For example, the Smith family owns a business with a current value of $2 million, a rental property with equity of $500,000, and retirement savings in stocks and bonds equal to $1 million. That’s a total estate of $3.5 million. (Although at the time of this writing, we have no current estate tax in 2010, unless changed by Congress, the individual estate tax exemption is scheduled to return at $1 million in 2011 and beyond. It may be raised from that amount, but for our example we will use this amount.) Under current law, with a properly designed estate plan, taking maximum advantage of the combined current exemption of $2 million, the estate tax on the balance of $1.5 million would be approximately $825,000. Mr. and Mrs. Smith would like to take steps to preserve the family estate for the benefit of their three children, but they do not wish to give up management over their assets during their lifetime.
One solution to the problem involves a properly structured estate plan including an FLP that is established to hold all family assets. Mr. and Mrs. Smith (or an LLC) would be the general partners of the FLP. As such, they would have management over the property in the FLP. Initially, they could make a gift of the limited partnership interests to their children (directly or indirectly through a Family Savings Trust) in an amount equal in value to the combined maximum gift tax credit (currently $2 million). Or they could use a portion of their credit now and take advantage of the annual exclusion amount, which is currently $13,000 per person per donee. That would be $26,000 that a married couple can gift to each child without using any portion of their lifetime gift tax exemption. In subsequent years, they could gift limited partnership interests equal to the amount that would bring their estate tax down to zero over a number of years.
That’s not a bad result, but we can push the advantages of the FLP a great deal further. According to IRS rulings and a significant line of court cases, the value of each gift of a limited partnership interest should be discounted in order to account for the lack of marketability and the lack of control associated with those interests. For example, if the parents transfer assets with a value of $1 million to an FLP, a gift of a 1 percent limited partnership interest should not be valued at $10,000. Instead, because the interest cannot be readily sold and because the donee has no right to participate in management of the FLP, a reasonable approach to determine value, suggested by many experts, would be to discount the transferred interest to reflect its true value in the market. Discounts in the range of 30 percent are fairly conservative, but some aggressive advisors push this number to the 50 percent range.
Once this discount is taken into consideration, potential tax savings can be accelerated. Using a conservative 30 percent discount, the value of the limited partnership interests in the Smith FLP would be discounted in value from $3.5 million to $2,450,000. A substantial amount of this value could be gifted in the first year without exceeding the combined gift tax credit of $2 million. The remaining $450,000 in value could be transferred out of their estate at a rate of $26,000 per year for each child or grandchild they wish to benefit. In a relatively painless fashion, the Smiths have eliminated $825,000 of estate taxes while maintaining management powers over the assets of the partnership. If a more aggressive discount is chosen, it might take only a few years of gifting to completely eliminate the estate tax.
As an added bonus, this approach will also remove future appreciation from the Smiths’ estate. In our example, the Smiths’ assets have a value today of $3.5 million. I know it seems unlikely now, but if there is any future appreciation in value or there is inflation at a rate of 5 percent per year, for example, in roughly fourteen years these assets would be worth $7 million with total estate taxes of roughly $2,750,000. This amount can be avoided entirely or at least in part by timely planning. If you own real estate or a business which you believe will increase in value over the years, the FLP provides an excellent planning opportunity to achieve meaningful estate tax savings. (See e.g., Kimball v. United States, 244 F. Supp. 2d 700. (N.D. Tex. 2003). For more information read our article “Avoid Estate Taxes with Family Limited Partnerships”