The IRS announced last month that it plans to increase audits of wealthy individuals and partnerships, with a special focus on the seventy-five largest partnerships. According to the IRS announcement, the purpose of the audits will be to, “identify sophisticated schemes intended to avoid taxes.” In response to this IRS announcement, in this month’s update I briefly summarize how a family partnership plan is generally implemented as well as the resulting legal and tax benefits of the planning.
A family limited partnership (“FLP”) plan is typically implemented in the following four steps:
- The current owner of an asset creates a legal entity, generally either as a limited partnership, or more commonly as a limited liability company, or “LLC.”
- The current owner creates a legal agreement governing the administration of the FLP.1 In addition to addressing management authority, the agreement limits the ability of the FLP owners to transfer ownership interests.
- The current owner transfers unique assets to the FLP in exchange for all ownership interests in the FLP.2
- The current owner’s FLP ownership interests are transferred to children or grandchildren, usually through regular lifetime gifts. Regardless of the extent of the gifting during lifetime, the owner’s remaining FLP ownership interests can be transferred to children or grandchildren following death.
The most common type of assets contributed to the FLP are rental real estate properties, family cabins, family farms, or businesses. A personal residence or any other assets the current owner needs for personal living expenses should not be contributed to an FLP.
The legal planning benefits of the FLP planning are as follows:
- Management Rights. The management authority can be separated from ownership of equity. This bifurcation allows for the senior generation to retain management rights even while gifting away a percentage of the underlying asset value to the junior generations.
- Creditor and Divorce Protection. The owners of the company are insulated from personal liability for any of the company’s creditors. The partnership agreement can also preclude a family member’s divorcing spouse from participating in the FLP.
- Ease of Transfer. In contrast to fractional interests in real estate, the FLP structure allows for a more efficient transfer of value through FLP transfer documents.
- Reduced Tax Cost of Transfer. Finally, and perhaps of primary significance, the FLP strategy can reduce the reported value of gifts made to the junior generations. The internal revenue code requires that a gifted FLP interest must be valued according to what an unrelated person would pay for it. 3 Since the FLP interest is subject to legal restrictions limiting a third party’s rights to both manage and liquidate for value, any FLP ownership interest is worth far less to an unrelated third party than if the assets of the FLP were individually owned by the FLP owners in proportion to their ownership interests. 4 As a result, the value of the FLP gift reported to the IRS must be reported below the proportionate value of the underlying assets. In many cases, the reported value of the transfer could be only 60% to 70% of the proportionate value of the underlying asset value. The FLP strategy could therefore significantly reduce estate taxes.
Rest assured, FLP planning is not the type of “sophisticated scheme to avoid taxes” that has drawn the attention of the IRS to the seventy-five largest partnerships that are under IRS scrutiny. Rather, FLP planning is a tried-and-true method of achieving transfer objectives, including reducing the reported tax value of gifted assets. Many of my client families have successfully implemented the FLP planning. We would be glad to speak with you or your clients about whether the FLP planning is appropriate in their unique situation.