The Practical Perspective
Family limited partnerships (FLPs) continue to be well established, flexible planning vehicles with tax, financial and administrative advantages.
Family limited partnership (FLP) documents create restrictions that may have important tax and financial implications. For example, the documents may provide for centralized management of the assets through a more senior member of the family. Assets in the partnership may also be sheltered from creditor claims.
Estate planning is not only focused on avoiding unnecessary transfer tax but making decisions about different needs within the family and management of different types of assets.
Reduced valuations are often critically important in planning for larger estates – avoiding or minimizing estate or gift tax. These taxes are still an issue for many families.
Family Limited Partnerships – The Basics
The FLP is governed by the statutes of the state where it is created.
Generally, its key characteristics involve the general partner but the bulk of the ownership is with the limited partners. Typically, the parents will exercise control by owning the general partnership interest directly or through a controlled entity. The limited partners have both limited liability and lack of control. This arrangement allows for some shifting of value to the children even though control remains with the parent(s).
In general, there are valuation discounts possible as to the different ownerships. Usually the limited partnership interests are transferred to the children. The creation of the FLP often has a principal goal of reducing the valuation of gifts to the kids. The kids own an interest in the assets, not the assets themselves. Their control is limited, which translates into lesser valuations, which translates into less or no estate or gift tax.
What assets get included in figuring one’s exposure to estate tax? Basically, anything you own or control at death (including life insurance) or gave away prior to death. There are also many deductions in figuring the base that might be subject to tax. The principal ones are: the estate tax exemption, assets passing to a surviving spouse under the marital deduction, and charitable transfers. The latter two are unlimited, whereas the estate tax exemption is limited, albeit fluctuating each year.
The Exemption from Gift/Estate Tax
Both spouses get an exemption. The amount fluctuates each year, generally going up each year through 2025. For those passing after 2025, the exemption gets cut in half.
Our estate and gift tax systems are integrated, which means the systems are supposed to make it not matter whether the transfer is during one’s lifetime or at death. Gifts are valued at the time of the gift whereas transfers for estate tax purposes are generally valued at death. With increasing values, later transfers may carry higher values for transfer tax purposes.
The exemption was $11,400,000 in 2019. The 2020 estate tax exemption is $11,580,000 for a single individual and $23,160,000 for a couple.
The 2017 Tax Cuts and Jobs Act doubled the available exemption for gift and estate taxes. The exemption increases in 2018 through 2025, but then after 2025 is scheduled to revert to its earlier, still indexed, level.
The $11,580,000 figure for 2020 is the indexed amount from a base exemption of $10,000,000, whereas the exemption reverts to a base of $5,000,000 in 2026. We don’t know the exemption amount for 2026 but indexing may raise it to, say, $6,000,000 to $7,000,000 by then.
Another important principle is “portability” which, with planning, allows the unused exemption of the predeceasing spouse to be used by the surviving spouse. The cut-back in the exemption after 2025 doesn’t apply to the exemption available under portability.
The estate tax is an important consideration if the individual’s assets, net of liabilities, exceed the following: Single individual, $11,580,000 in 2020, increasing annually until 2026, when the exemption may drop to perhaps $6,000,000 to $7,000,000.
Generally double these amounts for a married couple: $23,160,000 in 2020, increasing annually until 2026, when the indexed amount will be cut back 50%.
If both spouses pass in 2026 or later, the exemptions would be double the indexed $5,000,000 amount, perhaps $12,000,000 to $14,000,000.
If one of the spouses passed in 2018-2025, then the exemption passing forward under portability isn’t cut back, so the amount available under portability may significantly exceed that of the decedent passing after 2025. If the predeceasing spouse died in 2020 and none of the $11,580,000 exemption was used, the exemptions available in the survivor’s estate after 2025 may be the $6,000,000 to $7,000,000 amount arising from the indexed $5,000,000, plus the $11,580,000. So the couple’s assets passing tax free under these assumptions of one estate being entitled to a higher exemption may be more in the $17,580,000 to $18,580,000 range, well below the $23,160,000 if both spouses pass in 2020.
So the context is one of change. Exemptions increase due to indexing followed by a major reduction. Also, one doesn’t know whether there might be major appreciation in an asset; e.g., the sale of a closely held business. Legislative changes, if any, constitute another uncertainty.
The single biggest contingency may be possible increases in value for such assets as realty, closely held business interests, as well as listed securities. If values are increasing, it may be particularly important to sustain a 25% or higher discount for estate tax purposes.
If the estate’s value after deductions exceeds the exemption level, then even small estates incur an estate tax at rates beginning at 18%. The estate tax rate on the value of the decedent’s assets at death rises to a highest bracket of 40%.
If the estate(s) will be subject to tax, then valuation discounts may quickly run into major transfer tax savings. Also keep in mind taking advantage of the annual gift tax exclusion, which is $15,000 per donee in 2020.
Income Tax Planning
We noted that the FLP may achieve some degree of income shifting to members of the family in lower tax brackets.
Another important income tax consideration here, which is also a key part of estate planning, is basis planning with a view to step-up. Basis is the minus to proceeds that determines gain or loss. There are exceptions but basis normally steps up to fair market value at death.
An estate plan will often involve a “living trust” which becomes more than one irrevocable trust upon the death of the predeceasing parent. Funding the trusts can materially impact the income tax basis of the assets eventually received by the children. The assets passing to one trust may step-up to the value at the death of the predeceasing parent. Depending on the funding of the trusts, assets may or may not step up again to values at the death of the surviving parent.
In so far as the benefit of step up, the increased basis for C corporation stock and even S corporation stock doesn’t translate into higher income tax basis within the entity. With partnerships, it may be possible to elect to step up basis inside the entity upon the death of a partner. ((See I.R.C. Sections 743, 754.))
Another important planning consideration is that while there is step-up at death, assets passed to the children via lifetime gifts generally result in carryover basis. This route may minimize transfer tax considerations when values are expected to increase significantly, but there is also the carryover basis for gifts versus step-up when assets are held until death. What’s good for one type of tax may be detrimental when it comes to another type of tax.
Funding the Family Limited Partnership
FLPs are frequently funded with marketable securities and other major components of the family’s wealth but our principal focus is upon the other two principal components of family wealth – real estate and interests in closely-held businesses. How do these assets fit into the scheme of planning within family limited partnerships?
A major consideration with gift and estate planning for realty and closely-held business interests is that the assets may be candidates for major increases in value. They often introduce a higher level of uncertainty in projecting future estate tax valuations.
It may be an advantage to have realty outside of the business entity. If it is used by the business, then it may be rented, at a fair rental, to the closely held entity.
Realty generally appreciates. Appreciated assets are particularly difficult to get out of corporate solution without triggering tax, whether the entity is a C corporation or S corporation.
Ownership might be tailored differently to fit the family’s needs. Realty might vest only in the parents while ownership of the operating business is being shifted to the children, or perhaps to the one child who is active in the business.
Detailed planning here may look at lifetime vs. deathtime transfers for realty with differing considerations than may well apply to, say, marketable securities.
The topic is beyond our immediate scope but we note that one way to make gifts is via intentionally defective grantor trusts, which can have the effect of retaining ownership for income tax purposes while still having transfers under the gift and estate tax provisions. Such trusts can play a role in tailoring ownership within the family’s planning.
Transfers of fractional real estate interests may qualify for valuation discounts even if not made directly through a family limited partnership. Such assets may also fund the FLP.
In general, if business interests are interests in Subchapter S or C corporations or partnerships, then consideration might be given to the feasibility of transferring such interests to an FLP. It must be considered whether the ownership interests represent total ownership, controlling interests or minority interests.
In Rev. Rul. 93-12, the taxpayer transferred all of the stock in a closely held C corporation to five children, 20% each. There was no FLP or other organization other than the C corporation operating business. The IRS was open to valuation discounts despite everything staying within the family.
Planning with respect to transfers of business interests within the family may involve gift tax issues, valuation discounts, recapitalization, and sustainability of valuations when there are sales to children. The IRS may try to find disguised dividends or gifts in such transfers.
Buy-sell agreements may help establish values for transfer tax purposes. This means that buy-sell agreements may need to be implemented or updated.
The best planning keeps a perspective that considers all of the different types of taxes, keeping in mind the existing structures, as well as people skills and needs. The estate tax is still with us and needs to be part of the planning in many families, which many may not realize.
In general, the 2017 Tax Act reintroduces what is sometimes a recurring income tax topic: Should I incorporate my business or revoke my corporation’s S election and be taxed as a C corporation? There are limitations on switching back and forth, but it is possible for an S corporation to become a C corporation. One reason to consider being taxed as a C corporation is tax rate disparity. After the 2017 Tax Cuts and Jobs Act, the C corporation rate is 21%, whereas individual rates reach 37%. One has to factor in the possibility of double taxation with C corporations in that dividend distributions, unlike reasonable owner’s salaries, are subject to double taxation. How to best get cash out of the business may be a major focus of even short-term tax planning.
S corporations, as well as business partnerships and sole proprietorships, may qualify for the 20% of business income deduction introduced with the 2017 Tax Act. C corporations aren’t eligible for this deduction. The tax bracket disparity between these taxpayers and C corporations may be less than would appear by just looking at the various tax brackets. There are, however, limits and exclusions with the 20% business income deduction.
There are many general principles of tax planning such as shifting income to where it will be taxed at a lesser rate, which can include gifts of FLP interests to family members. It can also include, for example, direct gifts of securities. The latter may have the potential for shifting dividends as well as long-term capital gains.
Some of the 2017 Tax Act’s provisions can be quite generous. An example is the ability to write off capital expenditures if one is in business.
The maximum amount of qualifying property the taxpayer may elect to expense under Section 179 was increased from $500,000 per year to $1 million. The benefit of this provision doesn’t begin to phase out until capital expenditures exceed $2 ½ million for property placed in service during the year. There is indexing with this provision that generally applies to tangible personal property and off-the- shelf computer software. A building would not qualify for this special expensing provision but a large manufacturing press would qualify.
The first-year “bonus depreciation” under Section 168(k) was increased from 50% to 100% after September 27, 2017 through December 31, 2022, with some phase-down from 100% to 20% through 2026.
Basis is first reduced by the Section 179 expensing provision, then the 50% bonus depreciation provision, then the normal depreciation rules apply.
The 2017 Tax Act provisions are so complex and multi-faceted that they generally need to be revisited at least annually.
We have an emphasis on the potential benefits of family limited partnerships especially when they may avoid or reduce gift/estate taxes but even more so we stress the importance of understanding the family’s overall tax planning perspective. The 2017 Tax Cuts and Jobs Act made tax planning even more complicated because of all the taxpayer pluses and minuses in its provisions.
In valuation planning for realty, closely-held business interests and securities, family limited partnerships may be an important element in planning for these assets.
The most important principle is that planning needs to be balanced and thorough. Thoroughness here considers all the different types of taxes. Reasonably affluent families and their advisors need to remember, the estate tax is still with us.
Robert L. Rojas, CPA, M.S.-Taxation, CExP, Rojas & Associates, CPAs,
Los Angeles, Woodland Hills, Newport Beach, Sacramento; rojascpa.com;
J. Michael Pusey, CPA, National Director of Taxes, Los Angeles
Disclaimer: This information contained herein is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230, as the content if this document is issued for general informational purposes only, is intended to enhance the reader’s knowledge on the matter addressed therein, and is not intended to be applied to any specific reader’s particular set of facts. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. Applicability of the information to specific situations should be determined through consultation with your tax adviser.