A family limited partnership is often created in estate planning and used as a means to easily transfer business assets owned by the parents when they are ready to start gifting interests in the business assets to their children. Family limited partnerships are frequently created to hold real property used in a trade or business of the parents.
However, a family limited partnership can be created to hold many different types of assets. In the Central Valley, a common example would be a farmer contributing his farmland to the family limited partnership.
The family limited partnership is a California business entity that has two classes of partners: general partners and limited partners. The general partners have day-to-day control of the partnership and make the business decisions. The limited partners have a voice in major decisions of the partnership, but they do not have the right to make decisions for the partnership or control the general partners.
Typically, parents will gift limited partnership interests to their kids in order for parents to maintain a position of guidance of the partnership and its assets. Family limited partnerships sometimes help resolve family disputes faster and cheaper through the arbitration provision contained in many agreements. My partner started using limited partnerships in the 1970s for family farms that were worked by resident family members.
A partnership for federal and state tax purposes does not pay an entity level of tax. All items of income, deduction, gain or loss flow through to the individual partners and are reported on their individual or corporate tax returns. This single layer of tax makes partnerships attractive for tax purposes.
In the estate planning context, the family limited partnership has many benefits. One benefit is that there is a transfer of a portion of a person’s assets to the limited partnership, while still allowing the transferor to have a supervisory position with respect to the assets and the business through the terms of the limited partnership agreement, thereby, limiting loans, sales and transfers of interests in the partnership.
Another benefit is that the family limited partnership divides ownership interests in property for gifting and transfers. A further benefit is that the family limited partnership causes the value of the assets inside the family limited partnership to be discounted when interests in the partnership are transferred, whether pursuant to gifting during lifetime or transfers upon death. This means that the fair market value of a limited partnership interest is not simply computed based on a pro rata share of the assets of the partnership, which results in lower estate and gift tax costs to transfer the partnership interests. Still another benefit is that the family limited partnership provides a structure to bring the next generation into the family business to start training them on running the family business. Lastly, the family limited partnership provides a forum for dispute resolution through family business meetings and the arbitration process built into most limited partnership agreements.
When a gift or transfer of a limited partnership interest is made that gift or transfer must to be valued for gift or estate tax purposes. To determine the value of the transferred interest, a person must determine the fair market value of the limited partnership interest. In calculating the fair market value of the limited partnership interest, an appraiser will apply various discounts to the limited partnership interests. The discounts that are usually employed are the lack of marketability discount and a minority interest discount. The theory behind the lack of marketability discount is that someone will not pay full value for a partial interest in an entity.
Since the limited partnership agreement will contain restrictions on the transferability of an interest in the limited partnership, a discount to the overall value of the interest will be calculated to reflect those restrictions.
The theory behind the minority interest discount is that someone will not pay the same amount for a minority ownership position in an entity as they would pay for a controlling interest in the entity. The combined lack of marketability and minority interest discounts can be 30 percent to 50 percent. Currently, the Internal Revenue Service audit group is not challenging a 35 percent combined discount.
However, time may be running out to take advantage of some of the benefits that stem from the use of a family limited partnership. The current gift and estate tax exemption amounts of $5 million per person are set to revert back to $1 million come Jan. 1 unless Congress acts to extend them. And the White House and Congress have discussed legislating to prohibit discounts on transfers of family limited partnership interests. In today’s political environment it is possible that the current estate and gift tax exemption amounts will expire and revert back to $1 million per person and Congress may legislate to prohibit discounts on transfers of limited partnership interests.
Many people will mistakenly believe they have plenty of time to use this strategy if the estate and gift tax laws are going to be changed. Many people believe the estate and gift tax law has been revoked due to the substantial exemption of $5 million per person. However, a family limited partnership that will be respected for tax purposes takes time to create and for appraisals to be obtained. Act while the certainty still exists.
Anyone curious to see the possible benefits of using a family limited partnership should consult with an attorney that specializes in estate planning and taxes. The various laws applicable to family limited partnerships are complicated and proper steps must be followed to obtain the benefits sought.
In accordance with IRS Circular 230, the information provided in this article was not written to be used and cannot be used by any person for the purpose of avoiding tax-related penalties or promoting, marketing or recommending to another person any transaction or matter addressed in this article.