Using Family Limited Partnerships to Lower Gift and Estate Taxes
Family limited partnerships (FLPs) have had an important role in lowering gift taxes and estate taxes for generations. These fantastic planning tools can be coupled with trust funds to offer powerful asset protection for heirs, making them a cornerstone of many modern wealth management planning strategies. Learn how family limited partnerships work, why successful families tend to prefer them, and how the tax savings might look.
Tax Benefits of Family Limited Partnerships
Investors should already know it isn’t only about how much money you make, it’s also about how much you keep in your pocket. In addition to watching out for frictional expenses, such as brokerage commissions, it is important to learn how to reduce your tax burden. Many new investors know about capital gains taxes, but for those approaching retirement, gift taxes and estate taxes are equally important considerations.
By pooling your investments in a special type of legal structure known as a family limited partnership, you can transfer assets such as stocks, bonds, real estate, art, and collectibles to heirs by gifting partnership equity each year up to the gift tax limits. If you are married, one of the legal and financial benefits of marriage is that you and your spouse can combine your gift tax exclusion levels.
Using Annual Gift Tax Exclusion
The federal government allows a person to give away up to a certain amount annually without paying taxes. For the tax year 2020, the exclusion is $15,000 per person, or $30,000 for married couples.
This exclusion applies per recipient. That is, you and your spouse could give 10 different people $30,000 each, or $300,000 total, and pay no gift taxes. If you exceed the annual gift tax exclusion in any given year for any specific person, it will count against your unified lifetime estate tax and gift tax exemption. For those who died in 2020, estate taxes kick in after the first $11.58 million passed onto heirs.
As an example of how gifts during your lifetime can affect your estate tax, imagine you surpassed the allowable gift amount one year. Back in 2012, you surpassed the allowable gift limit by $80,000. That means, if you die this year, estate taxes will kick in after $11.5 million, instead of $11.58 million.
How Family Limited Partnerships Increase Gifts
Instead of simply gifting money directly to your children and grandchildren, you can use family limited partnerships to effectively increase the amount of your gift. The key is to put your assets into the FLP, including revenue-generating rental units, stocks, and even any business ventures you've started. Then, you can gift shares in the FLP, rather than directly gifting the assets themselves.
By gifting shares rather than assets, your children and grandchildren will receive all of the dividends, interest, capital gains, and other profits from their ownership stake. That means the future returns will accrue to their benefit and be excluded from your estate for tax purposes, creating a virtuous compounding cycle.
You can even insert provisions in the partnership agreement to help ensure that your gift isn’t squandered. For example, the gift can stipulate that they cannot sell their shares or transfer them to anyone else until they reach their 35th birthday.
Using Marketability Discounts
FLPs offer another tool for families to reduce their tax burden, and it's known as either the marketability discount or the liquidity discount. This means the IRS won't value the partnership units at their net asset value. Instead, the value is determined by a complex set of calculations that will attempt to account for things like a lack of control, an inability to sell unless the majority holders agree to it, and other drawbacks that don't apply to people who own assets outright.
If you and your spouse establish an FLP, you'll likely be the general partners of the FLP. That means you still control the FLP, even after you've gifted some shares in the FLP to your children and grandchildren. If the FLP contains stocks, for instance, your family members will still enjoy dividends and profits from sales, but they won't be able to decide when to sell or what to buy. They can't take cash out of the FLP to go buy a luxury car. Therefore, their share of ownership in the FLP's assets is discounted in the eyes of tax collectors.
These discounts can be significant, but the specifics will depend on the unique circumstances surrounding your particular FLP, so make sure to consult your tax, legal, and investment advisors.
Using the Applicable Federal Rate
While your children and grandchildren can't withdraw cash from the FLP at will, you can use loans with low interest rates to reduce your estate and gift tax burdens. You can't control what the recipients do with the loaned cash, but they could use that loaned cash to buy more shares in the FLP.
Over time, the rates of return from the FLP shares will (hopefully) pay for the interest costs. Also, as time goes on, inflation reduces the purchasing power of the original loan amount, so repayment becomes less burdensome.
Federal law determines the minimum interest rate you can charge before the loan becomes a gift that eats away at your annual gift tax exclusion. These rates, known as "applicable federal rates" are updated every month. Here are the rates for June 2020:
- Short-term (three years or less): 0.18%
- Mid-term (between three and nine years): 0.43%
- Long-term (more than nine years): 1.01%
Assets such as private operating companies and real estate can be leveraged, that is, used to borrow money. When those assets are held within an FLP, the FLP can itself go out and borrow money. The loans will have to adhere to the debt-to-equity ratio required by the lender, but any money borrowed could be used within the FLP to enhance returns for you and your family. For example, an FLP could leverage one property to invest in a new rental property.
Using Tax Rate Differences Between Family Members
Another huge advantage of FLPs is that you can shift shares to lower-income family members to reduce tax burdens on capital gains and dividends. In 2020, individuals who earned less than $40,000 don't pay any taxes on long-term capital gains and qualified dividends. FLP shares held by someone who falls in that lowest capital gains bracket could avoid taxes on many of the funds they receive from the FLP.
The Bottom Line
Family limited partnerships can—when used judiciously and with foresight—result in enormous tax savings. They offer flexibility and protection for asset allocation, depending upon how you hand out ownership in the FLP.
For those concerned with reducing their tax burden, it can serve you and your family to consider FLPs as one aspect of a comprehensive estate strategy. The benefits of an FLP can be used in conjunction with other investment tax strategies and structures, such as charitable remainder trusts, deferred tax liabilities, and the stepped-up basis loophole.
Internal Revenue Service. "Frequently Asked Questions on Gift Taxes: How Many Annual Exclusions Are Available?" Accessed May 25, 2020.
Internal Revenue Service. "Estate Tax." Accessed May 25, 2020.
Mercer Capital. "Family Limited Partnerships—a Valuation Overview." Accessed May 25, 2020.
Internal Revenue Service. "Section 1274.--Determination of Issue Price in Case of Certain Debt Instruments Issued for Property," Page 2. Accessed May 25, 2020.
Wells Fargo Advisors. "2020 Tax Planning Tables," Page 4. Accessed May 25, 2020.