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.