A few clients contacted me after reading my last blog post, Possible Major Estate Tax Change on the Horizon: Take Action Now to Minimize Tax While You Still Can. We are working with them now to take advantage of today’s favorable tax planning environment before proposed tax regulations could dramatically change the landscape of one of the most often used estate planning tools – the family limited partnership, also known as an FLP.
If your estate plan involves a family limited partnership, now is the perfect time to transfer wealth to the next generation. That’s because recently proposed regulations could soon make FLPs much less advantageous from a tax standpoint.
Many high net worth individuals and families have successfully used FLPs and other family-controlled entities as a wealth transfer tool, often at substantial discounts from the fair market value of the underlying assets.
How an FLP Works
Let’s take a step back and consider how an FLP works.
To execute an FLP strategy, you contribute assets — such as marketable securities, real estate and private business interests — to a limited partnership. In exchange, you receive general and limited partner interests.
Over time, you gift, sell or otherwise transfer interests to family members and anyone else you wish – even charitable organizations. For gift tax purposes, the limited partner interests may be valued at a discount from the partnership’s underlying assets because limited partners can’t control the FLP’s day-to-day activities and the interests may be difficult to sell.
This can provide substantial tax savings. For example, under federal tax law, you can exclude certain gifts of up to $14,000 per recipient each year without depleting any of your lifetime gift and estate tax exemption. So, if discounts total, say, 30%, in 2016 you can gift an FLP interest that worth as much as $20,000 before discounts (based on the net asset value of the partnership’s assets) tax-free because the discounted fair market value doesn’t exceed the $14,000 gift tax annual exclusion.
Now the IRS is proposing changes that could substantially reduce (or even eliminate) valuation discounts for certain family-entity interests. The proposed regulations, issued on August 2, 2016, address the treatment of certain lapsing rights and restrictions on liquidations in determining the value of the transferred interests.
More specifically, the proposed regs include provisions to:
- Amend existing rules on what constitutes control of a limited liability company or other entity or arrangement that isn’t a corporation, partnership or limited partnership,
- Address death-bed transfers (made within three years of the transferor’s death), and
- Modify what’s considered an “applicable restriction” by eliminating a comparison to the liquidation limitations of state law.
Under existing tax law, an applicable restriction is “a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the state law generally applicable to the entity in the absence of the restriction.” The IRS is proposing that restrictions imposed on a limited partner’s ability to liquidate his or her interest be ignored, irrespective of whether those restrictions are imposed by the partnership agreement or state law.
The proposed regs also add a new class of “disregarded restrictions” that would be ignored if, after the transfer, the restriction will lapse or may be removed, without regard to certain interests held by non-family members by the transferor or the transferor’s family. Restrictions that defer the payment of liquidation proceeds for more than six months or permit payment in any manner other than cash or other property also would be disregarded under the proposal.
Additionally, the proposed regs address FLPs that include charities and other unrelated parties as partners in an effort to preserve valuation discounts. Under the proposal, the existence of such an interest would be disregarded unless it’s “economically substantial and longstanding.” If all non-family interests are disregarded, the entity is treated as if it’s controlled by the family.
When to Consider Transfer Restrictions
Let’s look at a typical scenario where transfer restrictions may be disregarded under the proposal.
Suppose Jerry creates an FLP. Jerry owns a 98% limited partner interest, and his daughters, Gloria and Kitty, each own a 1% general partner interest.
Under the partnership agreement, the FLP will dissolve and liquidate on June 30, 2066, or by the earlier agreement of all the partners. It otherwise prohibits the withdrawal of a limited partner. Under applicable local law, a limited partner may withdraw from a limited partnership at the time, or on the occurrence of events, specified in the partnership agreement. Under the partnership agreement, the approval of all partners is required to amend the agreement. None of these provisions is mandated by state law.
Jerry subsequently transfers a 33% limited partner interest to each daughter. Under the proposed regs, would the transfer restrictions be considered when deciding on the valuation discounts for the limited partner interests?
By prohibiting the withdrawal of a limited partner, the partnership agreement imposes a restriction on the partner’s ability to liquidate his or her interest in the partnership that is not required by law and that may be removed by the transferor and members of the transferor’s family, acting collectively, by agreeing to amend the partnership agreement. Therefore, under the proposed changes, the restriction on a limited partner’s ability to liquidate that partner’s interest would be disregarded in determining the value of each 33% limited partner interest.
These proposed regulations won’t go into effect unless and until they’re finalized. (Unlike many IRS proposals, it’s not effective immediately or retroactively.) As we explained in our last article on this topic, the Treasury is now collecting feedback to discuss at its public hearing on December 1, 2016. Even then, any changes won’t into effect until 30 days after the Treasury finalizes the regulations.
Take Action Now
There could still be time to set up an FLP (or similar family-controlled entity) and be grandfathered from any new rules. But caution and diligence are the names of the game — as always, excessive discounts, do-it-yourself appraisals and other aggressive estate planning tactics are likely to attract IRS scrutiny.
Our estate planning experts can help you take advantage of today’s favorable tax planning environment. Call David Goldner, CPA, CFP, CVA, at 800.899.4623 or contact him to schedule a free estate planning consultation to make sure your plan is up-to-date and set to take full advantage of favorable tax planning opportunities. David specializes in maximizing wealth accumulation for high net worth families through proactive tax and estate planning techniques.