All posts in Family Limited Partnerships

08 Apr

Maintaining the Right To Enjoy FLP Gifting Strategies

In Family Limited Partnerships by admin / April 8, 2013 / 0 Comments

Estate Planner Nov-Dec 1998

Using a properly drafted family limited partnership (FLP) you can make tax-free gifts to family members or others while maintaining a degree of control over the assets. An FLP allows you to further reduce your taxable estate through minority interest discounts.

How does this work? Generally, you (or you and your spouse) can create an FLP by transferring assets to a partnership in exchange for all general and limited partnership interests. Typically, this will have no income tax consequences. Using the allowed gift tax exclusion, you can then gift limited partnership interests worth up to $10,000 per recipient each year to family members or others, while retaining the general partnership interests (and thus effective control). And, minority interest discounts may allow you to transfer even more than $10,000 of assets tax-free.

The Annual Gift Tax Exclusion

To qualify for the annual gift tax exclusion, the gift must be of a present interest. In other words, the people to whom you give limited partnership interests must have a present right to enjoy the ownership of the limited partnership interests. The more restrictions you place on the limited partnership interests, the less likely your gifts will qualify as gifts of a present interest.

This can have serious tax consequences. Most notably, if your gifts do not qualify for the annual gift tax exclusion, you will begin to use your applicable lifetime gift and estate tax exclusion amount (currently $625,000) and you may eventually have to pay gift tax on your gifts of the FLP interests.

Drafting To Ensure Annual Exclusion Qualification

The following guidelines will help ensure that your gifts will qualify for the annual gift tax exclusion. These guidelines also generally apply to gifts of membership interests in the newer family limited liability companies (FLLCs):

  • Carefully draft any restrictions limiting those to whom limited partners can sell or assign their partnership interests.
  • Permit limited partners to sell their limited partnership interests for fair market value. You can include a right-of-first-refusal provision requiring the limited partners to offer to sell their limited partnership interests to the other partners first.
  • Entitle limited partners to distributions equaling or exceeding their entitlement under general state rules.
  • Do not require your approval as general partner of assignments or sales of limited partnership interests.

Minority Interest Discounts

The Internal Revenue Service (IRS) recognizes that minority interests in privately owned business enterprises are worth less than the pro rata allocation of their assets, because the minority interest holders lack the ability to control the business enterprise. Consequently, the IRS allows a minority interest discount reflecting this lack of control.

The discount can be significant and can even be combined with other discounts, such as a lack of marketability discount. Through these discounts, you can transfer a greater amount of value of underlying assets to your family (or others) with less gift tax consequences — or even with no gift tax consequences — if your gift qualifies for the annual gift tax exclusion.

A Word of Caution

The IRS may review an FLP to determine whether it has a valid business purpose. If the IRS determines that you formed the FLP merely to avoid taxes, it may disregard the FLP entirely, resulting in a proportionate gift of the underlying assets, exposing you to additional gift or estate taxes. When drafting your FLP, keep in mind some recognized business purposes for a FLP:

  • Facilitating retention of assets in a family;
  • Centralizing asset management;
  • Providing for the orderly development and management of assets; and
  • Protecting assets against the claims of creditors. 

Also, the type of assets the FLP holds may affect the IRS’s view. For example,if the FLP only holds publicly traded securities, the IRS is likely to scrutinize the structure more than if it holds a variety of assets, such as real estate and shares of a closely held business, in addition to securities. If you can show a valid business purpose, the IRS may then review the discounts taken to see if they are warranted. The IRS requires you to state on your gift tax returns whether you have applied any discounts to the gifts reported.

Making an FLP Work for You

If you create an FLP in a way that qualifies your gifts of limited partnership interests for both the annual gift tax exclusion and minority interest discounts, you will reduce your taxable estate more rapidly and maintain control of your family assets.

How an FLP Can Save You Taxes

Suppose you created an FLP with assets worth $100,000. You allocated $1,000 to the general partner’s interest and $99,000 to the limited partner interests. If the combined minority and lack of marketability discounts equaled 30%, you could gift limited partnership interests that represented a total pro rata allocation of the FLP’s assets of $14,285, because with the discount, the value of the interest would be $10,000 ($14,285 – 30% of $14,285). Therefore, you would be able to gift an additional $4,285 of underlying FLP assets to each recipient annually without using any of your applicable exclusion or paying any gift tax. Furthermore, you would reduce your taxable estate more rapidly because you would be able to gift more value each year.

08 Apr

Avoid Income Tax Consequences of Funding FLPs

In Family Limited Partnerships by admin / April 8, 2013 / 0 Comments

Estate Planner Jan-Feb 1998

Many people use family limited partnerships (FLPs) to transfer wealth from one generation to the next. Why? FLPs enable the older generation to maintain control and the family to obtain discounts. While we generally focus on the estate planning benefits of FLPs, we often overlook the income tax consequences of funding them, which can be significant.

The “Investment Company” Issue

A family usually forms an FLP by contributing cash, securities and other assets to the partnership in exchange for interests in the partnership. The FLP then owns the family assets. In general, the partners recognize no gain or loss on the contribution of property to the FLP. However, if the FLP is considered an investment company under the tax law, the partners may be required to recognize gain on the exchange of appreciated assets for partnership interests.

The Internal Revenue Code defines an investment company to include a partnership holding more than 80% of the value of the assets (excluding cash and nonconvertible debt obligation) for investments that consist of readily marketable stocks or securities. If a transfer to an investment company results in the diversification of the transferor’s interest, then the transferor may recognize a current capital gain.

When Does Diversification Occur?

Diversification generally takes place when two or more people transfer nonidentical assets to the FLP. For example, if Paul and Linda create an FLP, and Paul contributes 100 shares of A Corporation and Linda contributes 100 shares of B Corporation, both publicly traded companies, Paul and Linda will recognize gain. What is the diversification? Paul and Linda each individually now hold 50 shares of A Corporation and 50 shares of B Corporation. In this case, the FLP is an investment company because it holds 100% of the partnership assets for investment and the assets consist of marketable stocks.

In reality, however, a family often creates a partnership with the transfer of already diversified portfolios. Realizing that the tax rules regarding recognition of gain generally were not aimed at those situations where partners did not realize any advantage by further diversification, Congress changed the law to broaden the nonrecognition rules. Portfolio transfers made after May 1, 1996, that are already diversified will generally not be subject to recognition of gain.

What Makes A Portfolio Diversified?

A portfolio is considered diversified if not more than 25% of the value of total assets is invested in the stock and securities of any one issuer, and not more than 50% of the value of total assets is invested in stock and securities of five or fewer issuers. While for the 25% and 50% tests government securities (such as Treasury bills) are included in total assets for purposes of the denominator, they are not treated as securities of an issuer for purposes of the numerator.

For example, assume Dad contributes his portfolio of publicly traded stocks to an FLP, and no single stock accounts for more than 20% of the value of his portfolio. His children contribute Treasury bills. Before the change in the law, Dad would have recognized gain on the contribution. With the new provision, however, Dad will be considered diversified prior to the exchange. The transfer avoids investment company rules because no more than 25% of the noncash assets are invested in any one issuer, and no more than 50% of the assets are invested in five or fewer issuers.

Avoiding Recognition Rules

While the rules regarding the income tax consequence of FLP creation can be confusing, they cannot be overlooked. You can avoid the recognition rules before forming an FLP, however.

For example, if Paul and Linda were married, they could have avoided recognition in the original example by each giving the other 50 shares of their respective stocks. Because of the marital deduction, this transfer would have had no gift tax consequence. Paul and Linda then could have each transferred their 50 shares of A Corporation and 50 shares of B Corporation to the FLP and avoided the recognition. In nonspousal situations, however, you must carefully review the assets before contributing them to the FLP.

We would be pleased to assist you in creating an FLP that avoids capital gains tax and meets your objectives.

08 Apr

FLPs Offer More Than Just Tax Advantages

In Family Limited Partnerships by admin / April 8, 2013 / 0 Comments

Estate Planner May-Jun 1997

In recent years, family limited partnerships (FLPs) have become synonymous with gifts and deep discounts. Yet FLPs have played an important role in family estate and management planning for more than 40 years because of the many nontax advantages they offer over making outright gifts.

Simplicity of Gifting

It is often easier to make gifts of property through an FLP, especially when the gifted asset is real estate or tangible personal property (such as art). You contribute assets to the FLP and gift limited partnership interests to your children. This is simpler than giving your children undivided fractional interests. Why? Undivided interests complicate the ownership and sale of real estate, both mechanically and from the standpoint of possible title issues, and of artwork, because all of the owners are entitled to possession rights of some sort.

Control of Property

When you transfer your interest in real estate, art, cash or securities to an FLP and gift limited partnership interests, you retain control over the actual property. Your children are entitled to receive only their own shares of the distributed cash flow as determined by you, the general partner. You can control this cash flow by reinvesting all or part of the FLP earnings. This power is a byproduct of being the general partner, not an estate tax retained power over the limited partnership interests, which would cause estate inclusion. On the other hand, if you make outright gifts of property that is readily divisible, such as cash or securities, you immediately have transferred control of that property to your children.

Modernization of Investments

An FLP can function like a private investment company and improve cash management. This can be particularly helpful when family wealth has already been distributed among two or more generations. The investment assets of the family members and family trusts are contributed to an FLP, which can have a managing general partner or management committee.

This consolidation can permit a reduction in the number of advisors and administrative assistants, eliminate the need to maintain multiple accounts, and allow access to investments that have minimum participation levels. In addition, modern portfolio theories can be more effectively applied and daily cash flow investment techniques can be used.

This can make an FLP a better option than a trust, where some flexibility is lost because the trustees are required to invest based on the prudent person rule (or variations). This standard is more limiting than the business judgment rule that applies to managing partners, under which a bad investment outcome may be easier to defend to other family members.

Protection of Assets

The FLP also serves as asset protection against future creditors. If a family member holding an FLP interest is subject to creditor claims that cannot be met, the creditor cannot attack the actual FLP assets, assuming there has not been a fraudulent conveyance. The creditor generally can only obtain a charging order against the family member’s partnership interest, which would entitle the creditor to FLP distributions only when the family member would have received them.

Parents are often concerned about making gifts of cash or securities to children whose marriages might be shaky. Even though gifted property may be separate property and not subject to a divorce proceeding, cash and securities often become commingled. However, a gift of an FLP interest creates wealth for your child that, by its nature, is segregated.
Buy/sell agreements within the FLP agreement further assist in minimizing creditor and divorce problems. When the partnership agreement provides for a buy-back in the event of an involuntary transfer, the fair market value of the FLP interest will be less than the proportionate value of the underlying assets. Accordingly, while the divorced child or debtor family member may lose value in the redemption of his or her FLP interest, the inherent value of the partnership interest is redistributed to other family members.

Can an FLP Work for Your Family?

An FLP offers you the flexibility to exclude or include family members in administration and investment philosophy at appropriate stages in their lives. It permits you to shelter, protect, and teach, and can enhance investment return.