A Valuable Transition Tool

Family Limited Partnerships Help Transfer Assets, May Reduce Estate Taxes

Escalating land prices mean an estate can quickly exceed its exemption level. (Progressive Farmer photo by Jim Patrico)

In agriculture, where the predominant asset is usually the land, estate planners often recommend creating business entities like a family limited partnership (FLP) to own the property. The move makes the transition of those assets from one generation to the next smoother.

"Farm owners don't want to find themselves in a position to leverage or sell their land to pay taxes," says Joel Green, an attorney with Sandberg Phoenix and Von Gontard P.C., in St. Louis, Mo., who specializes in estate and succession planning. "Transfers occur with shares of the partnership or shares of stock from a business interest that owns the land."

Though the amount of an estate exempt from estate tax has become more generous -- currently exceeding $5 million per person -- land values have escalated greatly in the past decade. The potential for an estate to exceed the exemption limit is more likely than ever before.

Additionally, the estate-planning process forces members of the business to look ahead and plan the moves that will be necessary for a smooth transition, Green explains. Forecasting a decade in advance, when possible, is ideal.

"I can transition a lot of wealth in 10 years without using up any or much of the allowable exemption amounts," Green says.

DISCOUNT VALUE

Family limited partnerships are extraordinarily useful for estates that exceed the $5 million limit since the value of the shares in an FLP in excess will receive a discount in their valuation for estate tax purposes. That's because the market for business interests generally only available to other family members isn't worth as much.

"Twenty-five percent to 50% is typically the range we see discounts fall," says Steven Dumstorff, a CPA with Kerber, Eck and Braeckel, in St. Louis, Mo. He has considerable experience with farm estate and succession planning.

IRS REVIEW

The Internal Revenue Service (IRS) seems to somewhat regularly challenge the amount of discount taken in cases where estate taxes may be due, Dumstorff explains. But the agency also often loses those cases.

"If you are a minority owner in a limited partnership and prohibited from selling shares to third parties, and only receive a dividend when the general partner declares one, that diminishes the value of the shares," Dumstorff says. "Those discounts are real."

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The planning and the process to create a family limited partnership or a family limited liability company (LLC) for this purpose has to be well-documented and professionally executed, Green says. The IRS has also challenged various aspects of these business entities as they relate to their ability to save family businesses tens of thousands, or even tens of millions, of dollars in estate taxes.

So what does a family limited partnership cost? "The entity itself is not hard to create," Dumstorff says. But creating that family limited partnership is usually part of the cost of an overall estate and succession plan that may involve numerous steps and hours of planning and discussion among family members and professionals.

The overall plan might cost $10,000, or it might cost $100,000, "depending on the family situation and how many moving parts you have," he says.

Often, the IRS challenges a family limited partnership if the agency believes its creation is purely a move to avoid taxes.

COURT CASE

In one case finally settled in 2012 (Keller v. United States, S.D. Tex. 2009), the IRS had contended that $250 million in corporate bonds and cash remained part of a Texas woman's estate, fully subject to estate taxes. The agency made its decision despite the fact the woman, along with her advisers, created a family limited partnership into which they were going to transfer the assets.

The woman died before the actual transfer occurred. The U.S. District Court, however, ruled that the woman's intent was to finance the partnership with the bonds and cash, and those assets should be treated as such.

Additionally, the Keller court held that those assets rightfully receive a 47.5% valuation discount. In other words, the market value of the assets, when considered for estate tax purposes, would be reduced by 47.5%. In total, the court victory for the estate meant a $40 million savings.

LESSONS LEARNED

Despite this case's limited scope, Green says it points out two things applicable to anyone using such an entity to transition assets.

First, it's crucial to keep good records. The Texas woman had held lengthy planning discussions with her CPA and her attorney about the formation and subsequent funding of the family limited partnership.

"Her intent was to fund the FLP, and her intent was the governing factor in the state of Texas and was sufficient to withstand scrutiny," Green says. He does add, though, that the Court's ruling was based on principles of Texas partnership law and that this view may not be applicable in every state.

"Taxpayers need to make sure every aspect of the planning process is documented as well as possible and everything is done by the letter of the law of the IRS and the state in which they reside," Green stresses.

Second, the court recognized and allowed the valuation discount applied to the assets placed in the family limited partnership. "I don't know that we can rely on the 47.5% discount applied in the Keller case, but you can expect a 25 to 30 or 35% in some cases," he says.

In considering the valuations, the court lent more credibility to the appraisals provided by the estate rather than those submitted by the IRS. "This highlights the importance of retaining qualified and reputable professionals experienced with valuing closely held business interests," Green says.

KNOW THE PITFALLS

Family limited partnerships have become a valuable estate- and business-planning tool. However, if not executed correctly, their use may jeopardize any estate or gift tax savings. The IRS has successfully applied Section 2036(a) of the Internal Revenue Code (retained life interests) to disallow the savings to some estates.

Most often, the flaws in the use or funding of a family limited partnership include one or more of the following when the estate of someone who has died is being administered:

-- Assets in the family limited partnership (FLP) are commingled with the decedent's assets during their lifetime.

-- The FLP is used to pay the decedent's personal expenses during their lifetime.

-- The FLP is used to pay the person's estate taxes and administration expenses upon their death.

-- The decedent was allowed to use FLP assets during their lifetime, which can include rent-free use of a residence.

-- Nearly all the person's financial assets are placed in the FLP during his or her lifetime. Not enough was kept out for normal living expenses.

-- Once assets are contributed to the partnership, the person whose estate is being administered retained control of and continued to use and enjoy those assets during their lifetime -- with no real evidence of their regard for the limited partners.

A general partner who creates the FLP, keeps unlimited control and who isn't careful with their fiduciary responsibilities to the limited partners can easily get tripped up by the tax code. As a result, he or she may cause the value of all the limited partnership's assets to be included in the general partner's gross taxable estate.

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