Filed under Start Up
by Mom in Muskegon | May 24, 2012
My husband and I want to start transferring our family business down to our kids, and we're considering using a Family Limited Partnership. One adviser told us this is a very effective tool, and another told us it's more trouble than it's worth. How would you cast your vote on this issue?
Mom in Muskegon
If you use a family limited partnership (FLP) primarily for non-tax avoidance reasons and can prove that, I'd vote to go with one . . . providing that the kids plan to continue the business after you're gone. (If they don't, the tax consequences are severe to them as appreciation accrues to them after they receive their FLP shares and they'll pay big time capital gains tax if they liquidate.) But if your mission is largely to reduce transfer tax, it would indeed be more trouble than it's worth because the IRS is very tough on this tactic and it almost never stands up to scrutiny.
An FLP is simply a hybrid of the plain-old limited partnership entity form. The basic objective of an FLP should be to create the ability to give away ownership without giving up control. A regular partnership, sometimes called a general partnership, is governed by state law, involves two or more parties with a profit motive and every partner is a general partner--that is, there is only one class of partners. A limited partnership, on the other hand, has two layers or classes of partners--general and limited. (This parallels a corporation that has two classes of stock--common and preferred.)
A limited partnership's general partners get all the risk but all the control; its limited partners are liable only to the extent of their investment but have no control. So you and your husband could be the general partners and give the limited partnership shares to your kids and still maintain control over the assets. (Make sure your general partners don't hold more than 50 percent maximum or else the limited liability for the limited partners will be lost.) You can give away 99 percent and still keep adequate control through an FLP.
And the non-tax avoidance reasons you'd want to do this would include providing for an orderly transfer/succession of management between the generations, providing for some siblings who may not be active in the business, and sheltering the assets from creditors. What creditors, you ask? Well, how about a spouse who is suing one of your "partner" kids for divorce sometime in the future?
Some tax reasons to form an FLP include the ability to discount the value of the limited partnership minority shares and also to freeze the value of the business. By freezing the value of the older generation's shares, growth appreciation of the business can pass, tax advantaged, down to the kids. But an FLP should not be the first tool used to minimize taxes. Your unified credit for each parent, the good-old A-B trust tactics, irrevocable life insurance trusts and other plain-vanilla estate planning strategies should be considered before even thinking of an FLP. And don't forget to capitalize on your $13,000 per year per donee gift exclusions as well.
But be careful not to die early! The IRS always challenges FLPs they construe as having been formed in contemplation of death. And be sure the partnership is active, not passive. Also, be sure a qualified attorney draws up the partnership agreement, incorporates a definite non-tax "business purpose" into it, and uses an experienced valuation specialist to establish the business's value. Don't get greedy and try to include your boats and vacation condos in it.
Be sure the valuation of the FLP is updated regularly and, most importantly, don't ever let anyone talk you into letting your discount rate exceed 35 percent. The rules of thumb are promulgated as a 20-40 percent discount for a minority share, a 10-33 percent discount for lack of marketability and a 15-50 percent discount for cases in which restrictive agreements apply. A valuation expert will use some combination of these "norms," but don't let them total more than 35 percent or the IRS will shoot you down in flames for sure. Even 35 percent is pretty aggressive--20 percent would be a lot safer. And don't try to take a discount on cash assets or stock portfolios. The IRS takes as dim a view of this as they do of your boats and vacation condos.
Scrutiny is tough because of all the abuses that have taken place. If your FLP is set up for a real business purpose, includes real business assets and isn't created in a death-bed scenario, the likelihood of its being challenged down the road is currently fairly small. The IRS may object to the level of the discount you propose, but it won't arbitrarily disallow a discount on a true business. If abuses are committed, unraveling an FLP years down the road and paying the penalties levied not only make this tool "not worth the effort" but downright self-defeating.
Take care to choose the best accountant, attorney and valuation expert you can find as the success of your FLP will depend entirely on they way they craft the original documents. Experienced specialists are the only way to go, regardless of their price tag. FLPs are complicated creatures, far too involved to explain in a column such as this. Do your homework, hire competent professionals.