Cut Wealth Transfer Taxes With a Family Limited Partnership
The family limited partnership (FLP) is a classic technique to shift income and wealth to your children and future generations. We began this structure with a client about 25 years ago. Ownership in income-producing real estate now includes both the children and grandchildren of Mom and Dad, who were my initial clients. No estate tax was owed upon either parent’s death — ownership was transferred to their children and grandchildren. Income is shared with future generations.
This transfer of wealth was made in a very tax-efficient manner, as the FLP operates as an ongoing legacy for this family. The FLP continues to grow and recently expanded into another state, taking advantage of opportunity zone tax benefits.
How a family limited partnership works
The parents create the family limited partnership. Initially, the parents will hold the general partnership interests, say 2%. As general partners, the parents maintain virtually full control of the business. A limited partner’s right to vote is restricted to voting on very limited issues, such as the sale of the company or to approve dissolution. The remaining 98% of the FLP interests are nonvoting. All management of the day-to-day operations of the FLP are vested in the general partners or parents.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail.
Profit and prosper with the best of expert advice – straight to your e-mail.
In some states, such as California, transfers of the real property can trigger a reassessment of the property tax. A transfer of the property into the FLP, when the ownership percentages are exactly equal to the ownership of the real property, is generally an exception to reassessment for change in ownership in those states. When more than 50% of the total partnership interests are transferred, the real property is reassessed for property tax purposes to the fair market value at that time.
The parents, as general partners, keep dictatorial control over the FLP. As general partners, the parents also remain personally liable for FLP activities. Greater asset protection can be achieved by holding the general partnership interest in a limited liability company (LLC) that is owned and controlled by the parents. At the same time, the parents can gift as many or as much of the limited partnership interest to their children or grandchildren as they wish. This reduces the parents’ taxable estates and shifts a portion of the income to the next generation as well. Gifts can be tied to the annual gift tax exclusion, which for 2024 is $18,000 per year per donee. For a married couple, a gift value of $36,000 ($18,000 from Dad plus $18,000 from Mom) to each child can be made without any gift tax effect. Gifts in excess of that value would reduce the lifetime exclusion, which is $13.61 million per person or $27.22 million for a married couple.
Limited partners, by both state statute and the limited partnership agreement, have no right to participate in the management of the limited partnership business. This ensures that the parents or general partners maintain dictatorial control over the business operations and assets. Limited partners may have some rights to vote on limited matters, such as the admission of new partners and the sale or dissolution of the business.
Here’s an example
Parents transfer a commercial building with a fair market value of $1 million to an FLP. In return, parents receive a 4% general partnership interest and a 96% limited partnership (LPS) interest. Parents wish to divide the LPS interests between their four children. To avoid paying gift tax or using the lifetime applicable exclusion amounts, each parent could gift LPS interests to each of the children worth $36,000 per year ($18,000 from each parent to each child). This value would be net of any appropriate valuation discount as described below. Parents would transfer .36% to each child each year without regard to a valuation discount. If the parents wish to transfer ownership faster, they can do so.
However, such a transfer in excess of that amount would reduce the parents’ available lifetime gift and estate tax exclusion. That exclusion is $13.61 million per person in 2024. On January 1, 2026, that exclusion drops to about $7 million per person (an inflation-adjusted $5 million level) under current law. Using that gift tax exemption before the credit is reduced and lost is appropriate for most people with a taxable estate. Even when all the limited partners’ interests are transferred to the children, the parents retain dictatorial control of the FLP as the general partners.
How valuation discounts work
Changes in ownership or transfer of minority interests in the FLP have a lower value than the pro rata portion of the total value. Discounts can be available for lack of control and lack of marketability — lack of control because owners of minority interest cannot control virtually any actions taken by the FLP business. This is actually true for all of the LPS limited partners. A lack of marketability discounts is appropriate if there is no available market for the sale of the family business interests.
Perhaps the best way to understand valuation discounts is to consider me owning a business with my brother, Joe. My interest is 30%, Joe’s interest is 70%. The company is worth $1 million. At first blush, you may think my interest is worth $300,000 (30% of $1 million). However, an unrelated buyer would not pay that much because Joe has control of the company. Discounts can range from 10% to 50% or more depending on the facts.
Conversely, Joe has greater control of a $1 million company while holding a 70% interest. His interest may be subject to a control premium with a buyer willing to pay more than $700,000. The amount of that premium would depend upon the facts, such as the terms in the company’s governing documents.
The most common valuation discounts are for minority business interests such as FLPs, LLCs, corporations and are as follows:
- Lack of control. The owner’s, partner’s, shareholder’s and member’s interest is worth less (reduced in value) because that owner is unable to control company activities, compensation, declaring dividends or other business decisions. A buyer of that interest would be along for the “ride” without a way to control the business or its activities or decisions.
- Lack of marketability. Business interest traded on a formal public exchange may be sold or traded easily for a readily ascertainable value. Companies not traded on a national exchange do not have a readily ascertainable value. The lack of such a market alone may warrant a discount. A minority interest or restricted stock is often even more difficult to sell to an outsider, perhaps warranting an even greater discount.
- Minority interest. A minority interest may be worth less than the pro rata share of the total company value due to the limited scope or ability to control critical aspects of the company, including financial, operational, regulatory, legal and even hiring or firing decisions.
These valuation discounts are very helpful in planning to minimize estate gift taxes. If we are able to reduce the value of the business interest, the gift or estate tax impact is good.
Once again, tax planning is a topsy-turvy world where income and higher values for tax reporting are not desired, and valuation discounts are good. Valuation discounts are a way to leverage the lifetime estate and gift tax exclusion to remove a greater amount out of your taxable estate.
In addition to the ability to move wealth to the next generation in a tax-efficient manner, the FLP also facilitates shifting income and the related tax burden to the next generation. The children (or grandchildren) may have a lower marginal income tax rate than the parents.
How family limited liability companies work
Family LLCs can be used in a similar manner. LLCs are intended to be hybrid business organizations or entities with the pass-through tax advantages of a partnership personally and limited liability of a corporation. Parents retain control and would be designated as managers, and nonvoting membership interests would be used for gifting to the children or for the next generation’s ownership.
LLCs may be preferred because of the following advantages:
- Limited liability for all members. Note that only limited partners enjoy limited liability in the FLP. This is resolved by using an LLC as the general partner.
- Flexible governance. In an FLP, if limited partners participate in management decisions, then they may be treated as a general partner for liability purposes, such as in a lawsuit against the FLP. That is not typically an issue for an LLC.
- Post-death liquidation. An LLC may be able to implement a post-death nontaxable liquidation. An FLP cannot.
Despite the advantages listed above, the FLP structure lends itself to the facts needed for maximum valuation discounts. Same state laws governing LLCs may result in a lower valuation discount without additional planning. Some states with favorable LLC statutes, such as Nevada, will provide comparable discounts.
How asset protection works in FLPs
FLPs provide significant asset protection, both from claims against the business and regarding claims against the partners. Limited partners’ personal assets beyond their initial contribution are typically protected from judgments against the LPS. Judgments against the limited partners cannot be used to reach FLP assets. A creditor is typically limited to obtaining a charging order to receive distributions that would otherwise be made to the limited partner from the FLP. The general partner or parent(s) may simply decide not to make any distribution that would go to the creditor and not the limited partner.
Other benefits of FLPs:
- Implementing a succession plan for the family business
- Reducing the expenses of managing assets
- Protecting assets from irresponsible family members
- Limiting the liability of individual owners
- Consolidating management of a family business across a single entity
- Ensuring the continuation of a business after the senior members die
- Simplifying estate administration
- Creating joint family management of assets
- Helping children learn how to manage assets
- Facilitating gifting
- Enabling family members to pool their assets
Related Content
Source link
