Planning with Family Limited Partnerships in 2012
A family limited partnership ("FLP") is a legal structure potentially offering a number of benefits for wealthy clients who are interested in transferring a portion of their wealth to future generations of family members. Estate planners have also utilized limited liability companies ("LLCs") for wealth transfer purposed. While the FLP structure has been used successfully by clients for many years, FLPs have been under attack by the IRS as an estate planning tool. Thus, the ability of clients to transfer their wealth through the use of FLPs largely depends upon the client's understanding of the rules and limitations of FLP planning, as described below.
What is a Family Limited Partnership?
An FLP is a type of partnership formed by family members for a variety of tax and nontax reasons. With a typical FLP, senior members of a family (e.g. parents) transfer a portion of their investment assets to an FLP in exchange for either general partnership interests, limited partnership interests, or both.
When Should One Consider Forming an FLP?
One may consider forming an FLP in the following situations:
- One is interested in transferring some of his or her wealth to younger generations of the client's family in a tax-efficient manner.
- One wants to educate younger members of the family regarding management of the assets owned by the FLP.
- One wants to protect the assets contributed to the FLP from the potential creditors of the FLP's partners, including anticipated future partners such as the client's children.
- One has sufficient assets outside of the FLP to maintain his or her standard of living and does not need to rely upon distributions from the FLP.
- One has nontax reasons for forming the FLP outside of estate and gift tax planning reasons (this is discussed in more detail below).
What are the Benefits of an FLP?
- Transfers of FLP interests generate discounts against the value of the assets owned by the FLP, which may result in gift and estate tax savings. The inherent lack of marketability of the FLP interests and lack of control by the limited partners over the operation of the FLP give rise to these discounts.
- Transferring FLP interests to family members rather than fractional interests in the actual assets owned by the FLP allows the client to transfer the economic benefit of the FLP assets without having to divide the ownership of the assets among different individuals.
- The FLP is a flow-through entity and, therefore, does not have to pay a separate layer of income tax. All items of partnership income, deduction, gain and loss flow through to the partners in the same proportions as their ownership in the FLP.
- Creditors of a limited partner are generally restricted to accessing the partner's share of distributions from the FLP, but cannot obtain voting or management rights over the FLP.
What are Some Possible Disadvantages of an FLP?
- Although FLPs are widely used to lower estate and gift taxes through the application of valuation discounts, the IRS continues to attack the use of FLPs to generate these discounts. Careful planning is required to avoid a potential IRS attack.
- If a client transfers an FLP interest during his or her lifetime, the transferee interest will not receive a step-up in the income tax basis of either the FLP interest or the transferee's share of the FLP assets on the client's death.
- The client may have increased annual expenses (e.g., accountants' and attorneys' fees) related to the administration and tax reporting of the FLP.
Other Issues One Should Consider Before Forming an FLP
Before forming an FLP, one should also be aware of the following issues:
- If the creation and funding of the FLP occurs too close in time to subsequent transfers of interests in the FLP, the IRS may argue that there was a "gift on formation" - essentially that the client made a gift of the underlying FLP assets to his or her family members rather than gifts of the discounted FLP interests. This may cause unintended gift tax consequences to the client. Gifts of FLP units should be made as far into the future as possible following the formation of the FLP.
- The size of the valuation discount on the transfer of the FLP units will largely depend upon the character of the assets held by the FLP. For example, the valuation discount applicable to units of an FLP that owns liquid assets such as cash, CDs, stocks and bonds will generally be smaller than the valuation discount applicable to units of an FLP that owns non-liquid assets such as real estate. In any event, the valuation discount must be determined by a qualified appraiser. The terms of the FLP agreement, drafted by an experienced attorney, also are crucial in determining the appropriate valuation discounts.
- 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.
Using FLPs in Estate Planning
Once the FLP has been formed and funded, the client can engage in a number of different strategies to transfer FLP interests to family members to reduce the size of his or her taxable estate. This would be particularly relevant during the remainder of 2012 while the gift tax exemption amount is $5.12M per person ($10.24M for a married couple). The following techniques are among the most widely used, especially this year to take advantage of the historically high gift tax exemption amounts before they expire:
1. Direct Gift of FLP Interest
FLP interests can be gifted directly to family members or trusts created for their benefit (see below). This is simple to do - most FLP agreements allow for these types of transfers without triggering a standard right of first refusal in favor of the other partners. Gifts of FLP interests should qualify for the valuation discounts discussed earlier, thus providing for greater gift and estate tax savings. If the limited partnership interests are gifted outright to individual family members, each individual will become a limited partner in the FLP and must agree to be bound by all of the terms of the FLP agreement. The client would be required to file a gift tax return to report the gift of the FLP interest. If the client does not have sufficient lifetime gift tax exemption available when the gift is made, the client may be required to pay gift tax on the gift.
2. Gift of FLP Interest to IDGT
Instead of gifting an FLP interest directly to a family member, the FLP interest could be gifted to a special type of trust known as an Intentionally Defective Grantor Trust ("IDGT"). An IDGT is an irrevocable trust generally created by the client for the benefit of a family member such as a child or grandchild. For income tax purposes, the client is taxed on all of the income generated by the IDGT, whether or not distributed to the beneficiary of the IDGT. A gift to an IDGT is an attractive option if a client does not want a beneficiary to own the FLP interest outright (for example, if the beneficiary is a minor), and/or the client desires to pay the income taxes on the income earned by the IDGT's assets, which is tantamount to a tax-free gift to the IDGT beneficiaries of the income taxes so paid. As with the gift of an FLP interest to an individual beneficiary, a gift of an FLP interest to an IDGT would require the donor to file a gift tax return, and possibly pay gift tax on the transfer. The client may also allocate a portion of his generation-skipping transfer ("GST") tax exemption to the transfer so that distributions from the IDGT to individuals two or more generations below the client are exempt from GST tax.
3. Sale of FLP Interest to an IDGT
Alternatively, the transfer could be structured as a sale of the FLP interest to an IDGT, rather than as an outright gift. In the sale transaction, the client would sell an FLP interest to an existing IDGT in exchange for a promissory note with a relatively low rate of interest (but not less than the "Applicable Federal Rate" released each month by the IRS). The term of the promissory note should generally be long enough to allow the IDGT to pay off the promissory note. The IDGT would use the income from the FLP interest it would then own to make interest and principal payments on the promissory note. This would allow the client to continue to receive an income stream from the FLP interest in the form of interest and principal payments on the promissory note. In addition, all of the appreciation of the FLP interest after the sale would be removed from the client's estate, with the client only retaining in the client's taxable estate the value of the note that has not been paid at death. Often the trust is funded with a seed money gift of at least 10% of the total sale to assure that the note is respected as bona fide debt; clients should consult with counsel on this step and the corresponding gift tax consequences.
4. Transfer of FLP Interest to a GRAT
One may also transfer all or a portion of his or her FLP interest to a special trust called a Grantor Retained Annuity Trust ("GRAT"). The GRAT is designed to pay an annuity back to the client for a set number of years. The annuity payment can be in the form of cash (generated from the income of the FLP interest), FLP units, or a combination of the two. The goal of using a GRAT in this context is to pay back to the client the entire value of the FLP interest initially contributed by the client to the GRAT, plus a rate of interest established by the IRS (currently 1.2% for June 2012). At the end of the term of the GRAT, any appreciation on the FLP interest in excess of the specified interest rate would be distributed free of gift and estate tax to the grantor's designated family members or trusts for their benefit.
Avoiding IRS Attacks on FLP Discounts
Over the years the IRS has repeatedly - and often successfully - attacked the use of FLPs in estate planning. Specifically, the IRS has attempted to reduce or eliminate the valuation discounts taken by taxpayers on the transfer of FLP interests reported on estate and gift tax returns. If the valuation discounts are ignored, the client would be treated as if he or she had transferred the full fair market value of the underlying FLP assets (in the case of a gift or sale of the FLP units) or as if he or she had died owning the underlying assets of the FLP, rather than the FLP interest itself.
Fortunately for those who wish to use FLPs in their own estate planning, there are a number of cases and IRS rulings that provide a roadmap for establishing and operating an FLP to best protect the structure from an IRS attack. One should be prepared to do the following:
1. Establish a Legitimate and Significant Nontax Reason for Forming the FLP
One should have "legitimate and significant" nontax reasons for forming the FLP other than reducing taxes by discounting asset values. For example, obtaining the creditor protection of the limited partnership entity can be a valid and significant nontax reason for transferring an asset into an FLP. Other possible nontax reasons include: allowing for the joint management of family investment assets, allowing for gifts of partnership interests to family members rather than fractionalized interests in the underlying FLP assets, providing for a single pool of assets that would allow the partners access to other investment opportunities that would not otherwise be available to them, providing a mechanism to resolve disputes among the various family members relating to the FLP property, and continuing to keep ownership of the FLP assets within the family by restricting the rights of non-family members to the assets.
2. Observe Partnership Formalities
One should treat the partnership as an actual business. If basic partnership formalities are not followed, the IRS may not respect the partnership as a legitimate business entity. Separate books and records for the FLP should be kept. Required state filing should be made on time. A separate bank account for the FLP should be established, and partnership assets should not be commingled with assets of any partner. The partners should attend regular meetings and minutes of those meetings should be recorded. Decisions regarding the management of the FLP assets should be made by the general partner only. Distributions to partners should be made in accordance with the terms of the FLP agreement and in the same proportionate interest as the partners' ownership in the FLP.
3. Forego Unrestricted Control and Access of Assets Transferred to FLP
One should not transfer substantially all of his or her assets to the FLP, nor should the client have the need for the income of the FLP to pay his or her current or future liabilities (including anticipated estate and gift taxes). The client should retain enough assets outside of the FLP to support his or her standard of living independent of any potential income from the FLP. The client should only transfer investment or business assets to the FLP. Personal use assets, such as personal residences or automobiles, should not be transferred. The IRS has been successful in invalidating FLPs in numerous cases where the donor/decedent operated the FLP as his or her personal checkbook, as if the assets were still owned by the donor/decedent in his or her own name. Neither should the client remain in control of the FLP as its general partner without full knowledge and understanding that the IRS could seek to pull back into the client's taxable estate the full value of the FLP interests gifted or sold, notwithstanding such gift or sale, by virtue of such retained control.
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.
Article contributed by Robert Strauss and Jeffrey Geida of Weinstock, Manion, Reisman, Shore, & Neumann. For over 50 years, the law firm of Weinstock, Manion, Reisman, Shore & Neumann, a Law Corporation, has provided expert assistance and counsel in the areas of estate planning, probate and trust administration, general business and corporate law, taxation, real estate, trust and estate, and litigation. The attorneys are highly respected by their peers. Several members of the firm, including each of shareholders, have received the Southern California SuperLawyer designation. This extraordinary distinction recognizes SuperLawyers as attorneys who are in the top 5 percent of their practice area.