Reducing Transfer Taxes: Could You Benefit from an FLP?

With so many recent changes in the tax laws, it’s more important than ever to look for tax planning strategies that can help reduce future tax liabilities of higher-income taxpayers.

One recent change that will negatively affect many taxpayers is an increase in the maximum estate tax rate from 35% in 2012 to 40% in 2013. As a result of this rate increase, taxpayers with highly-valued assets should be looking for ways to reduce their taxable estate during their lifetime without completely giving up control of their assets.

One planning strategy that can be used to shift estate value and investment income, free of transfer taxes, involves Family Limited Partnerships, or FLPs.

What is an FLP?

An FLP is a state-chartered limited partnership consisting of general partners (who control management and investment decisions) and limited partners (nonvoting or “silent” partners) who are all members of the same family.

In setting up an FLP, a written limited partnership agreement is prepared. The agreement includes provisions related to restrictions on the limited partners’ ability to participate in the operation and control of the FLP. It also includes restrictions on the limited partners’ ability to liquidate their interest in the FLP or withdraw from the FLP.

A general partnership interest, typically comprising 1% of the ownership, and a limited partnership interest, comprising more than 99% of the ownership, are created. When formed, the parents normally hold both the general and limited partnership interests. 

The parents will then contribute their investment assets, such as real estate or closely held securities, to the partnership in exchange for both the general and limited partnership interests. The general partnership interests and control of the partnership are retained by the parents for their lifetimes, while the limited partnership interests are given as gifts over time (to or for the benefit of children and grandchildren), taking advantage of the annual gift tax exclusion ($14,000 per donee in 2014).

What are the Advantages of an FLP?

There are many advantages of contributing personal assets to FLPs.

• An FLP is more flexible than an irrevocable trust, since the partnership agreement can be amended or changed.

• Senior family members can preserve control over their assets by giving limited partnership units rather than cash and securities to family members.

• The general partner controls all distributions of cash or property to partners. They can be made on a non-pro-rata basis to meet educational needs of young limited partners or to provide supplemental income for themselves and their adult limited partners.

• The general partner can maintain control of any management or investment decisions related to the assets that were contributed to the partnership even though he or she only holds a minimal ownership interest.

• The limited partnership protects assets from the claims of future creditors (and spouses of failed marriages) of any of the limited partners. Creditors may not force cash distributions, vote, or own the interest of a limited partner without the consent of the general partners.

• During the lifetime of the contributing taxpayer, income generated by assets in FLPs is divided and allocated to each partner (general and limited) in accordance with the terms of the agreement (usually pro rata). This means that the taxable income may end up being allocated among family members with lower income tax brackets.

• Real estate held in multiple states is converted into a single intangible asset inside of an FLP, and by use of the FLP wrapper, you make the real estate not subject to probate jurisdiction of courts of the state in which the actual property is located.

With respect to estate planning and the increase in current tax rates, the major reason for contributing assets to an FLP is to reduce a senior family member’s gross taxable estate. By transferring interests in the family limited partnership rather than interests in the underlying assets, the parents can reduce the transfer taxes that might otherwise be imposed. The reason for this reduction is that the fair market value of an FLP interest is often less than the fair market value of a proportionate interest in the underlying assets due to valuation discounts. Valuation discounts for the partnership interests are believed to be appropriate due to the following restrictions associated with FLPs:

• Each limited partnership interest typically is only a minority interest in the partnership.

• Limited partnership interests frequently lack marketability.

• A limited partner typically has no control over the enterprise.

• A limited partner generally does not have an unrestricted right to liquidate his or her interest by forcing a distribution of a share of the partnership assets.

• A limited partner may only be entitled to receive a distribution of partnership income determined at the sole discretion of the controlling general partner.

• The limited partners are not able to assign or pledge their limited partnership interest as collateral.

As previously noted, these discounted FLP interests should be transferred over time to take advantage of the annual gift tax exclusion, which allows a taxpayer to transfer up to $14,000 per person annually without decreasing the unified credit that will be available against estate taxes.

Words of Caution

The IRS has expressed concerns that taxpayers will focus on only the tax advantages of partnerships and maintains the position that partnerships must be able to demonstrate a business purpose as outlined above in order to avoid scrutiny.

Care should be taken both when creating the FLP and in observing the formalities of operating the FLP as a family business. A thorough analysis of state laws and the rights and obligations associated with transferred property is critical to the determination of fair market value, and valuations should be supported by professional appraisals.

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