Family limited partnerships and family limited liability companies are the Leatherman tools of estate planning - they offer features for almost every planning need. Amid the great uncertainty engulfing the estate tax, FLPs and FLLCs may prove particularly valuable.
Careful use of FLPs and FLLCs can help clients reduce estate taxes by creating the potential for valuation discounts. Simply put, if an FLP owns $100 of assets, a 40% limited partnership interest is worth less than $40 because the noncontrolling interest would be tough to sell and LPs by law cannot participate in management.
That means if assets are transferred into an FLP or FLLC and noncontrolling ownership interests are given to heirs - or better yet to well-designed trusts for the client and the heirs - the value of the transfers can be reduced for gift-tax purposes. If the client then dies, the limited partnership interests remaining in the estate may be valued at less then the pro rata share of FLP assets.
What if no planning was done before the client died? There may still be an opportunity to create an FLP to own assets held by different trusts formed under the client's will.
For example, a typical estate plan may set up three trusts on the death of the first spouse: 1) A bypass or credit shelter trust up to the amount of the state estate-tax exemption; 2) A gap trust with the amount equal to the difference between the federal estate tax exemption of $5.12 million and the lower state estate tax exemption; and 3) A marital trust to qualify for the unlimited estate tax marital deduction. While assets in the first two trusts will avoid federal estate taxation in the surviving spouse's estate, the marital trust will be taxed in the survivor's estate. If each of these three trusts contributed assets to an FLP, the FLP interests included in the marital estate might qualify for a valuation discount, reducing estate taxes.
But a word of caution about discounts: Their days may be limited. There have been a host of proposals in Congress to curtail or eliminate discounts. If a client might benefit from the technique, do it now. The most effective way to try to lock in discounts may be to make gifts of noncontrolling FLP interests irrevocable dynasty trusts.
FLP valuation discounts are not necessarily easy or assured. To have a reasonable shot at securing discounts, the partnership must have legitimate nontax purposes. A mere tax play won't fly. The discounts must be supported by a proper appraisal, and many clients may be disinclined to pay for one.
Comprehensive planning must be pursued. For example, in partnership agreements between unrelated parties, it is common to mandate that enough cash be distributed each year to enable each partner to pay the income tax liability attributable to partnership income. But if such a clause is included in a family limited partnership agreement when discounts are sought, it may reduce or jeopardize the discounts.
Most important, the FLP must be operated properly relative to the independent integrity of the entity. The FLP cannot pay personal expenses of the partners. If there are loans to or from the entity, they must be documented, with payment of interest and economic justification disclosed. Unfortunately, a substantial percentage of FLPs are not maintained properly.
BEING IN CONTROL
Every client wants to remain in control. When a client transfers assets into an FLP or FLLC, control over the assets can be exerted through the terms of the FLP partnership agreement or FLLC operating agreement that governs the entity.
For example, a general investment strategy can be specified in the agreement. Restrictions on the transfer of ownership interests or distributions can be detailed. A general partner (or manager of the LLC) can be named to act in a managerial capacity. In addition, a client can designate a successor to serve in these roles in the event of the client's disability or demise. This can all be especially helpful if there is a business or investment purpose that will benefit from unified management.
But if the client retains excessive control, whether under the terms of the agreements or through actual practice and operation of the FLP, the IRS may claim that FLP interests nominally held by others are really included in the client's estate. For example, if the client pays a wealth manager 1% of assets to manage FLP assets, but then withdraws almost all of the remaining profits as a management fee, that control over profits and cash flow may be unreasonable and tantamount to the client having never relinquished any FLP interests. Creditors might make a similar argument.
There are many creative ways that FLPs or FLLCs can be used to provide reasonable control. If a wealthy family has passed a vacation home on to later generations, having the property owned in an FLP and perhaps naming the oldest children as general partners may be an effective way to have the entire family own and enjoy the property, but centralize management to facilitate maintenance and care. FLPs can be used to aggregate assets from family members and family trusts to enable one person as the general partner to coordinate a unified family investment strategy.
An FLP can enable a client to avoid ancillary probate by holding real estate or tangible assets, such as, for example, an art collection, that may be in a state other than where the client lives. If a client resided in New York and owned a home in Florida, having an entity own the real estate would convert the real estate into an intangible property interest because FLP or FLLC interests are intangible assets like stock. This will avoid the need to have a second probate proceeding (called ancillary probate) in Florida.
But there is a price to pay. Having an entity own the property may jeopardize some of the tax benefits on the second home. Florida doesn't have an estate tax but New York does, which means converting Florida real estate into an intangible asset subjects it to the New York estate tax. In the right circumstances, having real or tangible property held in an FLP can be valuable, but mishandling it can prove costly.
Having assets held in an FLP or FLLC, rather than outright, can provide a measure of asset protection. Ours is a highly litigious society with a substantial divorce rate. It stands to reason that any client with meaningful wealth should take precautions to protect it.
Real estate rental properties and businesses should be owned by entities. But that alone may not be enough. If a client has a real estate property held in an FLLC with only one member, the FLLC structure may provide protection for the client's other assets (like the home and investment portfolio) if there is a suit related to the property held in the FLLC.
But if the client is sued as a result of a car accident, a claimant may have little difficulty in reaching into the real estate FLLC. If instead the FLLC is structured to have significant other members, state law may limit the rights of the claimant in the auto accident against the economic value of the client's interests in the real estate FLLC.
Proper planning can insulate assets both inside and outside the entity. But asset protection planning requires that formalities be observed if claimants are going to be limited. Also, when transfers are made to FLPs or FLLCs, or FLP or FLLC interests are transferred to irrevocable trusts, it is essential to corroborate that the transfers are not fraudulent conveyances.
Documentation of any existing claims should be sought out to prove that there were no known creditors whom the client was trying to harm by the transfers. Financial planners should create a budget and investment plan to demonstrate that the assets remaining in a client's name suffice to meet likely living expenses and other expenses. This can be invaluable if claimants later assert that a client formed, funded or gifted a FLP or FLLC to defraud them.
FLPs and FLLCs are incredibly flexible and valuable estate planning tools, but they are not simple to master. Planners should explore their use in creative ways with clients who could benefit, but crafting a plan and having it succeed can involve considerable cost and effort.
Martin M. Shenkman, CPA, PFS, J.D., is a Financial Planning contributing writer and an estate planner in Paramus, N.J. He runs laweasy.com, a free legal website. He is also the winner of this year's Financial PlanningPro Bono Planner of the Year Award.