Sheltering Growth From Estate and Gift Taxes

Family Limited Partnerships and Family LLCs:
Sheltering Growth From Estate and Gift Taxes
by John V. Ivsan
Shumamker, Loop & Kenkdrick

Introduction

A problem inherent in most family businesses involves the issues of succession and taxation. As a family business continues to grow, the business becomes an increasingly valuable asset in the hands of the elder family members. If the business remains in a parent’s estate, upon death there may be significant estate taxes, as well as liquidity problems involved with paying those taxes. The parent’s estate may be compelled to sell valuable assets to pay for estate taxes, jeopardizing the family business and leaving heirs with a diminished estate.

Parents are often reluctant to remove a family business from their estates.Typically, a parent does not want to part with management control over the family business, risking the fortunes of a growing enterprise with children who may be less experienced at the business.Additionally, many traditional forms of transferring ownership of the family business from parents to children are subject to high levels of gift tax.

The explosion in popularity of family limited partnerships (“FLPs”) in the past few years as a solution to these problems can be attributed to the versatility that a FLP offers to a family business.By contributing their interests in a family business to a FLP, parents may transfer future ownership and control of the business to their children at a substantially reduced transfer tax cost while at the same time permitting the parents to retain control over the business.

Reducing Estate and Gift Taxes with “Discount Planning”

Interests held in a FLP may qualify for substantial discounts when valuing transfers to children which are subject to gift tax. These discounts are attributable to unique traits of the FLP which make interests in the FLP less valuable when compared with more liquid investments.Designing the FLP to achieve these discounts (a.k.a. “discount planning”) may significantly reduce any gift tax liability upon lifetime transfers of interests in the family business from parents to their children, or any estate tax liability from business interests in a parent’s estate.

FLPs have been popularly regarded as a vehicle for discount planning when transferring ownership of the family business from parents to children.Many states have statutes which permit available in the context of estate and gift tax valuations of business interests:the discount for lack of marketability of a business interest, and the discount for lack of control over the business.

The discount for the lack of marketability of a business interest is a reduction taken against the value of a business interest because that interest cannot be liquidated very easily. Generally, the longer it takes to liquidate and get fully paid for an interest in a business, the greater the discount will be for lack of marketability.On the other hand, the discount for lack of control over the business (a.k.a. “minority interest discount”) is a discount taken to recognize the fact that a non-controlling interest in a business may be worth less than a controlling interest in the same enterprise.The less control one has over the business, the greater the discount will be for lack of control.

A common strategy has developed of organizing the FLP in a state whose limited partnership laws generate the greatest discounts.For example, a state that restricts a limited partner’s right to withdraw from the partnership will be an attractive choice of forum for organizing the FLP.In such a case, large discounts may be available for the lack of marketability of the interests, primarily from the “lock-in” effect of not being able to redeem these interests during the life of the FLP.

The Extent of “Discount Planning”

The benchmark discount given by many analysts for a well-designed FLP is 35%, although many taxpayers have obtained higher discounts in litigation with the Internal Revenue Service.Such a discount will, for example, allow parents to transfer $1,000,000 of equity in a family business to their children at a transfer tax cost of only $650,000.If such parents are in the 50% estate tax bracket, the discount will save them $175,000 of the estate taxes. Furthermore, all of the appreciation in this equity will inure to the benefit of the children and will not be subject to the parent’s estate tax.

In addition to the family business, FLPs are being used to provide substantial discounts for other income-producing assets. Such assets could include valuable stock portfolios or rental real estate interests.Transferred directly, these assets will tend to obtain little or no discounted value.However, by contributing these assets to a FLP, these assets can be transferred at a greatly-reduced transfer tax cost.

The New and Rising Star:The Family LLC

The FLP is popular for its ease of organization and operation. However, because the entity is a limited partnership, there must be at least one general partner who is exposed to the unlimited liabilities of the partnership.Although this may not be a primary concern for a family business which is rather passive in nature (e.g., a securities portfolio), this problem becomes more acute with regard to manufacturing, services, and rental real estate activities.

The limited liability company (“LLC”) provides a solution to this problem.The family LLC resembles the FLP in virtually every aspect except one:whereas the FLP must have at least one general partner who is open to unlimited liability, all the members of a family LLC enjoy the protection of limited liability.However, until now, LLC statutes have not provided the same restrictions that produce high discounts for limited partnerships.

Several states have recently changed their LLC statutes to provide the same high discounts currently available in other states through use of the FLP.The states that have changed their LLC statutes now provide for restrictions on LLC interests which more closely resemble restrictions on limited partnership interests. Thus, many family business owners may enjoy a new and unprecedented ability to obtain high discounts along with the protection of limited liability.

Additional Reasons for Creating a Family LLC

There are several other distinct advantages behind the family LLC compared to the FLP.For example, in a FLP, limited partners who participate in the control of the business will generally be subject to personal liability despite their limited partner status. However, with the family LLC, members can participate in management of the family business in most cases without potential exposure to personal liability.

The family LLC is a natural extension of the estate planning techniques that have made use of the FLP so popular.However, there are additional considerations upon forming a family LLC.For example, a family LLC more closely resembles a corporation for income tax purposes.The LLC must be carefully designed not to cross the line and subject the income of the enterprise to double taxation.By organizing the family LLC properly, family business owners can achieve limited liability while sheltering the income of the enterprise from double taxation.

The Family LLC as an Alternative to the S Corporation

For those considering organizing an S corporation, consider the family LLC as an alternative.S corporations are subject to strict rules regarding share ownership and corporate affiliation. The use of a trust holding stock in an S corporation is tightly restricted.Furthermore, the one-class-of-stock rules applicable to S corporations limits the ability to vest parents and their children with different ownership interests and to provide for special allocations of income and loss.

The family LLC avoids these restrictions.Many additional forms of trusts can be used to hold LLC interests.Furthermore, the family LLC can be organized to divide profits in the family business in many different ways without having to be concerned about the one-class-of-stock restriction applicable to S corporations.

Minimizing Income Taxes

The FLP or family LLC may offer additional benefits beyond simple estate and gift tax discount planning.For example, many business owners may be able to use a FLP or family LLC to minimize state income tax liability.Also, FLPs and family LLCs may be used to protect assets from intangibles taxes in many states. Therefore, by crafting a comprehensive tax plan, many family business owners can pass ownership and control of the family business while simultaneously reducing income taxes.

The Prospects of Tax Legislation to Curb Use of FLPs and Family LCCs

Congress and the Internal Revenue Service have long sought to tax parents on the transfer of valuable business interests to their children.Congress first legislated tax provisions to address situations in which a parent passes economic ownership of an incorporated family business while retaining voting control over the corporation.

In response, many taxpayers began structuring intricate buy-sell arrangements and similar devices to depress the value of stock in a family business passed on to children.Over the past decade, Congress has sought to eliminate many of these estate planning devices through a series of comprehensive statutes designed to eliminate the transfer of ownership in a family business from parents to children at substantially discounted values.The FLP has developed as the first response to these changes in the tax laws.

FLPs and family LLCs are now gaining such popularity that Congress may revisit this area in the next couple of years.If Congress acts in the same way it has in the past, more likely than not future tax legislation will not affect the current availability of substantial estate and gift tax discounts from the use of FLPs and family LLCs.Therefore, family business owners are well advised to act sooner rather than later to ensure that they enjoy the full benefits of this tremendous discount planning opportunity.

Conclusion

Families have traditionally organized their businesses using S corporations, close corporation agreements, and buy-sell agreements among family business while transferring ownership to children.Yet, the use of family limited partnerships and family LLCs is revolutionizing the process of succession in the family business.

The benefits of these two new entities are two-fold: (1) simplicity in organization and (2) an unmatched ability to transfer greater value to children tax-free.When further combined with a long-term retirement plan, FLPs and LLCs clearly present an undeniable opportunity to avoid needless taxation on the income of an enterprise and upon assets handed down from parents to children. Family business owners are well advised to take advantage of this unique opportunity while it lasts.