Family Limited Partnership

The Family Limited Partnership ("FLP") is a popular tool used by families to hold their business and investment assets. The FLP is often used by parents and grandparents as a vehicle to transfer assets to children and grandchildren during their lifetimes and at their deaths.

Utilizing an FLP allows you to do the following:

1. reduce the size of your taxable estate allowing you to retain control and management of the assets held in the FLP;
2. effectively compound your available gift and estate tax credits and exemptions;
3. spread income among children and grandchildren who are often in lower marginal income tax brackets; and
4. place assets beyond the reach of creditors. This chapter explains and illustrates these FLP advantages more fully.

Retention of Control Over Partnership Assets An FLP typically consists of two classes of partnership interests -- general and limited. As the creator of your FLP, you may designate yourself as the general partner, retaining the general interest in the partnership, and thereby retaining control over the assets which you transfer into the partnership. As general partner, you have the power to make and implement decisions regarding all partnership activities and operations.

The limited partners of your FLP (e.g., children and grandchildren), on the other hand, enjoy only very limited powers with regard to the partnership. As limited partners, they generally have no voice in management or control over partnership interests, regardless of whether they purchased the interests or made contributions to the partnership in return for the interests. They are considered to be only passive investors in your FLP. They have little influence in how you choose to manage your FLP.

Lifetime Gifts of FLP Interests Currently, federal estate tax rates run as high as 45% of your taxable estate (see Table 2.1 at the end of Chapter 2). Through proper estate planning, however, you can significantly reduce the size of your taxable estate which results in substantial estate tax savings. One way to achieve this estate tax savings is by gifting interests in your FLP during your lifetime to your children and grandchildren. Such gifts will help you reduce the size of your taxable estate while allowing you to keep the FLP assets intact and under your continued control.

As a general rule, lifetime gifts are subject to the federal gift tax. However, by taking advantage of the $11,000 gift tax "annual exclusion" and the lifetime Applicable exemption (currently, $1,000,000), you can make substantial lifetime gifts without incurring any gift tax. The kinds of gifts you can give which qualify for the $11,000 "annual exclusion" and the lifetime "applicable exemption" include interests in an FLP.

For example, the $11,000 gift tax "annual exclusion" allows you and your spouse each to gift property valued at up to $11,000 to as many individuals as you choose, every year, without incurring any gift tax. Thus, if you and your spouse are the general partners of an FLP and you have two children, both of you may give to each child a $11,000 interest in the FLP every year, for a total of $44,000 annually, while avoiding any gift tax liability for the gifts. In so doing, you reduce the size of your taxable estate every year while maintaining control over the gifted FLP assets.

The applicable exemption allows you to gift property valued at up to $1,000,000 (the current exemption amount as of 2004) during your lifetime without having to pay a gift tax. Of course, if you are married, you and your spouse can gift up to $2.0 million during your lifetimes without paying any gift or estate taxes. Thus, as the general partner or partners of your FLP, you and your spouse can apply this applicable exemption amount to the FLP interests you give away to members of your family and others. (Note that if any of your applicable exemption amount is not used through making lifetime gifts, the exemption amount will then be applied to your estate at death.)

Valuation Discounting of Gifted FLP Interests You can further enhance your gift and estate tax savings through lifetime gifting of FLP interests, in particular, by using so-called valuation discounts. Of the different valuation discounts available, the "minority interest" discount and the "marketability" discount are the most common. Taken together, minority interest and marketability discounts can reduce the value of the FLP interests you give to family and loved ones, for gift tax purposes, by up to 50%.

In general, gifts of FLP interests are valued, for gift tax purposes, at less than the underlying assets representing those interests. The reason for this decreased valuation is that individuals holding FLP interests have limited power or control over their interests. That is, they have no power to sell their interests, no power to force the distribution of income attributable to their interests, and no power to control the FLP as a whole. Thus, they have no market for their interests (hence, the marketability discount) and no majority control over their interests (hence, the minority interest discount). For this reason, the courts recognize these valuation discounting methods which allow taxpayers to make gifts of highly valuable property at little or no gift tax cost.

For example, assume you make a gift of an FLP interest with an actual value of $400,000 to your child. By applying a combined 50% minority interest and marketability discount, the gift, for gift tax purposes, may be valued at only $200,000. Thus, through proper valuation planning, you can effectively leverage your lifetime exclusion of $1,000,000 to allow for the gifting of property valued at $2 million or more ($4.0 million or more if you are married) without incurring a gift tax. You may also apply these valuation discounts for purposes of qualifying a gift of an FLP interest for the $11,000 annual exclusion, thereby allowing you to gift the equivalent of $22,000 per donee annually (assuming a valuation discount of 50%) while sheltering the entire amount under the gift tax "annual exclusion."

Post-Gifting Appreciation and Income Aside from reducing the value of your taxable estate by the FLP interests you give away, you may also reduce the value of your estate by the income and appreciation attributable to those gifted interests. By removing the gifted interests from your estate, any income and appreciation attributable to those interests which increase the interests, overall value is excluded from your taxable estate.

To illustrate, assume that you make a gift of an FLP interest valued at $400,000 (but discounted by a 50% valuation discount to $200,000), and that this interest appreciates in value to $800,000 between the date of the gift and the date of your death. When you die, you will have actually reduced your taxable estate by $600,000, rather than just the original $200,000, -- $800,000 (value of the gift at death) minus $200,000 (value of the gift when given) = $600,000 (reduction in your taxable estate) -- because the income and appreciation attributable to the gifted interest is not included in your estate for estate tax purposes.

Income Tax Savings As an additional benefit, the FLP allows you to shift income derived from partnership capital away from you and to the donees of your gifted FLP interests. This shifting of income occurs because the donee is deemed to be the owner of the applicable FLP interest; thus any income derived from that interest is properly attributable to the donee. Consequently, you (the general partner and donor of the FLP interest) can shift income out of your presumably higher marginal income tax bracket to the lower marginal brackets of your donees (i.e., the limited partners holding gifted FLP interests). Thus, the FLP arrangement helps you to realize substantial income tax savings year after year. Furthermore, if you choose to withhold distribution of partnership income from your donees, you will end up increasing the overall value of the FLP interests held by your donees.

To illustrate this income tax savings, suppose that your marginal income tax rate is 39.6% and you gift an FLP interest to your child who is in the 15% marginal income tax bracket. If the FLP interest you gift to your child generates $10,000 worth of income during any given year, the income is taxed to your child, and you (and your family) save approximately $2,460 -- $3,960 (tax due at your 39.6% income tax rate) minus $1,500 (tax due at your child's 15% income tax rate) = $2,460 (tax savings for the year). Of course, the income tax savings you achieve may either increase or decrease as your income levels change. Also, be aware that unearned income in excess of about $1,000 attributable to children under age 14 is taxed at their parents' highest rate under the "Kiddie Tax" rules discussed previously in Chapter 3. Thus, the "Kiddie Tax" may somewhat limit the income tax savings you achieve in certain situations.

Protection from Creditors Your FLP can be a highly effective tool for protecting personal assets held by you and the other members/partners of your FLP from the claims of creditors. Thus, if one of your partners (general or limited) has creditors seeking to lay claim to his or her personal assets, those creditors may not be able to reach the FLP assets which represent your debtor-partner's FLP interest. Under Nevada law, for example, a judgment creditor cannot force the liquidation of a partnership's assets to reach a debtor-partner's partnership interest. Rather, the creditor is only entitled to "intercept" partnership distributions made to the partner.

As to creditors' ability to "intercept" partnership distributions, you (as the general partner) may decide to withhold distributions of income from the FLP to your debtor-partner in order to accumulate assets within the partnership for partnership purposes. By withholding such distributions, you can effectively foreclose creditors from receiving any benefit from the assets held in your FLP. Thus, although it is theoretically possible for a creditor to proceed against the FLP interest of one of your debtor-partners, that interest, as a practical matter, would be of little or no value to the creditor because of your power (as the general partner) to withhold distributions of partnership income.

An illustration of the Benefits of an FLP Assume that Mr. & Mrs. D establish the D Family Limited Partnership ("FLP") which they fund with several real estate interests which they own worth approximately $1,000,000. In exchange for the real estate interests they transfer to the FLP, the D's each receive half of the 1% general partnership interest and each receive half of the 99% limited partnership interest.

Now, assume that the D's want their two sons to start learning about investing in real estate but that they do not want their sons to have full ownership of any of the FLP's real estate interests until they are much older and are in a much better position to wisely manage those interests. Assume further, however, that the D's also want to start passing some of their wealth to their sons to reduce the size of their estates for estate tax purposes. Thus, on the one hand, the D's want to reduce the size of their estates by gifting FLP interests to their sons, while on the other hand, they want to minimize their gift tax burden and maintain control over the property in their FLP representing the FLP interests which they intend to gift to their sons -- a perplexing problem for many taxpayers.

If the D's make gifts to their sons of FLP interests valued at $22,000 each (for a total of $44,000 in gifts) during the taxable year, they will avoid paying gift taxes on these gifts due to the $11,000 gift tax annual exclusion. This is because the D's qualify for a total of four $11,000 gift tax annual exclusions for the year -- two exclusions for each of their two sons since both spouses are giving $11,000 in FLP interests individually to each of their sons. Furthermore, the D's will maintain control over the property representing their sons' gifted FLP interests since their sons are only considered "limited" partners in the FLP. Thus, the D's reduce the size of their estates, save money in gift taxes and maintain control over their sons' FLP interests. However, the D's can still do more.

Since the D's are gifting FLP interests to their sons, they can take advantage of the valuation discounting methods (the marketability discount and the minority interest discount) discussed previously. Therefore, assuming a valuation discount of 50% and taking into account their respective $11,000 gift tax annual exclusions, the D's can actually gift to their sons FLP interest valued at $44,000 each (for a total of $88,000) during the taxable year without incurring any gift tax whatsoever. This is because the FLP interests the D's are gifting to their sons are only worth $44,000, taking into account the 50% valuation discount, even though those interests have an economic value to the D's of actually $88,000. Thus, the D's reduce the size of their estates by a substantially higher amount while avoiding gift taxes all together and while maintaining control over their sons' gifted FLP interests.

Over time, the D's can continue gifting FLP interests to their sons while taking advantage of their $11,000 gift tax "annual exclusions" and while applying a 50% valuation discount. Additionally, the D's can pass even more value to their sons, again using a 50% valuation discount, by gifting larger portions of their FLP and by applying their combined $2.0 million lifetime applicable exemption amounts ($1,000,000 for each spouse for a total of $2.0 million). Finally, any appreciation applicable to the gifted FLP interests will pass outside of the D's estates after the gifts are made. Thus, as is evidenced by this illustration, the benefits of an FLP are plentiful.

Conclusion The FLP is a valuable estate planning tool which you can use to enhance and protect the value of your estate, not only for your benefit, but for the benefit of family members and others as well. If you feel that implementing an FLP will help you achieve your estate planning and asset protection objectives, you should consult with an estate planning attorney who can help put the benefits of an FLP to work for you.