By Peter Rohr
While partnerships are widely known as a way to structure a business, these can also be a valuable tool for families with wealth. Over the past several years, the closely-held limited partnership has been examined as a vehicle for a taxpayer to obtain significant discounts for gift and estate tax purposes when family wealth is transferred to descendants or others by means of a family limited partnership (FLP).
Partnerships are not only flexible, but also generally enjoy a favored tax income status over trusts or other business or investment entities. There are many other benefits of FLPs beyond those associated with taxes, such as centralized management and the ability to pool family assets in order to have greater investment opportunities. In addition, FLPs offer some asset protection from outside creditors or the uncertainties of marriage, and they can also allow senior family members the opportunity to impart personal business principles and investment philosophies to future generations.
Despite, or perhaps because of, all the benefits associated with FLPs, they have recently come under scrutiny by the Internal Revenue Service (IRS) for being perceived as simply a tool to avoid paying estate taxes. As the U.S. Tax Court continues to see its fair share of cases involving the legitimacy of this popular estate planning tool for the wealthy, one thing is becoming clear – obeying the rules is the key to maximizing its benefits.
Rules of Family Limited Partnerships
A family limited partnership (FLP) allows wealthy individuals to manage family assets similar to running an efficient family business. By contributing personal assets to a business entity in the form of an FLP, affluent individuals can preserve family wealth and transfer that wealth to future generations by granting children and grandchildren limited interests in the partnership.
Outside a partnership, an individual can gift only certain limited amounts in fair market value, tax free, to family members. In an FLP, a taxpayer can contribute assets to an FLP which is formed for a valid business purpose, and make annual gifts in that entity instead of making direct gifts. Since limited partnership interests are illiquid and limited partners don’t control the assets, fair market value of such interests can be discounted for transfer tax purposes in some instances. Where tax laws allow such discounting, the grantor can make larger gifts to family members through an FLP than by making the gift directly to an individual, thereby reducing the tax liability.
Why is the IRS Concerned?
Courts have criticized the validity of FLPs that appear to have been established as merely a way to avoid estate taxes, while letting the general partner or senior family member maintain control of his/her wealth until their death. A tax enforcement initiative, led by IRS Commissioner Mark Everson, began in August 2004 seeking to increase the number of audits among high-income individuals and corporations. One of the most frequent items on the auditor’s list is the family limited partnership. Though the recent court rulings have been mixed, lessons can still be learned by attorneys and financial advisors alike by studying these cases and avoiding potential IRS “red flags.”
The IRS is alerted by the following situations when auditing an FLP, for example:
· Establishing an FLP exclusively for tax benefits that allows the grantor to retain control of his/her assets.
· Transferring a large percentage of the taxpayer’s total assets to an FLP.
· Putting a primary residence, car or furniture into an FLP.
· Establishing an FLP right before death.
· Failing to distribute earnings to children who are limited partners.
· Signing a “pre-packaged” FLP.
Although none of the previous points are prohibited in and of themselves, by following a few simple guidelines the FLP can be employed as an effective tool for wealthy individuals and their families.
Establishing an Effective FLP
The best family limited partnerships are formed by the coordinated effort of an “informal” network, consisting of a closely knit team of financial advisors, attorneys and accounting experts, as each professional, in addition to specialized expertise, has a unique understanding of their client’s long-term goals and personal wishes.
An FLP is often used as a way to alleviate a concentrated stock position. Diversifying your portfolio is the key to long-term financial success and splitting up certain assets of your estate into a partnership could be a great strategy.
It is important to always consider the following advice when considering establishing a FLP:
· Be sure the FLP emphasizes tangible business and financial purposes rather than solely a tax advantage; it should be managed as a business.
· Make sure that the grantor does not retain too great of an interest in the assets in violation of Internal Revenue Code Section 2036(a).
· Maintain adequate assets outside the FLP to cover standard costs of living, including tax, medical and funeral expenses.
· Use the FLP to solve family disputes and bring together family members who have a difference of opinion regarding the transfer of family wealth.
· Consider cost-cutting measures such as including the family vacation home in the partnership or reducing investment management fees by pooling assets together.
It is important to consider the complexities and potential pitfalls associated with the partnership and to seek advice from a team of advisors such as your attorneys, financial advisors and accountants. This team yields professional insight to keep you on track to meet your long-term goals, and help you reduce the risks of becoming a potential target for an audit by the IRS.
Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither Merrill Lynch nor its Private Wealth Advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.
Peter A. Rohr is a senior vice president-investments and private wealth advisor with the Private Banking and Investment Group at Merrill Lynch in Philadelphia.