The U.S. could experience some rather drastic tax changes in the near future. For instance, if the so-called Buffett Rule passes, capital gains taxes would increase from 15% to 30% for those with incomes above $250,000 or those with a $1 million in hard assets. Another looming tax hike are the Bush tax cuts that are set to expire in 2013, pushing rates up for many Americans.
While these two tax alterations are not set in stone, one sure thing to consider is that the estate tax will be returning to 55% (from the current rates of 35%), and the amount you can exclude from your estate for tax purposes will be reduced from $5.12 million to the 2003 rate of $1 million. When a valuable inheritance is rich in land but light in cash, paying more than half your inheritance is a greater burden, especially if you have to sell the property to pay the taxes.
If you are a business owner, you must plan ahead for any of these potential tax eventualities. The Buffett Rule may never transpire, but estate taxes will not go away, and there’s a good chance that the Bush tax cuts will expire or be altered.
But how do you plan for changes in the tax code that have not happened yet – or might not happen at all? It’s simple: Focus on financial instruments and entities that will allow you to protect your assets and mitigate changes in the tax code. If you have a business that involves family members, or a business or assets that you want to leave to your family, then one such entity is the family limited partnership (FLP).
What Is a Family Limited Partnership?
A family limited partnership is a partnership agreement that exists between family members who are actively involved in a trade or business. The partnership divides rights to income, appreciation, and control among the family members, according to the family’s overall objectives.
The family “business” does not actually have to be a business in the traditional sense – assets such as real estate or investments can also be in a FLP, as can the family farm, ranch, or real estate holdings. The nature of the FLP allows you to shift the value of assets to other members, thereby reducing the size of the estate for certain members.
A family, as defined for tax purposes, only includes a person’s spouse, children, ancestors (including parents), lineal descendants (grandchildren), and any other trusts established for the benefit of those people. So, for example, a newly married spouse could be part of the partnership, but not a second cousin.
The most common way of setting up an FLP is to create a general partnership first with limited partnership interests. The general partner (or partners) then gift the limited partnership interest to the children or other family members who are eligible. Whomever holds the general partner title maintains control over the enterprise or assets, but the limited partnership interest lets children or other eligible family memberships share in the ownership.
This is probably where the concept of not mixing family with business originated. Business interests are ripe for family conflict. So why would anyone create an FLP and risk family strife?
Advantages of FLPs
1. Estate Planning Is Simple and Estate Tax Savings Are Substantial
The FLP is a frequently-used technique to shift income tax burdens from parents to children as an estate planning tool. The interests transferred to your children, including all appreciation since the transfer, escape inclusion in your estate when you die. Only the value of the taxable gifts at the time they were transferred into the FLP are included for purposes of estate taxes.
For example, if the value of the partner interests are valued at $500,000, but in 20 years rise to a value of $5 million, only the $500,000 amount would be included in the estate for the purposes of estate planning. This can lead to estate tax savings down the road.
2. Transferring of Ownership Is Systematic
If a business is a sole proprietorship at the death of the owner, the value of the business is included in the value of the estate. If it is set up as a corporation, again, the value of the shares of the corporation is fully in the value of the estate.
An FLP, however, allows the owner to set up family members as limited partners, and allow them to transfer partnership interests over time. This results in a gradual, systematic transfer of ownership. The value of the partnership interests is not included in the value of the estate of the general partner when he dies.
3. There Are Significant Income Tax Benefits
Aside from the estate planning advantages, the family limited partnership can lead to substantial income tax savings. By including your children as partners and sharing partnership income with them, total family taxes may be reduced because your children, as limited partners, own part of the company.
For example, most small businesses in the country are set up as sub-chapter S corporations. This setup allows owners to take the profits of the corporation and pass them on as personal income to the owners – and this is the reason many in Congress oppose higher taxes on the $250,000 per year income threshold. If, however, you choose to set up an FLP, the general partner can share the income with his two kids. He may pay each $75,000, reducing his income for tax purposes to $150,000, not $250,000.
There is, however, an important caveat here: You cannot shift income to children younger than 14. In the old days, this was a favored tactic of the rich and infamous. Rich fathers and uncles would put the five-year old on the payroll and pay him $2 million. That is a no-no in today’s world. For any child younger than 14, any income over $1,600 will be taxed at the top marginal rate of his parents.
Disadvantages of FLPs
1. Children May Be Exposed to Major Capital Gains Liability
Gifted property does not receive the stepped-up basis treatment that bequeathed property receives. The term “stepped-up” refers to the value of an asset when a person dies and leaves the asset to an heir. For example, an uncle buys 1,000 shares of Apple stock when it is only $50 per share. He dies, and leaves it to his favorite niece. The value of the Apple stock, and what the niece gains or loses, is based on the market price on the day she took ownership, not the price the uncle paid. This is important, because if it were based on the latter amount, her capital gains liability would be steep.
In an FLP, however, this may not be the case, and children may be exposed to significant capital gains liability. This varies, depending on the type of property being transferred and what has happened to it. It’s always best to discuss with an attorney potential capital gains issues – and it’s always important to remember that property in an FLP does not have the same stepped-up value basis as property left to heirs.
2. General Partners Could Be at Risk
Unlike corporations and trusts, general partners are not insulated from potential lawsuits, judgments, or creditor seizures. The parents, as general partners, are 100% in control of the assets and 100% responsible for a potential lawsuit. General partners have no asset protection in these cases.
3. It Can Be Difficult to Transfer Ownership to Children Under 18
FLPs are not the best entity for transferring assets or business interest to family members who are under the age of 18. First of all, the minor’s interest would have to be held by a parent or guardian. Second, partners must be able to play a role in the day-to-day management and operations of the business. This also makes partnership interest unsuitable for family members who are older than 18 but are away in college.
4. Non-business Assets Could Become Large Tax Liabilities
If the FLP you have or will create is for the sole purpose of non-business assets, such as real estate or investment securities, then you must be careful – you could find the FLP to be considered an investment company. This may cause capital gains and, therefore, losses realized on the transfer of property into the partnership.
For instance, a beach house owned by a grandfather and grandmother increases in value from $50,000 to $2 million. If the FLP is labeled as an investment company, then transferring ownership of the beach house to the FLP could create a capital gain of just under $2 million, and a tax bill of approximately $300,000 dollars. If you only have one type of property, then other type of trusts are better suited to avoid large tax liabilities.
The scenario just described is not one that normally happens under partnership rules, but it can. Despite that, the benefits of the family limited partnership can be significant – but only if set up correctly.
When dealing with any type of estate planning strategy, using an attorney in conjunction with a financial advisor is a must. Speak with more than one. FLPs are the favorite of attorneys, while investment professionals and CPAs sometimes like to use other estate planning tools such as trusts, limited liability companies, or partnerships. Setting up an FLP can cost anywhere between $5,000 to $10,000 dollars with ongoing costs after setup. Given the costs, getting a second or even third opinion in this area is a smart move, worth the extra effort and time.