Income Tax Benefits

FLPs also provide a number of valuable income tax benefits to the partners. Among these benefits are the following:

* Allows pass through of items of income, expense, credit and deduction to the partners.
* Permits "step-up" in income tax basis in FLP assets for interests received from a deceased partner
* Generally permits contribution, withdrawal of assets or partnership liquidation without recognition of taxable gain, unlike corporate ownership.
* Allows income shifting since gifted FLP interests carry with them the responsibility for a proportionate share of the partnership income.

These income tax benefits make FLPs extremely attractive in planning for income tax responsibilities of the partners. If properly structured, the FLP will not increase income taxes and may even reduce income taxes in some cases.

Detriments

As exists with the formation of any entity, a FLP has some detriments. For example, the following issues will generally be encountered:

* The FLP will have to pay minimum franchise tax fees for the privilege of doing business in each state (approximately $300 annually in Illinois).
* The FLP must file annual income tax returns and keep separate accounting records.
* The cost of formation and transferring title of assets into the FLP is expensive.
* Transfer of Subchapter S corporation stock to a limited partnership will terminate the Subchapter S. election.

For the most part, the detriments which accompany the use of a FLP are heavily outweighed by its benefits and the decision to implement a FLP should not be materially affected by these issues.

Summary

A FLP can serve as an integral part of an estate plan and provide great flexibility in transferring assets to subsequent generations. FLPS offer considerable tax and non-tax benefits to family members and their use should be seriously considered by those individuals having taxable estates (over $1,000,000) and/or individuals who desire to pass ownership of assets to their children or spouse without giving up immediate control over the assets.

Example 1

In 1987, Mr. and Mrs. Timothy Taxpayer were each age 60. They had four children and six grandchildren and their estate consisted of the following assets held in trust:

Asset Value

Marketable Securities $ 1,500,000
Apartment Complex $ 1,000,000
Other Real Estate $ 1,500,000
Residence $ 500,000
Totals $ 4,500,000

Later that year, Mr. and Mrs. Taxpayer met with their attorney and agreed to implement a FLP to maintain ownership of their property in the family. The securities, apartment and other real estate (but not the residence) was contributed to a FLP, constituting a total value of partnership assets of $4,000,000. In return for their capital contributions, Mr. and Mrs. Taxpayer each received a 1% Managing Partner interest and the Taxable Family Trust received a 98% Limited Partner interest. The FLP agreement gave the Managing Partners the discretion to accumulate partnership income for future business needs and restricted the partners' ability to transfer their interests to persons outside the Taxpayer family.

In December 1987, the Taxpayers implemented a gifting program in which they each gifted a 6.25% limited partner interest to each of their four children, thereby transferring away a total of 50.00% of the gifted limited partner interest and $2,000,000 of the underlying asset value. An appraiser was hired to determine the value of the gifted limited partner interests. The appraiser concluded that a combined 40% discount for lack of control and lack of marketability was appropriate for the limited partner gifts to the four children. After applying this discount to the proportionate value of FLP assets, Mr. and Mrs. Taxpayer were found to have each gifted limited partner interests worth $150,000 to each child for a total gift by each parent of $600,000. Because the Unified Transfer Credit of each of the Taxpayers was enough to pay the tax on the gifts no cash payment of gift tax was required. At the end of 1987, ownership of the Taxpayer Family Limited Partnership was as follows:

General Partner Limited Partner

Mr. Taxpayer 1.00% 0.00%
Mrs. Taxpayer 1.00% 0.00%
Family Trust 0.00% 48.00%
Child No. 1 0.00% 12.50%
Child No. 2 0.00% 12.50%
Child No. 3 0.00% 12.50%
Child No. 4 0.00% 12.50%

Totals 2.00% 98.00%

In 1998 and each year thereafter, the Taxpayers made annual gifts of limited partner interests worth $10,000 to each of the four children and six grandchildren. They plan to keep making them through 1998. The same 40% discount to value was applied to the gifts. From 1987 to now, the assets in the Taxpayer FLP grew at a 5% annual rate and they are expected to continue to grow at that rate. The gifting program significantly reduced their ownership interests in the FLP although they remain in control as the Managing Partners.

Let us assume that first Mr. Taxpayer and then Mrs. Taxpayer die in 1998, having carried out their ten-year annual gifting program. At that time, the underlying value of the FLP assets would be $6,205,313 and ownership would be as follows:

General Partner Limited Partner

Mr. Taxpayer 1.00% 0.00%
Mrs. Taxpayer 1.00% 0.00%
Family Trust 0.00% 18.40%
Child No.1 0.00% 15.46%
Child No. 2 0.00% 15.46%
Child No. 3 0.00% 15.46%
Child No. 4 0.00% 15.46%
Grandchild No. 1 0.00% 2.96%
Grandchild No.2 0.00% 2.96%
Grandchild No. 3 0.00% 2.96%
Grandchild No. 4 0.00% 2.96%
Grandchild No. 5 0.00% 2.96%
Grandchild No. 6 0.00% 2.96%

Totals 2.00% 98.00%

The residence of Mr. and Mrs. Taxpayer, still held directly in their family trust, would have increased in value to $700,000.

At Mr. Taxpayer's death (assuming he is the first to die), his share of the FLP and the residence would go to the marital deduction trust for the benefit of Mrs. Taxpayer, resulting in no estate tax being due.

The residence and the FLP interests would be taxed in Mrs. Taxpayer's estate. The table below shows the comparative estate tax result on the basis of both carrying out the partnership and gifting program and the results if the assets had continued to be held by the taxpayers, ignoring the greater build-up of income that accumulated in the taxable estate if not gifting had occurred.

In determining the value of the FLP interests includible for estate tax purposes, a 25% discount was applied to the General Partner interest and a 40% discount was applied to the Limited Partner interest.

Results with Results With No
Partnership and Partnership or
Gifting Program Gifting Program

Taxable Estate

1. Residence $700,000 $700,000

2. Assets appropriate to
put into the partnership 0 $6,205,313

3. General Partner
interest (2.00%) $ 93,080 0

4. Limited Partner
Interest (18.40%) $ 684,474 0

5. Prior Taxable Gifts $1,200,000 0

6. Less: Unified Credit
of Deceased Spouse ($1,000,000) $(1,000,000)

Taxable Estate of $1,677,147 $5,905,313

Estate Tax Due $ 505,001 $2,733,922

Savings $2, 228,921

There were three important elements to this overall plan, in addition to avoiding probate and using trusts as effectively as possible.

One aspect was using the annual gift tax exclusion over a significant period of time to remove taxable value from the estate.

A second important element was using the Unified Transfer Credit early (making the $2,000,00 gift to the children) and eliminating a large portion of the ensuing growth from taxation.

The third important part of the plan was using the FLP to obtain big discounts on values transferred, while still retaining control over all of the partnership assets and keeping the assets within the family group in a way that will permit centralized management of the asset that will benefit all family members.

Example 2

Paul and Barbara Peterson, both age 52, have several rental real properties owned free and clear. Based on a 9% annual rate of return, four of the real properties are appraised at a total of $1,000,000 and produce $90,000 of income each year. Paul and Barbara expect that these properties will increase in value at a 7% annual rate for the foreseeable future.

Their attorney suggests that Paul and Barbara place the properties into a FLP and obtain a 40% discount on the value of their limited partnership interests. The attorney points out that now is the best time to shift some of the property values before they increase more in value.

The attorney does calculations to see if the properties may provide sufficient income so that Paul and Barbara's four children can acquire 90% of the limited partner interests because of the discount in value created by the FLP structure (producing an effective yield of 15%). Using Paul and Barbara's IRS table life expectancies of 31 years each, their advisor and attorney summarize the comparative tax savings which would be achieved in the event that Paul and Barbara both die unexpectedly in 20 years, if the 90% interest is transferred using a (1) private annuity, (2) self-canceling installment note or (3) regular term installment note over 40 years.

This summary is shown in Figure 1.

Figure 1. Comparison for
PAUL PETERSON and BARBARA PETERSON

Discount Pct 40.00%
Death Year 2015 No Sale PrvAnn SCINInt Install

Payments to Seller
Annual Payment 0 68,230 69,510 59.110
Ordinary Inc. 3,746,323 1,271,727 1,495,770 1,345,241
Capital Gain 0 334,840 148,316 0
Depreciation 0 0 0 0
Total Inc. Tax 1,723,309 678,752 729,584 638,825

Income to Buyer

Ordinary Inc. 0 3,269,546 3,497,662 3,546,127
Depreciation 0 210,000 210,000 210,000
Interest Ded. 0 0 1,218,738 1,099,550
Total Inc. Tax 0 1,407,391 951,707 1,028,834

Tax at Death
Est. Value 4,329,606 784,235 745,859 1,177,302
Death Tax 2,380,983 431,329 410,222 647,516
Inc. Tax/Death 0 0 103,792 0
Total Tax/Death 2,380,983 431,329 514,014 647,516

TOTAL TAXES 4,104,292 2,517,472 2,195,305 2,315,164
TO HEIRS 1,948,077 3,425,047 3,982,405 4,081,885

Obviously, making a transfer of the 90% limited partner interest at the current date makes good sense in view of the fact that the children can use their prorate share of income to make the required payments to Paul and Barbara (note that the self-canceling installment note results in capital gain on the amount of gain in the note as of the date of death). Based on this information, Paul and Barbara decide to go forward and us a self-canceling installment note to sell 90% of the limited partner interests to their two children with the expected tax results presented in the graphic form in Figure 2.

Clearly using the FLP to discount the value of the assets is the key to getting the price down to the level that will permit the purchase price to be paid for by the income produced by the interests purchased.

Rockford native Paul Nicolosi concentrates his legal practice in business law and transactions, and business and estate planning. He is active on several company boards and participates in regular company reviews for consideration by venture capital firms.