In San Diego, many families are using a legal strategy for estate planning. Attorneys use their education, training and experience to suggest strategies and techniques to assist clients in protecting their legal rights and trying to obtain their legal goals. On our website, you can see many different strategies. We encourage you to make an appointment for a complimentary consultation. You can also e mail our firm with any legal questions regarding estate planning.
One of these strategies is a “family limited partnership,” as the name implies, refers to the creation of a partnership business entity among close-knit family members. A family limited partnership does not necessarily have to involve a business. For instance, it can be created for a particular asset, such as real estate or a mutual fund. This structure is a popular estate planning tool because it can provide both tax and non-tax advantages.
One obvious non-tax advantage is that when a transfer restriction is made a part of the family limited partnership arrangement, there is assurance that the business will be kept in the family. The structure also allows the operator of the business (presumably a parent) to maintain control of the business assets until retirement or death. This is accomplished by having the parent retain a general partnership interest that includes management control of the business. The children become limited partners. If a particular child were to be groomed to take over the management of the business, the parent could, over time, transfer fractional shares of the general partnership interest to that child.
Another important non-tax advantage is the protection of business assets. Although the personal assets of the general partner can be reached by creditors of the business, the liability of the limited partners is restricted to their interests in the partnership. Also, the assets placed in the partnership by the donor/parent are protected from his personal creditors. His income from the partnership can be reached by creditors, but not the assets.
Federal Income Tax
The primary income tax advantage to be gained from forming a family limited partnership is the deflection of income from the parent, who is typically taxed at higher marginal rates, to the children, who are taxed at lower rates. Where the donor/parent retains control as the managing partner, the strategy is to allocate earned income to the parent at the lowest reasonable level. The unearned income (return from capital investment) is divided among the parent and children as partners in proportion to their capital interests. Our firm does not provide tax advice and we refer to a licensed Certified Public Accountant on tax issues.
Estate and Gift Taxes
An initial federal estate tax advantage derived from the creation of a family limited partnership is that the allocation of income among the children will prevent the accumulation of such income in the estate of the donor/parent. The main focus is on the savings that can be realized on federal estate and gift taxes.
If the donor/parent transfers limited partnership interests to family members, the value of those interests will not be included in the parent’s estate at death. However, when partnership interests are transferred to family members, there is potential gift tax liability, which is calculated at the same rates as the federal estate tax. This problem can be alleviated by taking advantage of the annual gift tax exclusion, which for 2002 is $11,000. A fractional interest can be transferred free of gift tax to each donee up to the amount of $11,000 per year ($22,000 if the donor’s spouse consents to the transfer).
The two primary features by which federal estate tax savings are achieved are the estate freeze and the valuation discount. The object of an estate freeze is to transfer the future appreciation of the family business to the children. The effect is to prevent the appreciation of the senior family members’ interests in order to minimize estate taxes.
The valuation discount feature discounts the value of the fractional shares into which the business is divided so that the total value of the shares will not equal 100% of the predivision value of the business. There are different methods that can be used to discount the value of the shares. These discounts reduce the value of each partner’s share for federal estate tax purposes and benefit both the donor of the partnership interests and the donees.
Recently, the IRS has taken the offensive against valuation discounts. One Tax Court case shows that, in order to secure the “lack of marketability” discount, the donee must not be given powers that would allow him to liquidate the partnership.
Another recent Tax Court case indicates that in order to avoid inclusion of the transferred limited partnership interests in the decedent’s estate, care should be taken to avoid the appearance of the decedent treating the property as his own. For example, the transferor’s residence should not be transferred to the family limited partnership unless the transferor is to pay rent.
Given that the family limited partnership is such a powerful and complicated entity with major business, tax, and personal consequences, anyone considering forming such a partnership should seek qualified legal advice.