By, Matthew S. Dana, JD, CPA, CLU, LLM
Over my 34-year career in limiting my practice to Estate Planning, many have asked me what I consider to be “the best” Estate Planning tool. Most people would expect me to say something along the lines of a Last Will and Testament, or perhaps the prolific Revocable Living Trust. Although I would admit that those two tools are perhaps the most common Estate Planning tools, they are not “the best”. Over the past 15 to 20 years I have publicly stated that in my professional opinion “the greatest” Estate Planning tool is the Family Limited Partnership (FLP).
So, with that said, maybe it is time to define what legal attributes of the FLP would lead me to say that it is the best Estate Planning tool. It certainly isn’t the most common. The most important legal attributes of the FLP, which will be briefly discussed in this article, will center around its benefits from an Estate Tax standpoint, and Income Tax standpoint and the Asset Protection standpoint. So when I label it as “the greatest” I am considering the economic benefit of this tool to the family in saving taxes and protecting family wealth. In my opinion, the amount of money that this single tool can save a family leads me to label the FLP as the GOAT (“Greatest of All Time”). It is the Tom Brady or the Michael Jordan of the Estate Planning world.
Let’s first discuss the Estate Tax savings benefits of the FLP. First, the FLP is the only entity that I am aware of where control of the entity can be separated from the value of the entity. For example, with a Corporation, one would have to retain a 51% majority of the entity to keep control. This limits the ability of the client to give away only a 49% interest yet maintain control. In an FLP, a client can keep only a 1% voting interest yet maintain control over the entire partnership. To put it another way, the client can give away 99% of the equity of an FLP yet maintain control. Giving up control of an entity is probably the most singular drawback that a client would have to reduce his or her estate by gifting assets to other family members. With an FLP, clients are more willing to make a sizable gift of the Partnership to his or her children or grandchildren.
The second most important feature of an FLP is the ability to “discount” the value of a Partnership Unit. In a nutshell, the IRS recognizes a 30% discount (national average) in valuing a Limited Partnership Interest when it is gifted to junior family members. When creating an FLP, two classes of Partnership Interests are created as described above. Limited Partnership Interests (non-voting) and General Partnership Interests (voting). When the senior family member makes a gift, he or she will gift the Limited Partnership Interests, the non-voting interest and maintain the voting Partnership Interest. Through years of court cases and IRS regulations, the Internal Revenue Service has been forced to recognize that a non-voting interest does not have the same value of a voting interest. This is commonly referred to as a “minority discount”. In addition, since a Limited Partnership Interest is not traded on an open market, there is also a “lack of marketability discount”. These two discounts generally are added together to achieve approximately a 30% discount. As an example, if an FLP had underlying assets of $1million, a 70% Limited Partnership Interest would not be valued at $700,000. Instead, a 30% discount would be applied to the value of the Limited Partnership Interest and would be reported to the IRS in a Gift Tax Return at $490,000. Essentially, $210,000 in value disappears. That is a powerful Estate Planning tool. The entire Estate Tax system is based upon Fair Market Value, the value that a willing buyer and a willing seller would agree on. And, the reality of the transaction is that a willing buyer would not pay full value for non-voting units that are not marketable.
In the most general terms, a client can create an FLP with $1m worth of assets, give away 99% of the value of the FLP yet retain control over the entire Partnership. And to make it even better, the value of the gift to the junior family members can be discounted by almost $400,000. Of course, this explanation is an overly simplified explanation of a complex topic. But it illustrates the value of “discounts”.
With the 1% voting interest, the General Partnership Interest, what can the client control:
- All of the investment decisions of the Partnership. What assets will be sold, and what the proceeds will be re-invested in.
- All distributions of the profits – the client controls the timing and the number of distributions from the Partnership to the individual Partners. All distributions are generally prorated when made, but the timing of the distributions can be controlled or completely withheld.
- Salaries – the Managing General Partner is entitled to a salary for his or her expertise in running the Partnership. So, even though the client has given away 99% of the Partnership, he or she can still maintain an income stream.
- The ability to borrow money or loan money.
- Timing the sale of assets and dictating the terms.
Now let’s focus on the income tax benefits of an FLP. Most of us know that a Partnership is a “flow-thru entity”. This means it pays no income tax at the entity level. Instead, the CPA will issue a K-1 each year to all of the Partners. Each Partner then pays a prorated share of income tax on all of the Income Tax Attributes of the Partnership. Ordinary income flows through. Capital Gains flow through. Tax Credits flow through. Income Tax Deductions such as Depreciation flow through. As such, each Partner reports his or her pro-rata share of the Tax Attributes of the Partnership on his or her return, regardless of whether or not any money or cash was actually distributed to them. In essence, they can have “phantom income”, where they have a tax liability and not the cash to pay the liability. As stated above, the General Partner dictates what the distributions will be to the Partners. Most Partnerships will at least distribute enough cash to the Partners to give them the ability to pay the Income Tax on their prorated share of the income.
The “flow-through entity” status allows income tax to be shifted to family members who are in a lower income tax bracket yet retain the income for capital growth of the family wealth. For example, let’s assume that grandchildren are Limited Partners in the Partnership owning 25% interest. These grandchildren will receive a K-1 each February and will be taxed on 25% of the Partnership Tax Attributes whether or not they received a distribution. As stated above, most Partnerships will distribute at least the amount of the Tax Liability of each Partner.
Now, what if instead of the grandchildren holding a 25% Partnership Interest, it is gifted into a Trust for the benefit of the Grandchildren by the senior family members. Now the Trust will receive the K-1 and pay the income tax. If the Trust distributes all of the income out to Grandchild A, at the exclusion of Grandchildren B and C, then Grandchild A pays all of the income tax, and Grandchildren B and C pay nothing. This gives the family a lot of flexibility in distributing the family income to the family members who have the greatest need. Distributions from the Trust need not be equal, and there is no “make-up provision” when the Trust is ultimately terminated.
Finally, let’s look at the Creditor Protection attribute of the FLP. The biggest benefit from a Creditor Protection standpoint is the limited remedy available to a Creditor who attaches a Partnership Unit of a family member. The sole remedy is to get a “charging order” against that Partner. Now, a charging order does allow the Creditor to attach any distributions subsequently made to that Partner. But it doesn’t allow a Creditor to force a distribution. As such, the General Partner seeing a Creditor issue with one of the family members would simply withhold distributions in the future until the Creditor problem has been resolved.
Also, a charging order does not allow that Creditor to force a liquidation of the Partnership. It can’t force anything. As such, the sole remedy of the Creditor is to sit there and wait for that distribution. How long will the Creditor wait? At least it gives the family some leverage to negotiate some sort of settlement with that Creditor for pennies on the dollar. And, better yet, who pays the income tax on that prorated share of the income that wasn’t distributed? Some lawyers and CPAs believe that the K-1 should be given to the Creditor. Some believe that the Limited Partner still gets the K-1. This issue should be researched further before giving the K-1 to the Creditor. At least, however, the Creditor can’t force the distribution and can only sit there and wait.
A Partnership can also make a nice “Holding Company” for family wealth. There always seems to be cash flow problems when the family owns a series of LLCs and Corporations. One entity always seems to have a cash flow need that is greater than its ability to generate income. As such, the Partnership can now serve as a “basket of assets” where the income from one asset can easily be applied to the needs of other assets in the basket.
Many times we will see multiple Trusts in the family dynamics. Maybe the husband has passed away and we have a Survivor’s Trust, a Decedent’s Trust and a QTIP Trust. In these situations, we also see cash flow problems in family wealth and dynamics. Maybe the assets in the Survivor’s Trust generates most of the income, but there are huge expense obligations with land or other assets held in the Family Trust and the QTIP Trusts. Let’s think about transferring the assets of all three Trusts into an FLP and give prorated Partnership Units back to each of these three Trusts based upon the fair market value of the assets contributed by each Trust. Now all assets are in a common pot, and the income from one set of assets can easily be applied to the expenses of the other piles of assets.
In conclusion, the FLP has been the most powerful tool to reduce, if not eliminate, the Estate Tax liability of senior family members. The ability to discount those units by 30% is an immediate Estate Tax savings if a senior family member dies. Also, the ability to give away a larger share of the Partnership and yet retain control helps facilitate the “downloading of wealth” from a senior generation to a junior generation. And, with most good Estate Planning tools, factor in the Creditor Protection feature of the FLP. Once Creditors realize that their sole remedy against these Partnerships is to receive a charging order, they will be much more willing to facilitate a settlement. And last, the income tax benefits of a Partnership by withholding distributions yet having the income tax paid prorated by the Partners is a nice feature. The Partnership is a sophisticated technique. And, it isn’t the type of strategy that you can set up and put in a drawer and forget about it. But, if you are willing to follow all of the formalities of a Partnership and have regular interaction with your CPA and your Estate Planning Attorney, it is the GOAT of Estate Planning.