A popular estate planning tool that has long been used effectively may be facing new challenges under the current administration in Washington, DC. The family limited partnership (FLP) is an estate planning tool that allows families not only to transfer significant amounts of their wealth to succeeding generations while reducing estate, gift, and income tax liabilities but also to achieve several other important estate planning goals.
What is an FLP?
An FLP is a business entity created under state law to hold and manage property. It is made up of partners that can be either individuals or other entities such as trusts and limited liability companies (LLCs). An FLP must have at least one general partner that is liable for the partnership’s debts and liabilities. The other partners can all be limited partners, which means that they are personally insulated from liabilities arising within the partnership, and the partnership is generally insulated from liabilities that a limited partner may incur outside the partnership.
In an estate planning context, FLPs are often created when a parent or parents own property such as real estate or business interests that they would like to retain control and management of but at the same time want to begin the process of transferring to their children for transfer tax purposes. The parents can form the FLP with themselves (or another entity such as an LLC that they own) as the general partner and name their children (or trusts created for their children’s benefit) as limited partners. Then they transfer property into the FLP and gift shares or partnership interests to their children over time or all at once. The Internal Revenue Service (IRS) acknowledges that when a family creates fractional interests in an FLP and distributes them among the limited partners—none of whom has any right to control the management of the property in the partnership (the general partner reserves that right)— the value of the underlying partnership interests is substantially less than the value of the undivided FLP assets in the hands of only one owner. This strategy can result in significant transfer tax savings, which is one primary benefit of using an FLP.
Other FLP benefits include the general partner’s ability to continue managing the property while the children benefit from the income it generates. While the general partner is managing the property, the limited partners can become familiar with how it should be managed in preparation for someday taking over when the general partner either dissolves the partnership or management changes hands to one or more of the limited partners.
The property within the partnership is also generally protected by state law from lawsuits against the limited partners. State laws typically provide that a creditor’s only remedy against a limited partner’s interests is the right to receive partnership profits and distributions payable to the debtor-limited partner. The creditor typically has no right to inspect the partnership’s books, vote as a limited partner, make management decisions, or force either a sale of the limited partner’s interest or liquidation of partnership property to pay the creditor. As a result, limited partnership interests can be unattractive to a creditor and encourage them to settle with the limited partner for substantially less than they would if the partnership interests were more easily accessible. In some cases, partnership interests can also be transferred to trusts for the benefit of chosen beneficiaries, which can further enhance the asset protection available to family members.
How are FLPs under attack?
In the spring of 2021, the Biden administration released the General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals, commonly referred to as the Green Book.[1] This publication highlights the tax law changes that the Biden administration has proposed to raise revenue in the near future. One of the Green Book’s many proposals may have serious implications for FLP owners or those who are considering forming an FLP for estate planning purposes.
The primary attack on the FLP strategy under this proposal is that a transfer of appreciated property to an FLP would trigger the recognition of capital gains on that property and subject the transferor to capital gains taxes effective January 1, 2022. Additionally, if an existing FLP holds appreciated property, the proposal would cause any property in the FLP that had not been subject to capital gains recognition within the prior ninety years to have a “recognition event” that would lead to income taxation on those capital gains. According to the Green Book, the earliest date when this type of recognition event could happen for such property is December 31, 2030.
An example illustrates this proposed change. Suppose Doris purchased one hundred shares of corporate stock for $1 per share thirty years ago. The fair market value of the stock is now $101 per share. Under the proposed law, if Doris formed an FLP and transferred the stock into it, the transfer would trigger a recognition of $10,000 in capital gains that would be subject to capital gains taxes in that tax year.
On the other hand, if Doris had transferred that stock into an FLP on January 1, 1940, and the shares had appreciated to a value of $101 per share by December 31, 2030 (ninety years later), the IRS would consider the expiration of the ninety-year period as a recognition event causing the excess of the fair market value over Doris’s tax basis in the stock to be subject to capital gains tax in that year.
Exclusions Apply
There are many exclusions that may mitigate the potentially harsh consequences of this proposal, particularly for people of more modest means. For example, exclusions apply in the following scenarios:
- Transfers to a spouse or a charity would not trigger a recognition event (carryover basis would apply).
- Capital gains on tangible personal property would be excluded.
- The $250,000 per person personal residence exclusion on capital gains would still apply and would be portable (transferable) to a surviving spouse.
- Exclusions for certain small business stock would still apply.
- There would be a new $1 million per person capital gains exclusion for other appreciated property transferred by gift or passed at death. A deceased spouse’s unused exclusion could be transferred to their surviving spouse to potentially shield up to $2 million of gains per married couple.
- Family-owned or family-operated businesses could delay recognition of gains until the family stopped owning or operating the business, and the family would then have up to fifteen years to make payments on the taxes due after the recognition of the gains.
Each of these exclusions has nuances that taxpayers will need to consider carefully and apply if Congress passes this proposal. And Congress will certainly have a say in how and whether these proposals are ultimately adopted. Nevertheless, it appears likely that the estate planning landscape will be changing in significant ways. Whatever the future holds for FLPs and other tried-and-true estate planning strategies, rest assured that we will be tracking those changes very carefully and will be ready to help you navigate the uncertainties. If you would like to learn more about FLPs and how they might fit into your own estate planning, please call us. We would love to hear from you.
[1] Dep’t of the Treas., General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals (May 2021), https://home.treasury.gov/system/files/131/General-Explanations-FY2022.pdf