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What is a Family Limited Partnership?
What are the Advantages of a Family Limited Partnership?
What are the Disadvantages of a Family Limited Partnership?
A family limited partnership, or "FLP," is a limited partnership which is designed to facilitate the transfer of wealth to a younger generation. The name of the game is to facilitate this wealth transfer at the lowest possible tax cost without losing control of the assets being transferred. To understand FLP's, you first need to know how a limited partnership operates.
A limited partnership is an entity formed under state law. In Vermont, a limited partnership is formed by filing a certificate of limited partnership with the Secretary of State. There are two types of partners in a limited partnership. General partners (there must be at least one) are responsible for the management of the partnership business - they control the partnership and its assets. General partners are liable for the debts of the the partnership. Their liability is not limited. In contrast, a limited partner has very little say in the affairs of the partnership. There is no limit on the number of limited partners, and such partners are not liable for the partnership's debts. Limited partnerships do not pay tax; rather, the income and losses from the partnership flow down to the partners generally in proportion to their respective percentages of ownership.
An FLP is simply a limited partnership which is owned by members of a family group and which hold one or more types of investment assets. In most FLP's, members of the older generation contribute investments assets to the FLP, and initially hold all of the general and limited partnership interests. Over time, limited partnership interests are gifted to members of a younger generation (children, grandchildren, etc.). These interests are subject to substantial restrictions on transfer which reduces their value for tax purposes (see Estate Taxation, below). The general partnership interests are retained by the older generation until they are ready to relinquish control of the partnership.
Under current law, you can gift up to $14,000 per year to each individual without adverse gift or estate tax consequences. However, because of their value or character, some assets may be difficult to transfer in $14,000 increments. For example, if you own commercial property of significant value, it may be difficult to make annual gifts of small percentages of that property to your heirs.
An FLP is often an excellent vehicle for transferring an asset to your heirs over a number of years. Using the above example, if you contributed the property to an FLP, you could then easily gift limited partnership interests to your heirs, the value of which would fall below the $14,000 annual gift tax exclusion. Over time, you could transfer the entire value of the property without the imposition of any tax -- estate, gift or income.
The discounts for lack of marketability and minority interest vary. In many cases, the discounts exceed 25%, and in some cases range to over 40%. This means that by using an FLP, you can effectively increase the amount of wealth you transfer each year without incurring gift taxation. At death, if you transfer any additional limited partnership interests, your estate may be able to claim discounts on those transfers as well. Depending on the assets held in the partnership, the estate and gift tax savings can be dramatic (see An Example, below).
As mentioned above, the general partner of an FLP controls the management of the partnership and its assets. If you establish an FLP, and retain the general partnership interests, you can effectively transfer the value of the underlying assets without losing control. When you reach a point in time where control is not an issue, then the general partnership interest can be transferred to your heirs, and control can be relinquished.
The main disadvantage of an FLP stems from a difference between transfers during life and transfers at death. If an asset is transferred during life, the donee's tax basis is equal to the donor's basis. So, if you transfer appreciated property to an FLP, and gift limited partnership interests to your heirs, they "inherit" your low tax basis. If the underlying property is eventually sold, your heirs will face the payment of income tax on the sale.
In contrast, if you hold an asset until death, the tax basis is increased to the fair market value of the asset on the date of death. If your heirs then sold the property, they would face no income tax on the sale (unless the property appreciated after your death). This disadvantage is not unique to FLP's, but is a factor which can affect any lifetime gift.
A minor disadvantage of an FLP is cost. To reap the benefits of an FLP, you need to establish the entity, obtain (in some cases) an appraisal of the property being transferred to the partnership, transfer limited partnership interests, file gift tax returns, and file an annual partnership return. Although this initial cost can be substantial, it normally pales in comparison to the estate and gift tax savings to be realized.
Here's an example of how an FLP can reduce the overall taxation of wealth:
Assume that Mr. Smith establishes an FLP and contributes a piece of commercial property worth $500,000 that he purchased twenty years ago for $100,000. He has three children, and decides to begin making annual exclusion ($14,000) of limited partnership interests to each of them. Assume further that the property will appreciate at 3% per year. Mr. Smith makes gifts over ten years, and then dies.
Because the children will receive minority interests in a limited partnership which are subject to transfer restrictions, Mr. Smith's account has advised him that he is entitled to reduce the value of each annual gift by 30%. This means that he can gift 4.0% of the partnership in the first year to each child without exceeding the annual gift tax exclusion, calculated as follows:
4.0% x $500,000 x 70% = $14,000 (the current annual exclusion)
The total gifts over a ten year
period are as follows:
At Mr. Smith's death, he owns 4.0% of the partnership (100% less 96.0%), which when discounted has a value of roughly $17,000. If his estate is subject to estate tax at a 40% rate, his heirs will face an tax of $6,800. His heirs have an income tax basis of 96.0% x $100,000, or $96,000, plus the fair market value of the interest held at Mr. Smith's death ($24,500), for a total tax basis of $120,500. If the property was sold for the value in 2021 of $614,937, it would generate a taxable gain of $494,436. At capital gain rates of 25% (state and federal), Mr. Smith's heirs would pay income taxes of $123,600. Added to the estate tax bill, the entire tax burden would be $130,400.
Contrast this with the tax due if Mr. Smith did not make gifts. The estate tax due on $614,937 at 40% would be $245,975, or $115,000 more than his heirs will pay if an FLP is used. This savings is realized without Mr. Smith losing control of the property, and with a comparatively minor administrative cost. These savings increase if the heirs delay the sale of the property for any significant period of time, thereby delaying the payment of income tax.
If you have any questions regarding Family Limited Partnerships or any aspect of the estate planning process, please contact Richard W. Kozlowski, Esq. at (802) 864-5756 or by e-mail.
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