Avoiding Estate Tax Through a Family Limited Partnership
By Loyd Rawls
Another method of avoiding estate tax is through the use of a family limited partnership (LP) or in some states, limited liability corporations (LLC). These are entities that facilitate transfers to the next generation by dividing the property rights of the assets other than the corporation's. A limited partnership, as you recall from the tax shelter years, has two types of partners. There are the limited partners, who are essentially passive participants. By statutory regulations, limited partners cannot be liable for the business affairs beyond their invested equity, or take part in the day-to-day management of the partnership. The general partner or partners must own at least 1% of the partnership and be designated as responsible for the liabilities of the partnership as well as the day-to-day operation. By statute, a limited partnership interest may not be transferred without the general partner's consent, or the partnership will run the risk of being reclassified as a corporation.
This splitting of the responsibilities and control rights within a limited partnership, as well as the restrictions or transfers, is very convenient for attempting to avoid estate taxes. The statutory definition of a limited partnership interest makes a profound case for lack of marketability and lack of control valuation discounts. The splitting of responsibilities and rights with a limited partnership is also a very convenient vehicle for family dynamics when parents want to maintain control with a very small ownership, or there are actively employed family members who are best suited for general partner and/or unemployed family members best suited for limited partner roles. Depending upon the state of jurisdiction, there are also other partnership derivatives, such as limited liability partnerships, that have special features but generally serve the same purpose.
A limited liability corporation is another planning tool that has emerged because of the liability issues impacting general partners. The capabilities and nature of an LLC are determined by the state of jurisdiction; however, in most instances the LLC does everything a limited partnership can do, plus it protects the manager(s) and general partners(s) from personal liability for the entity's liabilities. The individual who controls the operation of the LLC is the manager and does not have to be an owner. The owners of the LLC are classified as members. The LLC adoption agreement, as with LP adoption agreements, stipulates the restrictions relating to transferability (marketability) and voting rights (control).
Case Example
To illustrate the estate tax avoidance capability and the business succession planning compatibility of these structures, let's assume an auto dealer operates his dealership on a parcel of real estate valued at $2,000,000 from which he is receiving rental income of $200,000 per year. Mr. Dealer owns the real estate personally and in the event of his death, the estate tax appraisal of the real estate would be the $2,000,000 fair market value, creating an estate tax of $1,100,000. Mr. Dealer has two children to whom he intends to pass his property after the death of his wife, assuming he predeceases her. His son is the successor dealer who will inherit the family business, and his daughter is a homemaker living in another state. Mr. Dealer wants to currently retain control of the real estate. His stated succession planning goals are as follows:
- He wants to make a current gift to his daughter of a portion of the real estate with minimum gift tax implications while retaining the bulk of the lease income for himself and his wife during their lifetimes.
- Upon his death, he wants to give his son control and management responsibility of the real estate to prevent his widow or daughter from being an awkward partner and landlord.
- Upon his wife's death, he wants to minimize estate tax and pass the income stream of the real estate to his daughter to achieve equitable asset distribution.
- And of course, he wants to accomplish these goals at the lowest possible tax cost.
Mr. Dealer is advised by a well-informed succession planner to change the form in which he owns the real estate, so that he can divide and disperse the property rights of the real estate to accomplish his multifaceted goals. He consults with his attorney and accountant and they confirm that if he owns this property as a limited partnership, he can divide the property rights between himself, his wife, his son and ultimately his daughter so as to accomplish his ambitious assortment of goals.
Mr. Dealer adopts a family limited partnership designating himself in a dual role as a 2% general partner and 98% limited partner. Recognizing the utility of limited partnership interests, he transfers sufficient limited partnership interest to his wife to validate her unified credit. He also makes a 2% limited partnership gift to his son and a 10% limited partnership interest to his daughter. Based upon the advice of his advisors, the partnership agreement states that, upon Mr. Dealer's death or disability, his 2% general partnership interest is converted to a limited partnership interest and his son becomes the successor general partner. His daughter would currently receive 10% of the partnership cash flow to supplement her income and, in accordance with the provisions of the partnership agreement and as a general partner, his son would not have to worry about his limited partner meddling in partnership affairs or losing the interest because of her financial irresponsibility or divorce. On the other hand, his son would be ill advised to take advantage of his sister because, as general partner, he would have a fiduciary responsibility to manage the partnership for his sister's best interest.
In order to properly document the gifts to his son and daughter, the dealer engages a security appraiser to value the gifted limited partnership interests. In the valuation analysis, the appraiser takes into consideration many factors, including a fair market value appraisal of the real estate, the lease between the partnership and the dealership, the inherent passive nature of a limited partner and the documented restrictions relating to marketability and control. As a product of the analysis, the appraiser determines that the value of limited partnership interests holding 98% of the $2,000,000 in real estate should be discounted by 45% due to lack of control and lack of marketability. Accordingly, the 2% interest gifted to the son is valued at $22,000 ($2,000,000 x 2% x 55%). In the event of the dealer's death, the residual 88% limited partnership interest that his widow would own should also be valued accordingly, generating a value of $968,000 ($2,000,000 x 88% x 55%). Assuming the underlying $2,000,000 value of the real estate did not change, adoption of the limited partnership under these circumstances would remove $900,000 of asset value from tax computation with resulting tax avoidance of $495,000.
This example, hopefully, illustrates the theory supporting the achievement of tax appraisal discounts with limited partnerships and limited liability corporations, and the subsequent avoidance of estate tax. The example should also show the utility of a limited partnership for succession planning. The use of this structure for the conversion of property rights provides the basis for valuation discounts in Mrs. Dealer's estate. The limited partnership structure also facilitates the achievement of Mr. Dealer's other objectives. If he becomes weary of the liability of real estate management during his lifetime, he can resign as general partner and let his son manage the property. Furthermore, he can make substantial transfers to his wife without subjecting her to the hassles and hazards of property management.
He would also have a passive asset that he could begin gifting to his daughter, and even his grandchildren, which would provide them income and not give him concern about complicating management decisions or exposing them to liability. Notably, as limited partners, the wife, daughter and grandchildren could participate in the cash flow of the real estate without impacting his son's management of the dealership or creating concerns about disposition of the real estate in the event that his daughter divorced or his grandchildren never matured financially.
Loyd H. Rawls, CLU, ChFC, MSFS, of The Rawls Company in Orlando, Florida, has specialized in family estate and succession planning for closely-held, family owned businesses since 1973. lrawls@dealeronline.com
