Family limited partnerships (FLPs) have had an important role in lowering gift taxes and estate taxes for generations. These planning tools can be coupled with trust funds to offer powerful asset protection for heirs. This makes them a cornerstone of many modern wealth management planning strategies.
Learn how FLPs work, why many families prefer them, and how the tax savings might look.
What Are the Tax Benefits of Family Limited Partnerships?
It's not just about how much money you make: It’s also about how much you keep in your pocket. In addition to watching out for frictional expenses, such as brokerage commissions, you'll want to learn how to reduce your tax burden.
Many new investors know about capital gains taxes. But for those getting close to retirement, gift taxes and estate taxes are just as important to think about.
By pooling your investments in a special type of legal structure known as a family limited partnership, you can transfer assets such as stocks, bonds, real estate, art, and collectibles to heirs. This is done by gifting partnership equity each year up to the gift tax limits.
If you are married, one of the financial benefits is that you and your spouse can combine your gift tax exclusion levels.
FLPs were originally structured as limited partnerships. But it is not uncommon to see them set up as limited liability companies. This is particularly true for Nevada LLCs or Delaware LLCs.
How Does the Annual Gift Tax Exclusion Work?
The federal government allows a person to give away up to a certain amount each year without paying taxes. The exclusion is $16,000 per person in tax year 2022. It's $32,000 for married couples.
This exclusion applies per recipient. That means you and your spouse could give 10 different people $32,000 each or $320,000 total and pay no gift tax. If you exceed the annual gift tax exclusion in any given year for any specific person, it will count against your unified lifetime estate tax and gift tax exemption. Estate taxes kick in after the first $12.06 million for deaths that occur in 2022.
Here's how gifts during your lifetime can affect your estate tax. Let's say you went over the allowable gift amount one year. Back in 2021, you surpassed the limit by $80,000. That means that if you die this year, estate taxes will kick in after $11.236 million instead of $12.06 million.
How Do FLPs Increase Gifts?
Instead of simply gifting money directly to your heirs, you can use FLPs. This can help you effectively increase the amount of your gift. The key is to put your assets into the FLP; this includes revenue-generating rental units, stocks, and even any business ventures you've started. Then, you can gift shares in the FLP rather than directly gifting the assets themselves.
By gifting shares rather than assets, your heirs will receive all dividends, interest, capital gains, and other profits from their ownership stake. That means the future returns will accrue to their benefit. It will also be excluded from your estate for tax purposes, creating a virtuous compounding cycle.
You can even insert provisions in the partnership agreement to help ensure that your gift isn’t squandered. For instance, the gift can stipulate that they cannot sell their shares or transfer them to anyone else until they reach their 35th birthday.
How Do You Use Marketability Discounts?
FLPs offer another tool for families to reduce their tax burden. It's known as either the marketability discount or the liquidity discount. This means the IRS won't value the partnership units at their net asset value.
Instead, the value is determined by a complex set of calculations. These will attempt to account for things like a lack of control, an inability to sell unless the majority holders agree to it, and other drawbacks that don't apply to people who own assets outright.
If you and your spouse establish an FLP, you'll likely be the general partners of the FLP. That means you still control the FLP, even after you've gifted some shares in the FLP to your heirs. If the FLP contains stocks, for instance, your family members will still enjoy dividends and profits from sales, but they won't be able to decide when to sell or what to buy. They can't take cash out of the FLP to go buy a luxury car. That means their share of ownership in the FLP's assets is discounted in the eyes of tax collectors.
These discounts can be significant. But the specifics will depend on the unique circumstances surrounding your particular FLP. That means you should be sure to consult your tax, legal, and investment advisors.
Using the Applicable Federal Rate
While your children and grandchildren can't withdraw cash from the FLP at will, you can use loans with low interest rates to reduce your estate and gift tax burdens. You can't control what the recipients do with the loaned cash, but they could use that loaned cash to buy more shares in the FLP.
Over time, the rates of return from the FLP shares will (hopefully) pay for the interest costs. Also, as time goes on, inflation reduces the purchasing power of the original loan amount. Then, repayment becomes less burdensome.
Federal law determines the minimum interest rate you can charge before the loan becomes a gift that eats away at your annual gift tax exclusion. These rates, known as "applicable federal rates," are updated every month. Here are the rates for June 2022:
- Short-term (three years or less): 2.21%
- Mid-term (between three and nine years): 2.93%
- Long-term (more than nine years): 3.11%
How Do You Use Leverage?
Assets such as private operating companies and real estate can be leveraged. In other words, you can use them to borrow money. When those assets are held within an FLP, the FLP can itself go out and borrow money.
The loans will have to adhere to the debt-to-equity ratio required by the lender. But any money borrowed could be used within the FLP to enhance returns for you and your family. For example, an FLP could leverage one property to invest in a new rental property.
Using Tax Rate Differences Between Family Members
Another huge advantage of FLPs is that you can shift shares to lower-income family members to reduce tax burdens on capital gains and dividends. Single individuals who earn less than $40,400 in 2022 don't pay any taxes on long-term capital gains and qualified dividends.
FLP shares held by someone who falls in that lowest capital gains bracket could avoid taxes on many of the funds they receive from the FLP.
The Bottom Line
When used well, FLPs can result in enormous tax savings. They offer flexibility and protection for asset allocation, depending upon how you hand out ownership in the FLP.
If you're concerned with reducing your tax burden, an FLP can serve you and your family as one aspect of a larger estate strategy. You can use an FLP along with other investment tax strategies and structures such as charitable remainder trusts, deferred tax liabilities, or the stepped-up basis loophole.