Estate Tax Benefits of a Family Limited Partnership of Limited Liability Company

Note: This article assumes that the Federal Estate and Gift Tax will not be repealed.

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 $750,000 in his or her estate, the federal estate tax begins at 37% and goes up to 49%. When gifts of large amounts are made to grandchildren, the generation skipping estate tax can be as much as 80% 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 $750,000 to use up their estate tax exemption. Over a period of ten years, a couple with ten heirs could give away $3.7 million - estate and gift 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 $3.7 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.

In the past few years, the courts and the IRS have been more willing to accept the economic fact that transfers of limited partnership interests aren't worth as much as the full per share value of the property owned inside the partnership. For example, if a limited partnership had $1 million in cash and you were offered a 10% interest in the partnership, as a limited partner, would you be willing to pay $100,000 for that partnership interest? Not if you realized that you have no control or say-so over the use of those funds or when and how they are to be distributed. If you were willing to become a limited partner, you would not pay full value for your share of the assets in the partnership. But you might agree to pay less.

The difference between the value of the assets in the partnership and what people would be willing to pay for a limited partnership interest in the same partnership is called a discount.

Discounts for lack of control or lack of marketability can greatly cut the estate and gift tax. The IRS and the courts appear to be willing to agree with discounts of from 15% to 25% of the value of a limited partnership interest. In a few cases, larger discounts have been approved by the courts, but the IRS may make your heirs pay for the cost of litigation to get discounts of more than 25% of the liquid assets in a family owned limited partnership.

But there is little dispute about the future growth of the partnership or the future income of the partnership following a bone fide gift of a partnership interest to an heir. The heir pays income taxes on his or her share of the partnership income. Increases in the value of the partnership assets are removed from the estate of the parent or grandparent. The opportunity to also get a substantial discount on the gift value of the partnership interest would be a bonus in terms of the tax benefits of making gifts of FLP interests to your heirs while you are still alive.

In some cases, additional estate taxes can be saved by making gifts of an interest in a FLP or LLC to a parent -- where the owner of the business is an only child. The parent can then leave the FLP/LLC interest to the children of the business owner and thereby bypass the estate tax on the estate of the business owner.

CAUTION: 

This arrangement would not be suitable if there is any intention to have the parent become eligible for Medicaid. Any income from the FLP/LLC would usually make the parent ineligible, even if the income is not distributed. In addition, the spenddown requirements of Medicaid would required the parent to sell his or her interest in the VLP or LLC. 

This arrangement works best when the business owner is the only child of the parent. Thus, the share of the limited partnership or LLC will be left to the child when the parent dies. Where there are multiple children, it would be necessary to have a buy/sell agreement with the parent in order to regain control of the partnership or LLC interest that had been gifted.

This brief article does not deal with the income tax issues of a FLP/LLC, which are discussed in the section on ElderTax

Copyright, 2003, Vernon K. Jacobs

Vernon Jacobs is the Editor/Publisher of The International Wealth Protection Reports, which are a collection of research reports on legal methods of asset protection and tax avoidance. Further information on this subject is available at http://www.offshorepress.com/  Jacobs is a CPA who has worked as a free lance tax and financial author/editor since 1977. Details about his credentials and experience are online at http://www.offshorepress.com/vkjcpa/  

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