|
The Family Limited Partnership Legal Tax Angles: How to Save Taxes Without Going to Jail A limited partnership is a legal arrangement where investors are treated like partners for tax purposes, but like corporate stockholders for liability purposes. The limited partner is not subject to any debts of the partnership in excess of the limited partners' capital. Each limited partnership must have one or more general partners who are personally liable for any debts of the partnership. In order to avoid partnership liability, the limited partner gives up any management of the partnership. The general partner or partners have total discretion regarding the management of the partnership. A "family" limited partnership (FLP) is a limited partnership where all of the partners are members of the same family group. For this purpose, the "family" label is simply an adjective. The law doesn't really distinguish between a family limited partnership and any other type of limited partnership. In addition, in a FLP, someone in the family is the general partner so that control is retained by one or more family members. When a FLP operates a family business, the parent that manages the business is the general partner. The children, a spouse or other family members are limited partners. When the FLP is used to own family investments, the high risk spouse and children are often the limited partners and a spouse who is not susceptible to lawsuits is usually the general partner. Income Tax Issues Shifting income to lower bracket family members hasn't been as popular since 1986 as it was before the 1986 tax law. Before 1986, the top income tax rate was 50%. By shifting income from a family business to children or to dependent parents, the income could be removed from the top tax bracket of the taxpayer and taxed at the lower bracket of the dependent family member. The 1986 tax law imposed a new rule called the "kiddie tax" in which children under the age of 14 are required to pay income taxes on investment income at the top tax rate of their parents. In addition, the '86 law cut the top tax rate to 31% and thereby reduced the benefits of shifting income to children. (The top tax rate has since crept back up to 39.6% and is now at 38.6%) Even so, there are still substantial income tax benefits available by shifting investment or business income to dependents. With personal tax rates of up to 38.6%, the benefits of income shifting have become more popular. However ... most taxpayers are reluctant to give unlimited control of substantial amounts of money to their children - even when their children are adults. With a FLP, you can retain control of the money. With the FLP, you can also retain the cash in your business or for reinvestment. Generally, you only need to distribute enough cash each year to pay the taxes that are due by the partners on the income of the partnership. The general partner in an investment partnership can also control the taxes that will be due by the type of investments that are used. The partnership can invest in growth stocks, land, cash value life insurance or some other tax deferred investments. (However, this should not be construed to mean that the partnership can invest in annuities. Only individuals or grantor trusts can enjoy the tax benefits of a deferred annuity.) When any appreciated assets of the FLP need to be sold, the taxable gain is allocated to the various family members who are partners. Thus, part of the capital gain is shifted to lower bracket family members. Where a FLP is used to operate a family business, some self employment tax savings can be achieved to the extent that there are profits to be allocated to the limited partners. The self employment tax is only imposed on those who earn the profits. Limited partners (who are not active in the business) are not subject to the self employment tax on their share of the profits. (The IRS does require that the general partners be paid adequate compensation for their work on behalf of the partnership and that capital must be a significant income producing factor.) For one of my clients, a FLP was recommended instead of a trust to provide for the future college education of his children. After exploring the benefits and problems associated with using an educational trust, a FLP turned out to be a far better vehicle than a trust. The FLP allows the children to pay the income taxes on any income earned on the investments in the partnership, while the parents retain control of the assets and the timing of distributions from the partnership. The S corporation has become a popular device to shift income from a family business to dependent family members. However, until the 1996 tax law, there were severe restrictions on who could be a shareholder of an S corporation. In the past few years, the Limited Liability Company (LLC) has become very popular among lawyers as the preferred form of business for family businesses. It's still not clear whether the LLC is an effective alternative for a family investment fund, whereas the FLP has been the preferred entity for that purpose. Estate and Gift Tax Issues Families that own substantial businesses or illiquid investments are faced with the prospect that a substantial part of the business may have to be sold (or liquidated) to pay estate taxes upon the death of the family member who owns a large part of the business. The same problem occurs in a family farm. Where the parent has more than $1,000,000 in his or her estate, the federal estate tax begins at 37% and goes up to 50%. When gifts of large amounts are made to grandchildren, the generation skipping estate tax can be as much as 75% of the assets left to the grandchildren. Over four generations, the estate tax could consume 96% of a family's wealth. Estate taxes can be greatly reduced by making annual gifts of up to $11,000 to each heir by each spouse. If a family has four children and six grandchildren, each parent can make tax free gifts of up to $110,000 a year. Each parent can also make a tax free one time gift of up to $1,000,000 to use up their estate tax exemption. Over a period of ten years, a couple could give away $4.2 million - tax free. If a large part of the assets given to the heirs are used to buy life insurance on the parents, the heirs can leverage their gifts by five to twenty times the actual amount of the gifts. Thus, if the $4.2 million were used to buy life insurance on the parents beginning at age 45 to 50, the total amount transferred to the children and grandchildren could exceed $60 million - free of any estate or gift taxes. Not only are the annual gifts free of estate and gift taxes, the future income and appreciation on those assets will be transferred to the next generation. In the case of an ownership interest in a family business, the future income value of the transfers will often exceed the initial value of the gifts. Using annual gifts to buy life insurance owned by the beneficiaries can provide income tax benefits as well as estate tax benefits. By operating a business as a FLP, the parents can make gifts of the limited partnership interest to their heirs without giving up future control of the business. When you give your children shares of stock in a family corporation every year, the children will eventually acquire more and more voting control. Creating a second class of stock runs head-on into some complex tax rules that limit the value of gifts of interests where different interests are retained by the parents. For example, making gifts of common stock when preferred stock is retained by the parents may result in a minimal gift value for the common stock, leaving most of the value in the parent's preferred stock. Recently, the courts and the IRS have been more willing to accept the economic fact that transfers of closely held stock and limited partnership interests aren't worth as much as the full per share value of the property. Discounts for lack of control or lack of marketability can greatly cut the estate and gift tax. One of the most popular estate tax planning techniques used for many years is the irrevocable life insurance trust. The parent makes gifts to the heirs (indirectly) which are used to buy life insurance through an insurance trust. Some commentators are beginning to suggest that the FLP may be a better device than the irrevocable trust to own and manage insurance for the children. An extra benefit of the insurance FLP is that income received by the partnership could be used to pay the insurance premiums. Vern Jacobs Copyright, 2003 |
Books and Services by Vern Jacobs
|
.jpg)
