|
Family
Limited Partnerships
byJames
Lange, CPA, JD and Steven T. Kohman,
CPA, CVA, CEP
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 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 Over 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't vote on how the partnership is run or when it will
terminate. They can't use the funds or assets in the partnership,
and typically the partnership agreement will limit their ability
to sell or transfer their interests. They can't get distributions
unless the general partners approve. The children can't even 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.
Such control includes the power to invest and reinvest partnership
assets. More importantly, 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 $266,667 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 $266,667 or $26,667. However,
most valuation experts will estimate the value of limited partnership
interests at a maximum of $20,000 (reflecting a 25% discount) and
in some cases, depending on the terms of the partnership and the
nature of the underlying assets, at $13,000 or lower (reflecting
a 51% or greater discount).
Some FLP valuators assign a higher
level of risk when the underlying assets warrant it.
For instance, for cash and treasury bills, discounts of 5%
to 20% may be appropriate; for corporate bonds and large capitalization
equity securities, 10% to 30%; for small capitalization stocks,
20% to 40%; for real property, 25% to 45%. For investments in foreign
securities, the discounts vary but can be quite large, as indicated
in 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 associated
with family limited partnerships as well as valuations of many business
interests.
- 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.
- 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, 1996), 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 as well as the
Clinton Administration 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. As recently as two
years ago, I never recommended that my clients put only cash and
securities in a FLP. I thought the IRS would be able to successfully
challenge the partnership's purpose and disallow the discounts.
I knew there were other advisors taking those chances, but I thought
it was too aggressive.
Recently I have changed my tune. Though
I prefer using business assets or even business assets combined
with cash and securities to fund a FLP, now I am sometimes willing
to fund a FLP with just cash and securities. The reason for my change
of heart is that taxpayers are doing so well in tax court. Although
the case law is now minimal for FLPs consisting only of cash and
securities, suffice to say the taxpayers have been doing quite well
in most challenges. The word on the street is that if the discount
is 25% or less, the IRS doesn't even attempt to challenge the partnership
or the valuation of the gift. At the Thirty-Fourth Annual Philip
E. Heckerling Institute on Estate Planning in Miami, speaker after
speaker hammered home two points:
- 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.
- 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 has finally 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 $10,000 (or $20,000 if married). Let's assume a single
individual is worth $3,000,000 and wants to gift away his unified
credit shelter amount in the current year. He could just give his
children $675,000 in year one and by using his unified credit shelter
amount, he does not have to pay any gift tax. Alternatively, he
could create a FLP with $1,000,000 and make a gift of a 90% limited
partnership interest to his children. He could then file a gift
tax return showing a $675,000 gift ($1,000,000 times 90% = $900,000
less a 25% discount of $225,000 = $675,000 ¾
25% is a conservative discount). In effect, he is able to get an
extra $225,000 out of his estate in one year.
Another strategy is to fund the partnership
with well over $1,000,000 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 $675,000 and file a gift tax return
showing a gift of $472,500 ($675,000 – $202,500, i.e., 30%). 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 unified
credit shelter 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
$10,000 (or $20,000 including a spouse's) exclusions. In many cases,
I prefer the FLP to other methods of leveraged gifting such as second
to die irrevocable life insurance trusts or grantor retained annuity
trusts. Of course if you really want to have some fun, you can combine
several of these leveraged gift techniques to enormously reduce
estate taxes in the future. I have seen grantor retained annuity
trusts inside partnerships.
Recent 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 well-documented valuation reports with reasonable
assumptions and sound valuation practices.
A recent victory for FLPs is found
in the Tax Court decision in the gift tax case of Kerr vs. Commissioner
(113 T.C. No. 30 – December 23, 1999).
The IRS contested the taxpayer's claims regarding their tiered
entity discounts. The IRS also argued that the transfer was only
an assignee interest and not a limited partnership interest, and
that issues of IRC Section 2704 would disallow the discounts claimed.
The IRS's position that no discounts were warranted was defeated,
and the taxpayer was entitled to the full discounts reported at
about 46%.
Another recent victory for the taxpayer
came in the Church vs. Commissioner case decided by the USDC, Texas,
January 18, 2000. Mrs.
Church met an unexpected death two days after forming a limited
partnership, although she had other health problems that may have
influenced the IRS in taking their position that the partnership
was formed only to avoid taxes and had no legal substance. However,
the IRS lost this case and the full discounts amounting to approximately
58% were upheld in favor of the taxpayer.
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.
The April 1999 issue of The
Tax Adviser, the peer reviewed CPA tax journal where I published
my article on Roth IRAs, warns of a multitude of FLP traps. The
article concludes with “…by avoiding these tax traps, taxpayers
can reduce the likelihood of an IRS challenge while accomplishing
the objective of significantly lowering their tax burdens.”
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 $150,000.
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, JD, 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 over 20 years of experience in 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@faculty-advisor.com.
Steven T. Kohman works with the James
Lange and Associates. He
is a Certified Public Accountant, a Certified Valuation Analyst,
and a Certified Estate Planner.
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.
|
