Family Limited Partnerships (“FLPs”) and Family Limited Liability Company’s (“FLLCs”) are used to facilitate gifts of large assets not easily subject to division.

One of the challenges when counseling high net worth individuals is how to lower their estate tax exposure without causing them to lose control of their assets. It can be particularly challenging when an estate contains extremely valuable assets not easily subject to division. Some background is necessary to better understand the problem.

Whether through outright gift, transfers in trust or charitable transfers, reducing estate tax exposure involves some sort of gifting. Using the ten thousand ($10,000) dollar annual gift tax exclusion ($20,000 for married couples), the client (“donor”) may make substantial annual gifts. If the client begins a systematic gifting program early enough in life, and has enough beneficiaries to whom to gift, significant estate tax reduction can be achieved over time. Not only are the gifted assets removed from the donor’s and donor’s spouse’s estate, but the future appreciation of the gifted assets is removed as well.

There are a number of drawbacks to a substantial outright gifting program involving cash and liquid assets which don’t apply to gifts in a FLP or FLLC. First, the donor may not be willing to make substantial outright gifts, fearing that such unrestricted gifts will affect the donee’s work ethic. Second, the donor may not have enough liquid assets with which he or she is willing to part. Finally, the donor may simply not be willing to give up control of his or her assets.

Estates with substantial business or real estate assets, may create a separate entity (Family Limited Partnership or Family Limited Liability Company), transfer ownership of the business asset or real estate to the entity, and thereafter gift fractional interests of the entity to the beneficiaries. This approach allows the donor to retain his or her cash, as well as control of the gifted assets. It also allows for annual gifting of fractional interests in an illiquid or non-divisible asset.

Family Limited Partnerships and Family Limited Liability Companies allow the donor to divide one large asset or a pool of assets in order to make several smaller gifts. Not surprisingly, FLPs and FLLCs have become increasingly popular vehicles for making gifts of illiquid assets while retaining control over the assets’ management and ultimate disposition. As an added bonus, substantial gift tax discounts are available to the donor when valuing the gifted FLP and FLLC interests.

A typical FLP or FLLC is instituted by an older family member (i.e. a parent) who transfers business, investment or real estate assets to the partnership or LLC. The parent then gifts limited partnership interests and non-managing LLC membership interests to beloved family members (usually children) each year. The FLP and FLLC interests gifted to the children are calculated to come within the annual gift tax exclusion ($10,000/$20,000). In some cases, taxable gifts may be advisable (See page 55 “Planning Strategy”). Gifts can be made to the children each year, in the parent’s discretion, as long as the parent/donor retains at least a 1% ownership interest in the FLP or FLLC.

The general partner of the FLP or the managing member of the FLLC retains control over the day-to-day business activities of the entity, making investment and management decisions and determining when distributions should be made to FLP limited partners or FLLC minority members. Naturally, the donor/parent acts as the general partner or managing member of the entity.

The starting point in valuing the annual gifts is to determine the value the assets of the FLP or FLLC. The fact that the donee children are receiving a minority interest in an entity which they do not control impacts the value of the gift. A “valuation discount” is available to the donor, which recognizes that the gift is of an illiquid FLP or FLLC interest and not of the underlying FLP or FLLC assets. The advantages and disadvantages of each entity, including discount valuation, are discussed in greater detail below.

FAMILY LIMITED PARTNERSHIPS

A Family Limited Partnership (“FLP”) is a standard limited partnership with the donor parent acting as the general partner and the donee children owning limited partnership interests. Under Michigan law, a limited partnership must have both a general partner and at least one limited partner. Only general partners are fully liable for partnership recourse debts, while the limited partners are liable for partnership debt only to the extent of their individual investment in the limited partnership. A FLP is not itself a taxable entity. It is said to be a “passthrough” entity for the reason that items of income, deduction, gain and loss are calculated at the partnership level and passed directly through to the partners, based on their interest in the partnership, to be taxed at their individual rate.

FAMILY LIMITED LIABILITY COMPANIES

A Family Limited Liability Company (“FLLC”) is a cross between a corporation and a partnership. It offers the liability protection of a corporation with the pass-through income tax features of a partnership. FLLCs are created, owned and managed by its “members.” The members, in turn, may elect a managing member or members to manage the day-to-day activities of the LLC. One advantage of a FLLC over a FLP is that unlike FLPs, no FLLC member is personally liable for the entity’s obligations. Remember that the general partner in a FLP remains personally liable for FLP operations. By contrast, all members of an FLLC are liable for FLLC debts only to the extent of their investment in the FLLC. Members share in FLLC profits and losses based on their ownership percentage. Membership interests in an FLLC are personal property, like partnership interests, even if the underlying asset is real property.

Since their introduction into Michigan law in 1995, LLCs have been the entity of choice. All FLLC member may be permitted to manage the company and participate in control of the business without risking loss of limited liability. Under an FLP, at least one general partner must be fully liable for the obligations of the partnership, and the limited partners cannot participate in management without jeopardizing their limited liability.

Family Limited Partnerships and FLLCs are preferred over Irrevocable Trusts as gifting vehicles because they allow the doner to continue to enjoy the benefit of the transferred assets. The donor can also continue to actively manage the assets of the entity. By contrast, the Settlor of an Irrevocable Trust may neither retain an interest in the trust nor act as Trustee. An Irrevocable Trust cannot be amended, modified or revoked. The irrevocable trust, however, because of its ease of formation and administration, remains the preferred technique for excluding life insurance from the donor’s estate.

Notwithstanding which entity is chosen, both offer flexibility and valuation discount opportunities. Both entities also offer potential income tax savings. The parent in a higher income tax bracket can give FLP or FLLC interests to children in lower income tax brackets. Children will then report their share of income generated by the FLP or FLLC at their lower income tax rates.

Parents need not to be concerned that interests gifted to children will be voluntarily or involuntarily transferred to non-family members. Through careful drafting, limited partners’ and FLLC members’ interests are relatively secure against outside creditors. Both the FLP Partnership Agreement and the FLLC Operating Agreement prohibit voluntary transfers. Both agreements severely limit involuntary transfers as a result of the bankruptcy, divorce or insolvency of a partner or member.

Such events may trigger an automatic “buy back” under the Agreement for a nominal price. Buyback may not even be necessary. The inherent lack of marketability of FLP and FLLC interests make such interests unattractive to outside creditors. Creditors who acquire limited partner or non-managing member interests become only an assignee, and as such would not be eligible to participate in FLP or FLLC management. In divorce, a FLP or FLLC interest acquired by gift is considered seperate property. In a divorce action, separate property is typically awarded to the owner of the property rather than to the non-owner spouse.

VALUATION AND VALUATION DISCOUNTS

Asset valuation is a critical gift and estate tax issue. For gifts of cash or publicly traded securities, the value of the gift is simply its face value on the date of the transfer. The value of gifts and bequests of non-tradable assets must be determined through written appraisal.

Determining the value of a FLP or FLLC interest is a two-part analysis. First, the value of the assets owned by the FLP or FLLC must be determined. The effect of the restrictions placed on the donee limited partner or non-managing member by the FLP or FLLC arrangement must then be determined. The law of valuation discounts, as it has developed over the last several years, has consistently recognized that the donee’s interest in the FLP or FLLC is less than his or her pro-rata share of the underlying FLP or FLLC assets. Courts have held that this “discount” is the result of the donee’s lack of participation in the management of the entity, as well as the restrictions on transferability of the interest.

Courts have reasoned that the purchaser of a minority interest in a FLP or FLLC would pay less than if the interest was a majority and controlling position. A marketability discount results from the fact that the donee limited partner or member is unable to transfer his or her interest in the FLP or FLLC without the consent of the general partner or managing member.

The effect of valuation discounts is that the donor parent can gift a larger FLP or FLLC interest to his or her children each year. A thirty-five (35%) discount, for example, would allow the donor parent to make a 35% larger gift within the gift tax exclusion rules. Increasing annual gifting also ensures that a greater percentage of the future appreciation of FLP and FLLCs assets will be outside the estate of the donor parent. If valuation discounts seem too good to be true, someday you may be right. The IRS has indicated that it will attack aggressive valuation discounts especially where the FLP or FLLC has been organized for the primary purpose of holding marketable securities.

The following is an example of how valuation discounts work:

Harry and Wendy wish to give their children, Donna and Sam, an interest in real property they own together worth $1,000,000. Harry and Wendy create a family limited partnership to which they transfer the real property. Without the benefit of the valuation discount, Harry and Wendy would each retain a 48% interest in the FLP and gift to Donna and Sam a 2% limited partnership interest each. The value of their 2% gift is $20,000 (2% x $1M) to each child, all of which is sheltered from gift tax by Harry’s and Wendy’s annual gift tax exclusions.

By contrast, with the benefit of a 35% valuation discount, H and W can gift $30,769 ($20,000 gift exclusion divided by (1 -.35) = $30,769) annually to each child. Accordingly, H and W would each retain a 46.9231% interest in the FLC after the gift, while each child would have a 3.0769% interest.

The next year, assuming the real property has increased 5% in value to $1,050,000, H and W would agree to amend the FLP Agreement to give D and S an additional 2.93% (1,050,000 divided by 30,769 = 2.93%) limited partnership interest to each child to reflect an additional $30,769 gift in year 2. The additional gifts would increase D and S interest in the FLP to 6.007% in year 2 thereby reducing H and W’s interest in year 2 to 43.993 each.

H and W would follow this procedure annually until they have given away all but one (1%) percent of their interest in the FLP. Each gift is sheltered from tax by H and W’s annual gift tax exclusion.

H and W might have gifted an amount in excess of their annual gift tax exclusion (i.e. $10,000/$20,000). Had they elected to do so, they wold have reduced their Applicable Exclusion Amount dollar for dollar by the taxable gifts. This can be a very wise approach where the underlying asset is appreciating rapidly, since a larger percentage of the asset can be gifted before it appreciates. Earlier gifts of a larger percentage of the asset result in a greater percentage of the asset’s appreciation being realized by the donee.

Valuation adjustments vary depending on a number of factors including:

1. the level of control of limited partners;
2. limitations on transfers;
3. levels of partnership earnings and revenues;
4. the number of partners;
5. the nature of the partnership’s underlying assets;
6. the relevant economic environment;
7. the size of the interest being valued; and
8. the specific valuation assignment.

ADMINISTRATION

Since FLPs and FLLCs are separate entities in the eyes of the Internal Revenue Service, they must obtain a separate tax identification number and file annual Federal and state income tax returns (Form 1065 and MI 1065 and SBT). Further, all partners and members must annually include their distributive share of FLP and FLLC income and loss on their personal return. As a practical matter, this means that partners and members must wait to file their personal income tax returns until they have received a copy of the FLP or FLLCs income tax return, or K1.

Despite the increased administrative demands of FLPs and FLLCs, they are tremendous estate planning tools which save estate tax and provide creditor protection. For these reasons, FLPs and FLLCs are rapidly gaining in popularity as estate planning tools for larger estates.