Financial Planning for October 2000

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Family Fun
Those of us who remember Willy Wonka and the Chocolate Factory will recognize the beginning of Willyís song when he and his guests first entered his factory. For those who don't, it begins "Come with me, and youíll be in a world of pure imagination. ...Ē


We donít do chocolate around here, but we would like to take you on an imaginary trip ... to heaven. It goes something like this:

Imagine youíve done well in life and now control over $100 million in assets. You couldnít be happier. The kids live nearby, so you get to see them and the grandchildren as much as you like. And those cruises you have been taking recently are like heaven.

The fact is, life is perfect and you couldnít ask for anything more.

Then, you die.

Itís now nine months since your death. The family is coming to grips with their loss and going on with their lives. This makes you very happy from your heavenly home, but there is one more thing that can make this picture of joy in eternal retirement complete and it has just happened.

Your old high school rival, Barry, went to work for the IRS and has just received your estate tax return. He never really liked you and was extremely jealous of your success, but now heís thinking to himself that he gets the last laugh. He just can't wait to see that $50 million plus in estate taxes your heirs have to pay.

Just like a kid opening a present, he tears the envelope open. He reaches in and pulls out the estate tax return andÖno check. Barry can't believe his eyes. He knew you were worth a fortune because he wheedled it out of you at last yearís reunion. But he canít seem to find your estateís check. Finally, he decides the executor forgot the check. Thatís ok with him, though, heíll get to levy a really big penalty on $50 million plus.

Then, he looks at the estate tax return ... and it falls out of his hands. The return shows no tax due.

Now, he really canít believe his eyes. He rifles through the return. Where are all the assets? All he can find is a one-half percent interest in the You and Wife family limited partnership and itís only valued at $500,000.

Barry is crushed when he realizes what happened. Even in death, you beat him.

You smile.


This story isnít pure imagination. While shielding $100 million in assets may not be realistic, shielding a substantial portion of those assets from tax can be done by using a family limited partnership (FLP) Ė without losing control of the assets during your lifetime.

To understand this tax planning strategy, we have to be clear on a few concepts.

First, we need to understand the term limited partnership. A partnership is an entity formed when two or more people pool their assets and begin to work together toward a common goal. In a limited partnership, you generally have one or two general partners who hold 1/2 percent to 1 percent each in the partnership, and the remainder of the ownership is vested in the limited partners.

The general partner has the power to manage the business of the partnership. Substantially everything this general partner owns is subject to seizure by creditors of the partnership. The limited partner has no control over the affairs of the partnership and that is what makes family limited partnerships so effective.

Family limited partnerships are typically established by parents who have substantial assets and who prefer them to remain in the hands of their lineal descendants, not their Uncle Sam. In a typical FLP, mom and dad will be general partners to the extent of 1/2 of 1 percent each. Initially, they will also each have 49.5 percent limited partnership interests, but their intent is to give the 49.5 percent interests to the children over some period of time. By retaining the general partnership interests, mom and dad retain the control of the distributions and business of the partnership.

Generally, the FLP will be funded with the assets that mom and dad wish to protect and pass on to the children. This may include cash and securities, real estate, timber, etc. It would not typically include the family home. It is also a good idea for the FLP to own any real estate in a separate limited-liability company, so any creditors who have or acquire claims against the real estate canít get to the securities and cash.

Several advantages are gained by putting the varied assets into one or several FLPs:

ē asset protection
ē ease of transferability
ē estate tax savings
ē potential income tax savings

Letís take a closer look at these advantages.


Asset Protection

But what if your spendthrift son Lucius gets a 10 percent stake in the $100 million family limited partnership Ė and then goes bankrupt? Wonít that give his creditors some of your money?

Not if you donít want them to have it. As we stated earlier, one of the nice things about an FLP is the fact that you remain the general partner. That means you control the distributions, and creditors donít really like that kind of an arrangement. Properly executed, an FLP agreement can effectively shut a creditor out of receiving any distributions, while still being counted as a partner for tax purposes. This means they get charged taxes, without any money to show for it. This can be a powerful deterrent to the creditors. In some states, those interests are specifically not included in a bankruptcy estate.

The bottom line is that the assets are generally pretty safe as long as you control them.

Ease of Transferability

Do you have any land included in your estate? What about oil properties? Are you one of the few Americans left who arenít in the stock market in some way? Any other titled investments?

If you answered ďyesĒ to all but the third question, settling your estate wonít be the easiest thing in the world. The reason is simple Ė when you die, those assets will have to be put in someone elseís name. That means reams of paperwork to satisfy various state and federal regulations.

If you put the assets into an FLP, however, the only thing that will have to be transferred upon your untimely (which means anytime) demise is your interest in the partnership. Usually, this involves only changes in the partnership interests on the partnership tax return.

Estate Tax Savings

When mom and dad decide to give away the 49.5 percent interests they each own in the FLP, they will need to obtain an appraisal of the partnership to substantiate its gift tax value. This is best performed by a certified valuation analyst (CVA).

The appraiser typically computes the total value of the assets of the partnership, then reduces the value by using legitimate discounting techniques. Assuming we can justify a 35 percent discount, the $100 million in assets in our story go to $65 million with the stroke of a pen.

Getting to the true stretch in our example, now, we are going to assume that the assets in the FLP were put in 10 years ago when their value was $1.8 million. Mom and dad gifted the partnership interests to the children at that time. When they did so, the value of the interests given to the children was $1,200,000 ($1.8 million multiplied by 1 minus .35 discount). It just happens that, at that time, mom and dad could each give away up to $600,000 to the kids without paying any taxes. Since the total of what they could give away was $1.2 million, no taxes were paid.

No wonder Barry was so upset.

Income Tax Savings

Since the recipients of limited partnership interests become partners, the income and expenses of the partnership are attributed to them on their income tax returns. In some instances, it is possible to shift income from one income tax bracket to another.

Letís say you are in the 39.6 percent bracket and you establish an FLP. Letís say further that it has taxable income of $300,000 and your 21-year-old son has no income other than his 30 percent interest in the partnership. His top rate will be 28 percent. By shifting the $90,000 income to him, you have just saved a minimum of $10,440, and probably more.

The Drawbacks

Lest youíre now thinking that FLPs are the next best thing to sliced bread, there are some drawbacks you should be aware of.

First, FLPs can be expensive to set up and maintain. You will most certainly have initial legal and accounting bills for the formation of the FLP. You will also have one more tax return to file every year. Depending on how your plan works, there may be several additional returns to file.

You will also incur the cost of an appraisal of the FLP units at least every two years while you are continuing to give the ownership interests away. Depending on your age and your particular estate tax plan, this could take a few years or most of the rest of your life.

Second, when you gift an interest in a partnership or any other asset, the IRS treats the new owner the same as the old owner in many respects. One of those respects is the ďcost basisĒ to the new owner will be the same as your old basis. If you have highly appreciated assets, this can be detrimental.

Conclusion

The bottom line to the family limited partnership is simple Ė in some cases itís a good idea and in other cases it is not. What is certain is that it pays those with a significant estate to look at their options to determine if the FLP is a good idea. Fortunately, we, as your advisors, always stand ready to offer the assistance necessary to help you make the right decision.

Quit worrying about what you should do. Give us a call and let us help you decide.

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