The IRS does not like them, but for wealthy families, this kind of limited partnership is an effective means of transferring wealth within a family, while minimizing taxes. You’ll need to work with an experienced estate planning attorney who is familiar with family limited partnerships to do this correctly.
By establishing a business entity to hold assets that would otherwise be subject to transfer taxation, family limited partnerships are used by wealthy families to minimize tax liabilities, according to an article in ThinkAdvisor, “Estate Planning: The Family Limited Partnership Strategy.” The article examines a recent decision in U.S. Tax Court, known as Purdue, which held that a family business entity formed for non-tax reasons is permitted and using it to minimize transfer taxes is acceptable, even though that was one of the reasons that the entity was created.
The Purdues had five children and several grandchildren and great-grandchildren. Their estate was worth about $28 million, much more than the current $5.49 million per person estate tax exemption amount. The couple funded a Purdue Family LLC with about $22 million in marketable securities and other assets and, at the same time, created a trust to benefit the Purdue’s descendants and spouses. The trust was funded with interests in the LLC in proportion to the gift tax annual exclusion each year. Each beneficiary could withdraw up to the gift tax annual exclusion amount or a per capita share of the assets transferred each year. The LLC’s operating agreement spelled out some non-tax reasons for creating the LLC, such as
- Avoiding fractionalizing ownership;
- Retaining assets within the extended family;
- Protecting assets from future unknown creditors; and
- Providing flexibility in managing the assets that wouldn’t be available in other entities.
When Mr. Purdue died, he created a bypass trust, a qualified terminable interest property (QTIP) trust and a GST-exempt trust—each of which owned a portion of the LLC. Mrs. Purdue and her husband had retained the right to income and distributions from the LLC assets, although the decedent had approximately $3.25 million outside of the LLC and trusts. After the decedent’s death, the IRS attempted to collect more than $4 million in estate taxes and challenged the LLC structure. Trust beneficiaries and the QTIP trust loaned the estate funds to pay the estate tax. The estate attempted to deduct interest paid on the loan, but the IRS challenged this.
Tax Code § 2036 stipulates that property transferred to a trust, in which a decedent holds an ownership interest, will be included in his or her gross estate, except when that property is transferred for adequate consideration. The estate was also required to show that there were valid non-tax reasons for creating the family LLC. The IRS said the LLC was created primarily to transfer wealth to the next generation and to avoid taxes.
However, the Tax Court did not agree with the IRS. Seven non-tax reasons for creating the LLC were found to be compelling and acceptable for the existence of the LLC. They included:
- Relieving the decedent of having to manage the investments;
- Consolidating investments with a single advisor to reduce volatility under a written investment plan;
- Educating the children to jointly manage an investment company
- Avoiding repetitive asset transfers among multiple generations
- Creating common ownership of assets for efficient management and meeting minimum investment requirements;
- Providing voting and dispute resolution rules and transfer restrictions;
- Providing the children with a minimum annual cash flow.
It is worth repeating that these are complex legal entities and require the help of a sophisticated legal professional who is experienced in the formation of Family Limited Partnerships. Ask your estate planning attorney at Cottrell & Jacobs, if an FLP is appropriate for your situation.
Reference: ThinkAdvisor (March 14, 2017) “Estate Planning: The Family Limited Partnership Strategy”