Currently, according to Pew Research Center, about 40% of baby boomers have retired with the annual retirement rate up this past year due to Covid-19. Succession planning has been, and will remain, a major concern for this retiring population for many years to come. Tax-wise, the sooner you start planning to transition your assets or closely held business, the better. However, many people delay transitioning because they don’t want to give up control of their assets and they’re concerned their beneficiary children aren’t ready to take over fully. In these situations, a family limited partnership (FLP) can be beneficial because it provides a means by which control over your assets can be retained as well as tax-advantageously transferred over time.
How It Works
An FLP is created by transferring your assets or ownership interest of a closely held business to the newly formed FLP in exchange for general partner (GP) and limited partner (LP) interests. The LP interest can then be gifted to your children or other desired beneficiaries.
The GP interest would be retained by you, which can be as little as 1% of the FLP. As general partner of the FLP, you still have control over the assets in that you can make the business decisions and run the day-to-day operations. Over time, you can gradually transition control and responsibility to your beneficiaries as they learn the business.
Tax Advantages
The LP interest that you gift removes value from your estate. The annual gift exclusion is $15,000 per person for 2021, which means you and your spouse can gradually gift annually up to $30,000 of LP value to each beneficiary without using any of your lifetime exemption. Additionally, future earnings and appreciation of the assets in the FLP would now be moved to the next generation.
Currently the lifetime gift tax exemption is $11.7MM, but under current law is set to move down to $5MM in 2026. Additionally, President Biden has stated he would like to move the lifetime exemption amount down to $3.5MM. If your estate is worth more than $3.5MM, or $7MM if married, now is the time to begin making these transfers.
As holders of LP interest in the FLP, your beneficiaries would have no control over the FLP. They also cannot sell the FLPs assets or their interest in the FLP without your consent. This lack of control, and therefore lack of outside market for interest in the FLP generally means the interest in the FLP can be valued at a discount. For example, if you transfer $10MM worth of real estate into a FLP, and then gift 90% of the FLP to your children with a valuation discount of 35%, you will only use up $5.85MM (($10MM * .9) * (1 - .35)) of your lifetime exemption.
Another potential tax advantage is that the gifted portion FLP income will now be allocated to your beneficiaries who may be in a lower tax bracket than yourself. This would result in lower income tax paid overall by the family.
Disadvantages
In the past, the IRS has scrutinized the use FLP discounts and has even gone as far as issuing proposed regulations related to these discounts. Those proposed regulations were tabled under the Trump administration but have the potential to resurface under the Biden administration.
It is also important that the FLP is administered like a true business. If it appears it has no business purpose and was formed for the sole purpose of avoiding taxes, then additional taxes, penalties and interest could be assessed.
The cost associated with setting up a FLP should also be considered. Valuations of the FLP will need to be made each time interest is transferred, which can be expensive. There is also the cost of annual filing requirements to consider.
Finally, not all assets can be transferred to a FLP. An FLP cannot be the owner of S Corp stock, IRAs, and other qualified retirement plans.
How ADKF Can Help
ADKF has been helping our clients for 30 years with their tax and estate planning needs. If you’re ready to begin planning for your retirement, we can help.