Today I thought we'd discuss a rather mundane topic, the Family Limited Partnership but one that carries great significance nonetheless. I'm like everyone else I suppose in that I tend to lean away from some of the more heady topics that dig really deep into the nitty gritty of insurance/financial planning topics. Why? Well mainly because I've been talking about them ad nauseam for the past 13 years and I have the attention span of three year old who's been loading up on red kool-aid and cadbury cream eggs (i.e. the easter candy hangover).
But I also know because of the questions our readers send us routinely, these are topics that need to be discussed at length and that I can't take for granted that everyone has heard all this stuff before. So, here I go. And hopefully I can make this as painless as possible for you. Even more, my hope is that you can get some nugget from it that will at least give you an idea that could save your family some money down the road. Or at the very least help you untangle some of the mess that abounds in dividing up your assets among your family members.
Believe it or not Family Limited Partnerships were a fairly obscure topic back when I first started in the life insurance business. However, in the last few years I've noticed a significant increase in their popularity.
Now, I'm not sure if people have actually set them into motion with great frequency or if it's just something more people are wanting to discuss? Sometimes ideas sound really great at the intellectual level but the practical application can be somewhat more complicated.
But before we walk off the edge of the continental shelf into the deep water, I should probably start with a short primer on partnerships in general.
There are two basic types of partnership arrangement that exist:
First, let's look at general partnerships, this will help us to draw some lines of distinction as we go.
A general partnership can be held together with a written contract or an oral agreement (a handshake and a smile). There is no particular legal requirement that there be any type of paperwork filed at the state level. You can juxtapose this to any sort of corporation (c-corp, s-corp or LLC) where you don't actually have anything official, the corporation doesn't actually exist until you've filed your articles of incorporation with typically the secretary of state's office in your state. At least, that's how it is in most states that I've dealt with.
The big problem with any general partnership is the feature of unlimited liability.
If two guys, Bob and John decide to form a partnership and subsequently Bob incurs a debt or signs a contract on behalf of the partnership, he just made John personally liable for the full amount of the debt. That means Bob could incur debt on behalf of the partnership and John have no knowledge of it but still be 100% liable for the debt whether he knew the debt existed or not. Compare that with the personal financial protection afforded Bob and John if they had formed a corporation and the contract and/or debt was held by the corporation.
Now, let's look at the limited partnership, the much more handsome cousin of the general partnership.
I think we could all agree that the unlimited liability function or dysfunction rather of the general partnership is a deal-breaker for most of us. You can thank your friendly elected officials in your state legislature for adopting the limited partnership to help you mitigate the risk associated with unilimited liablility.
Basically, with a limited partnership you have a general partner and one or more limited partners. You can structure it so that the same person can be general partner and a limited partner, there just has to be at least two people to legally form the partnership.
What makes the limited partnership different?
The general partner has unlimited liability for all obligations and debts of the partnership, however, the limited partners do not have any personal liability for the debts and obligations of the partnership as such. I've seen limited partnerships most often used as the structure of large real estate invesment deals–think large apartment complexes, commercial office parks, and strip malls. Essentially any sort of investment deal that's going to require large investments of cash from multiple investors.
In this scenario, the limited partners will have ownership but not any management authority and thus no liability for the debts associated with the business. Limited partners can vote on items associated with the operation of the business (as determined by the original agreement) but are not actively involved in the management of the business. In many cases, the limited partnerships will require that the limited partners vote as a majority when it involves the ousting of the general partner or the sale of an asset.
For tax purposes, limited partnerships are known as “pass through” entities. That means that the partnership itself pays no income tax. No worry about the double taxation issue that always comes up when looking at c-corps as an example. As an entity, the partnership does not pay taxes. All gains and losses flow straight through to the partners. The only tax filing done by a partnership is to itemize its income and expenses which then determines the net income of the partnership.
The net income then flows through to each partner and the gains/losses are reported on each individual's tax return.
Now, there are other legal issues that make a limited partnership desirable from an asset protection perspective, but that falls outside the scope of this post and as such I'm gonna leave that to your own legal counsel and research. Suffice it to say that you can gain substantial protection for your assets from lawsuits by using limited partnerships.
In many cases, the Family Limited Partnership (FLP) is used to transfer highly appreciated stock to family members whether it be privately held stock or publicly traded common stock. The benefits of either sort of transfer are similar. There are certainly a lot of details that I've glossed over in both of those statements.
In fact, we've seen some headlines from popular publications that say things like, “Cut Your Estate Taxes in Half”. Gee if only I could get away with using such statements in our marketing! Although I have a feeling using statements like that would be come back to haunt me.
As a matter of full disclosure that I don't provide legal advice of any kind I'd like to suggest that based on all the research I've done on the topic and the case law I've studied regarding the topic, I'd suggest that the IRS would very much prefer you not wait to attempt these sort of transfers on your death bed. I suggest you read through this page that discusses the particular nuance of death bed transfers and how the IRS, Federal Appeals courts etc. have said so.
The best strategy to take full advantage of the FLP is to make your transfers early in your wealth building years and then allow your assets to appreciate inside the limited partnership and thus outside of your estate.
A classic example of this that almost everyone is familiar with comes from Sam Walton, the founder of Wal-Mart.
Here's an account of the story as detailed by Larry W. Gibbs:
According to Sam Walton as he detailed in his book, Sam Walton: Made In America, “What little we had at the time we put into that partnership with our kids. . . .” They call their family partnership Walton Enterprises. Wal-Mart grew out of this partnership. The ownership of real estate, area banks, and a newspaper also grew out of Walton Enterprises.
Sam Walton died in April of 1992. At the time of his death, Sam Walton only owned a 10% interest in the partnership. Helen owned another 10% interest. Although his book is not specific in detail, it appears that Sam Walton's 10% interest in the partnership passed to a marital trust for Helen Walton (deferring the estate tax) and will, upon Helen Walton's death) pass to one or more family charities (producing a zero estate tax).
Walton himself said, “The transfer of ownership [in the partnership] was made so long ago that we didn't have to pay substantial gift or inheritance taxes on it. . . . The principle behind this is simple: the best way to reduce paying estate taxes is to give your assets away before they appreciate.”
Sage advice if you ask me.
That's all fine and good if you have that kind of foresight…right?
But what happens if your ship has already come in?
For this scenario, I'll defer to a book that you've not likely come across in your local library or on the shelf at your local bookstore. The book is titled, Asset Protection for Physicians, by Robert J. Minz, Esq. He also has some great information over at his site.
The following is from his book(keep in mind these examples are a few years old, so numbers may be slightly different adjusted for today's rates and exemptions):
For example, the Smith family owns a business with a current value of $1 million, a rental property of $500,000, and retirement savings in stocks and bonds equal to $1 million. That's a total estate of $2.5 million. Under current law, with a properly designed estate plan, taking maximum advantage of the combined current exemption of $1.3 million, the estate tax on the combined $1.2 would be approximately $500,000.
By using the FLP, they could initially make a gift of the limited partnership interests to their children in an amount equal in value to the combined minimum estate tax credit. In subsequent years, they could gift limited partnership interests equal to the amount of the annual gift tax exclusion.
Under this approach, in roughly seventeen years, the Smiths would be able to eliminate the potential estate taxes and could preserver $500,000 of family wealth. At the same time that the Smiths are accomplishing this result, they would not relinquish any degree of control or authority over their real estate or their retirement savings.
There's also another nuance to the FLP that allows you to take advantage of substantial discounting of the assets.
Minz writes, “According to IRS rulings and court cases, the value of each gift of a limited partnership interest must be discounted in order to account for the lack of marketability and the lack of control associated with those interests. For example, if the parents transfer assets with a value of $1 million to the FLP, a gift of a 1 percent limited partnership interest should not be value at $10,000. Instead, because the interest cannot be readily sold and because the donee has not right to participate in management of the FLP, a reasonable approach to determine value, suggested by many financial advisors, would be to discount the transferred interest to reflect its true value in the market. Discounts in the range of 30 percent are fairly conservative, but some aggressive advisors push this number to 50 percent.
Using an aggressive 40% discount, the value of the limited partnership interests in the Smith FLP would be discounted in value from $2.5 million to $1.5 million. Almost all of this value could be gifted in the first year without exceeding the credit of $1.3 million. The remaining $200,000 in value could be transferred out of their estate in just one or two years. In a relatively painless fashion, the Smiths have eliminated $500,000 of estate taxes while maintaining control over their assets.
As an added bonus, this approach will also remove future appreciation from the Smiths' estate.
Did you get all that?
I hope so. It doesn't have all that much to do with insurance as we normally discuss but I did feel like it's one of those topics that could greatly benefit some of our readers. If nothing else hopefully it gets some things moving around in your head and gets you thinking toward planning for family's future.
I have one more thing to add here actually. Please make sure that you jump through all the hoops in the right direction if you're thinking of using an FLP. This is one of those times that hiring a competent attorney who's well versed in all sorts of estate planning will be well worth your hard earned dollar.
As always, if you have any questions or are wondering how we can help you, feel free to reach out to us and we'll do our best to help you.
Brantley is a practicing life insurance agent and has been for nearly 18 years. After years of trying to sell like his sales managers wanted him to, he discovered that people want to buy life insurance if you actually explain the benefits.