|
Taxation
Family Limited Partnerships
Abstract:
A
family limited partnership is a very attractive estate-planning tool because
it permits a parent to significantly discount the value of gifts to children.Ý
This material discusses the advantages and disadvantages of forming a
family limited partnership.
ISSUE
5: FAMILY LIMITED PARTNERSHIPS
A family
limited partnership is a very attractive estate-planning tool because
it permits a parent to significantly discount the value of gifts to children
that might not be discountable if made outright. A family partnership
enables a donor to divide a large asset or pool of assets to make several
smaller gifts, in much the same way that a family corporation enables
a donor to make multiple gifts of shares of stock. Like an S corporation,
a family partnership preserves the character of items of income, deduction,
gain, and loss recognized at the partnership level and taxed directly
to the partners.
A family
partnership, however, can be more flexible than a corporation (even an
S corporation) in that
- The partners
can, in their agreement, detail their respective rights and interests
with far greater precision.
- The tax problems attendant on withdrawal of contributed property
from a partnership are far fewer than those attendant on withdrawal
of contributed property from a corporation.
- The limitations on the number and type of stockholders imposed
on an S corporation do not apply to a family partnership.
Discounts. Two discounts generally are available: a lack
of marketability discount and a minorityÝ discount.
1. A
lack of marketability discount reflects the fact that the partnership
agreement will restrict the sale or transfer of the partnership interests
so that there is no ready market for those interests.
2. A
minority discount reflects the inability of the limited partner
to compel partnership distributions or to compel liquidation to obtain
the limited partnerís share of the partnership assets. It also reflects
the inability of the limited partner to control partnership investments.
Reversing its long-standing position, in Rev. Rul.
93-12, the IRS held that a minority discount is available with respect
to transfers between family members despite the fact that, after the transfer,
control exists as a family unit.
Economic
Effect. The combined discounts for lack of marketability
and minority can be quiteÝ substantial and might range from 30% to 60%,
depending upon the facts and circumstances.
Advantages. Family partnerships
offer a number of advantages as a means of transferring family wealth.
- The
creation of a family partnership is relatively simple, requiring a partnership
agreement, a deed of gift, and (in the case of limited partnerships)
formation as a separate legal entity under State law to receive a partnership
certificate.
- Using
a family partnership to make gifts of real estate located in a state
in which the donor does not reside can eliminate ancillary probates.
Real estate owned by the decedent directly is subject to probate in
the state where it is locatedóregardless of the state of residence of
the deceased owner. A partnership interest is treated as personal property
and is subject to probate only in the state of the decedentís domicile,
even if the partnership owns real estate.
- A
family partnership enables a donor to retain control over the property
being given away. The donor can be designated the managing partner (of
a family general partnership) or the general partner (of a family limited
partnership). In either case, the donor could retain most or all of
the managerial controls over the property, until all of it has
been transferred to the donee-partners, without jeopardizing the estate tax advantages
of the partnership. The IRS has ruled privately on a number of occasions
that the retention of control over the partnership activities by a donor
who serves as a general partner is not a retained right to control the
beneficial enjoyment of the transferred partnership interests. See Ltr. Rul. 9415007, 9310039, and
9310006.
- Unlike
a corporation, a partnership is not a taxable entity for income tax
purposes, so the donorís interest in the family partnershipís net income
escapes taxation at the partnership level.
- Multi-class
partnership interests can be used to freeze the value of the interests
of a deceased partner for gift and estate tax purposes under the special
valuation rules of Chapter 14 of the Internal Revenue Code.
-
A partnership interest is relatively
secure against the claims of the partnerís creditors. A creditor of
a partner may force the partner to transfer his or her partnership interest
to the creditor, but the transferee becomes an ìassignee,î rather than
a new partner, and is not eligible to participate in partnership activities
and management. The assignee may obtain only a ìcharging order,î entitling
the assignee to the assignor-partnerís share of any partnership distributions
that are actually made. Status as an assignee with a charging order
is generally very undesirable, because the assignee is treated as a
partner for federal income tax purposes and is taxed on a share of partnership
income, even if the partnership does not make any distributions. (Rev.
Rul. 77-137, 1977-1 C.B. 178).
- An
outright gift of a partnership interest in a family partnership (or
a gift in a trust that otherwise qualifies for the gift tax annual exclusion)
is generally eligible for the gift tax annual exclusion.
Disadvantages. Family partnerships
used as a means to transfer family wealth have relatively few disadvantages,
but any one could be significant for a particular situation.
- Legal fees for setting up a family limited partnership could
be substantial. When appraisal fees are taken into account, this amount
could be even higher.
- Loss of stepped-up
basis. Any lifetime transfer of assets results in a tax trade-off. Although
transfer taxes may be greatly reduced, the donee
may take a much lower basis in the transferred assets by taking the
assets with a carryover basis rather than a stepped-up basis. The transfer
tax (estate and gift)Ý advantages must be weighed against the possible
income tax (capital gains) disadvantages.
- The donorís annual gifts of a partnership interest are valued
on the date of each individual gift. Thus, a donor who retains a significant
partnership interest in a family partnership in which the underlying
asset continues to appreciate in value is credited with a portion of
the appreciation in the value of the retained interest, making it necessary
to make even more gifts to give away the donorís entire asset.
- Family partnerships are subject to the family partnership
rules under I.R.C. ß704(e) in order for a donee-partner
to be recognized as a partner for income tax purposes. Specifically,
capital must be a material income-producing factor for the partnership,
and the donee-partner must be the real owner of an interest in that
capital. If these tests are not met, partnership income will be taxed
solely to the donor and others who invested their own capital or services,
depriving the donor of the income-shifting advantages otherwise available
through the family partnership.
Example
5. John and Mary, each
age 55, jointly own and operate J & M Land & Cattle Company. Their
two sons Jim, age 27, and Joe, age 24, are each paid a salary and are
gradually taking additional management responsibilities. John and Mary
would like to keep control of the assets rather than give too much too
soon to their sons, who, they feel, may not be ready for the responsibility.
But they want to transfer the assets during their lifetime to protect
them from future creditors and reduce their taxable estate.
John and Mary have the following assets and liabilities:
| Asset |
Fair
Market Value |
Debt |
Tax
Basis |
Potential
Gain/Loss |
| Land
& Improvements |
$1,000,000 |
$250,000 |
$500,000 |
$500,000 |
| Raised
Livestock & Grain |
200,000 |
100,000 |
-0- |
200,000 |
| Machinery
& Equipment |
300,000
|
150,000 |
85,000 |
215,000 |
| Total
|
$1,500,000
Ý |
$500,000 |
$585,000
Ý |
$915,000 |
Assume
that John and Mary contribute their assets to a family limited partnership
in exchange for general partnership interests and limited partnership
interests. There is no gain or loss on the transfer.
If John and Mary each retain a 30% general partnership interest
and gift a 20% limited partner interest to each of their sons, the gift
may qualify for discounts for lack of marketability and a minority ownership
discount. Assuming a combined discount of 40%, John and Mary can
each use their annual gift exclusion to transfer free of gift tax $16,666
FMV of assets to each of their sons. The portion of the gift over and
above his or her annual gift exclusion will use up a portion of each parentís
unified credit. John and Mary would be able to give a larger share of
their estate by limiting the general partner interests to 10% and increasing
the limited partner interests to 90%.
Question
5A. What is the value of the gift to each son, and
how much of the parentsí applicableÝ exclusion amount is used?
Answer 5A.
Net value
of company $1,000,000
($1,500,000 FMV - $500,000 debt)
20% given
to each son 200,000
Less
40% discount -80,000
Less
split gift annual exclusion -20,000
Taxable
gift 100,000
Applicable
exclusive amount used 100,000
Gift
subject to tax -0-
Question
5B. How
much applicable exclusion amount would be used if discounts were not used?
Answer
5B.
20%
given to each son $200,000
Less
split gift annual exclusion $ 20,000
Taxable
gift $180,000
Applicable
exclusion amount used $180,000
Question
5C. Would
future annual gifts of partnership interests be allowed the same discounts?
Answer 5C. Yes. Assuming
the same combined discount of 40% (see Answer 5.1), John and Mary could
use their joint gift splitting to give $20,000 of discounted partnership
interest to each of their sons each year. The fair market value (FMV)
of the underling partnership assets would be $33,333.
FMV
of partnership assets $33,333
Less
40% discount ($33,333 40%) 13,333
Discounted
partnership interest $20,000
| Practitioner Note.
The $10,000 annual gift tax exclusion is indexed for inflation
and therefore may increase for future years. |
Question
5D. Would
John and Maryís individual remaining general partner interest in the
family limited partnership be eligible for the same discounts when valued
in their respective estates?
Answer 5D. Yes.
Planning Pointer. Reduction in estate
taxes and meeting the parentsí control objectives must be weighed against
a loss of potential step-up in basis and cost associated with formation
and operation of the family limited partnership.
Recommendation. To protect a gift of
a limited partnership interest from a possible valuation contest, make
a formula gift of the interest. For example, a married coupleís annual
exclusion gift to a child might be described as ìthat number of limited
partnership units (including a fraction thereof) equal in value to $20,000.î
If the IRS successfully challenges the valuation discount, the formula
simply absorbs the extra value allocated to the transferred interest.
Thus, the transfer remains fully protected by the annual exclusion.
Warning. These are complex rules. Advice from specialists is strongly
recommended to achieve the desired tax benefits.
Caution. Planners should be aware
of the provisions of the White House proposed 2000 fiscal year (Y2K) budget,
described in the Treasury Departmentís ìGeneral Explanations of the Administrationís
Revenue Proposalsî (known as the ìGreen Bookî). Among other provisions,
these budget proposals would eliminate the use of valuation discount planning
in most estates by precluding discounts for lack of marketability
and lack of control with respect to family corporations, partnerships,
and limited liability companies, except to the extent that they represent
an operating business. No discounts would be allowed for stock,
partnership interests, or LLC interests, to the extent that the entityís
assets consisted of cash, cash equivalents, foreign currency, publicly
traded securities, real estate, annuities, royalty- producing assets,
non-income-producing property such as art or collectibles, commodities,
options, and swaps. Interests in investment holding companies would be
valued at their net liquidation values. This proposal would be effective
for transfers made after the date of enactment. Congress flatly rejected
this proposal, also introduced as part of the fiscal year 1999 budget
proposals, in 1998, and again in 1999, and it seems no more likely to
be successful in 2000, an election year.
© 2001 Copyrighted
by the Board of Trustees of the University of Illinois
|
