By Robin S. Davis, CFP®
One of the biggest goals of the affluent is to reduce estate taxes as much as possible when passing family assets to the next generation. As of 2007, the Internal Revenue Service (IRS) allows every individual to pass two million dollars as an inheritance to be divided by their children or other beneficiaries, totally estate tax-free. This means a married couple can leave up to four million dollars tax-free. There is a creative tax-shelter that can help maximize these limits called Family Limited Partnerships, also referred to as FLiP’s.
You can compare a FLiP to a traditional Limited Partnership used by businesses with two or more partners. In the case of the FLiP, however, all of the partners must be family members. All limited partnerships have general partners and limited partners. General partners (in the case of the FLiP we’ll call them “the Parents”) run 100% of the business, even if they only have a 1% ownership in it, while limited partners (we’ll call them “the Children”) have no voice or voting rights.
When the FLiP is created, the Parents are the general partners and the limited partners. They put their assets into the limited partnership and then gift up to 99% of the shares of the partnership to their children, who become the limited partners. The Parents will remain the general partners and retain control over all the assets until their death, at which time the Children become the general partners.
One benefit of doing a FLiP is saving taxes. When the assets are transferred to the partnership, there is an immediate and substantial discount in the value of the assets for estate tax purposes. This discount is allowed by the IRS because, even though the Children own the assets, they have no control over them. In other words, instead of leaving your children four million dollars when you die, you can put four million dollars into the FLiP, which, because of the discount, would be viewed in the eyes of the IRS as a much smaller gift. Therefore, you can add more assets to the FLiP until the discounted amount equals four million dollars. The actual amount of the discount may be different for each estate due to various factors involved in the valuation. For example, cash in the partnership receives less of a discount than securities or real estate.
Another benefit of the FLiP is appreciation of the partnership assets is not included in the Parents estate. If the Parents live another 20 years, these assets could be worth double or triple the value they were at the time of transfer, saving hundreds of thousands of dollars in estate taxes to the Children. Since there is no limit to the amount of assets that can be transferred to a FLiP, very affluent families could save their children millions in estate taxes.
A third benefit to funding a FLiP is the income generated by the partnership is prorated to the general partners and the limited partners. This means the Children would pay taxes on 99% of the income and the Parents on 1% of the income, to the dismay of the IRS. This is advantageous to the Parents as they are usually in a much higher tax bracket.
A fourth benefit of a FLiP is there is creditor protection. Before the transfer, 100% of the Parents assets were subject to claims of creditors and law suits. After the transfer, if the Parents own 1% of the partnership, then only 1% of the assets are subject to those claims. Of course, the Children could be subject to creditor claims and law suits, but, because they have no control over the assets as limited partners, the creditors with legitimate claims are also treated as limited partners. This means they would have to pay taxes on income generated by the amount of their claim every year and may never receive a dime of the income or principle for the lifetime of the Parents which could be 30, 40 or 50 years. If I were a creditor with a claim, this would entice me to settle the matter for a much smaller, immediate payment, or discourage me from litigating in the first place.
Family Limited Partnerships are legitimate wealth preservation and asset protection strategies that can save multi-million dollar estates millions in Federal estate taxes. Because of this, the IRS is targeting abuses (such as outrageous discounts being used), and mistakes written in the partnership documents, to disqualify the validity of the plan. I highly recommend using a qualified Estate Planning Attorney who specializes in FLiP’s to create the documents, together, with a tax planner who is experienced in estate tax returns to help determine viable discounts, and your financial advisor who can help determine which assets should be transferred to your family limited partnership to avoid potential IRS scrutiny upon your death.