Powerful Combo: Family Limited Partnerships & Intentionally Defective Grantor Trusts
For our clients with significant means (> $5MM net worth for individuals, > $10MM net worth for marrieds), family limited partnerships (FLP) are a great way to provide asset protection and reduce estate tax. Because of lack of marketability of the FLP interests and constraints on control of the assets in the FLP, the IRS allows a discount on the valuation of the FLP of approximately 35%. Like normal limited partnerships, FLP's have their own tax return and the partners pay tax on the income from the FLP in proportion to their ownership. In addition to the valuation discount available to an FLP, FLPs provide very good asset protection. For this reason, FLPs are popular with our wealthy clients in risky professions (such as doctors, lawyers, etc.).
FLPs work great by themselves, but when combined with intentionally defective grantor trusts (IDGT), our clients can achieve a very powerful mechanism for transferring wealth to future generations while maintaining control and asset protection of the assets. Under an IDGT, assets are transferred to an irrevocable trust in such a way that they are defective for income tax purposes (the grantor pays the income tax) but effective for estate tax purposes (transferred out of the grantor's estate). The benefit to this approach is that income tax payments that the grantor pays for the IDGT amount to tax free transfers of wealth to the beneficiaries of the IDGT. Because the IDGT is disregarded from an income tax perspective there is no separate tax return.
There are a few tax rules that must be considered when thinking about transferring property to a FLP:
* Estate tax rate of 40%
* Capital gains rate of 23.8% (for those in the top income tax brackets)
* Step-up in basis of any property you personally hold at your death.
* FLP valuation discount rate of approximately 35%
* All US residents have a $5.34MM unified credit against gift and estate tax, indexed to inflation.
The benefits of using the FLP / IDGT approach must be analyzed in light of the tax rules above. First, if property is transferred into a FLP, the grantor will avoid estate tax but lose the future step-up in basis of the assets transferred to the next generation upon the grantor's death. However, because the estate tax rate is greater than the capital gains rate, there is an arbitrage opportunity if the grantor's estate is taxable (i.e. because the 40% estate tax rate is greater than the 23.8% capital gains rate).
Second, the FLP valuation discount reduces the size of the grantor's estate, also saving estate tax. The discount essentially allows the grantor to give more away to future generations tax free. The valuation discount transforms a $10.6MM combined unified credit into $16.4MM combined unified credit ($10.6MM grosses up to $16.4MM after the 35% discount rate is applied).
Third, transferring assets to a FLP also "locks-in" the unified credit amount. As noted above, every US citizen or resident has a $5.34MM unified credit against estate tax, indexed to inflation. The risk is that Congress will reduce the unified credit amount at some point in the future. If the grantor has already used their unified credit amount by making lifetime gifts, the grantor will not lose the larger credit (it is locked in on the date of the gift). For example, many of our clients made large gifts to FLPs in December 2012 because most people thought that Congress would reduce the unified credit from $5MM to $1MM.
Fourth, additionally, and perhaps most importantly, if the grantor gives away LP interests to kids and grandkids, any appreciation in the assets will appreciate in the estate of those future generations, rather than in the grantor's estate.
It is probably easiest to consider an example: A grantor transfer's property to a FLP with a fair market value of $2MM and a basis of $1MM. Then the grantor gives 25% of the limited partnership interests to intentionally defective grantor trusts to each of their 4 kids. The FLP later sells the property for $10MM.
Capital Gains – The grantor will be responsible for the first $1MM in capital gains since they contributed appreciated property. The limited partners will split appreciation on the remaining $8MM. Since the limited partners are intentionally defective grantor trusts in this case, the grantor will ultimately pay the capital gains on the entire $9MM gain. At a 23.8% capital gains rate, the grantor would owe $2.1MM in capital gains tax. Note that the grantor would have had to pay that tax whether it was in the FLP or not.
Estate Tax – The grantor transferred the property into the FLP at a FMV of $2MM. However, because of the valuation discount, the grantor was able to give away that entire $2MM with only $1.3MM ($2MM * 65%) counting against their unified credit amount. Additionally, the gain in value from the subsequent sale was in their kids' estates (because they had already given the property away). Therefore, the $8.7MM gain in value ($10MM - $1.3MM) occurred outside of their estate, saving approximately $3.5MM in estate tax.
Generally, my clients that use FLP's make large transfers to the FLP rather than a bunch of small gifts, mainly for practical reasons. Each time the grantor makes a transfer to the FLP, they will need a valuation on assets where the value is not readily apparent (such as real estate). The grantor will also need to do a gift tax return. Neither of these are difficult, but they do come with an expense and require a bit of work.
FLPs are great for real estate holdings as well as stocks and bonds. On the other hand, you would not want to put high-risk assets into the FLP. Although FLPs provide great personal liability protection, creditors can go after the assets within the FLP itself. For this reason, you would not want to put a toxic waste dump in the FLP with your low-risk real estate holdings. Additionally, FLPs cannot be a shareholder for S-Corps. It is also not advisable to transfer shares of stock in a family owned business that is a C corporation.
As you can see, there are a LOT of factors to consider. However, FLPs can potentially save millions in tax, as well as provide great liability protection.
See how Dossey & Jones can help you establish an FLP!