Ask the Experts!
The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers. Here’s the question of the day.
Question: My client’s estate planning attorney has recommended a family limited partnership to help the client reduce estate taxes. How does that work?
Answer: Consider this example:
- Frank and Barbara Buckley are each in their late 60’s, and have a combined net worth of more than $20 million.
- The Buckleys’ estate consists of a closely held business interest, personally-owned commercial real estate, personal real estate, liquid investments and cash.
- The Buckleys have four children and ten grandchildren.
- Frank and Barbara have already done basic estate tax planning, and are open to the idea of making controlled gifts to family members.
The Buckleys decide that they will put a piece of commercial property worth
$4 million into a new FLP. The implementation works like this:
- Frank and Barbara create the Buckley Limited Partnership, and transfer the property into it.
- The partnership is structured so that it has a 1% general partnership interest, and the other 99% ownership interests are limited partnership interests.
- At inception of the FLP, Frank and Barbara own all the partnership interests—both general partnership and limited partnership.
- The operating agreement for the FLP says that the general partner will make all the decisions for the FLP.
After the initial implementation, the Buckleys decide that they will give away some of the limited liability interests to their children and grandchildren. They divide the limited partnership interests into 1% blocks.
Each 1% block has a nominal value of $40,000–$4 million divided by a hundred 1% interests. A gift of an FLP interest, if an unrestricted gift to a family member, qualifies for the annual gift tax exclusion. If the value of the gift to each family member is $40,000, the Buckleys in 2012 could make a tax-free annual exclusion gift of $26,000, and the rest of the $14,000 would require them to use their $5.12 million lifetime federal gift tax exemption.
However, the FLP story is sweeter than that.
In many cases, the IRS has been forced to concede that a limited partnership interest is worth substantially less than its nominal value. In some cases, gift discounts of 40% or more have been allowed for limited partnership interests.
In the example of the Buckley Limited Partnership, a 40% discount on a 1% limited partner gift would reduce the gift’s value from $40,000 to $24,000. Each gift to a family member might qualify, then, for the Buckleys’ annual gift tax exclusion.
Implementation of the FLP strategy does not eliminate the Buckleys’ projected estate taxes, but it does remove a valuable asset from the taxable estate. If the FLP assets are appreciating, all the growth is on their heirs’ side of the ledger; not the Buckleys’.
At the deaths of the elder Buckleys, the value of their remaining limited partnership interests in the FLP should qualify for an estate tax discount.
Finally, and perhaps most importantly, by keeping a general partnership interest, the elder Buckleys retain control of the management of the FLP asset. The parties may even structure the FLP agreement so that the general partner is compensated differently from the limited partners. That means that Frank and Barbara might keep much of the income they made when they were the sole owners of the commercial property.
The IRS has attacked FLPs on various grounds, making some of the gift and estate tax results uncertain. Clients considering implementing FLPs should be prepared to spend a significant amount of money on professional legal, accounting and valuation advice.
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