What does an effective estate planning and what can it mean for you and your family? Effective estate planning should address wealth transfer from a practical and cost-effective approach. One estate planning strategy that families with significant wealth should consider is the Family Limited Partnership (“FLP”).
A FLP is a partnership agreement that exists between family members that divides rights to income, appreciation, and control of the FLP among the family members according to the family’s overall objectives. Under family partnership rules, family assets placed into an FLP can include real estate, investments (stocks and bonds), alternative assets (partnerships or LLC interests) or a closely held family business.
Under the most common form of the FLP, general and limited partnership interests are created. Once the partnership is established, you then gift the limited partnership interests to your children. By holding the general partnership interest, you are considered the “general partner” and maintain control of all decision making aspects of the FLP. Your children are the “limited partners,” and the limited partnership interest lets them share in the ownership of the FLP which includes rights to income, distributions and asset appreciation.
The FLP enables you to provide your children with an interest in family assets while achieving many goals. First, it removes assets from the parents’ estate, thus helping lower potential estate tax liability of the parents, if properly executed. In addition, you can transfer the limited partnership interests in increments over time, resulting in a gradual and systematic transfer of ownership. Finally, and perhaps most importantly, there may be immediate income tax benefits.
The limited partnership interests transferred to your children, including all appreciation since the transfer, escape inclusion in the parents’ estate when they die. Only the value of the taxable gifts of the limited partnership interests would be included in the parents’ estate. This results potentially large estate tax savings to the parents’ down the road.
By gifting the limited partnership interests in increments over time, you can take maximum advantage of the $14,000 annual gift tax exclusion. The exclusion increases to $28,000 if married and if each spouse elects to give the maximum amount. The annual gift tax exclusion is indexed for inflation over time.
The use of discounting, the allowable reduction of value of the gift because it is a minority interest, can lead to greater leverage of the annual gift tax exclusion and the unified credit. For instance, you may be able to discount the value of the gift by thirty percent (30%) or more. However, in order for the discount to be valid, there must be a legitimate business reason for the partnership. Generally, the consolidation of family assets for ease of investment management is a valid business purpose for the existence of the partnership.
Aside from the estate planning advantages, the FLP can result in substantial income tax saving. By including your children as partners and sharing partnership income with them, total family income tax burden may be reduced. You should be aware, however, that if the income in unearned (interest, dividends, capital gains) and the recipient is under age, kiddie tax rules could apply.
Another incentive for formation of an FLP is that it may protect assets in the event of future problems with creditors. Provided that the transfer of assets to a FLP is not a fraudulent transfer the creditors of the partner who made the asset transfer should not be able to attach the FLP’s underlying assets. Instead, such creditors limited to seeking a “charging order,” which is the equivalent of a garnishment on any distributions made by the partnership interest of the debtor partner. However, if the General Partners of the FLP elect not to make any distributions, the charging order has little or no value because the creditors have no ability to compel the General Partners to distribute FLP profits.
The benefits of the FLP can be significant. But they can only be realized if the arrangement is valid under the requirements of the Internal Revenue Code and regulations thereunder. Consult a qualified legal or tax advisor if you think your family could benefit from an FLP.
If you have questions, please contact Greg Gandy, CPA.