In the past few years, the family limited partnership has been a focus of Internal Revenue Service efforts to curb abusive tax shelters. The IRS maintained that a family partnership wasn't real; it was a tax dodge.
The agency had suddenly realized that family limited partnerships, sometimes called FLIPs, aren't just for the rich anymore. It's a solid tax strategy that advocates a way to protect a family's assets, potentially cutting in half or more what's owed on an estate-tax bill -- assuming there are any estate taxes to worry about.
That prompted the IRS to send out a flurry of "advisory notices," telling people that the agency may invoke a section of the tax code that allows it to disregard FLIPs because of potential abuses.
My response to this? Hogwash. If you or your family members have created a FLIP or are considering one, don't let the chest-thumping get in your way. As long as your motivation is to protect your assets from creditors or manage your assets more effectively -- just as in any limited partnership -- you're starting out on solid ground.
To understand a FLIP, you have to understand the basic structure of any limited partnership. After all, a FLIP is merely a traditional limited partnership where all the partners are family members. Remove the family relationship, and a basic FLIP is a basic limited partnership.
All limited partnerships have one thing in common: They all are run by general partners only. Under the law of all 50 states, by definition, no limited partner has any vote or voice in the running of the partnership business. A general partner, who may own only 1% of the partnership assets, will control 100% of those assets.
In a family situation, the parents put their assets into the partnership. They start by being both the general partners and the limited partners. Then, under the most common and simplest form, they gift their limited partnership interests to their children. Let's see what they have really done . . .
Several effects on the gift and estate tax
First, even though the parents have given away the limited partnership interests, they, as the general partners, still retain full control over all the assets in the partnership. The limited partners (who become the general partners upon the death of both parents) own and have title to the limited partnership interests. But they have no voice in the management of the partnership. In effect, the parents have given up ownership of the assets but have retained control. This does several things with gift and estate taxes:- Except for the 1% retention, the assets are out of the parents' estates. A completed gift has been made to their children. A gift tax may be due on the value of the gift. The parents, however, can use their unified gift and estate tax credit to pay that tax. In 2009, this credit, between both parents, shelters the tax on as much as $7 million ($3.5 million x 2). It is scheduled to become unlimited in 2010. In 2011, it's scheduled to fall back to $1 million per parent -- unless Congress votes to extend it. My best guess is that Congress will make the $3.5 million credit permanent before the end of the year.
- Since the gift has been completed, all appreciation on the assets is out of the parents' estates. Assuming both parents are age 40 when the transfer is made, and that one lives another 40 years, we have excluded 40 years of appreciation from the parents' estates. Further assuming a $7 million transfer and a rate of appreciation of only 7.2% per year, $112 million has been excluded from the parents' estates, and they have saved approximately $45 million in estate taxes. (Assuming there is an estate tax.)
Where the IRS gets really annoyed
Even if the parents die immediately after making the transfer and even if there is no appreciation in the assets, there is an immediate and substantial transfer-tax saving. Stay with me on this -- it's complicated.Remember that the parents gifted the limited partnership interests to their children, not the assets in the partnership itself. While the limited partners own the assets, they have no control over those assets. Because they have no control over those assets, the value of the limited partnership interests (the value of the gift) is less than the value of the assets transferred.
Look at it this way: If you can buy an asset for $1,000 and have complete control over that asset, it has to be worth more than a limited partnership interest where you have no control. The value of the limited partnership interest must be less than the market value of the asset because you don't control the money. All of the courts that have reviewed this, and even the IRS, agree that there must be a discount. The more liquid (meaning cash), the lower the discount. The IRS historically has allowed a discount of about 40%, depending on the assets transferred. That means that the parents can transfer as much as $11.67 million in assets structured as limited partnership interests without paying any federal transfer taxes. (60% of $11.67 million is the $7 million credit exclusion for 2009.) That's $4.67 million more than they could without the limited partnership.
The IRS argues that this is unfair to those who are unaware of the law or who can't afford high-priced attorneys to draft partnership agreements for them. And anyone who's married and has an estate of less than $7 million in 2009 can, if his will is appropriately structured, pay no federal gift or estate taxes. The FLIP is a real tax benefit only if your estate is $7 million or more. If you have that kind of money, you can afford to pay for competent estate planning.
Lower tax brackets and asset protection
The IRS does have one legitimate concern. In some cases, taxpayers have tried to take outrageous discounts of as much as 90%. Unfortunately, some people try to cheat; that's why we have audits.Also, since the children as limited partners own 99% of the partnership, 99% of the income will be taxed to them. This also has concerned the IRS. Traditionally, the parents will be in a higher income tax bracket than their children. If the parents are in the 35% bracket (the top rate for 2009) and the kids are in the 25% bracket, we have reduced the tax bite by 10 percentage points.
A FLIP also provides asset protection. Before the transfer, 100% of the parents' assets were subject to their creditors, now only 1% is exposed.
But what if the kids are sued? Well, against a limited partner, a creditor can get a judgment called a "charging order" only. This places the creditor in the same shoes as the limited partner. So if the partnership earns $100,000 and the limited partner owns 99%, the creditor is going to be taxed on $99,000. But as general partners, the parents decide whether to distribute any cash to the limited partners. So the creditors could then end up getting taxed on $99,000 in income every year, even though the general partners aren't giving them a single penny. This is a great motivator for creditors to settle.
The increase in the exclusion amount means that fewer taxpayers will have to use a FLIP to reduce their estate tax, at least until 2011. Few tax professionals believe that the unlimited exclusion will remain or that the reduction to $1 million in 2011 won't be changed. But in any case, FLIPs will still provide creditor protection and potential income tax reduction, regardless of what happens to the estate tax.
Family limited partnerships are legitimate wealth-preservation and asset-protection structures. Just because they are costing the government tax money doesn't make them bad. Remember, it's your money, not theirs.