Many high-net-worth individuals have successfully used family limited partnerships (FLPs) and other family-owned entities to transfer wealth to the next generation often at substantial discounts from the fair market value of the underlying assets. But recently proposed regulations threaten the valuation discounts that have made these estate planning tools so advantageous.
How an FLP Works
To execute an FLP strategy, you contribute assets — such as marketable securities, real estate and private business interests — to a limited partnership. In exchange, you receive general and limited partner interests.
Over time, you gift, sell or otherwise transfer interests to family members and anyone else you wish (even charitable organizations). For gift tax purposes, the limited partner interests may be valued at a discount from the partnership's underlying assets because limited partners can't control the FLP's day-to-day activities and the interests may be difficult to sell.
This can provide substantial tax savings. For example, under federal tax law, you can exclude certain gifts of up to $14,000 per recipient each year without depleting any of your lifetime gift and estate tax exemption. So, if discounts total, say, 30%, in 2016 you can gift an FLP interest that worth as much as $20,000 before discounts (based on the net asset value of the partnership's assets) tax-free because the discounted fair market value doesn't exceed the $14,000 gift tax annual exclusion.
Important note: An FLP must be established for a legitimate business purpose, such as efficient asset management and protection from creditors, to qualify for valuation discounts. Partnerships set up exclusively to minimize gift and estate taxes won't pass IRS muster.
Valuation of a Limited Partner Interest
Hiring a professional business appraiser is critical when using this estate planning tool. The valuation process begins by determining the partnership's net asset value, which is the combined fair market value of its assets on a controlling, marketable basis minus any liabilities.
If the partnership holds stocks, bonds or other marketable securities, you can simply find out the assets' values from brokerage statements or public market data on the Internet. Alternatively, you can use a real estate appraiser if the partnership manages a portfolio of properties, such as strip malls or farmland. And, of course, a business appraiser can be hired to determine the value of private business interests owned by the FLP.
Business appraisers are also needed for the next step in valuing a limited partner interest: quantifying the discounts for lack of control and marketability that apply to the partnership's net asset value. These discounts are separate from one another and from any discounts taken at the asset level (for instance, if discounts were taken on a private business interest that was contributed to the FLP).
The size of partnership-level discounts varies depending on numerous factors, such as:
- The nature and composition of the partnership's underlying assets,
- Historical and expected income distributions,
- Current market conditions,
- Partnership agreement rights and restrictions,
- State laws, and
- Relevant legal precedent.
Limited partners lack control over partnership affairs, which typically warrants a discount for lack of control from net asset value. In addition, FLP interests aren't sold on the public markets and may be subject to various transfer restrictions under the partnership agreement, which warrants a discount for lack of marketability. Combined, these discounts often reduce the value of limited partner interests by 40% or more, depending on the nature of the FLP.
This estate planning tool may seem too good to be true — and, indeed, FLPs have come under IRS attack on numerous occasions.
How the IRS Attacks FLPs
Regardless of how expertly a limited partner interest is valued, an FLP will crumble under IRS scrutiny if it isn't properly structured and carefully administered. An FLP generally won't pass IRS muster if, for example, the general partner has contributed substantially all of his or her personal assets to the partnership, paid personal expenses directly from the partnership's bank account or made death-bed transfers.
So far, the IRS's most effective line of attack has been Internal Revenue Code Section 2036, "Transfers with retained life estate." Citing Sec. 2036(a), the IRS may claim that a donor retained ongoing economic benefit — either express or implied — in the partnership's assets. If the IRS is successful, it can assess gift and estate taxes on the full value of the partnership's underlying assets. In other words, the IRS can specifically exclude valuation discounts for lack of control and marketability if the general partners retain an ongoing economic benefit in the assets.
The IRS has had only limited success under Sec. 2036, however. The U.S. Tax Court has upheld valuation discounts for dozens of carefully administered FLPs that were set up for bona fide, nontax business purposes.
Now the IRS is proposing changes to Sec. 2704, "Treatment of certain lapsing rights and restrictions," which could substantially reduce (or even eliminate) valuation discounts for certain family-entity interests. The proposed regulations, issued on August 2, address the treatment of certain lapsing rights and restrictions on liquidations in determining the value of the transferred interests.
More specifically, the proposed regs include provisions to:
- Amend existing rules on what constitutes control of a limited liability company or other entity or arrangement that isn't a corporation, partnership or limited partnership,
- Address death-bed transfers (made within three years of the transferor's death), and
- Modify what's considered an "applicable restriction" by eliminating a comparison to the liquidation limitations of state law.
Under existing tax law, an applicable restriction is "a limitation on the ability to liquidate the entity (in whole or in part) that is more restrictive than the limitations that would apply under the State law generally applicable to the entity in the absence of the restriction." The IRS is proposing that restrictions imposed on a limited partner's ability to liquidate his or her interest be ignored, irrespective of whether those restrictions are imposed by the partnership agreement or state law.
The proposed regs also add a new class of "disregarded restrictions" that would be ignored if, after the transfer, the restriction will lapse or may be removed, without regard to certain interests held by nonfamily members by the transferor or the transferor's family. Restrictions that defer the payment of liquidation proceeds for more than six months or permit payment in any manner other than cash or other property also would be disregarded under the proposal.
Additionally, the proposed regs address FLPs that include charities and other unrelated parties as partners in an effort to preserve valuation discounts. Under the proposal, the existence of such an interest would be disregarded unless it's "economically substantial and longstanding." If all nonfamily interests are disregarded, the entity is treated as if it's controlled by the family.
When to Consider Transfer Restrictions
Here's a typical example of a situation where transfer restrictions may be disregarded under the proposal: Suppose Adam creates an FLP. Adam owns a 98% limited partner interest, and his daughters, Abby and Anna, each own a 1% general partner interest.
Under the partnership agreement, the FLP will dissolve and liquidate on June 30, 2066, or by the earlier agreement of all the partners. It otherwise prohibits the withdrawal of a limited partner. Under applicable local law, a limited partner may withdraw from a limited partnership at the time, or on the occurrence of events, specified in the partnership agreement. Under the partnership agreement, the approval of all partners is required to amend the agreement. None of these provisions is mandated by state law.
Adam subsequently transfers a 33% limited partner interest to each daughter. Under the proposed regs, would the transfer restrictions be considered when deciding on the valuation discounts for the limited partner interests?
By prohibiting the withdrawal of a limited partner, the partnership agreement imposes a restriction on the partner's ability to liquidate his or her interest in the partnership that is not required by law and that may be removed by the transferor and members of the transferor's family, acting collectively, by agreeing to amend the partnership agreement. Therefore, under the proposed changes to Sec. 2704, the restriction on a limited partner's ability to liquidate that partner's interest would be disregarded in determining the value of each 33% limited partner interest.
These proposed regulations won't go into effect unless and until they're finalized. (Unlike many IRS proposals, it's not effective immediately or retroactively.) The Treasury is now collecting feedback to discuss at its public hearing on December 1, 2016. Even then, any changes won't into effect until 30 days after the Treasury finalizes the regulations.
So, there may still be time to set up an FLP (or similar family-controlled entity) and still be grandfathered from any new rules. But caution and diligence is the name of the game — as always, excessive discounts, do-it-yourself appraisals and other aggressive estate planning tactics are likely to attract IRS scrutiny.
Many practitioners predict these controversial proposed regulations face an uphill battle against taxpayers and their advisors. Regardless of whether the changes are finalized as they are, modified or abandoned, the estate planning benefits of FLPs and other family-owned entities could be significantly reduced in the future. In light of these developments, it may be prudent to meet with your estate planning team — including your attorney, tax advisor and valuation professional — before year end to discuss your estate plan.
Editor’s Note: At the recent American Institue of Certified Public Accountants Forensic & Valuation Conference in Nashville Tennessee, IRC Section 2704 was a hot button topic. A senior technician reviewer representing the IRS indicated the service received over 9,000 distinct comments on the proposed changes.
Given the number of comments by practitioners and interested parties, there is likelihood that the proposed changes will not be implemented before the end of 2016.
WILLIAM P. ALLEN, CPA/ABV, CFE
Bill is a member of the American Institute of Certified Public Accountants accredited in Business Valuations (ABV); a Certified Fraud Examiner (CFE) accredited by the Association of Certified Fraud Examiners; and the New York State Society of Certified Public Accountants. He has more than 5 years' experience in public accounting serving both commercial businesses and nonprofit organizations. As a member of the Brisbane team, Bill is responsible for valuation, forensic accounting, and litigation support services. Bill is a graduate of Le Moyne College and has worked with our Firm since graduating in 2006.