Family Limited Partnerships
Family limited partnerships are a great organizational tool for many wealthy families. They have always been one of the simplest and hardest to screw up frameworks to implement a successful succession planning and tax planning strategy. After the basic estate plan and a whole life (or guaranteed universal life) insurance policy owned by an irrevocable life insurance trust, the family limited partnership is the next “go to” tool for those implementing sophisticated estate planning in an easy to understand way that does not break the bank. This entity can be used to own closely held family operating businesses, publicly traded securities or income generating real property. Since commercial real estate is the primary investment asset class for most wealthy families in California, this article will focus on partnerships funded with this asset.
Organizational Purpose
First and foremost, they provide an efficient organizational structure from which a family can manage and run their family business and/ or investments.
- They provide a great apparatus with which to implement an overall succession plan.
- They help protect assets from being wasted by spendthrift heirs by controlling the distributions they receive outside of expensive and tax inefficient trust settings.
- They provide limited liability protection to segregate partnership assets that may need asset protection.
- If desired, they can enable various family members to vote on family decisions in a democratic way.
- They avoid California Franchise Tax Board gross receipts tax on real property owned directly by the partnership.
- They help to avoid audits. Taxpayers who receive a K-1 are five times less likely to get audited as opposed to taxpayers who report their income on Schedule C.
- They encourage participation and interest in the family business and investment portfolio by making family members “partners” in the business. Giving younger generations investment training wheels, senior family members can observe how they handle distributions and choose to participate in the family business.
Fractionalized Ownership
Under current law assets in a family limited partnership will receive a 30% to 40% discount off of the fair market value of the assets owned by the partnership on the date of death for 709 estate tax return valuation purposes. This one simple and relatively inexpensive tool can effectively eliminate or reduce to a much more manageable size, most families’ estate tax liability. The 2024 estate tax exemption amount is $27,220,000 for married couples and $13,610,000 for singles. When you divide up an asset amongst multiple owners its gross value is no longer 100% of the underlying asset, appraisers will apply a 15% to 20% discount for lack of marketability and a 15% to 20% discount for lack of control.
What is rational behind these discounts? Would you buy a 1% interest in my family’s widget factory business for a full 1% of the business’s underlying asset value if you have to deal with my crazy family? They have never paid one dividend, the asset is extremely illiquid, you would have no voice in the management of the company and they are totally insane.
When we heard so much uproar about the proposed Section 2704(b) Regulations from the estate planning community that family limited partnerships are forever gone, many fell victim to the mass hysteria. What everyone was saying did not make any sense from a practical perspective because a minority restricted share in a closely held asset is truly not worth its equal share of the asset’s underlying value. If the IRS was really trying to say that they are going to do away with all discounts (or greatly limit discounts), there were plenty of people chomping at the bits to litigate the issue. It would not take long for taxpayers to win in court. If the IRS was trying to send a signal by lobbing this grenade at the estate planning community they had succeeded. My personal feeling is that the IRS was trying to say that the days of taxpayers getting away with greater than 40% aggressive discounts were over. Pigs get fed and hogs get slaughtered. Perhaps they were trying to limit discounts to 20% and maybe the end result after years of litigation would have been that regular discounts would be in the 20% to 30% range instead of the 30% to 40% range. There are people still out there trying to get away with 90% discounts and the IRS is right in putting their foot down and stopping abuses. Then Trump was elected President and the proposed Section 2704(b) Regulations went right out the window.
Since Donald Trump was elected and the passage of “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” (yes, this is the actual name) also known as the “Tax Cuts and Jobs Act” (“Act”), some paranoid people have been shy of family limited partnerships and some have even refrained from doing any planning at all. There is almost no chance of the estate tax exemption staying this high for long. First of all, with the exception of the cut in the corporate tax rate, most of the other provisions of the Act, including the new high estate tax exemption, sunset in 2025. On January 1, 2026 the old $5,000,000 exemption comes back indexed for inflation (I would guess that should be around $7,500,000 given recent inflation). Second of all, it seems that Donald Trump has been alienating much of the electorate which means that we are likely to have Democrats control the legislature and the White House. During the last presidential race both Hillary Clinton and Bernie Sanders stated that they wanted to lower the estate tax exemption amount to $2,000,000 and raise the estate tax rate from 40% to as much as 60% for the wealthiest Americans! Since we are likely to see a Democrat in the White House in the near future it is very likely that they will attempt to drastically lower the estate tax exemption.
The government needs any revenue they can get due to their spendthrift habits and the majority of legislators probably agree that the estate tax still serves its original purpose, a stance with which almost everyone who pays estate tax (less than .2% of Americans) vehemently disagrees. What is the purpose of estate tax? Estate tax in the United State dates back to 1797. If there was no estate tax, wealthy people would transfer their assets to others in lower tax brackets avoiding income tax. Additionally, taxing at death is less painful than increased taxes during one’s lifetime. The claim is that if there was no estate tax wealthy families would hoard wealth, stimming investment and innovation, and creating a landed aristocracy that would be adverse to working. Heirs would be shackled from becoming productive members of society and reaching their potential. Winston Churchill (himself a member of Britain’s aristocracy) argued that estate taxes are “a certain corrective against the development of a race of idle rich.” Andrew Carnegie stated “the parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would.”
All this to say: estate tax planning, family limited partnerships and discounting are here to stay regardless of the temporary reduced exemption amount.
Steps Necessary to Create a Family Limited Partnership
- Create a limited partnership or limited liability company under local state law.
- With limited partnerships only the limited partners have limited liability so if the entity is going to directly own real estate, the general partner needs to be a limited liability entity like a limited liability company to completely shield the family from unscrupulous plaintiff attorneys.
- Transfer the assets to the entity. In California if you are transferring real property to the entity it is imperative that you complete this step prior to gifting any limited partnership interest to family members so that the transfer can qualify as a proportional transfer under California Revenue and Taxation Code 62(a). If you make a gift and then transfer the real estate you have just created a change in ownership as the transfer is not proportional.
- If you are assigning limited liability companies that in turn own the underlying real estate assets it is important to remember to purchase a 107.9 endorsement from your title insurer so that you don’t lose your title coverage.
- Make a gift to the family members that are receiving the minority fractionalized interest.
- Obtain appraisals on the underlying real estate (or other assets).
- Using the real estate appraisals, obtain a business appraisal of the gifted minority interest.
- File a 709 gift tax return.
- Upon the death of the first grantor spouse (or earlier), the surviving spouse must relinquish all control of the general partner of the limited partnership so that a true lack of control argument can be made.
Conclusion
Family limited partnerships remain as the most efficient business organizational and estate tax planning tool available to families. By gifting a minority interest in a closely held business or investment portfolio the controlling family member can stream line their business, engage the younger generation of family members in their good fortune and reduce their eventual estate tax liability.
The information in this article is intended to be a general description of real estate law and is not advice as to any transactions, nor is this article advice to any person or to any client and should not be relied upon as such. If you or your client desire to receive specific legal or tax advice on a specific transaction, then please call Caldwell Law at (818) 651-6246.