appears that the right of a general partner in an FLP to vote corporate stock owned by the partnership should not cause this inclusion, the result is not entirely clear. Accordingly, there may be some risk in holding closely-held stock in an FLP and retaining the right to vote the stock by reason of being the partnership’s general partner.
Title Transfer Issues
Care should be taken to address all other issues other than estate and gift tax planning with respect to the formation and operation of the FLP. For example, if real estate subject to a loan will be transferred to the FLP, lender consent may need to be obtained prior to the transfer so as not to trigger a “due-on-sale” clause in the loan document. If the property has been leased to tenants, lease assignments will need to be executed to reflect the new owner of the property. Property tax issues must be analyzed to insure that the property is not reassessed upon the transfer of the property to the FLP by the partners or, thereafter, upon the transfer of partnership interests by the client to his or her family members.