Family limited partnerships (sometimes known as FLPs and pronounced “flip” by tax experts) are an increasingly popular tool utilized by owners of family businesses who wish to pass on their companies to their children while minimizing the federal tax burden that sometimes accompanies such a transfer. The family limited partnership is a legal agreement that allows business owners and their children to address tax issues, business-succession, and estate-planning needs all at once. In simple terms, a parent may transfer assets, such as a family business, into a family limited partnership formed with the children.
The parents, as general partners, maintain control of the assets. The children are limited partners. The assets that are transferred to the FLP are restricted—less liquid, harder to sell—and consequently, their value is discounted for tax purposes. The result is that a typical business may have a discounted tax value of 20 to 50 percent under its pre-FLP value. After the older family member dies, the FLP is taxed as part of his or her estate but the amount due is reduced since the value within the FLP has been reduced. Thus, a tax saving is realized. The resulting reduction in tax burden has propelled family limited partnerships to the forefront of estate-planning techniques.
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Estate Planning In The Family- Owned Business
When considered in the context of family-owned businesses, estate planning is basically the practice of transferring ownership of the family business to the next generation. Families must plan to minimize their tax burden at the time of the owner’s death so that the resources can stay within the company and the family.
The complexity of American tax law, however, makes it necessary for most estate planning to be undertaken with the assistance of professionals in the realms of accounting and law.
Since estate planning is such a vital element of longterm family business strategies, consultants encourage business owners to establish an estate plan as soon as their enterprise becomes successful, and to make sure that they update it as necessary as business or family circumstances change. A variety of options are available that can help a business owner defer or otherwise minimize the transfer taxes associated with handing down a family business. A marital deduction trust, for example, passes property along to a surviving spouse in the event of the owner’s death, and no taxes are owed until the spouse dies. It is also possible to pay the estate taxes associated with the transfer of a family business on an installment basis, so that no taxes are owed for five years and the balance is paid in annual installments over a ten-year period.
Current Estate Tax Rates
Recent changes in estate tax law have resulted in a great reduction in the number of estates that are subject to any federal estate taxes. In fact, in 2006 only 0.27 percent of all U.S. estates will be affected by federal estate tax, leaving 99.23 percent able, if necessary, to pass on all of their assets to heirs on a federal tax-free basis. State taxes on inherited property are another subject. Each state assesses its own estate tax.
In 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was passed. This act substantially changed federal estate and gift tax laws. The new law increases estate exemption levels every two years—from 1 million in 2003 to 3.5 million in 2009—and abolished the estate tax completely in 2010.
EGTRRA also gradually reduces the top marginal federal estate tax rate to a low of 45 percent in 2009. In 2011, unless Congress votes to repeal the tax altogether, estate and gift laws will revert to their pre-EGTRRA form. The very unusual single-year abolition of federal estate taxes in 2010 has led to many jokes along the lines of the one in the title of a 2006Money magazine article: “Could You Please Die Sometime in 2010?” This law has been highly controversial and there is much uncertainty surrounding what will happen with estate taxes after 2010. Congress was scheduled to vote on a permanent repeal of the estate tax in 2005 but the measure was tabled in the wake of devastating hurricanes that hit along the Gulf Coast in the summer. According to editors of Mondaq Business Briefing, “The consensus among observers appears to be that permanent repeal is not likely to occur in the immediate future, if at all.
While a total permanent repeal would obviously remove a major obstacle in estate planning, we will probably have to settle for legislation that would set the exemption at a definite amount (e.g., $3- $5 million) with an inflation index.” In the absence of legislation clarifying what will occur after 2010, the prudent action is to plan well and as flexibly as possible. Family limited partnerships are one useful tool for preparing to minimize estate taxes now and in the uncertain tax environment future.
Advantages Of Family Limited Partnerships
The primary purpose of family limited partnerships is to blunt the impact of estate taxes. Estate taxes can hit family businesses hard because the full value of a parent’s business may be included in the parent’s estate when he or she dies. The estate tax is one of the highest taxes levied. It is only born by individuals with very large estates. The first $2 million of an individual’s estate is exempt from federal estate tax, but amounts above the exempt portion are subject to a tax rate of 46 percent (in 2006). One way to dampen the impact of this tax is to make use of an Internal Revenue Service (IRS) rule that allows individuals to make annual gifts of up to $12,000 ($22,000 if joined by your spouse) to other individuals without incurring gift taxes. The other way to elude the full brunt of this tax is via an FLP.
A basic family limited partnership operates as follows.
The parents (or a single parent) retain a general partnership interest in the property—as little as 1 percent—and give limited-partnership interests to their children, usually over a number of years. The general partner, or partners, retain complete control over the assets in the partnership, and no management authority is given to the limited partner(s).
In the most basic terms, a family limited partnership allows the business to be transferred to the next generation at considerably less than its full value. This reduces the size of the estate and thus the amount of federal taxes owed. Indeed, observers indicate that these discounts can amount to as much as 50 percent of a business’s value.
The discounted valuation occurs because the shares cannot be easily sold or otherwise transferred and because such partnership interests do not carry any voting rights or control in the business in question. Since the gifted shares are discounted, the partnership pays lower gift taxes on those shares. For example, if a $15,000 limited partnership share is appraised at $8,000, the parents can transfer that share to a child plus $4,000 worth of something else in a single year and stay within the $12,000 annual tax exclusion on gifts. Second, this reevaluation also applies to the shares in the FLP that the parents continue to hold. Third, because the parents are transferring shares out of their estate, they’re reducing the value of the estate for annual tax purposes as well.
Many estate planners and business consultants encourage their clients to look into FLPs, but they do note that family business owners should weigh some other non-tax factors as well. These include: Lawsuit Protection A family limited partnership may serve as asset protection in the case of a lawsuit.
Because the assets within an FLP are not the personal property of its partners, any legal judgement against one of the partners does not include the assets held by the FLP. The portion of the plaintiff’s assets that are located within the FLP are thus protected from a legal judgment until disbursements are made from the FLP to the partner.
Timing of the Formation of the Limited Partnership Estate planners and business consultants warn that the Internal Revenue Service will not necessarily approve a family limited partnership if it is transparently obvious that the FLP was formed simply to skirt paying taxes.
Family business owners who attempt to institute an FLP a few weeks before their death from some foreseeable illness will likely find their efforts blocked.
Divorce In most instances, a child’s ownership of limited partnership shares will not be impacted by a divorce action by his or her parents, but business owners seeking to ensure protection for their child can take a couple of steps to provide additional insurance. Since limited partners (children) receive their shares as a gift and are not permitted to vote or otherwise exercise any authority in the partnership, the child’s shares will not be considered part of the marital assets. Instead, they will remain the sole and separate property of the child. The key, say legal experts, is to make sure that the shares were never formally made part of the marital property.
Expense of Setting Up an FLP Establishing a family limited partnership can be somewhat expensive, although the price tag depends in large part on the size of the company, the value of its assets, the number of intended minority owners, and other factors. As of 2006, a familyowned company would need to have a value in excess of $2 million (or $4 million if a husband and wife team were partners in the business) before it would have any estate tax liability upon the death of its principal. If the value of the firm exceeds this threshold than the cost of setting up an FLP will likely be justified by the savings it will be able to generate by reducing the tax obligations due upon the transfer of the company.
Compatibility with Business FLPs are better suited to some businesses than others. The effectiveness of FLPs is greatest when used in family companies related to real estate or companies whose business relies greatly on capital assets. For service-oriented companies—firms that do consulting, computer networking, software development, landscaping, childcare, and/or small retailers, for example—the vehicle is not as beneficial since firms of this kind tend not to have large asset balances that they wish to protect from taxation.
Increased Risk of IRS Audits Although family limited partnerships can be very valuable, and their use is increasing, accountants and estate planning attorneys do caution family business owners that the use of an FLP will almost certainly lead to an IRS audit. This is not a reason to avoid forming an FLP but it does emphasize the need to do so with care and to keep thorough and complete documentation on its formation and activities.
A string of recent court cases in which the IRS successfully challenged the legitimacy of particular FLPs can provide guidelines to follow in forming FLPs that will withstand an IRS challenge. Gary Williams explains why FLPs based on true family-owned businesses are more likely to survive an IRS challenge in his Daily Record article entitled “Commentary: IRS Looks More Kindly on Family Limited Partnerships That Serve Business.” He states that “commentators think you’ll be on safest ground if the FLP includes an active family business or investment that requires active management by the FLP’s partners, such as rental property.”
Another measure that can be taken to improve one’s likelihood of a successful audit outcome is to have the business appraised by an experienced, respected professional who can provide a solid valuation. For information on securing the services of an established appraiser, contact the American Society of Appraisers at (800) 272-8258.
Dissatisfaction Among Minority Owners Ironically, some family businesses find that FLPs actually spark difficulties between parents and their children, despite the formidable savings that such a plan can provide and the ultimate aim—reduced estate taxes upon succession—of the partnership. This is certainly not always the case; many families put together family limited partnerships that garner tax savings without a ripple of internal dissension or dissatisfaction. But it is a factor that can crop up, depending on the personalities and financial situations of the persons involved. When conflict arises it is usually caused by the minority owners who may feel constrained, unable to sell their shares and convert them into a liquid asset as desired. This feeling of not having control often manifests in the form of harassing the management, criticizing business decisions, lobbying for dividends, and generally causing unrest.
Need for Professional Guidance Establishing a family limited partnership is a complex estate-planning strategy, made even more complicated by the uncertainty of the regulatory environment. Subsequently, business owners are strongly encouraged to secure qualified legal and/or accounting help in setting up such plans.