Many of the recently proposed tax “reforms” call for drastic changes in — and even elimination of — the estate tax. Despite any promised changes, however, the Family Limited Partnership, or FLP, continues to be an extremely valuable tool for both business and estate planning. After all, what other tool can ease or even eliminate the tax bite often associated with transferring the snow removal business — or its income — to family members, all the while keeping the owner’s current tax bills to a minimum?
FAMILY LIMITED PARTNERSHIPS
On the downside, the IRS makes no secret it dislikes FLPs for their ability to transfer wealth within a family and minimize transfer taxes in the process. However, as the courts continue to point out, when properly executed, FLPs are a perfectly legitimate multiple tax-reducing strategy.
FLPs pool together a family’s assets into one single family-owned business partnership that family members own shares of. A FLP differs from a conventional trust, as family members actually own a share in the snow removal or ice management business. Shares can be gifted to family members over a period of years, thus taking advantage of the gift tax exemption each year.
The Family Limited Partnership or "FLP" is simply a limited partnership consisting of the members of a family, designed to centralize a family business or investments. A family, as defined in the tax rules, includes only a person’s spouse, children, ancestors (including parents), lineal descendants (grandchildren) and any other trusts established for the benefit of these people. Thus, a newly married spouse could be part of the partnership, but not a second cousin.
Any type of property can be contributed to an FLP. For example, FLPs have been formed to hold family compounds, rental real property, business equipment and assets, marketable securities and, even the family snow and ice management business. Thus, the parents might retain control of the business; draw a salary or wages from it, all the while sharing the profits with other family members who are taxed on those profits at a lower tax rate than the parents/owners.
The partnership agreement usually governs how partnership income is divided among the partners. Generally, both the general and the limited partners will share in income and cash flow based on their respective share or percentage of interest in the partnership. Although income tax liability passes through to each partner automatically, actual cash does not have to be distributed to the partners until the general partners decide to make a distribution.
In this manner, the general partners retain control over the FLP ‘s assets while the limited partners are granted very limited rights. Limited partners also have restrictions on their ability to sell or transfer their partnership units to others preventing the transfer of units outside the family.
THE VALUE OF FLP DISCOUNTS
To create a partnership, property and assets are normally transferred into the partnership entity. Frequently this involves a transfer tax at the state level. Because rarely is there an established market for the sale of limited partnerships, not to mention the lack of control that limited partners have, the limited partnership interests are often valued at a “discount” for transfer tax purposes. Valuation discounts for limited partnership interests can range from 15-percent to more than 50-percent. It is a similar story when valuing assets for estate tax purposes.
The tax benefit of the discounted value of the partnership interests, coupled with significant non-tax benefits such as liability protection and centralized management, have contributed to the popularity of limited partnerships as has the ability of the contributing partner to participate in the management of the partnership as a general partner.
FLPs VERSUS THE IRS
As family limited partnerships have grown increasingly more popular, the IRS began attacking their tax benefits. The IRS frequently argued that creation of a FLP involved a “gift” of the limited partnership interest.
Because assets transferred into the partnership and the limited partnership interest received in exchange, were usually valued at a discount, the value of the assets transferred into the partnership usually exceeded the value of the limited partnership interest. The IRS contended that the reduction in the contributing partner’s net worth was a “gift” by that partner.
Two rulings by the U.S. Tax Court shot down that argument. In one case the appellate court, the U.S. Court of Appeals for the Fifth Circuit, upheld the taxpayer’s position despite the IRS’s contention that the value of the assets transferred to the partnership should have been included in her gross estate because the transfer was not a bona fide sale for full and adequate consideration.
The appeals court concluded: “There is nothing inconsistent in acknowledging on the one hand that the investor’s dollars have acquired a limited partnership interest at arm’s length for adequate and full consideration and, on the other hand, that the asset thus acquired has a present, fair market value, i.e., immediate sale potential, of substantially less than the dollars just paid – a classic informed trade-off.”
The IRS will challenge FLPs, but with limited success. That shouldn’t deter anyone with an honest desire to transfer their snow business, its assets, or its income, to family members. After all, IRS challenges have not been successful in eliminating FLPs, nor have they severely affected any professional snow removal contractor who closely adhered to the rules.
FLPs FOR YOUNG AND OLD
FLPs have long been touted as means to transfer wealth to younger generations at reduced federal gift and estate tax costs. In the past, the IRS has mounted largely unsuccessful challenges.
Typically, a partnership is formed by the older generation, usually the parents, who contribute assets to the partnership in return for both general partnership units and limited partnership units. The parents can then embark on a plan of giving unlimited partnership units to their children and grandchildren while retaining the general partnership units that actually control the partnership.
Transferring assets or income-producing property to children or other family members can be an invaluable tax planning and tax-reducing tool. Income can be shifted to an individual in tax bracket lower than that of the donor.
The bottom-line is that FLPs that hold financial assets for a real business purpose and are properly formed and administered, have a much better chance of success in the face of an IRS challenge.