By: Randall A. Denha, Esq.
It may seem that Family Partnerships have recently come into vogue, but the truth is they have been a useful estate planning tool for more than 40 years. For purposes of this article, the term Family Partnership is generically used to describe what we, in Michigan, more customarily call a Family Limited Liability Company (“FLLC”). However, for illustration and simplicity, the terms “general partners” and “limited partners” are instead used to reference Managers and Members and others that have voting and/or non-voting membership interests in the FLLC context.
The popularity of Family Partnerships has grown primarily because of a 1993 IRS clarification specifically authorizing the ability to consider gifts of stock to family members eligible for minority discounts. The IRS ruled in Revenue Ruling 93-12 that a stockholder who gave a 20% interest to each of his five children would not be denied a minority discount in valuing those shares, despite the control still being held in the family. In effect, a controlling shareholder who chooses to give away minority stakes in a company can claim they together total much less than the value of the control block for transfer tax purposes. Moreover, the estate of a shareholder who dies owning a minority interest can get a minority discount for that interest, notwithstanding the fact that the decedent’s estate and family members together may own a controlling interest.
The Family Partnership is one technique that permits the ability to gift an asset at a reduced value, allow the senior generation to maintain control, save both income and transfer taxes, facilitate family succession and provide asset protection to all of its members. In effect, family members (usually parents) contribute assets into this partnership, than give a minority interest to other family members (still retaining control of the assets). Through a Family Partnership, parents can begin to shift wealth to their children, introduce them to asset management, educate them about investments and wealth, facilitate and manage pooled resources, provide business succession planning and achieve different economies of scale. Put another way, this is more than just about taxes. It truly becomes a family enterprise.
The ability to take discounts on partnership interests in a Family Partnership is a wonderful gift tax and estate tax planning tool. As with most Family Partnerships, the holder of a limited partnership interest is not able to participate in partnership activities. For example, under Michigan law, a limited partner cannot make investment decisions, decide when to make distributions, force the partnership to buy their interest, or dissolve the partnership. Because of these restrictions, discounts for minority interest and lack of marketability are generally applied to the minority interest. It’s this ability to take discounts that allows larger gifts of wealth to reduce gift and estate taxes.
A FEW EXAMPLES
Assume two parents jointly own $1 million in real estate, stocks, bonds, etc. They create a Family Partnership and receive all of the general interest and limited partner interest. Each parent owns 50 percent. If they each gave away 1 percent of the assets, that would be a gift of $10,000 each. If, however, they gave away the same 1% limited partnership interest with the value discounted by 50 percent, each of the parents could distribute $20,000. The parents are able to give more assets away each year, shifting wealth out of the estate. This is particularly important when the estate is too large to effectively be reduced through traditional gifts of the assets.
Here is another example. Fast forward to the year 2013 where the estate tax rates increase to 55% from the present day 35% and further suppose Aunt Betty has a $3 million estate. She is entitled to an estate tax and/or gift tax exemption of $1,000,000, which she gifts in equal amounts to three nieces. After the initial gift, the aunt and nieces put all $3 million into a Family Partnership. The aunt owns $2.0 million and the nieces own the balance. The nieces are the general partners and the aunt retains a limited partnership interest. When the aunt dies, the $2 million limited partnership interest less discounts is included in her estate. For illustrative purposes, assume a 50% discount. The aunt’s estate is now valued at $1.0 million. The aunt’s beneficiaries now pay estate taxes on $1.0 million instead of $2.0 million. Very tax wise!
THE INTERNAL REVENUE SERVICE IS WATCHING
A Family Partnership is able to take a discount (for lack of control and lack of marketability) if properly defined under state law, but the question from an IRS audit remains “how much of a discount is too much?” Typically, discounts in the 30-45% range are taken. If your goal is to get a 60% discount or more, you have more exposure, but in many cases there is ample justification. Either way, a thorough valuation appraisal is required in order to support the discount if the IRS comes knocking.
Finally, another reason to establish a Family Partnership is for creditor protection. Suppose a business owner has personally guaranteed loans for the business. Provided no fraudulent transfers or fraudulent intent exists, by placing stocks and individual liquid assets into a Family Partnership with the spouse as general partner and the business owner as limited partner, the assets are more protected than originally owned. If the creditor calls in the personal guaranty, the creditor only receives the business owner’s limited interest. As a limited partner, the creditor is taxed on income associated with the limited partnership even though there may not be any cash distribution. The creditor can’t force distribution and can’t liquidate the assets. The bank will soon want to negotiate out of the limited partnership.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.
CIRCULAR 230 DISCLAMER: NONE OF THE ARTICLES IN THIS NEWSLETTER ARE INTENDED OR WRITTEN BY THE VARIOUS AUTHORS OR DENHA & ASSOCIATES, PLLC, TO BE USED, AND THEY CANNOT BE USED, BY YOU (OR ANY OTHER TAXPAYER) FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU (OR ANY OTHER TAXPAYER) UNDER THE INTERNAL REVENUE CODE OF 1986, AS AMENDED.