Family limited partnerships (FLPs) reduce estate taxes by the combined operation of discounting the value of limited partnership interests, and gifting the discounted limited interests.
The two principals work together:
First, the value of a limited interest in the FLP is discounted.
Once discounted, more FLP interests can be gifted tax-free to the next generation, which results in more assets passing out of an individual s taxable estate.
It is important to remember that control of partnership assets always remains with the general partners, and is never given away.
The principal of discounting recognizes two inherent reductions in the value of a limited interest in a family limited partnership.
One discount recognizes that a limited interest in an FLP is a non-controlling interest.
A second discount recognizes that there is no ready market for the sale of FLP limited interests. The courts have forced the IRS to recognize the validity of these two discounts and such recognition has been codified by the IRS in Revenue Ruling 93-12.
The IRS routinely accepts discounts in values of limited interests in FLPs varying from thirty percent to as high as fifty percent, depending, among other things, on the liquidity of the FLP’s assets, the likelihood of a distribution or liquidation and the profitability of the FLP.
It is important to understand that the discount applies to the value of the interest in the FLP; the value of the asset held in the FLP remains the same.
Thus, for example, a family home worth $1,000,000 before estate planning, remains valued at $1,000,000 after its contribution to an FLP.
If the home is sold, it would command a sale price of $1,000,000 whether or not it is contained within the FLP.
Consider the case of “Dr. and Mrs. Jones,” fictitious characters derived from actual client situations:
The Jones family home, valued at $1,000,000, is contributed by Dr. and Mrs. Jones to the Jones Residence Family Limited Partnership.
Although the value of the home is preserved after its transfer to the FLP, the FLP can accomplish significant estate tax savings via gifting of discounted limited interests in the Jones Residence Family Limited Partnership.
[NOTE: Although, for illustration purposes, we have created a hypothetical physician, the principles discussed herein apply equally to all individuals who have accumulated significant wealth.]
The IRS would recognize a 50% discount in the value of a limited interest in an FLP containing non-liquid assets such as real estate. Thus, although the FLP containing the Jones family home is worth $1,000,000, the value of all the limited interests of the FLP, discounted at a rate of 50% equals $500,000.
Assume that Dr. and Mrs. Jones wished to gift as much as possible to their children during their lifetimes in order to minimize the value of their estate at death. Using $500,000 of their combined $2,000,000 unified credit,
Dr. Jones and his wife would make a tax-free gift of $500,000 worth of limited partnership interests to their three children. Because of the discounting, this gift would effectively transfer all the limited interests in that FLP out of their estate to their children.
[NOTE: The unified credit (currently $1,000,000 per person) is not exclusively reserved for death; it may instead be used to exempt a gift made during one’s life from gift taxes.]
In effect, by making a $500,000 tax-free gift of discounted interests, Dr. and Mrs. Jones transferred 98% of a $1,000,000 partnership.
Upon their deaths, Dr. and Mrs. Jones, as 1% general partners, would each own $10,000 worth of partnership interests (subject to negligible estate tax), but they would have controlled the entire $1,000,000 FLP until the very end.
In addition, future appreciation on the value of the limited partnership interests given to the children will be excluded from Dr. and Mrs. Jones taxable estate.
In summary, Dr. and Mrs. Jones goals of minimization of estate taxes and preservation of family wealth for their heirs are efficiently and completely accomplished by the use of FLPs.
Through the principle of discounting, coupled with tax-free gifting of the discounted limited partnership interests, the value of Dr. and Mrs. Jones taxable estate will be reduced to zero, although they will retain complete control over their assets, as general partners of the FLPs.
Through the implementation of the FLP plan, the Jones children will be able to inherit all of their parents’ wealth, with nothing paid to the IRS.