Family limited partnerships deserve fresh consideration for inclusion in many Estate Planning strategies that don’t already have them. This is an especially good time to consider an FLP because of the potential tax changes scheduled at the start of 2013. FLP also offer substantial non-tax benefits. Another reason to take a fresh look at FLPs is that court decisions in recent years established some clear guidelines and rebuffed the IRS’s efforts to render all FLPs invalid.
You know the story about the estate and gift tax. For 2012, everyone has a lifetime estate and gift tax exemption of $5.12 million. But if Congress doesn’t act by December 31, the estate and gift tax will revert to its 2001 version. That means the lifetime estate and gift tax exemption would shrink to $1 million per person.
Many financial and estate advisors recommend people remove a lot of assets from their estates in 2012 because of the potential for the exemption to shrink. (See our January 2012 issue for details.) FLPs offer a great way to reduce the size of your estate while retaining significant control.
I suspect the folks in Washington will work out some sort of deal in a lame duck session and the exemption won’t shrink, at least not by much. But that’s no reason to be complacent about estate planning. As I said, FLPs offer significant non-tax benefits, and those are good reasons to give FLPs a close look. Any tax benefits are a bonus for many of you.
The FLP strategy works like this. You, the estate owner, set up the partnership with you and usually your spouse as the general partners with 1% ownership interests. You transfer assets to the FLP and in return receive the limited partnership interests that account for 99% of the FLP. You transfer some or all of these limited partnership interests to your children, either at once or over time.
The FLP is flexible, and so many variations are possible. The children, for example, could contribute cash or property for at least part of their interests.
Here are the benefits of an FLP. The prime tax benefit is the estate and gift tax discounts. A minority interest in a non-publicly traded partnership is worth less than its proportionate share of the assets held by the FLP, because a minority owner can’t control business decisions or cash distributions. There’s also a liquidity discount, because it would take time to find a buyer to pay full price.
The combined discounts can be as high as 60%. That means by using an FLP you can give more property free of gift taxes or pay gift taxes on less than the underlying asset value. It also means any FLP interests in your estate could be taxed at less than the underlying asset value.
There also can be income tax benefits because of income splitting. Each partner reports his or her pro rata share of FLP income. This might result in lower family taxes when the other partners are in lower income tax brackets than you. The income is spread over several tax returns instead of all being on yours.
Even people with estates that aren’t likely to be taxable should consider FLPs because of the non-tax benefits.
As the original owner and general partner, you retain significant control over management of the assets. In most states, limited partners have a say only in major decisions such as whether or not to sell the business. The general partners control everything else, including cash distributions. The result is the FLP allows you to engage in some good estate planning and begin the transition to new owners without suffering the complete loss of control and potential givers’ remorse that can accompany other strategies.
Because of this control feature, an FLP is ideal for a small business, farm, or real estate. But it also can be a good choice for sizeable investment portfolios. You receive the estate tax benefits now but can delay actual shift of control.
The FLP also is good for annual gifts of hard-to-divide assets, such as a small business, real estate, or a diversified portfolio. Instead of recording a new deed for a fraction of a piece of real estate, for example, each year you give each person a few shares of the FLP.
In addition, an FLP provides asset protection benefits in case one or more limited partners has marital or creditor problems.
A major benefit of the FLP is to establish joint family management of assets. The family members have to learn how to manage the assets, whatever they are, and also learn to work together toward common goals while merging the different abilities and needs of individual members. Joint management also can generate lower costs and other efficiencies. Joint management probably is the top non-tax reason for establishing an FLP. It makes the FLP a very good way to make family wealth last.
If things don’t work out, the FLP ownership or structure can be changed over time. The tax consequences and cash cost of a restructuring will depend on the details, but it is more viable than trying to change the terms of an irrevocable trust or other structure.
The IRS doesn’t like FLPs, so you have to do everything properly. Don’t attempt an FLP for estate planning without the guidance of an experienced estate planning attorney. You need to establish the non-tax reasons for creating the FLP and giving property to it. All the formalities of the FLP formation and operations must be followed, including changing the ownership and titles to property, having a separate checking account, and holding annual meetings.
The creator of an FLP needs to retain personal assets outside the FLP and not depend entirely on FLP distributions for income. If the FLP appears to be the personal checking account of the general partners, it likely will be ignored for tax purposes.
You also need to avoid procrastination. The IRS and the Tax Court haven’t been kind to FLPs that were formed after a person already was gravely ill or unable to participate in financial decisions.
One problem estate planning advisors have is convincing owners to give property before it is extremely valuable or before they have estate tax issues. That’s when the tax savings are the greatest. An FLP is a very good choice for estate owners who are hesitating, because the general partner retains operating control of the property. You can dole out substantial ownership and reap the tax savings without relinquishing full control. You can transition control to others on your schedule.
RW June 2012.