A family limited partnership is a device that allows gifts to be made at discounted values for gift tax purposes. A partnership is a consensual association of two or more persons or entities to carry on a business for profit. Each partner is fully liable for the debts of the partnership. In a limited partnership, the liabilities of certain partners can be limited. They are called limited partners, and their interests in the partnership are called limited partnership interests. They can lose what they invested in the partnership but are not personally liable for partnership debts. There must be a general partner who is liable fully for all partnership debts. However, this can be a corporation or some other entity in which the owners have limited liability. The general partner controls the partnership, and the limited partners do not, although, in limited circumstances, they can have a vote.
What is a family limited partnership?
The family limited partnership is merely a limited partnership of family members with a few special features that allow it to be used to reduce gift tax. One of the main special features is that it must be created under the limited partnership statute in a state where the limited partner cannot get out of the partnership and get his or her or its share of the partnership assets. The partnership agreement also restricts the transferability of the interests.
What are the advantages of a family limited partnership?
One of the ways to reduce estate and gift taxes is to make lifetime gifts. All the appreciation in the assets given away after the time of the gift escapes estate tax. This is because it will not be in the estate of the donor on his or her death. The gift tax is also effectively at a lower rate than the estate tax because the amount of the tax is not included in the gift. For instance, if you die with $1,000,000 and there is a 50% estate tax, your estate pays a $500,000 tax. On the other hand, if you gave away everything during life, except enough to pay the gift tax at 50%, you could give $666,667 and pay a tax of $333,333, in effect a 33-1/3% tax.
Now suppose you have $1,000,000 worth of publicly traded stock. You put it in a family limited partnership and make gifts of limited partnership interests to your children. The interests entitle the children to 2/3’s of the partnership distributions. You keep the general partnership interest and control the partnership. You can determine whether or not you receive a salary (which must be reasonable for what you do). You also determine whether or not and how much distributions will be. What is the value of the taxable gift you gave your children? $666,667? No. Since the children as limited partners do not have control of the partnership, their interests are worth less than yours (per dollar of distribution entitlement).
Furthermore, they cannot easily sell their interests, so their interests are worth less. Their interests are subject to minority interest and lack of marketability discounts. Perhaps as much as 40% at the high end. As a result, at a 40% discount, the children’s interest in $666,667 of partnership assets gets valued at $400,000. The $400,000 is what the tax is paid on, not the $666,667. (When this works, a lower discount is usually allowed – this example is towards the upper end of the discounts that have been allowed.)
What has the IRS said about family limited partnerships?
When a family limited partnership is created with cash for the purposes of discounted giving, it looks like magic. $666,667 becomes $400,000. Because of this, the IRS is challenging family limited partnerships whenever it can. The court cases show that the exact details of how the partnership is set up can be crucial. This means at a minimum that the general partner’s fiduciary duties, imposed by law in the absence of any agreement to the contrary, cannot be negated by the partnership agreement. For example, the general partner cannot have absolute discretion over whether or not to make distributions and over their amounts. Also, the restrictions on the transfer of the limited partnership interests cannot be absolute.
The partnership or the other partners can have a right of first refusal (i.e., the partner who wishes to sell must offer it to the partnership or other partners at the price the third party buyer has agreed to pay before the third party can make the purchase). If the transfer takes place, the transferee can be denied partner status but must be allowed to receive all distributions that would otherwise be made concerning the transferred partnership interest.
How is a family limited partnership taxed?
The same discounted giving effects can be obtained without using a limited partnership if a corporation conducts an active business. You can create non-voting stock and make discounted gifts of that stock to your children. If the corporation is a regular C corporation (as opposed to an S corporation that does not pay tax), you can create all sorts of restrictions on the stock. This device does not draw challenges from the IRS.
The IRS has successfully challenged some of the family limited partnership transactions under Internal Revenue Code Section 2036, which provides that a decedent’s taxable estate includes property the decedent transferred to the extent the decedent retained control of the property for life. IRS maintained that a decedent who creates a family limited partnership had retained control of the assets transferred to the partnership. Those assets are in the decedent’s estate at their full value.
Section 2036 contains an exception for transfers made as a bona fide sale for an adequate and full consideration in money or money’s worth. Is the transfer of property to a family limited partnership in return for partnership interests (before some of the interests are given away to family members) a transfer for full consideration? So far, courts have differed on this point.
Gifts of Family Business Interests
One of the simplest techniques in estate planning for business owners is to give interest in the business to children while alive. The interests can be non-voting interests. The interests will also usually be minority interests, and they qualify for a discount in value. Substantial value can be transferred this way by making initial gifts of the tax-free amount ($5,340,000 in 2014) to the children. Also, each year, each parent can give $14,000 (as of 2014) worth of business interests to each child. Suppose one of the parents does not own any of the business. In that case, the owning parent can transfer any amount of the business to the non-owning parent tax-free because of the unlimited marital deduction. Over time a very significant value can be transferred to the children, this way free of estate and gift tax, especially if the value of the business is appreciating. Note that taxable income can also be transferred to the children this way.
The gifts can be made to the children outright, or they can be made to a trust for their benefit.
Use of this device requires an appraisal whenever gifts are made, and business appraisals are expensive, so that must be considered when using this device.
A countervailing consideration is that if gifts are not made, and the parents keep the business, then any interest held by a deceased parent which is in their estate will have a stepped-up basis in the hands of the children who get it. This effectively removes capital gains on the difference between the parent’s basis and the date of death value of the interest.
Disclaimer: The site is for educational purposes only, as well as to give general information. This blog is not intended to provide specific legal advice. The site should not be used as a substitute for legal advice from a licensed professional attorney in your state.
