Transfer to Limited Partnership Included in Taxable Estate

The point of transferring assets to a limited partnership or a family limited partnership concerning estate tax is to remove the assets from the taxable estate and then PASS THEM to the next generation – not hold 99% interest in the limited partnership.

The first goal of a family limited partnership (FLP) is asset protection, which is defined as the safeguarding of personal wealth from lawsuits by future creditors. Those assets could be cash, securities, cars, homes, or anything worth protecting.

Creditors are also broadly defined and include actual creditors as well as identifiable probable creditors, such as litigants, soon-to-be ex-spouses, disgruntled business partners, or anyone who you know that has a claim against you, even if they do not yet know it. Creditors may even include government agencies such as the I.R.S.[1] The FLP effectively codifies asset protection as law.

The FLP basically provides a joint venture between family members. It is formed with the senior family members holding the partnership interests through a shell corporation as general partners, and then the children or grandchildren hold their interests as limited partners. The general partners are effectively in control of the partnership while the limited partners have none. The FLP is then funded with these assets. CAUTION: if not funded correctly, you can run into some gift tax issues.

A note needs to be added here about fraudulent conveyance. What that means is that the person forming the FLP is already under a lawsuit and puts their assets into something to protect them. The courts can see right through that and call it fraudulent conveyance.

Now let’s discuss the estate tax reasons for this. Let’s say the assets coming over are worth $5 million. This removes those assets from the taxable estate. First, the value of a limited interest in the FLP is discounted. Once discounted, more FLP interests can be gifted tax-free to the next generation, which results in more assets passing out of an individual’s taxable estate. It is important to remember that a limited interest has no right to control the FLP.

The principal of discounting recognizes two inherent reductions in the value of a limited interest in a family limited partnership. One reduction in value is because a limited interest in an FLP is a non-controlling interest in a family enterprise. A purchaser of such a limited interest would be an outsider and would have no right to expect any distributions from the FLP unless the general partner decided to make one, or unless all general partners died and the FLP liquidated.

Another hint created here is a second reduction in value that is due to the fact that there is no ready market for buying and selling the assets. The Courts have repeatedly forced the IRS to recognize the validity of these discounts and it has been officially recognized in Revenue Ruling 93-12.

Let’s say that an asset worth $1 million is put into the FLP. The IRS would give a 50% discount in the value of the limited interest in the FLP with a discount leaving the assets value at $500,000. If this is a husband and wife, they have a lifetime exclusion of $10.56 million due to portability. In effect, the $1 million asset is tax free, removed from the taxable estate, and provides asset protection.

Back to the case… On Aug. 8, 2008, Nancy Powell’s son, Jeffrey Powell, acting on her behalf, transferred cash and securities to NHP Enterprises LP (NHP), a limited partnership, in exchange for a 99% limited partner interest. On that date, the transferred cash and securities were worth $10 million. NHP had been formed two days earlier on Aug. 6, 2008, when Jeffrey, as general partner, executed and filed with the Delaware secretary of state a certificate of limited partnership. NHP’s limited partnership agreement gives him, as general partner, sole discretion to determine the amount and timing of partnership distributions. That agreement also allows for the partnership’s dissolution with the written consent of all partners. 

Also on Aug. 8, 2008, Jeffrey, purportedly acting under a power of attorney, transferred Nancy’s NHP interest to a charitable lead annuity trust (CLAT), the terms of which provided an annuity to a charitable organization for the rest of Nancy’s life. Upon her death, the CLAT’s corpus was to be divided equally between Nancy’s two sons. 

Nancy died on Aug. 15, 2008. The Court concluded that Nancy had control over her assets and the assets transferred became part of her taxable estate.

The moral of the story is that FLP’s work, but you have to understand them in full.

 —–

[1] Efficiency of Family Limited Partnerships: A Case Study

————-

Craig W. Smalley, MST, EA, is the Founder and CEO of CWSEAPA, PLLC. He has been admitted to practice before the Internal Revenue Service as an Enrolled Agent and has a Master’s Certificate in Taxation from UCLA. In practice since 1994, Craig is well-versed in U.S Tax Law and U.S. Tax Court cases, and specializes in individual, partnership, and corporate taxation for high-net-worth clients; entity structuring and restructuring; and representation before the IRS regarding negotiations, audits and appeals. Craig is currently a columnist for CPA Practice Advisor and AccountingWEB and has had 12 books published. His articles have been featured in publications including the Wall Street Journal, The New York Times, and Christian Science Monitor, and he has been interviewed and appeared as a featured guest on numerous radio shows and podcasts. Craig can be reached at craig@craigwsmalleyea.com.