If you have affluent clients, you should know about Family Limited Partnerships (FLPs) and Limited Liability Corporations (LLCs), two extremely useful vehicles for helping reduce inheritance taxes. An FLP is simply a partnership created by two or more family members in accordance with state law. The family members contribute property that they expect to appreciate and, in return, receive general partnership interests or limited partnership interests, or both. The FLP is managed by the general partners, who have unlimited liability for the activities of the partnership. The limited partners also are essentially passive investors with few, if any, management rights. The limited partners' liability for the activities of the partnership is limited to the amount of his or her investment in the partnership.
Example: Husband and Wife form an FLP. Husband contributes the diversified portfolio of securities (a defined term) valued at $250,000 and an interest in real estate worth $250,000 in return for a 1 percent general partnership interest and a 49 percent limited partnership interest. Wife similarly contributes a diversified portfolio of securities valued at $250,000 and an interest in real estate worth $250,000 in return for a 1 percent general partnership interest and a forty-nine percent 49 limited partnership interest.
It is important to follow certain rules upon the formation of a partnership in order to avoid the recognition of capital gain upon funding. In other words, if you do not follow these rules and Husband and Wife in the preceding example put property into the partnership not in accordance with the formation rules and their basis in assets contributed to the partnership was $25,000 separately, they would each recognize a capital gain on the difference between their basis in the property that they contributed to the partnership and its fair market value on the date of contribution. These rules are beyond the discussion of this article, but we will deal with them in detail later, in the series of articles on family partnerships.
A family LLC on the other hand, is an entity formed by family members under state law that has characteristics of both a partnership and a corporation. The family members with ownership interests in the LLC are called “members.” Like shareholders in a corporation, members are not personally liable for the activities of the LLC. In addition, like partners in a partnership, the legal specifications of one's ownership interest are governed by an operating agreement. An LLC can either be “member-managed,” where each member has equal rights in the management and operation of the LLC, or “manager-managed,” where a manager or managers specified in the LLC agreement are given the right to manage and operate the LLC. In addition, an LLC could have voting and non-voting membership interests, in which case it is managed by voting members or a managing member designated by them.
Example: Husband and Wife form an LLC. By creating voting and non-voting membership interests, Husband and Wife could structure the LLC in an identical manner to the FLP in the previous example. Assuming the same property is contributed, Husband could receive in return for his contribution a 1 percent Class A membership interest (with voting rights) and a 49 percent Class B membership interest (without voting rights). Wife would receive identical interests in return for her contribution.
The choice of whether to use an FLP or an LLC for estate planning purposes will depend on which state law the creator intends to use. Either entity can be used to accomplish a client's estate planning objectives and is one of the most used techniques to exclude assets from a taxable estate — notwithstanding attempts by the Internal Revenue Service to disallow them.
There are also a variety of non-tax and tax reasons for using FLPs and LLCs. They can provide a vehicle to transfer assets while retaining control over distribution to family members, protection from creditors (and failed marriages), consolidation of the ownership in family property and one level of Federal income taxation. Also, FLPs and LLCs facilitate the making of gifts in much more efficient ways than direct gifts of property. Other advantages include the investments of the FLP and LLC and flexibility in governance.
Tax reasons for using FLPs and family LLCs are legion. Principally they involve discounting the property for gifting and for estate tax purposes. How so? The persons forming the FLP or the LLC no longer own the property contributed to the entity; they have units or membership interests in the entity. Because the interests are illiquid (there is no market for the partnership interests and the assets in the entity can't be sold by a single member), the shares are generally eligible for valuation discounts under IRS rules.
For example, if there is $1 million inside a partnership and 1,000,000 units valued at a dollar apiece, and 500,000 units are given away to children by the creators of the partnership, Husband and Wife, the units might be valued at anywhere between $250,000 to $350,000 for tax purposes, depending upon the discount range. That's a big improvement over paying taxes on $500,000 — usually by children. Remember that these discounts are available because the property put in an FLP or LLC is no longer under the sole control of the individual who made the contribution of the property to the entity.
Does an FLP or an LLC need to have a business purpose? Some attorneys, under recent case law, are more comfortable without too much emphasis upon a business purpose. But I personally believe it is an important aspect of planning for the creation of an FLP or an LLC in order to minimize IRS attacks.
We plan to do a series of articles on the family partnership and LLCs so that you will be on solid ground when helping your clients to these very useful tools.
Roy M. Adams is a partner in Sonnenschein Nath & Rosenthal in New York and chairman of the editorial advisory board of Trusts & Estates.