Family limited partnerships (FLPs) and family limited liability companies (LLCs) have been a mainstay of estate and related planning for decades. FLPs and LLCs (collectively, FLPs) could have been formed for a myriad of reasons. However, in many cases, achieving valuation discounts for gift or estate tax purposes was a major motivation. Many clients who created these entities hoping to obtain discounts have forgotten the many other benefits these entities can afford them and their families and, as such, are pushing practitioners to dissolve these entities, or worse, terminate them on their own with no professional help. While in some instances it might make sense to liquidate the entity, in many, perhaps most cases, other options might warrant consideration. In Part I of this article, I’ll outline the general issues and considerations. In Part II, I’ll present several options that don’t receive enough consideration.
Valuation Discounts
Perhaps the primary benefit sought through the use of the FLP has been the discounts on the value of the FLP interest as contrasted with the fair market value of the underlying partnership assets. The Internal Revenue Service has regularly attacked valuation discounts taken on FLPs in the gift and estate context under many different theories and approaches. Recent tax law changes have fundamentally changed the tax-planning paradigm:
- The $5 million inflation adjusted estate tax exemption, $5.43 million in 2015 or $10.86 million for a couple,
- Portability (the surviving spouse can use the deceased spouse’s unused exemption) was made permanent.
- The 3.8 percent net investment income tax (NIIT) became law.
- Capital gains tax rates are higher.
Thus, for many even wealthy taxpayers, there’s no federal estate tax benefit to FLPs because the discounts won’t save a tax if none is due. But there may now be a tax planning negative (for all taxpayers, even wealthier taxpayers paying a federal estate tax). That negative is that the discounts reduce the basis step-up obtained on death. The cost for tax purposes increases in simple terms from what the decedent paid for the assets to its fair value on death. That can eliminate the unrealized capital gain inherent in the assets at death. Because discounts reduce the fair value of the FLP as compared to its underlying assets, the step-up is less ,and heirs may realize a larger capital gain when the assets are sold.
Get Real
The Dr. Phil approach to estate planning is to “get real.” As with so much of estate and tax planning, generalizations are dangerous. If the family faces a state or federal estate tax, and the entity owns a building used in the family business that might not be sold for generations, if ever, the capital gains tax on a present value basis is irrelevant. This is perhaps the critical threshold planning point. Before a decision is made to dissolve or otherwise tamper with the structure of an existing FLP, all the relevant facts for the particular client should be looked at. Relying on generalizations in the planning literature, or worse, what your golf buddy has done, are rarely going to lead to optimal planning results.
Other Benefits of Using and FLP/LLCs
FLPs can provide a host of benefits besides discounts. Before dismantling any FLP, evaluate the continued relevance of the FLP in light of your client’s actual circumstances. Some of the many benefits include:
- Limited Liability: An FLP can, with the proper structure and operations, limit liability exposure. An FLP provides the limited partners the benefits of limited liability if they don’t undermine this benefit through acts reserved for general partners. A properly formed FLP should provide all limited partners with limited liability. The general partner, if structured as an S corporation or LLC can also obtain limited liability. The pursuit of liability protection is a valid business purpose pursued by almost every business, regardless of the form of entity selected. FLPs should never have been only about discounts. Even if the senior generation at the current stage of their lives isn’t concerned about liability exposure (often they should be), the next generation may well benefit from an existing “old and cold” entity that has been operated for years. It might make sense to recapitalize the FLP with funds contribute by future generations, regardless of what’s done for the senior generation’s interests.
- Limit Transfers: The use of an FLP and the restrictions on the transfer of partnership interests can safeguard assets from being transferred outside the family. This safeguarding can include protection from donee’s making unauthorized transfers, attacks by creditors and challenges in a divorce. An FLP can be used to preserve family business and investment continuity. If your client wants to preserve family business and investment continuity, the partnership agreement should include succession provisions, transfer provisions and a statement of intent in the recital clauses.
- Dispute Resolution: An FLP partnership agreement can incorporate several different types of dispute resolution mechanisms. These can include variations in the level of approval necessary for certain acts, designation of a managing general partner to control designated decisions or a mandatory arbitration clause. A partnership agreement can reserve certain issues to the general partner, others to a majority vote of all of the partners including limited partners and almost an endless variety of variations on these. The agreement can set forth a host of mechanisms to address particular decisions. Practitioners should assure that all partners contribute thoughts to the development of the partnership agreement so that as many control and decision-making points as possible can be addressed. This purpose can be noted in the recital clauses for the partnership agreement. However, the inclusion of detailed provisions in the agreement itself should demonstrate the importance of the dispute resolution method purpose. It might be advisable to save all superseded drafts of the partnership agreement to demonstrate to the IRS or other third parties the importance placed on these issues.
- Control: Where an FLP is used, the principal of the business can, for example, serve as the sole general partner having substantial control (subject to fiduciary responsibilities to the entity and other equity holders) over the FLP operation. The key employees, children (or other donees), can own their economic interests as limited partners, but have virtually no control. In fact, by law, the limited partners aren’t permitted to participate in the management of the business. The principal can manage the degree of control over the FLP through the control provisions of the limited partnership agreement and through applicable provisions of state law. The designated general partnership can exercise exclusive management and investment control over the FLP’s assets. The partnership agreement can limit the right of a partner to demand a distribution or a return of his capital account.
- Avoid Ancillary Probate: Real estate or tangible personal property in a state other than the state of domicile will be subject to ancillary probate proceedings in that other state. The FLP provides a vehicle to avoid ancillary probate and represents a viable alternative to the use of a revocable living trust in some circumstances. An interest in an FLP is deemed to be intangible personal property. This can be important for a non-resident, because the ownership of intangible personal property shouldn’t subject the estate of a non-resident decedent to ancillary probate proceedings to effect the transfer of an FLP interest.