Family limited partnerships (FLPs) and family limited liability companies (FLLCs), if properly structured, are attractive vehicles for administrative convenience; income, estate and gift tax savings; and creditor protection. It is important that an FLP or FLLC be formed for valid business purposes and not merely as a tax device. Otherwise, the IRS may not respect the entity. Some non-tax reasons for establishing an FLP or FLLC are:
1. Avoiding Co-Tenancies. Gifting partial interests in property to multiple donees can be problematic. For example, real estate owned as tenants-in-common would require the unanimous consent of all owners to sell the property. If held by an FLP or FLLC, the duly appointed general partner or manager could sell the real estate. Such centralized management helps to minimize the potential conflicts that can arise with co-tenants.
2. Simplified Gifting. Certain assets such as real estate, oil and gas interests, artwork and personal property are not easily divided into separate shares for gifting to multiple parties. But if held in an FLP or FLLC, such gifts are easily made by simply assigning a percentage of the FLP’s or FLLC’s interests to the donees. An FLP or FLLC can also provide professional management of assets that can enhance family members’ incentive to lead productive lives.
3. Keeping Family Assets in the Family. A well drafted partnership/operating agreement will generally provide that the remaining or surviving partners/ members will purchase (at the price and terms set forth in the agreement) the interests of the deceased or withdrawing partner/member before such interests can be transferred outside the family. These same buy-sell provisions can be used to purchase the interests of a partner/member in the event of an involuntary transfer such as bankruptcy or divorce.
4. Pass-Through Income Tax Treatment. Unlike a regular corporation, FLPs and FLLCs are “pass through” entities for income tax purposes. As such there is no entity-level tax, and generally they may be terminated without adverse income taxes.
5. Creditor Protection. Assets held in an FLP or FLLC offer “charging order” protection. This means that a creditor of a partner or member cannot attach the assets in the FLP or FLLC, cannot become a partner or member of the FLP or FLLC, and may not control the FLP or FLLC. Instead, the creditor is only entitled to any distributions made to the debtor partner/member. However, if properly drafted, the limited partnership agreement or operating agreement will not require that the general partner or manager make distributions. As such, the creditor is frustrated, thereby possibly facilitating a favorable settlement of the debt.
Apart from the non-tax advantages of FLPs and FLLCs discussed above, a key appeal of these vehicles is that the gift and estate tax value of limited partnership interests in an FLP and non-voting membership interests in an FLLC are discounted from the fair market value of the entity’s underlying assets. The value is lower because the limited partners or non-voting members do not control the entity’s assets, and the interests are less marketable than the underlying assets. These discounts are typically in the range of 20% to 35% (depending on the nature of the assets held by the entity), resulting in lower gift and estate taxes. Moreover, these discounts can improve the performance of other wealth transfer planning techniques such as GRATs and sales to intentionally defective grantor trusts.
IRC Section 2704(b) generally requires that certain “applicable restrictions” be ignored when valuing interests in an FLP or FLLC. However, much to the IRS’s dissatisfaction, various judicial decisions and state statues interpreting “applicable restrictions” have made the Code section ineffective (according to the IRS) to limit the application of valuation discounts for intrafamily transfers of FLP and FLLC interests.
To combat those end runs around IRC Section 2704(b), it appears that the IRS will issue proposed regulations that restrict valuation discounts by creating an additional category of restrictions (called “disregarded restrictions”) that would be ignored in valuing an interest in a family-controlled entity transferred to a family member if, after the transfer, the restriction will lapse or may be removed by the transferor or members of the transferor’s family. The regulations will be based on the President’s 2013 Green Book which only outlines the proposed regulations, leaving most specifics to the IRS’s discretion.
Valuation discounts for interests in FLPs and FLLCs, particularly those holding marketable securities, will likely be severely restricted. It’s possible that actual operating companies (as opposed to holding companies) will be exempted from the new rules. It’s also possible that many taxpayers will benefit from the new rules, particularly if they do not have taxable estates. That’s because without discounts the FLP and FLLC interests will be worth more at death resulting in a higher “step-up” in basis under IRC Section 1014.
The exact scope and timing for release of the proposed regulations remain uncertain, but the release is expected by year end and possibly as early as this September. Although the effective date of such regulations is uncertain, it’s likely that transactions completed prior to the release date will be grandfathered from the new rules. Thus, to take advantage of possible “grandfathering” for transactions completed before the effective date of any proposed regulations, individuals considering gifts or sales of FLP and/or FLLC interests should complete those transfers promptly.