Brown & Associates - Attorneys & Counselors at Law, P.L.L.C.

PROPER PLANNING WITH FLPs AND LLCs CAN SAVE ESTATE TAX
(4/22/01)

Over the past few weeks, I've discussed the benefits of using Family Limited Partnerships and Limited Liability Companies in planning your estate, especially if you qualify for "valuation discounts" which can significantly reduce the size of your estate. The IRS doesn't like discounts because they reduce the amount of tax collected, but efforts to legislate them out of existence have failed because, as I noted last week, "the discounts are grounded in solid economic principles."

What do you mean by "solid economic principles?" Why should I receive
a discount when the FLP or LLC owns property equal to the full value?

Good questions. Let's look at an LLC with investments valued at $2 million. The $2 million equals the total value of the stocks, mutual funds, and other investments owned by the LLC This, however, is not the "fair market value" of the Company. Fair market value is what you get if a willing buyer purchases the company from a willing seller, both aware of all the facts and without any compulsion to buy or sell. A willing buyer will demand discounts if the property lacks marketability and/or control.

Let me show you how this works. First, we need to create a new family limited partnership. I want you to transfer everything you own to the FLP. In exchange, you'll receive a 1% General Partner's interest (control of the FLP) and a 99% limited partner's interest (lacking marketability and control).

You no longer own any of your assets. They are owned by the FLP. Instead, you own a partnership interest.

Now try to sell your limited partnership interest to a willing buyer, but retain the 1% general partner interest. Is he going to pay full price when you control the company and make all the decisions? Of course not. He will insist on a discount. The only question is, how much?

A prospective buyer will have the company valued by a qualified business appraiser who can tell him how deep the discount should be. If the Company is property structured, most qualified business appraisers will probably come up with a 20% to 40% discount, sometimes even higher.

These same rules apply if you gift a portion of your limited partner interest to your children. Because the interest you gift to them lacks control and marketability, it isn't worth its proportionate share of the underlying investments. You can give $150,000 to your children and the gift will only be valued at $90,000 to $120,000 for gift tax purposes. You have successfully avoided taxes on the difference between the "true" value (the total worth of the assets) and the "discounted" value (the value of the ownership interest in the company).

The same thing happens to your retained ownership interest. Let's say your FLP was worth $1M and you gave your children a partnership interests worth $150,000. Your share of the FLP has shrunk by the size of the gift or15%. Since you only own 85% of the company at your death, you will only be taxed on 85%.

The 85% you retained qualifies for a discount because it lacks marketability. If we discount it by 20%, this $850,000 is only worth $680,000 for tax purposes. That's a tax saving of over $62,000 at the lowest possible estate tax rate.

As you can see by this example, if you make creative use of an FLP (or LLC) and gift part of your ownership interest each year, you can reduce the size of your estate in two ways--one, by giving away part of your estate and two, by qualifying the rest for entity discounts. Giving your children part of their inheritance early resulted in a double tax benefit which shrank your estate by $320,000.

Each year, as you give more and more of your ownership interest away, your estate shrinks even more and (at least up to a point) will qualify for increasingly larger discounts.

Next week I'll wrap up this series on family limited partnerships and limited liability companies by discussing how they can help you protect yourself from losing everything in a lawsuit or creditor claim.

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