Family Limited Partnerships and Family Limited Liability Companies

Don and Kate Bell had a typical estate planning problem. They were making maximum use of their gift tax exemptions with annual gifts of cash to each of their three children and seven grandchildren. However, given their large estate of over $20 million, they wanted to do more. They had already used up $1 million of their lifetime gift tax exemptions ($500,000 each), so they were limited to giving approximately $9 million more unless they also wanted to pay gift taxes.

The Bells were also concerned about making gifts of nonliquid assets, such as real estate. Such assets are not easily divisible. Don did not want to sell off his real estate, which had a low cost basis, and then end up paying capital gains tax as well as gift tax. Also, the properties were in excellent locations, increasing in value and producing a substantial amount of income, so selling now would not be wise. Don was successful because of his knowledge of real estate and his excellent management skills, so he wanted a plan that would allow him to stay in control of his real estate.

The Bells were introduced to the idea of a family limited partnership and learned how it would not only allow them to make leveraged gifts but also leave them in control of their money for their lifetimes. In addition, Don would be able to continue to collect a management fee if he felt he needed the income. As a bonus, the family limited partnership plan provided excellent protection for the assets in the partnership from the claims of creditors.

In 1953, Sam and Helen Walton put what little they had into a family partnership that included their four children. They called their partnership “Walton Enterprises.” From this partnership the well-known chain store, Walmart, evolved. Eventually, the partnership assets grew and included real estate, banks and a newspaper. In 1985, the Walton family’s wealth was estimated to be $20 to $25 billion. But when Sam Walton died in 1992, he owned only a 10 percent interest in Walton Enterprises. He had used a family partnership to transfer assets that grew to over $18 billion to other family members without gift or estate tax. To Sam Walton, the gift of a business opportunity to a loved one was much more valuable than a gift of cash. With a flat rate of 55 percent at the time of Sam Walton’s death, this advanced planning saved approximately $10 billion in estate taxes.

When individuals own business or investment assets whose value is high enough to potentially subject their estates to federal estate taxes, they are faced with the unappealing option of giving assets away at a substantial gift tax cost and, thus, giving up the income stream generated by the assets. By transferring these assets to one or more partnerships, individuals can maintain control of the assets and continue to receive at least a portion of the income and tax benefits of those assets. At the same time, they can give family members the assets in a tax-efficient manner and reduce—and in some cases even eliminate—the potential for federal estate taxes. If you would like an effective way to protect family assets and keep them where they belong while avoiding estate taxes, a family limited partnership may be for you.

 

Advantages

A family limited partnership (FLP) offers the following benefits:

Allows the general partner (including the parents, for example) to remain in control of partnership assets, investments and distributions, even if the general partner share is 1 percent or less.

Creates a vehicle for transferring substantial amounts of wealth to family members at discounted values, significantly reducing estate and gift taxes.

Eliminates potential estate taxes on the appreciated value of partnership interests given to family members or to trusts for their benefit.

Ensures continuity of family management and an orderly transition from one generation to the next.

Provides a potential way to fund an insurance policy to help cover estate tax costs without having to use gift tax exemptions or pay gift taxes.

Provides income to the general partner through management fees and partnership distributions.

Provides a way to split income among family members.

Protects assets from the claims of creditors.

To different individuals, some of these benefits are more important or appealing than others. However, virtually everyone who is interested in estate planning wants to control assets and protect them from creditors. These are two of the most compelling reasons for using a family limited partnership.

 

FLP Basics

Although an FLP can be a complex planning strategy, the basic concept is relatively simple. Here, in essence, is how an FLP works:

  1. A husband and wife have business or investment assets (such as real estate) that they would like to share with other family members (children, grandchildren, parents, siblings) or even a favorite charity, but they still want to maintain control over these assets.
  1. A qualified attorney who is experienced in the preparation of FLPs and estate planning prepares a limited partnership agreement and a certificate of limited partnership for the couple.
  1. The certificate of limited partnership is then filed with the appropriate state agency. The filing, registration or recording fees vary from state to state costing from as little as $50 to as much as $5000…or more.
  1. Usually, at least initially, the husband and wife (or a trust, corporation or limited liability company controlled by them) serve as the general partners of the FLP.
  1. The couple transfers some of their assets to the FLP in exchange for both general partnership and limited partnership interests. A qualified appraiser then appraises these interests and, if necessary, the underlying assets of the FLP. The appraiser values the limited partnership interests on the basis of the terms of the FLP agreement and the types of assets in the partnership. Usually, the value of the limited partnership interests is substantially less than the value of the partnership’s assets, because the appraiser discounts the value of the limited partnership interests for lack of control and lack of marketability. These discounts can range from 25 to over 50 percent depending on the partnership agreement and the assets held in the FLP.
  1. If they choose, the general partners, who are also limited partners, give some or all of their limited partnership interests away. The gifts are usually made to family members, trusts created for family members, charities or short-term split-interest trusts, such as grantor retained annuity trusts or charitable lead trusts.
  1. The value of the gifts of limited partner interests is subject to the discounts determined by the appraiser. These discounts leverage the giving ability of the husband and wife, so larger gifts can be made on the basis of a discounted, or lower, value for gift tax purposes.
  1. No matter how small a percentage the general partners own, they always have full control over the day-to-day management of the FLP and the assets in it. In fact, the general partners determine if and when any distributions of income are made.
  1. General partners are entitled to a reasonable management fee for their management of the partnership. The fee varies depending upon the duties of the general partner, but typically ranges from 1 to 5 percent of the value of the assets in the FLP.

 

Partnership Classes

A family limited partnership is a legal entity formed under a state’s partnership laws. It consists of two classes of partners. The first are the general partners, who have total control of the day-to-day management of the partnership and are completely liable for the management obligations, debts and liabilities of the FLP regardless of their percentage ownership, just as if they owned the assets outright.

The members of the other class are the limited partners. They have no control over, or participation in, the day-to-day management of the FLP regardless of their percentage of ownership. Because of the lack of control, under state law they do not have any personal liability exposure for any of the obligations, debts or liabilities of the FLP. A limited partner’s exposure to loss is generally limited to the extent of his or her investment in the FLP.

 

The General Partner

Because the general partner controls the operation of the limited partnership regardless of the percentage ownership, the old control rule of 51 percent majority is really not applicable or necessary. Even a general partner with an interest of less than 1 percent still maintains 100 percent control.

An individual can be the general partner or several individuals can be the general partners. The downside to having individuals as general partners is the exposure to unlimited liability for the obligations, debts and liabilities of the partnership. Whether this is a problem depends on the nature of the partnership’s assets. If, for example, the FLP owns assets such as rental real estate, rental aircraft or any asset that could potentially cause a personal injury, the liability exposure of the general partner can be substantial. On the other hand, if the FLP owns only intangible assets (such as stocks, bonds or mutual funds), the general partner’s liability exposure is very limited. With intangible assets, the general partner’s only serious liability is for debts incurred by the partnership. Another potential problem with having individuals as general partners is that individuals die or can become incompetent. Most states’ laws provide that a limited partnership will terminate upon the death or incapacity of all the general partners.

 

Taxation

Partnerships normally do not pay federal income taxes. Nonetheless, partnerships must still determine their taxable income, which is computed in basically the same manner as it is for individuals. Because the partnership does not pay income taxes, the partners are responsible for paying income taxes on partnership income. Tax liability accrues to the partners of an FLP even if income is not actually distributed to them. Generally, the partnership agreement controls the allocation of taxable income, loss, deductions and credits. When a partner is a member of the partnership for only a portion of the tax year, he or she is allocated only the portion of such items attributable to his or her tenure.

For income tax purposes, all items passed from the partnership to its partners retain the same character they had for the partnership. As an example, if the partnership receives tax-exempt income, the partner’s share of that income is also tax-exempt. The partner’s distributive share of such items as income credits, deductions and nondeductible partnership expenses is identified on IRS Schedule K-1 of Form 1065. The partners receive individual copies of Schedule K-1 to allow them to prepare their individual 1040 income tax forms.

 

Life Insurance

If an FLP owns and is the beneficiary of any life insurance on the life of a partner, the insurance death benefit will be included in the partner’s estate indirectly in an amount determined by the current value of the deceased partner’s partnership interest. So, if a deceased partner’s interest is 10 percent, the amount of death benefit included in the estate is equal to 10 percent of the proceeds.

To avoid inflating the deceased insured’s partnership interest by any portion of life insurance proceeds, a life insurance policy may be structured with adult children as owners from the policy’s inception. Alternatively, the children could create an irrevocable life insurance trust (ILIT) with each child contributing his or her pro rata portion of the life insurance policy’s annual premium from distributions from the FLP. Through an ILIT, the children, as grantors, could protect the policy’s cash value in the event of a grantor’s divorce or death. Trust design could also help ensure that policy proceeds would be available to help cover liquidity needs created by estate taxes at the death of the parents.

 

The Family Limited Liability Company Alternative

Legal developments can sometimes take a while to catch on with the public and limited liability companies represent a good example. Most states adopted laws allowing the creation of limited liability companies in the 1980s; but, until the IRS signaled their acceptance and courts confirmed their asset protection benefits, most attorneys continued to recommend using family limited partnerships for planning purposes. However, in recent years, the use of family limited liability companies (FLLCs) in place of family limited partnerships (FLPs) has become common, if not the norm.

While the benefits achieved by FLLC planning are the same as with FLP planning, FLLCs often require only nominal state filing fees compared to FLPs. Additionally, rather than requiring a general partner to serve and accept potentially unlimited liability for partnership liabilities, an LLC has no general partner. Instead, the LLC is typically managed by a designated manager who accepts no personal liability for LLC liabilities. As a result, there is no reason to create an entity (LLC, corporation or trust) to serve as the general partner.

Through careful planning, the same discounts for lack of marketability and lack of control achieved with FLP planning can be achieved through FLLC planning, with potentially less administrative expense and fewer complexities.

 

Planning Risks

Family partnership arrangements have been coming under greater scrutiny as their use has increased in recent years. The Internal Revenue Service will disregard a partnership as an entity if the principal purpose of the partnership is tax-motivated either at inception or during its operation. Thus, in the formation of an FLP, it is important to have a “business purpose” and to have the documents prepared by an attorney who specializes in estate planning and FLPs so that they will withstand any scrutiny by the IRS.

 

The costs involved in forming and maintaining an FLP should be considered, including:

– Attorney fees for forming the partnership and handling related legal matters (e.g., transferring assets).

– Appraisal fees for underlying assets and for the interests of the partnership given to the younger-generation family members.

– Continuing administrative fees and expenses for matters such as the FLP’s yearly income tax return (1065 partnership return and partnership K-1 forms).

– Transfer tax costs, such as documentary stamps when transferring real property into the FLP, and, possibly, title insurance costs.

– Registration fees, which, depending on the state in which the FLP will be registered, can range from $500 to over $5,000.

FLPs #1

 

 

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