FAMILY LIMITED PARTNERSHIPS & FAMILY LIMITED LIABILITY COMPANIES
Two of the most powerful and flexible estate planning tools available today are the family limited partnership and the family limited liability company (“FLLC”). For purposes of this article, “family limited partnership” shall be used to refer to both entities, unless a specific distinction needs to be made. Among the many advantages offered by the family limited partnership are the following: a method for reducing the size of your taxable estate while at the same time allowing you to retain full control and management of your estate; a way to effectively compound your available gift and estate tax credits and exemptions; the spreading of income among children who are in lower tax brackets; and placing assets beyond the reach of creditors. The following will introduce you to some of these planning techniques.
RETENTION OF CONTROL OVER ASSETS.
A limited partnership generally consists of two classes of partnership interests – general and limited. (An FLLC can be established with voting and nonvoting interests.) The general partnership interest carries with it many rights and obligations. The general partner (or partners) retain full control of the partnership operations. The general partner has the power to make and implement decisions regarding the purchase, sale, development and investment of partnership assets; to control the purse strings, determining the amounts and timing of distributions to limited partners; and, in most cases, the general partner may choose to forego all distributions of partnership profits, and retain funds for payment of taxes, debt service, expenses and for funding future acquisitions and development of partnership interests.
Along with the right to manage partnership properties, the general partner is personally obligated for all debts of the partnership, and conversely, the limited partners’ liability is limited to the extent of their partnership investments. Thus, if the partnership becomes obligated for debts in excess of what the partnership can pay, then the general partners will be jointly and severally liable for such excess debt obligations. For this reason, it is often recommended that a corporation, of which the general partner is the controlling stockholder, be the general partner so in the event of unforeseen liability, the excess debt may be satisfied only from partnership and corporate assets.
One advantage of an FLLC over a Limited Partnership is that an FLLC provides limited liability to all of its members, not just the limited partners. Another advantage an FLLC has over a Limited Partnership is that all of the voting members can participate in the management of the FLLC without losing their limited liability status. Whereas, in a Limited Partnership, only the general partners can participate in the management of the business.
GIFTS OF LIMITED PARTNERSHIP INTERESTS
Lifetime gifts of partnership interests are an excellent way of reducing the size of your taxable estate, while at the same time keeping certain properties intact and under your continued control.
As a general rule, lifetime gifts of interests in property are subject to the gift tax. However, through utilization of the annual gifting exclusions and the unified credit, substantial lifetime gifts may be made without incurring this tax. The annual exclusion allows you and your spouse to each gift up to $12,000 in value of property to as many individuals as you choose without incurring any gift tax. For example, if you have two children, you and your spouse could each give each child $12,000 every year, or a total of $48,000 per year.
In addition to the annual exclusion, you and your spouse may each gift property valued at $1,000,000 1 during your lifetimes, not including the $12,000 per donee annual gifts, without incurring a gift tax.
Currently, the estate tax rates run as high as 45% 2 of the taxable estate; therefore, reducing the taxable estate as much as possible can result in substantial tax savings. By making lifetime gifts of partnership interests, the taxable estate is reduced not only by the amount of the gifts, but also by the income and appreciation of the gifted assets, which, if retained in the estate, would be taxed at the very high estate tax rates. For example, if you make a gift of $200,000 in partnership interests, and the value of the partnership assets double between the date of the gift and your date of death, then you have actually reduced your taxable estate by $400,000, not just the $200,000 which was initially gifted. The tax savings achieved through lifetime gifting can be further compounded through the use of valuation discounts. There are two types of valuation discounts available.
The first, the minority discount, is applicable where a gift of a minority interest in a closely‑held business is made. The minority discount is based upon the fact that the lack of control in a closely‑held business is a severe limitation on the value of the minority interests and should, therefore, be taken into account in valuing those interests. Minority discounts of twenty to fifty percent of fair market value are commonly allowed.
The other valuation discount is the discount for lack of marketability. Because partnership interests are not listed on a securities exchange, there is no ready market for the partnership interest. Obviously, if there were no ready market, a seller of the partnership interest would encounter difficulty in finding a buyer willing to pay full market price for the partnership interest, especially when the sale of that interest is restricted by the partnership agreement. Marketability discounts of up to forty or fifty percent are often found acceptable by the courts (although the IRS may challenge them).
By combining the minority and marketability discounts to the gift of $200,000 described above, the gift, for gift tax purposes, may be valued at only $100,000,
assuming a combined discount of fifty percent. Thus, through proper valuation planning, your lifetime exclusion of $1 million 3 may be effectively increased to allow
giving away property valued at $2 million4 without being subject to the gift tax. Valuation discounts may be applied to your annual exclusion gifting as well.
INCOME TAX SAVINGS
Your family limited partnership will be drafted in a manner which allows for the shifting of income from you to the donees of the partnership interests. This shifting of income occurs because the donee is deemed to be the owner of the partnership interest, and income is properly attributable to the owner. The partnership, however, cannot act as a conduit to transfer your personal service income to a donee. Income is shifted only for the income that is earned from capital where the capital is a material income-producing factor. Earnings by a partner for personal services are attributable solely to that partner.
Shifting income among family members may have the effect of shifting income to children who are in tax brackets lower than those of the parent-donors. However, income in excess of $1,600 attributable to children under 14 years of age is taxed at the parents’ top marginal rate, thus limiting some of the potential benefits of income shifting.
LOSS OF DEATH TIME STEP-UP IN BASIS
Although the benefits of lifetime gifting are substantial, in certain cases the benefits may be outweighed by the loss of the step-up in basis to fair market value on assets owned at death. For example, assume you purchased stock in XYZ Corporation in 1985 for $50 and it is now valued at $100. If you were to sell it now, you would have a taxable gain of $50.
However, if you were to hold the stock until your death, and then your heirs receive the stock from your estate and sell it for $100 (the value of the stock on the date of your death), then there will be no taxable gain because of the step‑up in basis to date of death value of $100. When you make gifts of property, the donee must take a basis equal to the basis in the hands of the donor. So if you were to make a lifetime gift of the stock in XYZ Corporation, and then the donees sell it for $100, they will have a taxable gain of $50. Of course, in most cases, the advantage in avoiding the confiscatory estate tax of up to 55% outweighs the increased income taxes, with a probable capital gains rate of 20%; however, each case should be evaluated separately to determine the best course of action.
PROTECTION FROM CREDITORS
It is our position, and the opinion of many other legal practitioners, that a limited partnership may be a highly effective tool for protecting assets from the claims of creditors. Nevada limited partnership laws provide that in the event a partner is liable to a judgment creditor, the debtor’s partnership interest may only be reached to the extent allowed under a “charging order.” The charging order does not allow the creditor to force a liquidation of the partnership and a distribution to the creditor of the debtor‑partner’s share of partnership assets. Rather, the creditor is only entitled to “intercept” partnership distributions made to the partner. Therefore, if the general partner can withhold distributions in order to accumulate assets for partnership purposes, a creditor of a partner may be effectively foreclosed from receiving any benefit from the assets held in the partnership.
Although it is theoretically possible for a creditor to proceed against a limited partner’s interest, as a practical matter the interest would have no value to a non‑family member because of the general partner’s power to withhold distributions of partnership income. Furthermore, as an added layer of protection, the children’s interests in the partnership could be transferred to a trust for the benefit of the child, so that any partnership distributions could be controlled by the parent/trustee and held or distributed in the parent’s discretion.
As all of the foregoing illustrates, the family limited partnership is a valuable tool which can be used to enhance and protect the value of your estate, not only in your hands, but to the objects of your bounty as well. If you would like to meet with us to discuss how these techniques may be put to work for you, please give our office a call.
1 This individual exemption is now $2 million and will increase to $3.5 million in 2009. In 2010, the individual exemption will be unlimited, as the Estate Tax is repealed for one year. However, the exemption will revert to $1 million in 2011, unless Congress acts to make the repeal of the Estate Tax permanent.
2 The current estate tax rate is 45% and will disappear in 2010. However, the maximum estate tax rate will revert to 55% in 2011, unless Congress acts to make the repeal of the Estate Tax permanent.
3 See Footnote 1
4 Or twice the prevailing individual exemption amount.