Business Succession Planning

businessSuccession

WHAT IS A FAMILIY LIMITED PARTNERSHIP (FLP)?

 

Estate planning tool.

A FLP is a limited liability business entity created and governed by state law, and it is generally composed of two or more family members. It can be a powerful estate planning tool that (1) may help reduce income and transfer taxes, (2) lets you distribute assets to your heirs while keeping control of the business, (3) ensures continued family ownership of the business, and (4) provides liability protection for all the limited partners.

 

Allows you to shift business income and appreciation to family.

By organizing your business as a FLP, you can shift business income and future appreciation of the business assets to other members of your family. In addition, you can concentrate the management of the business in your own hands without causing your interest in the partnership to be included in your taxable estate. Gifting interests in a FLP may reduce taxes by letting you take advantage of the transfer tax laws (e.g., the annual gift tax exclusion). Most importantly, gifts of FLP interests qualify for discounts that reduce the taxable value by as much as 35 percent. A FLP also guarantees that there will be continuous family ownership of the business because family members’ ability to sell or transfer their interest to nonfamily members is restricted. At the same time, a FLP affords all of the limited partners liability protection, regardless of the extent of their participation in the business.

 

You and your family keep ownership interest.

Upon formation of a FLP, you and your family members transfer property in return for an ownership interest in the capital and profits of the FLP. At least one family member must be designated as the general partner(s), or a corporation must be set up to act as the general partner. The general partner(s) retains exclusive control over the assets and operations of the business and determines if, when, and how much of the partnership income is distributed. However, the general partner(s) also assumes personal liability for all the debts and liabilities not satisfied by the assets of the FLP. Also, the limited partner(s) has no say in how the business is run. In return for giving up that right, the personal liability of the limited partner(s) is limited to the value of the capital account (generally, the amount of capital he or she has contributed to the FLP).

Often, a FLP is formed by a member(s) of the senior generation, who becomes the general partner(s) and converts the remaining interests to limited partnership (LP) interests, which are then gifted to the junior generation. The general partner(s) need not own a majority of the partnership interests. In fact, the general partner(s) can own 1 percent of the partnership and still be designated as the general partner. Conversely, the limited partner(s) need not own a minority interest in the partnership but can own virtually all the interest (e.g., 99 percent).

 

**Caution: The general partner should own at least 1 full percent of the FLP. Anything less will raise the IRS’s eyebrows. The FLP is a very popular vehicle right now. However, the legal and tax issues relating to the FLP are extremely complex. In addition, the FLP entity is fairly new in most states, so some of these issues may still be unresolved in your state. It is imperative that you seek the advice of an experienced partnership, tax, or estate planning attorney if you are considering creating a new FLP or changing the status of your current business organization (especially if death is imminent).

 

 

 

 

 

EXAMPLE

Tyrone (an ex-fighter who is already very wealthy) owns a national chain of gyms. The business is growing rapidly because of his reputation. In fact, he is opening a new site almost every month. His sons, Tyrone Jr., Tyrone III, and Tyrone IV, all work with him in the business. Tyrone Sr. is proud of his business and would like to see it thrive for generations to come. He wants to transfer ownership of the business to his sons now, before the assets appreciate in value even more, but he is afraid the boys aren’t experienced enough yet to manage such a large enterprise. In addition, Tyrone Sr. wants to protect his sons against any personal liability that might arise in connection with the business. So he contacts his attorney (an expert in partnership law), who draws up an FLP agreement.

The terms of the agreement designate Tyrone Sr. as the general partner, owning 1 percent of the business, and his sons as limited partners, owning 33 percent each. With the help of his attorney, Tyrone Sr. transfers the business stock to the FLP and completes all other formalities of existence. Tyrone Sr. then gifts 99 percent of the FLP to his sons (33 percent to each son), reports the gifts, and pays gift tax on the value transferred, less the annual gift tax exclusion and unified credit. Tyrone Sr. runs the business for the next six years, until he is comfortable that the boys are fully able to manage on their own. During those six years, Tyrone Sr. files annual reports with the state and carefully follows all the necessary formalities. Tyrone Sr. distributes the FLP income each year—1 percent to himself and 33 percent to each son. The family collectively saves income tax because the boys are in a much lower tax bracket than Tyrone Sr. At the end of the sixth year, the partners vote to name Tyrone Jr. as the general partner and Tyrone Sr. as a limited partner. Tyrone Sr. turns over the reins of the business to Tyrone Jr. and retires to Hawaii. Ten years later, Tyrone Sr. dies. The value of the business has increased dramatically over the last 16 years, but only 1 percent of that value is included in Tyrone Sr.’s estate for estate tax purposes.

 

WHAT ARE THE ADVANTAGES OF AN FLP?

 

Shifts income among family members.

A FLP is a pass-through entity for income tax purposes. This means that the IRS does not recognize an FLP as a taxpayer (as it does for a corporation), and income of the FLP passes through to the partners. The partners must report the income earned by the FLP on their personal income tax returns and are responsible for payment of any tax owed. Income is allocated to each partner to the extent of his or her share attributable to the contributed capital (or pro rata share).

 

EXAMPLE

Alan establishes an FLP with his children, Bob and Carol. Alan contributes $40,000 to the partnership—$20,000 for himself (50 percent) and $10,000 each for Bob and Carol (25 percent each). If the FLP has $100,000 of income (assume no expenses), Alan will be taxed on $50,000 of this income (50 percent), and Bob and Carol will be taxed on $25,000 each (25 percent each).

**Caution: The general partner is entitled to a management fee, which is taxable to the general partner as ordinary income.

 

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This may be especially attractive if you are transferring interests to family members in a lower tax bracket. The family as a whole enjoys the tax savings. In addition, you can transfer interests in the FLP to your minor children as long as they are competent to manage their own property and participate in FLP activities. As a practical matter, minors generally do not possess such maturity. Therefore, interests to minors should not be given directly but rather to a guardian or in a trust. Be aware, however, that unearned income of children under age 18 may be subject to the kiddie tax and taxable at your (the parent’s) income tax rate.

**Caution: For tax years beginning after May 25, 2007, the Small Business and Work Opportunity Tax Act of 2007 expands the kiddie tax rules to apply to children who are 18 years old or who are full-time students over age 18 but under age 24. These expanded rules only apply to children whose earned income does not exceed one-half of the amount for their support.

 

May help avoid transfer taxes.

One of the most powerful advantages of a FLP is that it can help avoid transfer taxes, which may include generation-skipping transfer taxes (GSTT) and federal gift and estate taxes. This avoidance is accomplished in three ways:

 

  1. Removes future appreciation–Business assets generally appreciate (increase in value) over time. Distributing your assets among family members (through the FLP) now freezes the current value and keeps any growth in value out of your estate later. You may have to pay GSTT and/or gift tax now, but it will be less than if tax is calculated on a higher future value.

 

  1. Takes advantage of the annual gift tax exclusion —Gifts of interests in a FLP are subject to gift tax. However, you can minimize or eliminate your actual gift tax liability by taking advantage of the annual gift tax exclusion. The annual gift tax exclusion currently allows you to give $13,000 per donee without incurring gift tax. Generally, a gift must be a present interest gift in order to qualify for the exclusion. A present interest gift means that the recipient is able to immediately use, possess, or enjoy the gift. If the FLP agreement is properly drafted, an outright gift of interests in a FLP will qualify for the exclusion. In order to qualify the gift as a present interest gift, the FLP operating agreement can’t place too many restrictions on the donee (the limited partner) to presently derive some economic benefit from the gift. The key here is to draft the FLP agreement to allow some ability for the limited partners to reach the gift when it is given. An agreement that is too restrictive may cause the IRS to rule that the gift is a gift of future interest, and the annual exclusion will be disallowed.

 

You must be even more careful if you put the interests in the FLP into a trust. Gifts made into a trust are usually considered to be gifts of future interest and do not qualify for the annual exclusion. However, you can qualify the gifts in trust if you structure the trust to include Crummey withdrawal rights. A Crummey withdrawal provision gives the beneficiaries of the trust (the limited partners) the unrestricted right to demand, for a reasonable period of time, any amounts you place into the trust. The inclusion of such a provision will enable the trust to pass the IRS’s inspection, and the transfer of the interests in the FLP will qualify for the exclusion as gifts of present interest. Of course, so as not to defeat the purpose of the trust, the limited partners should not actually exercise their Crummey withdrawal rights. In structuring the trust to take advantage of the annual gift tax exclusion, you should follow these rules:

 

  1. Include a Crummey withdrawal provision in the trust document.

 

  1. Carefully draft the trust document to clearly state that Crummey withdrawal rights are given.

 

  1. Fulfill all notice requirements.

 

  1. You must carefully follow the notice requirements of the Crummey withdrawal provision. The basic requirement is that actual written notice must be made in a timely manner. It is best to give written notice to each beneficiary at least 30 to 60 days before the expiration of the withdrawal period.

 

  1. The Crummey withdrawal power is treated as a general power of appointment. This means that if the power is not exercised, the power is treated as a lapse. The lapse may be considered a taxable gift by the IRS if the value of that power exceeds the greater of $5,000 or 5 percent of the value of the trust fund (this is the so-called five or five power). To avoid this situation, construct the Crummey withdrawal right so that it does not exceed $5,000 per year, or include a so-called hanging power, which pushes the excess value into future years.

 

**Caution: Whether you give interests in the FLP outright or in a trust, you must be very careful when drafting the FLP agreement so that it does not completely restrict the right of the limited partners to immediately enjoy some economic benefit from the contributions made into the trust. An agreement that is too restrictive will cause the IRS to disallow the annual exclusion.

 

  1. May be entitled to valuation discounts — This is one of the most attractive features of the FLP form. The transferor (the one making the gift of the FLP interests) is able to discount the value of the FLP interests given away. The value of the FLP interest can be discounted because the limited partner has very restricted rights, such as: (1) the inability to transfer interest, (2) the inability to withdraw from the FLP, and (3) the inability to participate in management. These restrictions result in a business value significantly less than the value of the underlying assets. This discount can be considerable (as much as 35 percent) and is available for GSTT, gift, and estate tax purposes. The discounts available include:

 

  1. Minority interest (lack of control) discount.

 

  1. The minority interest discountis allowed because no limited partner can force distributions or a liquidation or dissolution of the partnership. In other words, the limited partner can’t cash in his or her interest.

 

  1. Lack of marketability discount. The lack of marketability discountis allowed because the limited partner is generally unable to sell or transfer his or her interest in the FLP.

 

**Caution: The IRS may offset these discounts by a control premium. The control premium will attach if there is a partner who has voting control (a partner with a majority general partnership interest) or a swing interest (the power to swing the majority either way). This is based on the IRS’s position that such centralized control increases the value of the business.

 

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The discounts you take should be reasonable, or you will be inviting the IRS to challenge them. It is recommended that you hire an appraiser experienced in valuing business property for tax purposes in order to appropriately value the business assets and discounts. You may find an appraiser through the phone book or by asking a bank or real estate broker for a referral.

 

 

 

Allows you to maintain control of the business.

Another attractive aspect of a FLP is that it gives you the ability to distribute your assets now and, at the same time, to continue to control them. As long as you designate yourself as the general partner, you control the business, even if you own as little as a 1 percent interest. You control the cash flow, distribution of income, investment of assets, and other management decisions. This may be advantageous if you are afraid the younger generation may mismanage, waste, or otherwise dissipate the partnership assets. This may also be advantageous if you are the only one really interested in running the business but must share ownership with other family members, or if family members don’t really get along with each other and cooperation seems unlikely.

 

Keep the business in the family.

You may be concerned about your hard-earned assets winding up in the hands of people outside the family. Limited interests in a FLP are restricted by the terms of the partnership agreement. Such restrictions may include the inability to transfer a FLP interest (by gift or sale) unless the other partners are first given the opportunity to purchase (or refuse) the interest (this is called a right of first refusal). This virtually guarantees that outsiders will not own the business.

 

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Be sure to include a right of first refusal provision in the FLP agreement.

 

WHAT QUALIFIES AS A FLP?

 

Six factors must be satisfied in order to qualify as a valid FLP:

 

  • Distributions of interests in the FLP must be to family members only. The IRS defines family for income tax purposes as your spouse, ancestors, lineal descendants, and any trusts established for the benefit of these persons.
  • Reasonable compensation must be paid to partners who actually work for the partnership.
  • FLP income distributed to a partner cannot be disproportionately greater than the capital contributed by that partner.
  • Partners must receive partnership interests through a bona fide transaction (by gift or sale).
  • The FLP must own income-producing capital (e.g., inventories, plants, machinery, and equipment).
  • All formalities of existence must be observed.

 

**Caution: Under the legal test established in the Kimball case, a sale is bona fide if, as an objective matter, it serves a “substantial business or other nontax purpose.” However, as illustrated by the Strangi case, it is unclear what this standard means precisely, or how this standard can be satisfied. Also illustrated in the Strangi case, an FLP will be disregarded if there is an “implicit understanding” that the transferor would continue to use the transferred assets as needed. It is, therefore, additionally recommended that you clearly state your business purpose for forming the FLP in the FLP agreement, and do not fund the FLP with nonbusiness property.

 

 

 

 

 

 

HOW DO YOU IMPLEMENT A FLP?

 

Hire an attorney.

The first thing you should do is hire a competent and experienced attorney, preferably one with knowledge of partnership, tax, or estate planning law. The attorney should advise you about the legal issues and complexities of an FLP. In addition, the attorney will carefully draft all the necessary documents to effectively create the FLP, file all necessary forms with the appropriate state agency, and transfer title to all assets. You may need to hire a tax accountant as well to give advice on future tax consequences.

 

Hire an appraiser.

You should have the value of the assets contributed to the FLP professionally appraised in order to assign a reasonable value to the partnership interests and the discounts that may be used. If the IRS questions these values, the burden is on you to prove that they are legitimate. Therefore, you should have a written appraisal from a reputable appraiser to back up your numbers.

 

Observe all formalities of existence.

Disregarding the formalities of existence can have disastrous consequences. The IRS will disregard the FLP, and all your tax-saving plans will go down the drain. Be sure to follow these rules:

  • Execute a written agreement (called a partnership agreement) setting forth all the rights and duties of the partners
  • File all necessary certificates and documents with the state
  • Obtain all necessary licenses and permits
  • Obtain a federal ID number for the FLP
  • Open new accounts in the name of the FLP, and transfer title to all the assets contributed to the FLP
  • Amend any existing contracts to reflect the FLP as the real party in interest
  • File annual federal, state, and local reports
  • Maintain all formalities of existence
  • Do not commingle partnership assets with the personal assets of any individual partner
  • Keep appropriate business records
  • Include partnership interest on personal annual income tax returns