The biggest challenge for estate planners is how to reduce estate and gift taxes but allow the client to retain control over his assets. Family limited partnerships (FLPs) provide a solution to this problem.

When you place investments, a business, or real estate holdings in a FLP, you retain control of the assets while at the same time making gifts of limited partnership interests to your beneficiaries so that they own part of the equity. Because the limited partnership interests that are given to the beneficiaries are not marketable, they are valued at a discount which maximizes the amount of the underlying assets that can be transferred free of gift taxes. The family limited partnership also provides other benefits for asset protection from creditors and providing for centralized control and management.

How does it work? The older generation members ("Mom and Dad") form a partnership and contribute assets to the partnership. The contributed assets now belong to the partnership. Mom and Dad are the general partners and control the partnership. Mom and Dad make gifts of the limited partnership interests to children, grandchildren, trusts for grandchildren, as they wish.

What can a child or grandchild do with the limited partnership interest? Nothing. The interest can’t be transferred, can’t be sold, doesn’t give the owner decision making authority or authority to exercise control over the partnership assets. It is documentation of an interest in the partnership which entitles the owner to partnership distributions if they are made, and to liquidation proceeds if the partnership is liquidated. The terms of the partnership agreement restrict the limited partners’ ability to transfer or, otherwise, enjoy the asset.

A FLP gives a two-fold benefit: (1) Mom and Dad stay in control even though they have made gifts, and (2) because of the restrictions placed on the limited partnership interest by the partnership agreement, the value of the gifts is much less than a pro rata value of the underlying assets. Thus, Dad can transfer more property by making gifts of limited partnership interests than by making outright gifts of the assets. Both the psychological goal of retained control and the estate planning goal of a reduced taxable estate are reached.

The gift and estate tax savings are a function of gaining IRS acceptance of the discount. Let’s say you form a FLP and claim a 45% discount on the gifts of limited partnership interests. The IRS objects and, rather than go to litigation, you agree on a 25% discount. What do you call that? I call that "victory." You won a 25% discount. (If you think that losing the whole 45% is failure, a family limited partnership is not for you.)

There are things you need to do to make your case for a discount compelling. The FLP has to be a "real deal." It must be operated as a genuine partnership with a business purpose. It is not just a document. It is an operating entity, and the entity must be respected.

Some tests of whether or not it is a real entity are: Do you follow the partnership’s requirements for votes, meetings, contemporaneous records, and other requirements set forth in the document? Do you file a Form 1065 – Partnership Income Tax Return? Does the partnership have its own bank accounts and investments, contracts for services and pay its own bills? Does the FLP maintain books and records? Also, make sure that there are sufficient assets outside of the FLP. Don’t use the partnership as your own personal piggy bank. It cannot be stressed enough that FLPs have to be planned, documented, implemented and operated.

Next, make sure you have the best possible valuation appraisals from a qualified appraiser. Two appraisals are required, at two different levels. One appraisal is for the assets owned by the partnership. The second appraisal is for the value of an interest in the partnership. The valuations are key to defending the discount, so they are not something to stint on.

There are considerable non-tax advantages as well. The partnership can protect property against claims. Creditors that may sue the partnership cannot reach the personal assets of the limited partners and the general partner (if the general partnership is a limited liability company or corporation). Creditors of the partners themselves may be more willing to settle than be saddled with limited partnership interests and non-controlling general partnership interests that will cause them to have income tax liability, but no guarantee of distributions with which to pay the taxes.

The partnership property can be managed through one account, thus consolidating and simplifying the management of the family’s investments. The partnership simplifies the manner in which you make gifts to your beneficiaries. Instead of being required to select and give several securities or other assets, you simply could transfer limited partnership units.

FLPs are not for everybody; but if you can abide by the constraints of the entity, this estate planning technique is an important one that can provide significant benefits.

 

 

Thanks to Congress’s failure to act to "fix" the estate tax by the end of 2009, your estate plan may have a serious problem. If your estate plan divides your assets by use of a formula that refers to the estate tax, your plan could be in trouble.

Many people have this type of plan. It goes by various names. Some call it an A-B Trust, some call it credit shelter trust planning, some refer to it as by-pass trust planning. Whatever you call it, the salient feature is a word formula that directs part of the decedent’s assets to a trust and part to the surviving spouse (or to a trust usually for his or her benefit). These formulae were put into your plan so that your plan could adapt to changes in the federal estate tax, like the increasing exemption amount, and to take account of gifts you may make in your lifetime.

The formula divides the assets by reference to the federal estate tax law. Since we don’t have a federal estate tax right now, these formulae don’t work – they are either meaningless gibberish or they produce a bad result. (Thank you Congress.)

On December 31, I sent out letters to all my clients who had such formula provisions in their wills or revocable trusts. Many of them have been in to sign codicils or amendments already. If your plan has a formula, you really should get it fixed up for 2010.

One example of a formula would direct the distribution of the maximum portion of your estate amount that can pass free of estate tax to the credit shelter (or by-pass) trust. Since there currently is no estate tax, the maximum amount that can pass free of estate tax is 100% of your estate. Thus, if you died now, all of your assets would go to that trust; and your surviving spouse would not receive anything (except that he or she may have some interest in that trust). This is probably not what was intended when you signed the document.

Another example of a formula is one which provides that an amount passes to the spouse which is the whole estate minus an amount equal to the amount the federal exemption equivalent which is directed to the credit shelter (or by-pass) trust. Using this formula, if you died now, since there is no estate tax in 2010, 100% of your estate would pass to the surviving spouse, and nothing would go to the trust. Again, this is probably not what was intended when you signed the document.

With neither formula do you get the result that was intended when you signed your estate plan. Thanks to our venerable Congress’s failure to act with regard to the estate tax prior to the end of 2009, your plan now has a serious problem.

Remember, this type of planning was done to save estate taxes, specifically to use both spouses’ exemptions from the federal estate tax. In most cases, the only purpose of including a by-pass or credit shelter trust was to save estate taxes. It would not be good to saddle your surviving spouse with a trust to administer when the trust was completely unnecessary to save taxes and was funded only because of Congress’s current shenanigans.

The solution is to amend the formula provision. There is not sufficient time to revisit your whole plan. As an immediate "band-aid" fix, if your plan contains a formula division, you should contact your attorney to make a simple codicil to your will or amendment to your trust. The codicil or amendment should provide that if you die in 2010 when the estate tax and generation-skipping tax do not apply to your estate and if these taxes are not retroactively reinstated by Congress, any computations required to apply the formulae in your plan shall be made as if the Internal Revenue Code in effect on December 31, 2009 is then in effect.

If you make a change like this, your plan will be the same as when you signed it. That may or may not be good for you. Depending on when you created the plan, the federal exemption may have been $600,000. In 2009 it was $3.5 million. That’s a big difference. Maybe you don’t really want to direct up to $3.5 million where you had directed $600,000 before. If that is the case, you need a complete review of your plan, not just a band-aid fix.

The objective is to make sure your plan works and makes sense in 2010 until Congress acts, if it does. Don’t delay. This needs attention.

In 1981 with the passage of the Economic Recovery Tax Act (ERTA), Section 2035 of the Internal Revenue Code was amended so that most gifts made within three years of death were no longer pulled back into the estate.  The 3-year rule was not eliminated completely, however.  Transfers of life insurance within three years of death can still cause inclusion of the death benefit in the estate and transfers of the "strings" under IRC Sections 2036, 2037 and 2038 that cause estate inclusion can cause a pull back. 

Also, any gift tax paid within three years of death is pulled back into the estate.   The reason for this gift tax rule is that the federal estate tax is a tax inclusive tax and the gift tax is a tax exclusive tax.  These examples illustrate the point:

Gift:         Donor has $150; transfer tax rate is 50%. Donor can give $100 to donee and pay $50 gift tax.

Bequest:       Decedent dies with $150; transfer tax rate is 50%. Decedent can leave $75 to beneficiaries and pay estate tax of $75. 

Without the 3-year pull back for gift tax paid with 3 years of death, one could cut the federal transfer tax payable by 1/3 simply by transferring everything days or moments before death.  OK.  So, decedent made taxable gifts and paid gift tax within three years of death.  Gift tax is brought back into the estate.  Who pays the estate tax on the gift tax?

See Gary Freidman’s blogpost about  Matter of Rhodes, __ Misc.3d __, __ N.Y.S.2d __, 2008 NY Slip Op 28472 (Sur. Ct. Westchester Co. 2008), where the issue was whether donees of gifts made within three years of death are responsible for paying estate tax attributable to the inclusion of the gift tax paid on such transfers.

The Court held that the donees of the gifts made within three years of decedent’s death are responsible for paying their ratable share of the estate tax attributable to the inclusion of the gift tax paid.  Ouch!  

Here is what the tax clause in the will said:

All inheritance, succession, transfer and estate taxes . . . payable by reason of my death in respect of all items included in the computation of such taxes which shall have passed under the provisions of this Will, shall be paid by my Executors as follows:

(A) All taxes with respect to property passing under this Will shall be apportioned in accordance with the law of New York, notwithstanding the foregoing, I direct that any such taxes resulting from the bequests under Clauses SECOND, THIRD and FIFTH of this Will shall be paid by my Executor out of my residuary estate, without apportionment or reimbursement from any beneficiary.

(B) I intend that all taxes described in paragraph (A) of this Clause with respect to property passing outside of the provisions of this Will shall be apportioned in accordance with the law of New York . . ..

(D) I wish to record that I have given great consideration as to how I have directed that the taxes described in paragraph (A) of this Clause are to be paid with respect to property passing under and outside my Will and to whom I have burdened with the payment of such taxes. I believe that the provisions which I have arrived at are equitable for all of my family members.

Looks like the decision is correct.  The gift tax paid certainly didn’t "pass under the terms of the will."   Another reminder to be very careful with tax clauses.