A family limited partnership is generally funded with specific assets. Real estate provides the ideal investment, but not all assets are suitable for transfer to the partnership. Regarding corporate partners, S-corporation stock cannot be held by a partnership. Partners do not recognize gain or loss when they contribute property to the partnership in return for their partnership interests. Additional capital contributions do not generate a gain or loss for partners or the partnership.
When a partner contributes capital or assets to the partnership the partner is given an interest in the partnership in accordance with the partner’s contribution as a percentage of all contributions. Any additional contributions will increase the partner’s share and other shares must be adjusted accordingly.
Gifting of Partnership Units
Easy division of partnership interests into units offers the ability to transfer assets to family members within the available annual gift-tax exclusion which is $14,000 per year per donee for 2014-2015 or the unified credit exemption equivalent is $5,340,000 in 2014 and $5,430,000 in 2015. There are valuation discounts that may be used to reduce the value of the 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 referred to as the comparable sales method) compares the closely held company with its unknown stock value to similar companies with known stock values.
The income (or discounted cash flow) method discounts to present value the anticipated future income of the company whose stock is being valued. The net asset value (or balance sheet) method relies generally on the value of the assets of the company net of its liabilities.
The Market method or income method is most often used when the closely held company carries on an active trade or business. The net asset value is most often used when a closely held company holds primarily real estate or investment assets and does not carry on an active trade or business.
The value of a gift to a donee is the fair Market value of the gift when it is made, not what the fair Market value was once or may be some day. In revenue ruling 93-12, the IRS accepts that a minority interest in a limited partnership with restricted ownership rights for the limited partner qualifies for a discount off the fair Market value of the underlying assets. This allows parents to gift considerably more to their children within the gift-tax exclusions and without loss of 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 the donor’s taxable estate of corporate stock in a controlled corporation in which the donor retained the right to vote the stock. There is no corresponding tax code section for partnership interests.
Donors may want to structure transfers, or gifts, of limited partnership units to qualify for the current unified credit exemption equivalent as stated previously. These transfers do not have to meet the criteria as present-interest gifts, but estate elimination at death is usually desired. Even if the donor continues to serve as a general partner of the partnership and acts in a fiduciary capacity for all partners, gifted partnership units will not be included in the deceased donor/general partner’s estate.
Operating a Family Limited Partnership
In their capacity as general partners, the parents may accept an equitable salary from the partnership for their managerial capacity. They also can establish whether the partnership will preserve or allocate income to its partners or they can loan funds to a limited partner. The parents can get money out of the partnership to sustain their existing or retirement needs, subject to fiduciary standards (which are lower than that for a trustee). Salaries paid to anyone in the partnership are subject to withholdings as dictated by the IRS and State in which the partnership operates.
A partnership is required to file tax returns annually. The Federal return is form 1065 and the State has an equivalent form. Any income received by the partners must be included on their appropriate tax return. Even if no distribution occurs, the partners must claim the amounts reported on form K1 which is provided by the partnership.
Taxation and Insurance for a Family Limited Partnership
When considering income taxes, all assets transferred from the partnership to the partners retains the same nature as with the partnership. IRS Revenue ruling 83-147 explains the estate taxation of life insurance owned by a partnership on one of its partners. The result should be the same as corporate-owned life insurance. If the partnership is the beneficiary of the life insurance, then the insurance death benefit will be included in the partner’s estate only indirectly by the change in value of the deceased partner’s partnership interest.
In order to stay away from increasing the partnership interest of the deceased partner by a portion of the life insurance income, the policy could list any adult children as owners and beneficiaries of the policy at the beginning of the policy’s existence. General partners can distribute income to the children as limited partners to pay the premiums of the policy owned by the children or the grantor of a trust that the children have created. The grantors could direct beneficiary succession in the event the grantor predeceases the parent which could help protect the policy’s cash value if any in the event of a divorce.
The Risks of the Family Limited Partnership
The IRS has issued, without administrative hearings, new regulations under Subchapter K of the IRC. In summary, the IRS will disregard a partnership as an entity if the principal function of the partnership was the avoidance of income tax either at inception or during its operation. The proposed regulations are income-tax specific and have no application to gift- and estate-tax valuations. This does not mean the IRS will not address estate and gift valuations at some future time. There are costs involved in forming and maintaining an FLP, including:
• Attorney fees to form the partnership (however an attorney is not required
• Appraisal fees for underlying assets and for the partnership “slices” gifted to the younger generation family members;
• Accounting fees for partnership K-1’s and other financial assets;
Transfer-tax costs such as documentary stamps when transferring real property. But for many investors, the benefits of well-planned FLPs easily outweigh the risks and costs.