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Funding the Family Limited Partnership
A family limited partnership is generally financed by specific assets. Real estate is an ideal investment, but not all assets are suitable for transfer to a partnership. As for corporate partners, S-corporation stock cannot be held by the partnership. Partners do not recognize gain or loss when they contribute property to the partnership in exchange for their partnership interests. Additional capital contributions do not create profit or loss for the partners or the partnership.
When a partner contributes capital or property to a partnership, the partner is given a share of the partnership in accordance with the partner’s contribution as a percentage of all contributions. Any additional contributions increase the partner’s share, and other shares must be adjusted accordingly.
Donation of partnership units
A simple division of partnership interests into units offers the ability to transfer assets to family members within the available annual gift tax exemption of $14,000 per year per recipient for 2014-2015. or the single credit exemption equivalent is $5,340,000 in 2014 and $5,430,000 in 2015. There are valuation allowances that can be used to reduce the value of partnership units by 20 to 40 percent for gift tax purposes.
Three types of valuation techniques are generally used in calculating the fair market value of an interest in a closely held entity. The market method (also called the comparable sales method) compares a closely held company with an unknown stock value to similar companies with known stock values.
The income (or discounted cash flow) method discounts to present value the expected future income of the company whose stock is being valued. The net asset value (or balance sheet) method generally relies on the value of a company’s assets less its liabilities.
The market or income method is most commonly used when a closely held company carries on an active trade or business. Net asset value is most often used when a closely held company primarily holds real estate or investment assets and does not conduct an active trade or business.
The value of the gift to the donee is the fair market value of the gift when it was made, not what the fair market value once was or might one day be. In Revenue Rule 93-12, the IRS accepts that a minority interest in a limited partnership with limited ownership rights for the limited partner qualifies for a discount from the fair market value of the underlying asset. This allows parents to gift their children significantly more within the gift tax exemptions and without losing control.
To be eligible for the discount, the limited partner’s interest must be considered a minority interest (lack of control discount) and/or not freely transferable (lack of marketability discount). IRC §2036(b) includes gifts in a donor’s taxable estate of corporate stock in a controlled corporation in which the donor retained voting rights over the stock. There is no corresponding section of the tax code for partnership interests.
Donors may wish to structure transfers or gifts of limited partnership units to qualify for the current consolidated equivalent of the credit exemption as noted above. These transfers do not have to qualify as gifts with a present interest, but disposal of assets upon death is usually preferred. Even if the donor continues to serve as the general partner of the partnership and acts as fiduciary for all partners, the donated partnership units will not be included in the estate of the deceased donor/general partner.
Management of a family limited partnership
In their capacity as general partners, the parents may accept fair remuneration from the partnership for their managerial capacity. They can also determine whether the partnership will retain or allocate income to its partners or can lend funds to a limited partner. Parents can receive money from the partnership to meet their existing or retirement needs, subject to fiduciary standards (which are lower than those for a trustee). Wages paid to anyone in the partnership are subject to withholding by the IRS and the state in which the partnership operates.
Partnership is required for the annual filing of tax returns. The federal return is Form 1065, and the state has an equivalent form. Any income received by the partners must be included in their respective tax returns. Even if there is no distribution, the partners must claim the amounts reported on the K1 form provided by the partnership.
Taxation and insurance for a family limited partnership
As far as income tax is concerned, all assets transferred from the partnership to the partners retain the same nature as with the partnership. IRS Ruling 83-147 explains the taxation of life insurance assets owned by a partnership by one of its partners. The result should be the same as business-owned life insurance. If the partnership is a life insurance beneficiary, then the death benefit from the insurance will be credited to the partner’s estate only indirectly by changing the value of the deceased partner’s partnership interest.
To avoid increasing the deceased partner’s partnership interest in a portion of the life insurance proceeds, the policy could name any adult children as policy owners and beneficiaries at the inception of the policy. General partners can distribute income to children as limited partners to pay the premiums of a policy owned by the children or the grantor of a trust created by the children. Providers can direct beneficiary succession in the event the provider passes away to a parent, which could help protect the cash value of the policy if it exists in the event of a divorce.
Risks of a family limited partnership
The IRS issued, without administrative hearings, new regulations under Subchapter K of the IRC. In short, the IRS will disregard a partnership as an entity if the main function of the partnership was to avoid income tax either at its inception or during its operation. The proposed regulations relate to income tax and do not apply to gift and estate tax assessments. This does not mean that the Tax Administration will not deal with the assessment of assets and gifts in the future. There are costs involved in forming and maintaining an FLP, including:
• Costs of a lawyer for establishing a partnership (however, a lawyer is not required
• Fees for valuation of underlying assets and for “departmental” partnerships gifted to younger generation family members;
• Accounting fees for partnership K-1 and other financial assets;
Transfer tax costs such as documentary stamps when transferring real estate. But for many investors, the benefits of well-planned FLPs easily outweigh the risks and costs.
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