Families are most familiar with partnerships or limited liability companies in the context of asset protection for business assets. Some families are starting to see the benefits of putting non-business assets like family real estate, hedge funds, and securities portfolios in a partnership or limited liability company as well.
The term family limited partnership refers to a limited partnership or limited liability company structure that is designed specifically with wealth transfer planning in mind. The structure allows the parents to transfer wealth in a tax-advantaged manner, while still retaining some control over the assets transferred.
Example: Parents establish a limited liability company, retaining the voting interests (2% of the company) and transferring the nonvoting interests to their children. The company owns $1 million of publicly-traded securities. A qualified appraiser values the non-voting interests (representing 98% of the company) at only $700,000 for gift tax purposes due to fact that the non-voting members have little control over and marketability of their interests.
The IRS is challenging and Congress is trying to stop taxpayers who take business valuation discounts on the transfer of partnership or limited liability company interests with underlying non-business assets. With so much recent judicial and legislative activity, it is honestly hard to keep-up.
Taxpayers landing in court defending their estate or gift tax business valuation discounts on non-business assets have had about a 40% success rate. These statistics are a bit misleading as the IRS most often challenges taxpayers with really “bad facts” like sloppy formation documents or careless administration.
If valuation discounts are a goal, nothing is more important than having experienced, coordinated, professional advice and oversight.
In each of the following cases, courts found a legitimate business purpose for funding a family limited partnership with non-business assets, and permitted the use of business valuation discounts in valuing partnership interests for transfer tax purposes:
To consolidate undivided interests in real estate (Church); to settle family hostilities (Stone); to pool investment assets, and to provide for active management succession (Kimbell, Murphy and Mirowski); to consolidate company ownership in one entity rather than multiple trusts (Bongard); to perpetuate a specific securities investment philosophy (Schutt and Miller); and, to protect assets from divorce or other dissipation (Keller and Murphy).
Many partnership governing documents contain a list of business purposes in an effort to document its reason for existence. But, actions speak louder than words, and if subsequent actions don’t prove these purposes valid, the list will not have much effect. For example, if a stated partnership purpose is to pool family investments to access certain asset classes (e.g., private equity), and the manager never alters the partnership’s asset allocation, this purpose will likely be disregarded.
With all the pending legislation attempting to halt discounts on non-business assets, time is certainly “of the essence” if gift tax planning is warranted. Savvy estate planners know how to mitigate the effects of potential IRS valuation challenges on lifetime transfers.
Because of all the IRS valuation challenges, some advisors have declared they are officially out of the family limited partnership “game”. Others were never in the game in the first place – a trust being their “go-to” vehicle for transferring non-business assets. Advisor sentiment may largely explain why many high net worth families are not using partnerships to manage non-business assets.
Those advisors that continue to embrace them know that a partnership is often a good alternative to a trust, offering asset protection with more flexibility. And, a partnership, when combined with a trust, can improve a trust’s tax-related performance and may even reduce the Trustee’s administrative duties. Some advisors recommend “wrapping” securities in a partnership before making transfers to an irrevocable grantor trust or charitable trust for these reasons.
Now that the estate tax exemption is at $3.5 million, the family limited partnership, viewed primarily as an estate & gift tax planning vehicle, will likely get even less attention from advisors. This would be unfortunate, as less tax should result in more wealth to manage, either responsibly or irresponsibly.
Families and their advisors should take a fresh look at the family limited partnership as a wealth management tool, not a tax planning device. Managing wealth can be a tremendous emotional and administrative burden for ill-prepared family members. Partnerships can help a family transition wealth and management duties responsibly and effectively.
The primary wealth management benefits of forming a family limited partnership are as follows:
Centralize asset management with the most capable family member;
Simplify investment reporting and recordkeeping;
Simplify inter-family gifts and transfers;
Provide parental control over assets gifted or transferred;
• Limit access to assets for children who can’t control their own spending habits;
Encourage communication about cash-flow and financial planning;
Encourage respect for wealth as a family enterprise, not a personal pocketbook;
Diversify and optimize family asset allocation based upon a “total view” of family assets;
• Meet accredited investor hurdles to take advantage of more asset classes;
• Make investments in nontransferable assets (e.g., private equity) inside a partnership to enable asset transfers;
Protect underlying assets from future claims in the event of divorce or bankruptcy;
• A convenient means of segregating assets to avoid inadvertent commingling of marital property and separate property;
• An alternative to a prenuptial agreement, when a child is opposed;
Assist the family in conflict resolution through arbitration, buy-sell and personal asset usage provisions;
Create a “holding company” to reduce tax compliance requirements; and,
Facilitate the appointment of a professional advisor (like a family office representative) who can serve as a liaison and support for an entire family.
We all know families tangled-up in the web of an active business, where emotions run high about salaries, management and ownership succession, and what is or isn’t fair. Non-business assets do not present the same challenges; they can be consolidated with a much greater success rate.
As an aside, most active family businesses do not start out as wealth transfer vehicles, and therefore its owners could benefit from incorporating more comprehensive family limited partnership “style” conflict resolution and ownership transfer provisions into governing documents.
Most high net worth families can better manage family cottages and family farms, access more investment options, temper family hostilities, reduce gift administration costs and duties, and mitigate financial risks by consolidating non-business assets under the watch of the most capable member, or an external advisor.
For families who are looking for a way to manage wealth responsibly and efficiently, a family limited partnership is a good play to make. Partnerships can ultimately improve the odds that a family’s hard-earned wealth is sustained.
By: Elyse Germack, President
AVANT FINANCIAL, LLC
Elyse Germack is a CPA, licensed in Illinois and Michigan and an attorney, licensed in Illinois and Michigan. In addition to running the multi-family office, AVANT FINANCIAL, Elyse also helps form and manage nonprofit organizations.
AVANT FINANCIAL, LLC is a Multi-Family Office located in Birmingham, Michigan, providing estate planning, trust administration, nonprofit management, partnership accounting, tax compliance, and family office services.
Please visit us at www.avantadvisors.com to learn more about our organization. To download future monthly wealth reports please visit our blog at avantadvisors.blogspot.com. Last month’s report was “Test-Drive the Family Office Model”.
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