Linas Sudzius, J.D., CLU, ChFC is working on the book The Guide to Transferring Your Closely Held Business with some colleagues. Here’s an excerpt.
Using FLP Planning to Give a Business Away to Family
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’ advisors recommend that they implement FLP planning to help manage the size of their estate tax exposure.
The Buckleys decide that they will put their stock in a closely-held business, worth about
$9 million into a new FLP. The implementation works like this:
- Frank and Barbara create the Buckley Limited Partnership, and transfer the closely held stock 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 one-half of 1% blocks.
Each one-half of 1% block has a nominal value of about $45,000–$10 million divided by one hundred ninety-eight one-half of one percent 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 $45,000, the Buckleys in 2013 could make a tax-free annual exclusion gift of $28,000, and the rest of the $17,000 would require them to use their $5.25 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. The FLP’s operating agreement might provide that the limited partners have no ability to sell their ownership interests without the permission of all the other partners. The operating agreement might also limit their ability to influence control over the management of the partnership’s operations. Finally, the agreement might require all the owners to agree to any proposed liquidation of the entire LLC.
The limits on the limited partners’ abilities, along with the fact that many limited partners own minority interests in the business, mean that the value of a limited partner’s interest is probably 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 one-half of 1% limited partner gift would reduce the gift’s value from $45,000 to $27,000. Each gift to a family member might qualify, then, for the Buckleys’ annual gift tax exclusion.
As an aside, not every gift of an FLP interest can qualify for the annual exclusion. For instance, if the FLP is too restrictive on the ability of limited partners to transfer their membership interests, gifts of limited partnership interests may not qualify for the annual gift tax exclusion. See Hackl v. Commissioner, 225 F.3d 664 (7th Cir. 2003).
The Buckleys might also decide to use Frank and Barbara’s $5.25 million lifetime exclusion to maximize the value of their gifts to family. Here’s how that could work:
- The Buckleys determine, with the help of a qualified appraisal, that the value of the business is $9 million.
- The Buckleys also determine, with the help of an appraiser, that a 40% discount for limited partnership interests in the Buckley Limited Partnership is appropriate.
- The Buckleys calculate that the value of all the limited partnership interests they intend to give away is about $5.4 million.
- The elder Buckleys, in 2013, make annual combined spousal gifts of $28,000 to each of their 14 beneficiaries—4 children and 10 grandchildren—sheltering nearly $400,000 of gifts from federal estate taxes.
- Frank can use most of his $5.25 million lifetime exemptions to shelter the rest of the limited partnership gifts from federal gift taxes.
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 closely held business interest is appreciating, all the post-transfer 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.
Does this seem too good to be true? There have been plenty of cases in which the planning has been successful. However, in recent years, the IRS—and more recently Congress and the President—have been working to try to limit or eliminate this planning strategy.
Linas is an attorney who works with business owners from his office in Franklin, Tennessee. His first book, What Most Life Insurance Agents Won’t Tell You, is available on Amazon.com.