Example

For example, the Smith family owns a business with a current value of $3 million, a rental property with equity of $1 million and retirement savings in stocks and bonds equal to $1 million. That's a total estate of $5 million. 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 $3 million might be approximately $1.5m (Depending on the date of death and the amount of the credit at that time). 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 control 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 would be the general partners of the FLP. As such they would have management and control over their property in the FLP. Initially, they could make a gift of the limited partnership interests to their children in an amount equal in value to the combined maximum estate tax credit (currently $2 million). In subsequent years, they could gift limited partnership interests equal to the amount of the annual gift tax exclusion of $22,000 per child ($66,000 per year).

Under this approach, in roughly forty-five years, the Smiths would be able to eliminate potential estate taxes and could preserve $5 million of family wealth (plus much future appreciation). At the same time that the Smiths are accomplishing this result, they would not relinquish significant control or authority over their real estate or their retirement savings. The forty-five year period makes it unlikely, however that the Smith's would complete this planning. That's more forethought than most people will exercise.

We can accelerate the advantages a great deal further by utilizing IRS rulings and court cases which hold that the value of each gift of a limited partnership interest must 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 $5 million to an FLP, a gift of a 1 percent limited partnership interest should not be valued at $50,000. 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 financial advisors, 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 an aggressive discount, the value of the limited partnership interests transferred in the Smith FLP would be discounted in value from e.g. $5 million to $3 million. Significant value could be gifted in the first year without exceeding the credit of $2 million. That creates an immediate reduction in estate tax liability of $1 million. Over the remaining years additional interests are transferred to the children, further reducing the size of the parents' estate and the amount of the estate tax liability. And this all occurs in a relatively painless fashion. The Smiths have eliminated $1 million or more of estate taxes while maintaining control over their assets. If a less aggressive discount is chosen, the immediate and long-term savings are still substantial.

As an added bonus, this approach will also remove future appreciation from the Smiths' estate. In our example, all assets have a value today of $5 million. Increasing in value at a rate of just 5 percent per year, these assets would be worth an additional $3 million plus in just ten years. That's another $1.5 million in estate taxes that the Smiths have avoided by the use of the FLP strategy. 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.