Family Limited Partnerships
Family Limited Partnerships
Paul J. Hanley
Family limited partnerships (sometimes called FLPs) are limited partnerships that are principally used to transfer wealth among members of the same family. They are completely legal and are used to reduce the level of taxation, but they may not be used to evade taxes. Family limited partnerships have several benefits.
Historically, family limited partnerships were formed as limited partnerships so that the controlling family member(s) would be designated general partner(s) and thus retain operational control of the partnership, along with control over distributions, while spouses, siblings, and other family members not involved in management would be designated limited partners and therefore not have any managerial control, but would be limited to economic rights in the partnership. Today, limited liability companies are increasingly used for the same purpose, since they are flexible entities that can be organized to consolidate control and yet take advantage of the discounting rules in connection with discounting because they can elect to be taxed as partnerships.
Initially, family limited partnerships were used for income shifting to family members in lower income tax brackets, but with reduction in marginal income tax rates, and increased IRS scrutiny, this is no longer the principal purpose of family limited partnerships. Family limited partnerships nevertheless retain the significant characteristic of potentially shifting income related to future appreciation in property and asset values that have been contributed to the partnership.
Although the principal purpose of family limited partnerships is for wealth transfer planning, an ancillary benefit, not discussed as much, is their use as a holding company for asset protection relating to multiple business and investment interests. Because it has become very common to create single purpose entities (SPEs) to segregate different business interests, investment properties, real estate, securities, and other assets for purposes of asset protection, many families use a family limited partnership as a top-tier entity for holding their varied business, investment, and property interests, including SPEs.
Family limited partnerships are primarily used to make gifts by the controlling family member(s) to other family members in a manner that is advantageous from an estate and gift tax perspective, specifically to take advantage of the annual gift tax exclusion and gift splitting. The annual gift tax exclusion ($14,000 in 2014) is an amount that may be excluded from gift tax in addition to the lifetime unified tax credit for estates and gifts ($5,340,000 in 2014).
Through gift splitting and the application of discounts, significantly greater amounts of property and assets can be transferred through the family limited partnership with minimized taxation. Gift splitting allows a husband and wife to make separate gifts to any number of different donees in an amount equal to the annual gift tax exclusion each year. In addition, the value of these gifts, when they consist of family limited partnership interests, is subject to the application of various discounts, principally consisting of marketability and lack of control (minority) discounts.
Marketability discounts are applicable because the family limited partnership interests are not readily tradeable or saleable in an established market. Lack of control (minority) discounts are applied if the recipient of the gifted partnership interest does not have the practical ability to control the affairs of the partnership by virtue of being a minority limited partner. The combined range of discounts is quite broad, depending on the circumstances, but typically is between 30%-45%, although sometimes they have been as high as 75%.
Discounting and gift splitting can be effective in transferring wealth with minimum taxes. Suppose John and Cindy Donor own all of the interests in a family limited partnership equally. They each decide on an annual basis to give a 1% interest to each of their two children, resulting in annual gifting of 4% of the interests in the family limited partnership. A 4% interest (based on the underlying assets before discounts) is appraised at $80,000. The appraiser suggests a 30% discount, resulting in a value of the 4% interest after discount of $56,000, equal to the combined 2014 annual gift tax exclusion after splitting with respect to the gifts. Without discounting, John and Cindy would only have been able to give an aggregate of 2.8% of the interests. The difference of 1.2% per year, when multiplied over a number of years can become quite material.
Fair market value of the gifted interests and the applicable discounts are typically determined by experienced, qualified appraisers. The underlying assets are valued first, and then the discount analysis is applied to the partnership interests being gifted. Gifts are typically reported to the IRS to begin the three-year statute of limitations and the IRS requires disclosure regarding the appraised valuation and the methodology used to establish the value and the applicable discounts.