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Family Limited Partnerships (FLPs) are often
used in estate plans as a vehicle for making “leveraged” or
“discounted” gifts to the children, which generally reduces
the value of the transferred interest for gift tax purposes by
20%--60%, thereby reducing the taxes on that interest by
10--25%
or more.
An
FLP is simply a partnership arrangement between family members.
Typically, an FLP is established by senior family members for
purposes of making gifts to junior family members, while
allowing the senior family members to maintain control over the
management and investment decisions relating to all of
the underlying partnership property.
Click on any of the Frequently Asked
Questions below to learn more.
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How
is an FLP established? |
To
establish an FLP, you, as the senior family members,
would transfer property to the partnership in exchange
for a small general partnership interest (e.g. 1%) and a
very large limited partnership interest (e.g. 97%). Your
children would make a contribution in exchange for a 1%
general partnership interest.
Typically, you would hold both general and the limited
partnership interests as Trustee of your Revocable
Trust, although that need not be the case. You would be
the managing general partner with sole management
control over the partnership. Your retained general
partnership interest would allow you to have complete
control over the day-to-day investment and management
decisions relating to the partnership property. The
limited partners and other general partners would not
have any voice in the management of the partnership.
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| How
does an FLP reduce the value of my estate? |
Your
FLP can also be drafted to provide that the limited
partners will not be allowed to transfer their
partnership interests during their lifetime without the
consent of the other partners. This restriction on the
transfer of the partnership interests will discount the
value of the gifted partnership interest for gift tax
purposes by reducing its marketability (“marketability
discount”). Because the limited partners will not have
any voice in the management of the partnership, the
value of the gifted limited partnership interest will be
discounted to reflect this lack of control (“control
discount”). Combined, these two discounts typically
reduce the value of the transferred interest for gift
tax purposes by 20%-60% (and the taxes by 10-25% or
more), depending on what type of assets are held by the
partnership (a greater discount is typically allowed
when the assets held by the partnership are not readily
marketable, e.g., closely-held securities, interests in
real estate, etc.).
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| Can
I retain control over partnership property? |
You
can maintain control over partnership property for as
long as you like. The plan can be drafted to make you
the managing general partner with sole management
control over the partnership. Your children can have as
much or as little control as you want them to. You can
go so far as to allow them only the right to prevent you
from unilaterally dissolving the partnership. You could
retain all other powers.
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| Can
the FLP help me transfer control to my children? |
The
family limited partnership is an ideal vehicle to
transfer control of the family business and/or property
to your children as quickly or as gradually as you wish.
Often the first step to developing responsibility in
children is to provide them with a small share of the
family business that will attract and develop their
interest. The FLP is flexible enough to allow you to
transfer control and responsibility for the business as
you see fit.
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| Why
and when should I start making gifts to my children? |
After
the FLP has been established, your FLP could be used as
part of your estate plan to make “discounted”
lifetime gifts to your children. Alternatively, the
interest in your FLP could be held until the first of
your deaths, after which time the survivor could then
begin making gifts of the limited partnership interests
to your children. This second use of an FLP has a double
benefit; the survivor will receive a full step-up in
basis of the underlying partnership assets for income
tax purposes after the first death, and following the
survivor’s death the limited partnership interests
could still be discounted for estate tax purposes.
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| How
can the FLP help me make discounted lifetime gifts? |
If
you establish an FLP and subsequently make lifetime
gifts of the limited partnership interests to your
children, the limited partnership interests would
entitle your children to all of the economic benefits
from their gifted partnership interest, but without any
management authority relating to the partnership
property. Because of the restriction, as discussed
above, the limited partnership interest has a reduced
value. The value of any limited partnership interest you
give to your children during your lifetime will be
removed from your estate for estate tax purposes.
Following your death, only the value of your general
partnership interest and any remaining limited
partnership interest you still own will be includible in
your estate for estate tax purposes.
The
restriction on transfer referred to above, has an added
benefit when the limited partnership interests are
gifted to your children, since the restriction will
provide some protection from a child’s judgment
creditor (such as a divorced spouse). A child’s
creditor will not be allowed to reach the underlying
partnership assets to satisfy a judgment, but rather
will only be entitled to the child’s economic interest
in the partnership, i.e., the right to partnership
distributions, if any.
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| How
does the reduced value help with annual giving? |
These
discounts in the value of the limited partnership
interests allow you to effectively make larger annual
tax-free gifts. For example, if for gift tax purposes a
40% discount is allowed for the limited partnership
interests (due to the lack of control and lack of
marketability discounts), you could transfer limited
partnership interests representing up to $16,600 in
“underlying” partnership assets without exceeding
your annual gift tax exclusion of $10,000 per donee
($16,600 X 60% = $10,000).
Under current law, your annual gift tax exclusion allows
you to transfer up to $10,000 per year to each
individual without such transfer being subject to gift
tax; together, you and your spouse can transfer up to
$20,000 per year (in the above example, your combined
annual gift tax exclusions would allow for a transfer of
$33,200 in “pre-discount” partnership interests.) As
can be seen by this example, the discount associated
with your gifted limited partnership interests will
allow you to transfer a greater amount of
“underlying’ partnership assets without exceeding
the amount of your annual exclusions from gift tax.
Continuing this example, if you wish to
use your unified credit to shelter the gift tax on gifts
of partnership interests in excess of your annual
exclusion amount, $1,125,000 in partnership interests
could be transferred without exceeding the $675,000
amount sheltered from tax by your unified credit
($1,125,000 X 60% = $675,000).
Under current law, your unified credit will shelter the
first $675,000 of transferred assets (whether during
your lifetime or at death) from gift or estate tax,
respectively. If both you and your spouse wish to use
your unified credits to transfer limited partnership
interests to you children, using the above example of a
40% discount in the value of the partnership interests,
up to 2,250,000 partnership units (interests) of
partnership assets could be transferred without paying
any gift tax ($2,250,000 X 60% = $1,350,000)."
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Questions
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| Can
the FLP protect family members from creditors (including
ex-spouses)? |
If
you or some other family member are unable to satisfy
your future creditor, that future creditor’s only
remedy against the partnership is the right to receive a
“charging order” against that member’s partnership
interest. Assuming there has not been a fraudulent
conveyance, the creditor may not reach partnership
assets.
While the charging order does allow the creditor
to reach income, the assets are safe.
Additionally, the FLP can be drafted to provide that an
involuntary transfer to a creditor (or any other outside
person) is not permissible and that the transferred
interest is to be purchased by the partnership at its
fair market value (frequently much less than the
underlying asset value). An ex or divorcing spouse would
receive the same treatment provided the partnership
interest is the separate property of the family member.
The
restrictions on transfer likewise deter an irresponsible
family member from wasting family assets.
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Questions
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| Does
the FLP provide the flexibility I want in estate
planning and business operations? |
Compared
to an irrevocable trust, which may not be amended, an
FLP is a flexible document. If all of the partners in
the partnership agreement agree (usually, they are all
family members) the partnership agreement may be amended
or terminated. Also the partnership may be terminated
without adverse income tax consequences.
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Questions
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| What
are the disadvantages of a Family Limited Partnership? |
The
Primary disadvantage is the ongoing cost. After the
initial start up cost, there are the annual franchise
taxes and tax returns just as for corporations. Also,
there is the obvious: the reduction in value for estate
tax purposes is due to the very real affect of the lack
of control and length of marketability discounts. This
is not just a trick being done with re-characterization
of your property. At the same time, it is just these
aspects that give the family limited partnership its
significant chance of success in accomplishing your
estate planning goals.
While family limited partnerships are being used by
estate planners all over the country, it must be
remembered that they are a relatively new tool, which is
dependent on several recent developments in the law.
There is no assurance that the law will not be changed
in the future or that they will not at some time in the
future come under serious attack by the IRS. However, it
is our opinion based upon the current state of the law
that these techniques have a significant possibility of
achieving all or part of their goals and that the
potential savings exceed the costs.
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| What
happens to property taxes? |
When
done correctly, there will be no property tax
reassessment. A change in ownership does not include a
transfer between any person and a partnership in which
the proportionate share of that person’s ownership in
the subject real estate remains the same (California
Revenue & Taxation Code Section 62(2)).
In establishing your partnership with your children, a
small percentage of the interest in the underlying real
estate will be transferred, first to the children.
Together, you and the children will transfer the real
estate to the family limited partnership and receive in
return limited partnership shares in the same proportion
to your ownership in the real estate. This technique
which we have used and recommended has been specifically
approved in a recent decision, Hunter v. County of
Santa Barbara (1995), 37 Cal Ap 4th 1672, 44 CR 2d
606.
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| How
will placing my real property in an FLP affect the risk of liability for other
assets? |
Placing
your real property into a family limited partnership
should reduce the risk that liability originating in the
assets in one family limited partnership would reach to
other assets. In general, a creditor of a family limited
partnership will be limited to the assets of that
limited partnership to satisfy any liability of the
partnership.
In order to reach other assets, the creditor
would have to prove personal liability of your or
another general partner or some liability that existed
prior to the creation of the family limited partnership
in order to reach your personal assets or those of
another general partner.
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| How
does the FLP affect the risk of liability experienced by
my children? |
As
limited partners, your children will experience no
liability, other than the investment they may have in
the limited partnership. As general partners, they would
have some potential liability, just as the operator of
any business would.
However, the children are unlikely to be a
managing general partner and thus, unlikely to have such
additional liability until after you have died or
resigned as managing general partner. This liability
could be further protected against by having a trust or
limited liability company, wholly-owned by your
children, act as the successor general partner.
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| Will
I still a receive a step-up in basis on my death? |
Yes,
you will still achieve a step-up in basis at your death.
However, because at your death you own shares in the
limited partnership, not real estate, it is the shares
in the partnership that receive a step-up in basis. If,
as a result of creating the limited partnership, a
discount has been achieved, then your step-up basis will
reflect the discounted value.
For
example, a piece of real estate valued at $1,000,000 is
conveyed to a family limited partnership. Thereafter, a
forty percent discount is established for the value of
the family limited partnership containing the real
estate. The total value of the family limited
partnership at the date of death is $600,000. This
represents the new basis value of the limited
partnership shares you own at death. If you and your
spouse own your shares as community property, both your
half interest and your spouse’s half interest in each
of the shares achieves a new basis, equal to the
discounted value at the date of death.
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| Who
manages property in the partnership and decides when it
can be sold? |
Typically,
one or both of the of the spouses are made managing
partners of the Family Limited Partnership. Even if
there were other general partners, for example, children
without management powers, the managing partner would be
allowed to make decisions as to when to sell the
property in the limited partnership. The limited
partnership will continue on until the end of the period
set forth in the partnership agreement, typically,
thirty to forty years. It can also be dissolved with the
unanimous vote of all the general and limited partners.
Prohibiting dissolution without unanimous consent, and a
long-term partnership creates the desirable discounted
value for estate tax purposes.
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| How
will the FLP affect my
relationship with lenders, insurers, and others? |
As
the managing general partner, you will have sole
control over the property. Usually, this will meet the
requirements of any lender or government agency,
including a rent control board or the Small Business
Administration, which may have requirements that certain
control or ownership be invested in a minority or
otherwise qualified person. Before transferring property
to a family limited partnership, approval should be
sought from any lender and insurance should be modified
to name the family limited partnership as the loss
payee.
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